NCPA - National Center for Policy Analysis

Corporate Earnings Confusion

June 10, 2002

One of the most puzzling aspects of the economic recovery has been the lackluster performance of the stock market. There has been no shortage of explanations. These include:

  • Belief that recent positive growth numbers are merely a temporary rally in a double-dip recession.
  • Congressional and White House actions on steel tariffs, the farm bill and the apparent administration backtrack on global warming -- which could impose massive new regulations on virtually all U.S. businesses.
  • Continuing uncertainties about war and terrorism, future Federal Reserve policy and the outcome of the mid-term elections.

However, according to the NCPA's Bruce Bartlett, the most important factor holding back stocks is the enormous post-Enron confusion and skepticism about corporate earnings -- some of it justified (see figure).

  • There was pervasive misuse of a non-standard accounting method called "pro forma earnings," abused by many now-bankrupt dot-coms to hide factors that negatively affected earnings.
  • Widely used stock options diluted earnings while their impact wasn't apparent to investors because the data are often buried in footnotes.
  • However, their impact is huge -- reducing profits by roughly $5 per share for all the companies in the S&P 500.
  • As a result, Standard and Poor's has switched to "core earnings," to calculate company earnings figures to accurately reflect how companies are really doing in their primary business operations.

There are daily fresh reports of large profit write-downs at major corporations, despite an improving economy, as companies clean up their books and try to produce earnings data markets will trust.

In the meantime, investors must also labor to interpret them and calculate appropriate values for stocks based upon them. Until this process, which could go on for months, is completed, the stock market will probably struggle to rise much above current levels.

Source: Bruce Bartlett, Senior Fellow, National Center for Policy Analysis, June 10, 2002

 

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