A Look Behind the Numbers Driving Up Stocks
What’s going on? In recent weeks major U.S. companies have reported massive losses--IBM wrote off $5 billion, United Technologies, Sears, Xerox and ITT more than $1 billion apiece. Kodak and many others registered heavy losses and General Motors wrote off $22.5 billion, including a provision for retiree health benefits.
Yet the stock market has soared to record highs on tremendous trading volumes, often pushing up the very companies reporting losses.
The inevitable question: Is the market rising on thin air, or building upon substantial strength in U.S. business and the economy?
Real strength, for the most part, is pushing up prices. To understand why you have to look behind the loss figures to operating profits and cash building up in U.S. companies. No question, good things are happening.
But be cautious also, because the enthusiasm running in the market today often overlooks or plays down perils that lie ahead.
Still, sometimes you feel good when you just stop feeling bad. Write-offs get rid of losing operations, leaving cash for healthy parts of the business and for shareholders. Sears, by closing its money-losing catalogue operation, stopped a drain of almost $200 million a year.
In many cases, losses are bookkeeping entries recognizing past mistakes. Xerox wrote off more than $700 million before jettisoning an old and unwise diversification. But it paid out no real money. Instead, the company now has extra cash to devote to its improving office products business.
It’s a bit like your tax refund. You’re only getting back money you overpaid to the IRS, but the refund check is like a cash windfall nonetheless.
Smart investment pros recognize that write-offs distort the profit picture and that stocks hitting historically high price-to-earnings ratios are not really in the stratosphere. The Standard & Poor index of 500 major companies is not really selling at 25 times the profits of those companies, a very high ratio, but at roughly 17 times their true earnings.
Charles Clough, chief investment strategist for Merrill Lynch, goes further, dividing the total of U.S. corporate profits into the Wilshire 5,000 index, which covers 90% of U.S. publicly traded companies. The resulting ratio shows stock markets pricing companies at a modest 12 times earnings.
Such arithmetical ratios are not infallible guides, but they do indicate that stocks are not as expensive as they may seem, and that prices could rise further.
And they probably will because driving the markets today is a river of money--$9 billion in December, perhaps $12 billion in January--moving into stock mutual funds as investors seek higher yields. But keep in mind that much of that money is coming out of certificates of deposit and Treasury bills--which now pay only 3% or so. Those investments could move swiftly back to Treasuries and CDs if interest rates turn up, as they might in an economic recovery.
That’s one peril ahead for the bull market. Another is the charge for retiree health benefits mandated by Financial Accounting Standard 106, a rule that says corporations must recognize future obligations on their balance sheets today. GM has just taken a $21-billion charge, Ford took $7.5 billion last year, IBM and others have taken big charges. These are bookkeeping entries recognizing that in the past companies had underestimated rising bills for health care and making some provision for the future, explains management consultant James Warner of Foster Higgins & Co.
But today’s write-offs only begin the burden. From now on, companies will reduce earnings every year to recognize and pay out cash for retiree benefits, says accountant Michael Sirkin, of Price Waterhouse.
Every firm will have to pay--in GM’s case the charge could be $400 million to $2.5 billion a year. “The FAS 106 rule will reduce earnings in the future and affect stock values,” says David Shulman, a managing director of Salomon Bros.
The upshot is that GM and all other companies will have to earn more to pay for health benefits; it’s yet another facet of America’s chronic medical cost malady.
OK, let’s bring the good news and the bad together. While obligations are increasing, so is available cash and real earnings. The cash will allow business investment to go forward without new borrowing, which means no upward pressure on interest rates.
And investments are going forward. We are in a business spending boom, says economist Anthony Vignola of Kidder Peabody. “The spending is less on traditional machine tools than on computers and other productivity-raising equipment, up $25 billion or 7.3% last year,” says Vignola. The equipment is making office work and services more efficient.
That’s why U.S. productivity--output per unit of work--rose 2.7% last year, the biggest rise in two decades and a very hopeful sign. Rising productivity means the economy can grow without inflation or rising interest rates. It means the pie is getting bigger, allowing greater shares for all.
True, the recovery hasn’t seen many jobs created yet, and the picture remains particularly clouded in Los Angeles. But the latest national employment report--106,000 new jobs added in January--was a decent start. It was one more sign that the recovery is real. That’s why the stock market is up, even though some economic signposts are conflicting. Sometimes you know you’re getting better when you just stop feeling bad.
