Saturday, July 31, 2010

Strong Profits. Weak Economy. Odd Couple?

Weak economy, strong profits? Not as strange as it sounds.
Gross-domestic-product figures due Friday are expected to paint a disappointing picture of U.S. economic performance. Second-quarter GDP is likely to show growth roughly in line with the first quarter's 2.7% annualized pace, an unusually weak result for this stage of recovery.
Investors may find that difficult to square with what is shaping up to be a decent run for corporate profits. Second-quarter earnings among S&P 500 companies are on track to post 35% growth over the same period last year.

But the seemingly contradictory developments aren't as inconsistent as they might at first appear.
For one, the disparity partly reflects the way the figures are presented. GDP growth, which is seasonally adjusted, is usually reported on a quarter-to-quarter basis. Corporate profits, which can be highly seasonal, are typically expressed in year-on-year terms. When GDP growth is viewed on an annual basis, the story is more consistent: Growth turned positive in the fourth quarter, the same time S&P 500 earnings growth resumed after nine quarters of declines.

Meanwhile, earnings figures have been sharply inflated by the rebound in profits from financial firms following their spectacular collapse during the crisis. For example, the 205% leap in fourth-quarter earnings was a gain of only 17.5% excluding financials, according to Thomson Reuters. And revenues over the same period increased by just 2.9%, excluding financials.

Revenue growth among S&P 500 companies is today higher, so far up 11.6% in the second quarter from a year ago, excluding financials. In contrast, Friday's report is expected to show year-on-year GDP growth of only 3.2%. But companies often rebound at a quicker pace than the overall economy. For consumers and governments to rebuild their balance sheets and start spending again is a much lengthier, and painful, process.
Companies' global exposure also plays a role. About half of S&P 500 revenues come from foreign countries, according to OppenheimerFunds. Meanwhile, exports account for only about a tenth of U.S. GDP.

The apparent paradox of a sluggish U.S. economy coinciding with strong corporate profits won't last forever. But, with companies still very disciplined on costs, it isn't something for investors to get too worried about just yet.

Write to Kelly Evans at

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