CEOs Got It Bad. That Could Be Good
By Margaret Popper
On the eve of the Federal Reserve's June Open Market Committee meeting, the usual debates are swirling: Will the Fed cut rates 25 basis points or 50? And when will all this rate-cutting have any impact? Two weeks ago, the 25-basis-point camp dominated the betting. Now, more economic analysts seem to be coming around to the view that we'll get the big 50.
Why the Full Monty? Look to the corporate-earnings picture. Judging by second-quarter preannouncements, earnings have continued on a downward path. CEOs preparing shareholders for worse-than-expected second-quarter results are still complaining of "lack of earnings visibility." Read: more trouble ahead. And their pessimism is fueling a growing sentiment that the economy won't hit bottom until as late as this year's fourth quarter -- or possibly the first quarter of 2002.
Don't get too depressed, though. Just because the projections are negative doesn't mean they're any more realistic than the soaring optimism that created the tech bubble in the first place. Given the pressure to meet or better their earnings forecasts, CEOs have ample incentive to lower investors' and analysts' expectations. Even if they aren't trying to manipulate market expectations, chief execs tend to project earnings on a more-or-less straight line from where they are today.
GLUM AND GLUMMER.
And many CEOs equate their industry, especially if in high tech, with all other businesses and the overall economy. They miss the bigger picture of how U.S. industry as a whole responds to economic stimulus. So investors taking in the earnings preannouncements for the second quarter should maintain a healthy skepticism about management projections.
"These are the same guys who missed it on the way down. Why should I trust them when they're talking about when it will turn back up?" asks Nancy Tengler, CEO of San Francisco-based Fremont Investment Advisors.
Also, survey data show some odd disparities in managers' assessment of the earnings and economic outlook. "A modest recovery for the overall economy, with 2% growth in the third quarter, and a healthier economic recovery, with over 3% growth in the fourth quarter of this year," is how National Association of Manufacturers (NAM) President Gerry Jasinowski summed up the association's survey of 55 manufacturing executives conducted in late May. At the same time, 80% of those surveyed said they expected no more inventory problems after August and a roughly 2% increase in orders in the third quarter.
Sounds pretty good, until you hear the earnings outlook. Of the executives surveyed, 56% said they "expect either stagnant or reduced earnings growth for the remainder of 2001," according to NAM Chairman W.R. Timken Jr. of Timken Co.
This earnings pessimism could have to do with fears about energy costs or shrinking exports due to the strong dollar and economic weakness abroad. But more than likely, the pervading gloom is more a result of CEOs' flagging stamina in the face of repeated downward earnings revisions. The analyst community is particularly unforgiving of surprises on the downside.
"CEOs have been beaten up," says Ed Yardeni, chief economist at Deutsche Bank Alex Brown, who cautions: "You don't want to ignore this psychology." Particularly when it comes to timing the bottom.
Some market watchers believe CEO pessimism is actually a positive sign. "It's a good contra-indicator," says Harry Dent, president of the H.S. Dent Foundation, a money-management and advisory firm. "The longer things are down, the more pessimistic they get." That means, like analysts who tend to use the recent past to project the future, chief execs generally miss the upturn, according to Dent.
According to the NAM survey, managers believe the upturn will happen in the fourth quarter, "when the inventory hangover is worked off, and the cumulative effects of the tax cut and interest-rate reductions begin to boost consumer spending." Many economists would argue that, even if consumer spending isn't as robust as it was in the first half of last year, it has still held up pretty well. "Housing and auto sales never really dropped, so they can't rebound," points out Deutsche Bank's Yardeni. "The risk for the consumer is on the downside."
In fact, what could be going on is nothing more than a business shakeout that will end in a much-needed industry consolidation in the tech sector. The parallels between this wreck and the recession of 1920 to 1922 are striking to economic-history buffs. "There is always a shakeout in the middle of a technology boom," says Dent. "Everyone entered the car business between 1904 and 1919. Between 1920 and 1922, the price of General Motors dropped 75%. The Dow dropped 45%, autos by 70%, and tire manufacturers by 72%."
The good news is that the market grew by 22 times over the seven years that followed. Dent says we've already witnessed the worst and that CEOs who can't see beyond this quarter's earnings are missing the bigger picture.
So take the mood of pessimism as a portent. While it may not turn out to be an indicator of how many more quarters the economy will slide, it sure increases the likelihood of a half-percentage-point rate cut at the Fed's next meeting.
Popper covers the Fed and markets for BusinessWeek Online
Edited by Douglas Harbrecht