Have Profits Peaked?

Earnings season is getting under way on Wall Street. Over the next few weeks most of the US’s big corporations will be reporting their third quarter profits.

Over recent weeks, investors have become pessimistic on the outlook for corporate profits to keep rising. By a two-to-one ratio companies are warning investors that their profits will fall below earlier expectations, and estimates of overall profit growth for S&P companies has been lowered repeatedly.

The national accounts data suggest that such caution may be warranted. The following graph shows corporate profits since 2000 (at annualized rates). The dark line shows a measure of “real” profits, while the light line shows the profits that companies can legally report on their tax statements.

The sizeable difference between the two lines is the result of the 2001 and 2003 tax cuts, which allowed companies to report far lower profits than they actually earned. But the suspicious thing about the graph is that it shows that by the second quarter of this year, profit growth had already slowed to a virtual halt.

What remains to be seen, and something that we’ll get some clues about over the coming weeks, is whether this is just a pause in profit growth, or a sign that companies have already seen the peak of their profits. Given the recent sluggish growth in income, higher oil prices, and the lack of pricing power for firms, I will not be at all surprised if it’s the latter.