Record Profits Don't Excite Corporate Executives
William Hester, CFA
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"Anchoring" is one of the most common behavioral traps that ensnare investors. Anchoring is the tendency to be influenced more by recent events than by the distant past. It happens so frequently in the financial markets that it's usually not worth highlighting. That is, unless you observe a group that usually anchors, but suddenly doesn't. That's the situation now.
This earnings season brings a lot of excitement. Recovering from its deep recession lows, the S&P 500 has 16 quarters of double-digit operating earnings growth under its belt - a record-setting performance according to S&P. It looks like another quarter of profit growth is just about in the bag. S&P analysts expect earnings to grow 12 percent in the second half of the year, versus the same period last year.
This optimism about the next few quarters is understandable. A four-year trend is a sufficient period of time for people to anchor their expectations. And it's not surprising that analysts and investors are influenced by recent strength. The catch is that there's one group that should be anchoring but isn't. This group is made up of the CEO's of the largest companies, and the absence of this group's bullishness may turn out to be an important indicator.
You can see this in the graph below. The blue line is the "expectations" component of the Conference Board's CEO Confidence Measure, a quarterly survey asking bosses about their confidence in the economy. Figures above 50 mean executives are upbeat about the near future, while readings below 50 signal growing pessimism. The violet line shows the actual change in corporate profits over the following two years (and therefore ends in the first quarter of 2004).
Look at the recent divergence. Corporate profits (at the national level) are still rising nicely, just like those reported by the companies in the S&P 500. And in the past, booming profits have usually meant an upbeat mood in the executive suite. But this month, the Conference Board reported that the CEO expectations index (the blue line and measured on the left axis) fell below 50 - the first time this has happened since 2000.
Two trends seem to be observable in the expectations index. Recent profits seem to play a role in the current confidence of CEOs. Sustained increases in CEO confidence are often aligned with improving profits. There's also a predictive element to the survey. Since 1976, when CEO optimism has risen above 55, the subsequent 12-month growth in profits has averaged 12 percent. When the index was below 45, indicating pessimism, profits grew at just 1.1 percent.
That's what makes the current split between CEO confidence and profits interesting. Poor corporate performance would explain any pessimism. But executives are lowering their expectations despite impressive earnings gains. We'll need to wait on the remainder of this year's earnings data to judge the current predictive component of the index.
Not In My Yard
In addition to what CEO's are expecting over the next six months in the broader economy, the Confidence Survey reports the answers to three other questions: How do CEO's feel about the current conditions of the U.S. economy? How do CEO's feel about the current conditions in their own industry? What are their expectations for their own industry six months out? A small, but interesting divergence has occurred among the answers to two of these questions. Since the beginning of the year CEO expectations for the over-all economy have dropped 9 points from 56 to 47. But forecasts about the outlook for the industries that the CEO's do business in have held up better, dropping just 4 points from 56 to 52.
So CEO's have turned more pessimistic about the overall economy than the industries that they compete in. This industry-dependent optimism may help explain why merger and acquisition activity has held up in certain sectors, but more wide spread capital investment has been limited. Last Friday's GDP report showed that spending by businesses on equipment and software fell 1 percent in the second quarter, the first decline since the first quarter of 2003.
Big company executives aren't alone in their growing pessimism for the overall economy. The Index of Small Business Optimism fell in June to its lowest level in more than three years. Half of the decline in the index came from owners of small businesses expecting lower revenues and less capital investment for the rest of the year.
Confidence surveys are fickle tools. When consumers are surveyed they sometimes report feeling one way and end up acting in a different manner. But corporate profits face a host of other head winds that include a flat (and recently inverted) yield curve, peak earnings, and elevated profit margins. Since 1950, when the spread between the 10-year bond and the three-month bill narrowed to less than 100 basis points, the 3-year average earnings growth of companies in the S&P 500 has been 1.1%, while the 5-year average growth has been just 2.1%. The long-term average growth rate of earnings has been about 6%. When S&P 500 earnings have been at record levels, earnings have grown at just 0.6% a year over the following 3 years and 1.1% over 5-year periods. A similar pattern follows periods of elevated profit margins.
Although the Conference Board doesn't ask CEO's about the likelihood of a recession, company leaders have a good record of becoming pessimistic prior to economic downturns. Confidence plummeted below 35 leading up to the recessions of 1980 and 2001. A similar drop foreshadowed the 1990 slowdown. Still, the indicator can have a long lead-time. Although CEO's became pessimistic in 1998, the economy did not slow for another two years.
In any case, you can see that the angst of something more than a garden-variety soft landing is growing. Economists are displaying the same angst - privately. Of more than 60 economists that Bloomberg polls for their individual forecasts, not one is forecasting lower output in the first half of 2007. But the Survey of Professional Forecasters - an anonymous survey of roughly 40 economists, many of which also participate in Bloomberg's poll – gives a 17 percent chance of a recession next year. So even though most economists aren't ready to go on record forecasting a recession, many appear to believe the odds are increasing.
The results of these business confidence surveys probably say more about the likely trend in earnings and the economy than the depth of any reversal. But it's noteworthy that CEO's are overcoming the natural tendency to anchor their expectations in recent performance. Analysts may turn out to be correct in forecasting continued earnings growth. It's just that the people running those companies seem to disagree.
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