These days the economic news is good: the economy is recovering more rapidly from last year's recession than nearly anyone had thought likely. But the stock market is not matching the economy: it is going down, not up. Why?
One likely explanation is that the breakdown of our corporate accounting system led nearly every investor to think that corporate profits over the past five years were higher than they were in fact.
According to the national income accounts at the Department of Commerce, profits peaked in 1997. But in 2000 S&P 500 firms reported profits 50% higher than in 1997. S&P 500 firms pushed the envelope of accounting practices to generate better numbers. But the real story was that profits were flat, for the coming of the information age meant heightened competition and reduced margins, as the benefits of higher productivity went not to corporate profits and shareholders, but to consumers in the form of lower prices and to workers in the form of higher wages and salaries.
In the late 1990s, however, American investors did not hear this real story of the profit squeeze. Instead, they heard how information technology would enable first-movers to exploit enormous information-age economies of scale, entrench monopoly positions, and reap huge profits. Now--as more and more leaks out in the way of accounting problems and earnings restatements--investors are finally learning pieces of the real story. It seems likely that this is the source of the current downward trend in the stock market: the bad news about how corporations had overestimated the profits is outweighing the good news about the stronger than expected recovery.
I'm Brad DeLong
Source: Economist.
