A Closer Look at Profits

As companies release their second-quarter earnings figures, it's still tough to gauge the true health of the corporate sector. According to the latest filings of companies in our flash profits sample, corporate profits were down 30% compared with a year earlier, which was a weak quarter to begin with. But take out AT&T and Lucent Technologies Inc.--which accounted for $20.6 billion in losses all by themselves--and the remaining 123 companies were up by 14%, more than expected.

The confusion in the profits numbers reflect the crosscurrents in the economy and the financial markets. On the one hand, there's plenty of bad news. Stock markets are still way down in the U.S. and abroad, and the scandals have touched some of the country's largest banks. Telecom and energy companies are in trouble no matter where you look, technology companies are reducing their forecasts for the rest of the year, and many large corporations may be forced to start putting money in pension funds for the first time in years.

However, despite the drumbeat of negative news, there's still some reason for cautious optimism about profits in coming quarters. The key is that by cutting workers and boosting productivity, companies seem to be taking the steps they need to trim costs and increase profits going forward. In recent days, Lucent, General Electric, SBC Communications, and Intel have all announced job reductions. And economic growth, while not stellar, remains positive.

While the news is still dominated by corporate scandals and huge bankruptcies, it may be time for shell-shocked investors to start paying attention to profits. Earnings are by far the biggest influence on stock prices. In the bear market of the 1970s, for example, corporate profits adjusted for inflation were basically flat, and so were stocks. Conversely, the stock boom that started in 1995 was preceded and accompanied by a major-league runup in profits.

The same connection holds today. It's no coincidence that earnings per share peaked in the first quarter of 2000, just as the market hit its high and started downward. Only when profits start to rise, on a sustained basis, will the stock market recover.

Of course, after all the reports of financial hocus-pocus, investors are understandably wary of earnings figures being put out by corporations. But with all the attention given to corporate accounting these days, CEOs are going to be much more reluctant to adopt the sort of aggressive accounting practices that they used in the past. That trend toward honesty will be reinforced by the requirement that, as of Aug. 14, CEOs must certify their financial reports as being honest and correct.

As a result, there's a reasonable chance that these numbers will be cleaner than they have been in a long time. When published earnings start to rise, that's a good sign for investors.

    Before it's here, it's on the Bloomberg Terminal.