April 6, 2005

Lost in the concerns about the dollar, oil prices, and inflationary fears has been the spectacular performance of corporate profits during this economic rebound.  The fourth quarter revision to GDP showed no change in the inflation adjusted growth of the economy, but a modest gain in price increases. 

In the back tables of that release, tables show that labor costs embedded in a unit of production did not rise.  While some higher costs of imports accounted for some price pressures, this was offset by little change in the interest needed to finance a unit of production along with an actual reduction in the amount of capital exhausted in the production of each unit of output. 

If prices are rising, but labor and nonlabor costs other than those related to imports are stable or falling by more than import costs are rising, then profits must be increasing for each unit of production.  Even after an increase in the taxes paid per unit of production, operating profits reached 9.1 cents for every dollar of production.  This is among the highest after tax operating profits per unit of production ever recorded in the United States. 

Some of these profit gains are directly related to high energy costs.  In 2002, profits from domestic petroleum and coal products were $4 billion.  In the fourth quarter of 2004, profits in that sector were a staggering $42.5 billion.  They almost certainly rose significantly higher during the first quarter of this year. 

Not surprisingly, the higher petroleum costs significantly impacted profits from chemical products.  From $17.1 billion in 2002, those chemical profits had sagged to $8.4 billion by the end of 2004. 

All other nondurables, including the paper, food processing, tobacco, and hard pressed textiles and apparel experienced much more modest profit gains over this period.  Now that apparel quotas are suspended from China, the apparel and textile industries are announcing plant closings almost daily.  Thus, profits are not likely to improve there. 

If America is losing its manufacturing prowess, as some claim, then the surge in profits for durable manufacturing is hard to explain.  In 2002, the industry was still reeling from the recession with losses of $8.3 billion.  In the fourth quarter of 2004, not only had the losses been erased, but profits jumped to $48.1 billion.  Metals, appliances, and autos all contributed to that improvement. 

The stalled sales in previously very profitable SUVs may end the gains in autos but other durables appear to remain highly profitable during the winter. 

Even with higher energy costs and relatively mild weather in most parts of the U.S., the utility industry also has recorded large profit gains in recent quarters.  Not only is American production rising, but the growth is very profitable. 

Nevertheless, the high energy prices are impacting some previously strong industries.  For example, transportation and warehousing experienced a surge in profits to $15.5 billion last spring.  Since then profits have plunged to $4.5 billion.  I would be surprised if any profits are earned in this sector during the winter. 

The distribution of goods associated with wholesale and retail trade has experienced little profit growth in the past two years.  We probably have too many stores for the current growth in consumer activity.  While wholesale trade has fared better, profits there also appear to be stalling. 

The information economy, which includes communications from the wired phones to the wireless communications devices and the internet purveyors saw a significant dip in profits during the fall.  However, this followed two very profitable quarters that reversed losses in the previous two years. 

Surprisingly, the surge in profits was not apparent in those earning abroad.  While those profits are up from two years ago, profits from the rest of the world showed no growth in the fourth quarter and actually remained sharply below previous year levels. 

Those rising insurance premiums and finance charges also have done little for profits in the financial sector.  Profits are growing in these industries (at least after subtracting the huge hit to capital that insurance companies suffered in the summer because of hurricanes), but the gains are only slightly over 3 percent in the past year. 

In summary, profits continue to grow faster than economic activity.  I believe operating profits after taxes (and taxes are rising as accelerated depreciation expires) will grow about 10 percent this year.  Unfortunately, about half those gains will remain concentrated in the petroleum sector.  Nevertheless, stock values probably do not reflect such continued profit gains. 

Indeed, I believe stock values can grow another 8 to 9 percent in the remainder of this year.  Then we will see if higher finance costs and some rise in labor costs per unit produced finally begins to erode this enormous recovery in profits of U.S. enterprises. 

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