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Sunday, 30 June, 2002, 11:07 GMT 12:07 UK
Illusory profits cloud USA Inc
A European trader looks on glumly as shares slide
How many more skeletons in the closet?


Nearly a year ago - well before Enron, WorldCom and other scandals - Graham Turner warned that the US economy was driven by a huge bubble of artificially inflated profits. Writing for BBC News Online, he explains why these corporate misdeeds are just the tip of the iceberg.

The recent spate of accounting scandals in the US has left many investors dismayed and perplexed.

It was not so long ago that US companies were routinely reporting double-digit growth in their earnings as the stock markets soared repeatedly to new heights.

But in truth, even then it was not difficult to see that US corporates were their cooking the books. Investors did not have to look far to realise that the profit figures put out by many companies in the late 1990s were inflated.


Now the chickens are coming home to roost, investors are entitled to ask how many more skeletons may be lurking in the cupboard?

The government's own profit figures detailed in the national accounts, showed that companies were never making the money that they claimed.

During the last five years of the bull market, the companies that make up the S&P500 reported that profits had risen by 96.2%.

By contrast, the government's own figures revealed that corporate sector profits had only risen by 36.1%. The figures implied that US companies could be overstating profits growth by more than 150%.

Inconvenient facts

The national accounts figures were hardly a secret.

But they were largely overlooked by analysts who wanted to believe that the US was enjoying a profit boom on the back of a productivity renaissance.

The facts were too troublesome for those who vehemently believed that the US economy had been transformed by corporate restructuring during the early 1990s.

So instead it was claimed that the national accounts data cover the entire gamut of quoted and unquoted companies.

The data, the argument went, was therefore not representative of the select companies that made up the S&P500.

Too many cooks

In part that was true, but it also disguised an important point.

Productivity gains can boost profits. But in an environment of low inflation and low nominal GDP growth, double-digit profit growth is only going to be possible if workers are taking home a smaller slice of the national income pie.

As it was, the US was operating close to full employment and wages were being bid up. The share of national income taken by workers was going up.

The corporate sector could not be securing a bigger part of national income cake too. There was something inconsistent about the claims of US companies that they were boosting their earnings so sharply.

Rotten apples?

Of course, now we know that companies were indeed inflating their earnings. Some analysts are still clinging to the belief that Enron, WorldCom, Xerox, QWest - to name but a few - were exceptions to the rule.

A laid-off WorldCom employee
A laid-off WorldCom employee leaves his office for the last time
It may well be that only a minority of companies were engaged in fraudulent accountancy. We shall have to wait and see.

But in some sense, that is still missing the point.

Many other ruses were being used to inflate profit numbers.

The discrepancy between the national accounts data was not just the result of accounting irregularities.

The indiscriminate use of stock options, which effectively allow a company to take staff costs off-balance sheet, have long been used to inflate earnings - as well as provide 'incentives'.

The habitual pension holiday was also another ruse that allowed companies to flatter profits.

As the stock market soared, US companies did not grant retirees more generous benefits. They simply booked the capital gains as lower operating expenses.

Many companies routinely booked capital gains from cross-shareholdings as operating profits too.

Pandora's box

Now the chickens are coming home to roost, investors are entitled to ask how many more skeletons may be lurking in the cupboard?


Investors have been duped, and it is going to be a long time before they can trust corporate America again

It is not possible to say. But the stock market may well come under further selling pressure anyway.

Even if there are no more accounting scandals, the stock market remains historically very overvalued.

If we believe the national accounts data, then company profits are currently showing an increase of 31.4% since the turn of 1995.

However, the broad stock market has still risen by 121.8% in price terms, and by 204.6% in market capitalisation terms.

Depending on which benchmark you choose, share prices have still risen by between 4 and 6.5 times corporate earnings.

Some analysts will no doubt point to the fact interest rates are at a 40-year low. But record low borrowing costs have not done anything for the Japanese stock market.

For choice, there is every chance the Dow could be trading in the low 8,000s before the end of the summer, taking the FSTE down below 4,000.

Thereafter, the Fed may well cut interest rates down towards 0.5% by the autumn, as the US economy lurches back towards recession.

No doubt we will then have a year-end rally. But the bear market is not going to go away that quickly.

Investors have been duped, and it is going to be a long time before they can trust corporate America again.

WorldCom

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29 Jun 02 | Business
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