Why the party's over
When the credit crisis hit home in 2007, everyone felt the pain - including America's largest companies. For the first time in five years, corporate profits dropped.
(Fortune Magazine) -- On June 13, 2007, the world changed for the Fortune 500. Why? Because on that day, the financial markets finally woke up from a dream. As a result, the companies of the 500 are still coping with the trauma of their abrupt return to reality, which included the group's first profit decline in five years. And, no, the trouble isn't over. Nor is it strictly a U.S. problem.
The shock to the U.S. financial system created aftershocks around the globe. The IMF has lowered its estimates of world growth for 2008, and the higher cost of capital is hurting businesses that need to borrow - which means everyone.
What happened on June 13 is that the markets rediscovered risk. Specifically, that was the day after the interest-rate spread between the main junk-bond index (what might be called the dross standard) and the ten-year Treasury bond (the gold standard) shrank to 2.4 percentage points - 7.7% for junk, vs. 5.3% for the Treasurys. That meant there was very little difference in the prices investors were charging for accepting hugely different levels of risk. It couldn't last, and it didn't.
On June 13 investors came to their senses: They started accepting lower yields (5.2%) for the safety of U.S. Treasurys and investment-grade corporate bonds. A few days before, they had started demanding higher returns from risky junk bonds and collateralized debt obligations. The spread, which represents the value of safety, has been growing ever since; in mid-April it was back to about seven percentage points.
Riskier bonds, like those based on subprime mortgages, plunged in value. Banks holding such bonds lost billions. Panicky, the banks crimped lending; credit dried up. Without ready credit, all elements of the U.S. economy - from consumers and mom-and-pop shops all the way to the Fortune 500 - got hit.
Consider the following: In 2006, 156 companies in the Fortune 500 reported lower profits than the year before, and 43 lost money - a total of $48.4 billion. In 2007, all those numbers were worse; 183 companies saw their profits fall, and the 57 that lost money lost a lot more: $116.7 billion.
The importance of June 13 is obvious only in retrospect. Still, the further we get from that date, the more important it seems. The cavalier attitude to risk that prevailed before that day also helps illuminate how the big companies that constitute the 500 were able to sustain huge profit increases for four straight years, how those increases finally became unsustainable, and why some companies and not others have been clobbered.
Jeremy Grantham, chairman of the GMO fund, warned explicitly of what was going to happen. He calculated in 2006 that the risk-return relationship had actually been inverted. Analyzing global investments of all types, he found "the first negative-sloping risk-return line we have ever seen." That is, investors were paying a bit extra in return for higher risk, rather than the previously universal (and obviously sensible) practice of paying extra for lower risk.
Why would investors do something so apparently boneheaded? The answer explains how the United States and world economies were being powered until last year. A self-perpetuating cycle of borrowing and buying had started spinning.
One element was the unprecedented abundance of capital. The supergrowth of China, India, and other savings-oriented economies released new capital into the world; the efficiency of global capital markets meant trillions of dollars were being continually directed to their best use worldwide. When anything is that plentiful, it's cheap.
The other major element behind the economic craziness that finally stopped last year was the global boom following the 2001 recession and the slow 2002 recovery. During those two years, the 500's profits fell 84% from their peak in the wonder year of 2000. But then, starting in 2003, the 500 and the world economy enjoyed the best of times, with almost all the planet's economies growing fairly briskly.
Normally, worldwide economic prosperity is a good thing, but it became a problem when combined with easy money. The mixture stimulated borrowing. Specifically, people began to believe that the more they borrowed, the better off they would be. Their thinking went like this: With the cost of capital so low and asset prices rising steadily, risk was evaporating.
Yale economist Robert Shiller, another lonely voice of reason during the boom years, observed that global economic growth had picked up in recent years for exactly that reason: He wrote last fall in the New York Times that "a good part of the extra growth since 2004 has probably been the increased spending caused by the speculative booms themselves."
In the United States, the world's largest economy, the cycle spun most powerfully in housing. That's significant because housing is the most valuable asset owned by most consumers, and they drive the economy. For them, the logic of leverage was especially potent: As long as home prices kept rising, people figured they must buy a home now or perhaps never be able to afford one, and they should buy the most expensive home possible. So that's what millions of them did, and in the process they pushed values even higher.
The momentously important result was that consumers felt rich and spent accordingly. America's largest corporations enjoyed the benefits. When the 500's profits bounced back in 2003, they roared past the 2000 record and kept right on rocketing - 15% the next year, then 19%, and finally a blowout 29% jump in 2006. Such increases are not remotely sustainable.
The reckoning that began on June 13 represented investors deciding that the basic concept underlying the whole profits boom - that risk didn't matter much - was wrong. So they began bailing out of higher-risk investments like structured bonds built from rickety subprime mortgages and moving into things like Treasury bonds.
As a result, the great boom cycle stopped and then began to spin backward, as did the many benefits that flowed from it. With home prices falling, the cost of debt rising, and the economy slowing, U.S. consumers didn't feel rich; they felt worried. So they began to live within their means, shutting down the profit-growth machine.
Thus the damage within the 500 was distributed roughly according to how directly an industry was exposed to consumers. Homebuilders and financial institutions suffered hugely; the best performers were mostly companies that consumers have never heard of. The electronics and electrical equipment industry - such non-household names as Rockwell Automation (ROK, Fortune 500) and SPX (SPW, Fortune 500) - saw median profits rise 60%. Packaging and containers (Smurfit-Stone Container (SSCC, Fortune 500), Owens-Illinois) (OI, Fortune 500) also did well, up 50%.
The trouble for the 500 is that no company is more than two or three steps removed from the consumer, so the worst may still be ahead. The U.S. economy didn't begin its descent until last year's third or perhaps fourth quarter; that means the 500's profit drop in 2007, while significant, reflects a year of mostly strong economic growth with a tag end of misery. This year will be just the opposite, a painful front end with a recovery near the back - at best. And because the Fortune 500 rely so much on foreign markets and the global economy is so interconnected, investor behavior in New York and Chicago inevitably influences what happens in Frankfurt and Tokyo
The only way to find optimism in this picture is to take the long view. Even after last year's decline, the 500's profits have grown from the 2000 peak at a compound annual rate of 5.7%. For as big a chunk of the economy as the 500, 5.7% is reasonable. And if profits drop further in 2008, well, that will probably be a trough. Just wait: You have to figure they'll rise in 2009 - though the wait may feel awfully long.