US "economic" profits far above last-recession low
Simon Ward
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US companies included in the S&P 500 index recorded a large aggregate loss in the fourth quarter, reflecting financial write-downs, a fall in the value of inventories due to plunging commodity prices and other recession-related charges – see first chart.
By contrast, the national accounts measure of “economic” profits was still firmly in the black in the fourth quarter. This covers all companies, excludes valuation effects and other charges, and adjusts for under- or over-depreciation in reported accounts. It is a better guide to underlying profitability.
Fourth-quarter economic profits were down by 18% from their peak in the third quarter of 2006 but 94% above the trough reached in the last recession, in the third quarter of 2001. Companies have limited damage to profitability by acting fast to shed labour and slash other costs.
The second chart shows inflation-adjusted economic profits together with a log-linear trend. At the 2006 peak, profits were 41% above the trend-line – the largest deviation since 1966. The subsequent plunge has closed the gap and profits should move below trend in early 2009.
Market valuations already discount earnings gloom. As the third chart shows, a price / earnings ratio based on trend economic profits stood at 12.6 at the end of 2008 versus a long-run average of 13.8. The P / E, however, reached much lower levels in the 1970s and 1980s.
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