US companies are on course to slump into their first "earnings recession" in five years after the financial sector's deepening troubles forced Wall Street to slash profit forecasts for the last three months of 2007.
After weeks of bad news and large writedowns from banks and other financial institutions, the largest sector in the S&P 500 index, analysts are for the first time expecting US companies to record a fall in earnings in the fourth quarter.
With third-quarter profits also down from last year's levels, investors' hopes that large parts of corporate America could be insulated from the credit crunch and housing crisis are quickly evaporating.
The prospect of a contraction in earnings for two consecutive quarters will heighten concerns over the depth of the US economic slowdown ahead of next week's interest rate decision by the Federal Reserve.
S&P 500 earnings for 2007 are on track for a gain of 3.2 per cent, its worst rate of growth since 2002. At the start of the year, analysts had expected a rise in earnings of 9.3 per cent.
With consumer and small business' confidence at their lowest levels since the end of the tech boom, some analysts say the US economy could slide into a deep recession, the FT.com reports.
Little more than a month later, in a Nov. 19 interview, Ellen Hughes-Cromwick, Ford's chief economist, said the economy was "in some dicey territory,'' though would likely edge by'' without a recession.
Profits for the Standard & Poor's 500 companies fell almost 25 percent on a per-share basis in the third quarter, the biggest year-over-year decline in almost five years. David Wyss, S&P's chief economist, expects their earnings to fall as much as 30 percent in the fourth quarter as companies take more writedowns for bad investments. Excluding such extraordinary items, operating profits may fall as well, he says.
Consensus estimates compiled by Bloomberg indicate S&P 500 operating profits may rise just 1.1 percent in the current quarter, Bloomberg reports.
History suggests that a turn in the profit cycles has a big effect on earnings. This is because of many companies' “operating leverage”: they have high fixed costs, so extra revenue is passed straight through to the bottom line. Conversely, when revenues start to fall, companies can be slow to cut costs in response.
But this time analysts are forecasting that profits will rebound remarkably quickly. The consensus is that earnings will grow by 14% in 2008, with every single sector managing an advance. In the first half of the year, when many economists think that America will be dicing with recession, analysts are forecasting that corporate profits will be growing at an annual rate of 9%.
Going by experience, profits start to fall when the annual rate of economic growth falls below 1.5%. “Consensus forecasts for next year's US profit growth border on the hallucinatory,” says Tim Bond of Barclays Capital. “Even allowing for the typical bullish bias, the prevailing consensus suggests that equity analysts are collectively reading their spreadsheets upside down.”
In part, analysts' optimism reflects the belief that financial profits will soon return in spite of this year's mortgage-induced losses. Certainly, you would not expect the same level of write-downs in 2008 on structured products (like the now infamous collateralised-debt obligations). But with both lending growth and the economy slowing, you would expect defaults to increase next year along with banks' bad-debt provisions, economist.com reports.