Profit Outlook for 2003                                          January 2003

While the prospect of economic recovery continues to dominate the news, Thunder Capital remains unconvinced of long-term recovery without the improvement of the single most important economic factor; corporate profits.

In an effort to make their bottom lines, companies have resorted to cutting headcounts, reducing capital expenditures, and other cost cutting. While cutting costs can lift profits when one company cuts on a micro level, it becomes a real macro issue when many companies are slashing costs. In effect, they are withholding potential revenues from other businesses as the cutting snowballs. In addition, accounting methodologies have been increasingly liberal regarding what to include or exclude on the bottom line resulting in the highly variable pro-forma earnings.

GDP Increases While Profits Decrease

Profits for companies in the non-financial sector were down to $321 billion in the third quarter of 2002, compared with profits of $358.7 billion in the year earlier period, despite what was lauded as a very strong increase in the GDP figures. We mention this because we believe it is curious that investors and reporters are so enamored with the growth in the economy, even though it is at the expense of profits, which make up the foundation necessary to sustain higher stock prices.

Only the Strong (and the Subsidized?) Survive

The creative destruction aspects of capitalism are no longer allowed to work, yet they are the natural corrective mechanisms of our capitalistic system. Witness the planned revival of bankrupt WorldCom. Instead of failing which would provide profit potential for survivors AT&T and Verizon, WorldCom may now be able to participate in the marketplace unhampered by its past debts. WorldCom’s previous mismanagement and misallocation of capital are in essence being forgiven at the expense of AT&T and Verizon, who did not go bankrupt and must continue to meet their debt obligations. On a grander scale, every time the economy was destined to enter a recession the Fed unnaturally cut short the cleansing process with lower and lower interest rates and higher and higher levels of credit. This has resulted in a serious and extensive misallocation of capital that will be painful and time-consuming to reverse.

Savings = Investment: The Forgotten Equation

Businesses do not have the capital for investment because the economic stimulants to encourage consumption are exactly the same stimulants, which are discouraging savings. Savings rates in the U.S. have approached zero, so there is little if any foregone consumption that can be channeled into investment to kick-start the business cycle. Not only is this lack of investment likely to continue, as consumption is encouraged, but we are drastically unequipped as a nation to deal with this deflation in profits. In Japan, consumers had high savings to benefit from declining prices. Americans are loaded with debt and have little savings. Our policy makers have flooded the system with credit and encouraged $130 trillion worth of derivatives. That could well explain how imbalances have continued on for so long, since we have never had such massive leverage in our financial system before. What we do know is it will not help businesses make a profit, which is the most fundamental factor needed for true economic growth and prosperity.

Trade Imbalance and Profits

There exist some very large and complicated imbalances in the U.S. economy that will be most difficult to unravel. The important point is that this unraveling process has not started, despite what you would be led to believe by the media. In fact, imbalances are still being increased. The most glaring imbalance is the current account deficit, which is approaching a $500 billion annual shortfall. That translates to almost $1.5 billion of offsetting investment inflows by foreigners every day and with the dollar breaking to new lows, seems highly unlikely to continue, if not reverse. One of the biggest drains of this deficit is that money spent on imports does not recycle as domestic business revenues. It only benefits the specific country exporting to us. Economist Dr. Kurt Richebacher, in his November 2002 letter, describes the trade imbalance as the profits-reducing factor that is least understood and yet “this leakage has played the single most important role in ravaging U.S. business profits since 1997.” This growing imbalance has been sustained by the willingness of foreigners to invest in U.S. assets. Foreigners now hold well over $7 trillion in U.S. assets including 13% of equities, 32% of Treasuries, and 21% of corporate bonds.

Rising Depreciation Costs Hurt Profits

The basic economic maxim that investing in tangible assets such as factories, which provide jobs, supply, income, and demand, has been lost in the U.S. Instead our investment has gone into shorter-term, higher-depreciation, capital investment in technology. With such rapid obsolescence, many times, the original investment can’t be recouped. Additionally, Dr. Richebacher notes the government has been fudging its economic statistics through a process called hedonic pricing. This technique arbitrarily increases the economic impact of the sale of the computer to account for the increase in a computer’s power even though the actual price of the computer has decreased. This results in additions to GDP, which are actually fictitious, because no one actually paid or received any dollars for that extra GDP value. Add to this the financial engineering that has provided little more than goodwill, related to takeovers, and the increasing obsession with consumerism, and we can view an economy that does not invest in assets that generate returns. Instead we put money into the purchase of items, which are simply consumed, with no offsetting return of capital. As a result, consumption as a percentage of GDP has risen from 62% in the 1970’s, to 66% in the 1980’s, while reaching 70% by the late 1990’s. Incredibly, as a share of current GDP growth, consumption percentage now exceeds 90%!

Summary

The credit that has been bestowed upon the remarkable American consumer has been well deserved. Unfortunately it is this very pronounced shift toward consumption that has seriously damaged the U.S. economy and it’s historic ability to generate capital formation. These are the real reasons the outlook for corporate profits in 2003 are overestimated and frankly, very bleak. The attempts of the government to revitalize the economy over the past several years through interest rate cuts, extended unemployment benefits, tax refunds, etc., have only pushed us further into the already extreme imbalance toward consumption-based GDP growth. This has come at the expense of a healthy and balanced economic growth platform encompassing saving and investment. The point again is that the policies being employed to stimulate the economy are only pushing us further toward the imbalances, which have seriously damaged our economy in the first place. The Fed is hoping to hyper-inflate the impending deflation away but this will do little to boost profits in a world of overcapacity and ever-higher debt burdens. Every day the debt burden grows and excess capacity further strains the bottom line for businesses – PROFITS.

Richard J. Greene