One of the more puzzling aspects of the economy today is the
lackluster performance of the stock market. Historically, it has been a
leading indicator of the economy, if not necessarily an infallible one.
Hence, a lagging stock market may indicate that future economic growth
prospects are not as rosy as economists have thought. Alternatively, the
Enron-induced cleanup of corporate accounting may be confusing investors
about the true state of corporate profitability.
Although most economists have been fairly bullish on the economy
since the first of the year, there have always been a few naysayers warning
of a so-called double-dip recession. They say that recent positive growth
numbers, such as the 5.6 percent increase in real gross domestic product in
the first quarter, are the result of temporary factors, such as the
restocking of inventories, and do not guarantee that the economy is now on a
firm upward trend.
Another group of economists were previously bullish, but have
turned somewhat more pessimistic lately as the result of actions taken by
Congress and the Bush administration. They point to the imposition of steel
tariffs, which increase the cost of business for many companies; the farm
bill, which has all but killed the chances of a meaningful new trade
agreement even if the president gets "fast track" trade authority; and an
apparent backtrack by the administration on global warming, which could lead
to the imposition of massive new regulations on virtually all American
Hovering over these concerns are continuing uncertainties about
war and terrorism; future Federal Reserve policy, with some economists
already urging it to raise interest rates; and the outcome of midterm
elections in November. Many of the administration's most criticized actions
have been taken, perhaps against President Bush's better judgment, in part
to improve Republican chances of keeping the House and retaking the Senate.
However, they do not appear to be having that effect. At present, experts
say the most likely electoral outcome is maintenance of the status quo.
These points are well taken and no doubt are casting a pall over
the stock market. However, I believe that the most important factor holding
back stocks is the enormous confusion about corporate earnings. Investors
are disgusted by fraudulent profit figures put out by companies such as
Enron, Tyco, Global Crossing and Adelphia Communications. And they are
deeply skeptical of those put out even by "blue chip" companies such as
Investors have good reason to be skeptical. One of the factors
that fueled the dot-com bubble was the pervasive use of a non-standard
method of calculating profits called "pro forma earnings." This term was
originally intended to provide guidance for investors when a company
underwent a major change, such as a merger, which made comparisons with
previous earnings difficult. However, the reporting of pro forma profits was
badly abused by many now-bankrupt dot-coms, which used it as a way of hiding
factors that negatively affected earnings.
Another important area of confusion is stock options, now used
by almost all big corporations to compensate their employees. In effect,
stock options dilute earnings, but their impact has not been apparent to
investors. The data are often buried in footnotes in annual reports and
reported in ways that are difficult even for accountants to interpret. But
their impact is huge -- reducing reported profits by roughly $5 per share
for all companies in the Standard and Poor's 500 index.
Many in Congress are calling for accounting changes, such as
requiring companies to deduct stock options from reported earnings. However,
new legislation is totally unnecessary because investors are already
demanding such information. On May 14, Standard and Poor's announced that it
would soon begin calculating its widely used company earnings figures to
include the value of stock options as well as other items, such as gains on
company pension plans, that have often been used to artificially inflate
The new measure of profits is called "core earnings," and it
attempts to gauge how companies are really doing in their primary business
operations. In the case of General Electric, the calculation of core
earnings shaved close to $1 billion off its reported profits in both 2000
and 2001, according to Standard and Poor's.
Almost daily, there are 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.