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Once More, With Feeling: This Is False Prosperity   (January 31, 2006)

What if the foundation of the stock market's incredible rise since 2002 is in fact bogus? The foundation of any stock market is earnings: rising earnings lead to rising values for the companies pocketing all that profit. So what happens when the cloak of ever-rising profits turns out to be threadbare?

Consider this from Barrons issue dated 1/2/06:
One of the big arguing points of the bulls is the extraordinary strength in corporate earnings. And, no question, we've had a spectacular boom in profits. In the third quarter of 2005, to illustrate, operating profits of the S&P 500 were up a neat 11.5%, the 14th quarter in a row of double-digit gains.

However, as the indefatigable David Rosenberg of Merrill Lynch points out, such a splendid performance reflects not so much any inordinate growth of revenues as the impact of an unprecedented mass of buybacks -- $456 billion worth of stock repurchases that TrimTabs Investment Research estimated took place last year.

Operating earnings in dollar terms -- as against per-share net -- actually were up only 7.8% over the comparable year-earlier total. Which, David notes, was the narrowest gain in three years.
In plain English: let's say your company has a million shares of stock, and you net a million dollars annually in profit. Your earnings are a buck a share. Now let's say you buy back half a million shares in a stock buyback plan; there are now only a half a million shares outstanding.

Let's say your profit dips to $600,000. Yikes--what will your shareholders think of this horrendous drop in profitability? What drop in profits, you reply; that works out to $1.20 per share in profit, 20% more than the prior year. Your shareholders and the market are ecstatic with your wonderful 20% increase in profits per share, and your share price promptly rises by 20%.

But what a minute: didn't your actual profit drop by 40%? Yes, but lo and behold, the profit per share went up by 20%. That's the essence of this "profit boom": slight of hand accounting and bogus "pro forma" earnings.

The Wall Street cheerleaders like to talk about unprecedented profits as the driver of this current "prosperity," but the chart above reveals the actual source of all this easy money floating around: unprecedented borrowing by individuals, government and businesses. So, once more with feeling: this is false prosperity, one that will soon meet reality with a mighty crash. Hint: reality can't lose forever.

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copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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