The stars are aligned, market's up. Go profits!

By Charles Stein, Globe Columnist, 10/19/2003

It is a good bet that no one running for president -- not even President Bush -- will make a speech applauding the strong corporate profits that have been reported lately. The phrase "fatter profits" conjures up an image of a greedy chief executive stuffing his pockets, perhaps illegally. But the truth is the earnings numbers are good news and important news -- not just for chief executives and investors, but for the rest of us. Profits always matter. Given the events of the past three years they matter more than ever. The economic slump that began in 2000 was first and foremost a profits recession. During the boom of the late 1990s corporate America overspent and overinvested. When the slowdown hit, companies were stuck with expenses that were far out of line with sales. The result: a profits meltdown. Allen Sinai, the chief economist with Decision Economics, says the profit decline of the past few years was the steepest since World War II. In 2001 profit margins -- profits divided by sales -- reached their lowest level on record.

Businesses reacted predictably. They stopped spending money -- on people, computers, air travel, and paper clips. When they did spend money it was for technology that further cut their costs and allowed them to get more out of their existing work force. Ken Heebner watched the retrenchment process and sensed opportunity. Heebner, who is with CGM Funds, is one of Boston's smartest money managers. Heebner figured that the belt-tightening and productivity improvements meant that corporate America was sharply reducing its break-even point. Heebner reasoned further that once the economy picked up even modestly -- a sure thing given lower interest rates, tax cuts, and a weaker dollar -- profits wouldn't just grow. They would explode.

EMC Corp. offers a textbook case of what Heebner was talking about. Last Thursday, the Hopkinton technology company reported that its sales rose 20 percent in the third quarter. Yet profits rose 650 percent, thanks to several years of cost-cutting, including a reduction in staff of 7,000 people. Profits for the firms in the Standard & Poor's 500 index are expected to be up 16 percent in the third quarter from the same quarter a year ago, the best performance in three years. The profit bump explains why the stock market is up almost 20 percent this year.

By now you are asking the question: What does all of this have to do with me? The answer is pretty straightforward. If the disappearance of profits caused companies to spend less, the return of profits should prompt them to spend more. "Historically, stronger profits have been followed by stronger investment and more hiring," said Mark Zandi, the chief economist at Economy.com. In fact, business spending on computers and software has started to inch up. Even the job market is looking a little healthier. New claims for jobless benefits last week dipped to their lowest level in eight months. If historical patterns hold, the news should get better in subsequent months as corporations feel more confident about the bottom line. In short, the return of profits could be the catalyst for an economic recovery that actually looks and feels like a recovery.

The key word in that last sentence is "could." As they say in the investment ads, "Past performance is no guarantee of future results." The fact that companies typically begin hiring when profits rise doesn't mean it has to happen now. It may be that the hard times of the past few years have spooked companies so much that they will stick to their penny-pinching ways longer than usual. If that is the case, a bona fide recovery could still be further than we think.

For the moment, I am in the optimists camp. With profits on the upswing, the stars appear to be aligned for a comeback. The stock market saw it coming six months ago. The rest of us are seeing it now. Eventually even the politicians may get on board. I can see the political billboard now: "Higher profits equals more jobs. Go business."

Charles Stein is a Globe columnist. He can be reached at stein@globe .com.