Is there an upside to a dip in corporate profits?July 5, 2012: 12:48 PM ET
The drop may be small, but if it persists, the decline might just get companies to start investing more.
FORTUNE – For the first time since the Great Recession, corporate profits fell during the first three months of this year. While the dip may be small, the $6.4 billion (or 0.3%) decline is significant as it just might inspire a shift in tone within corporate America, which saw profits soar even as joblessness has persisted.
Ironically enough, there's an upside to down profits: Executives may realize they need to invest more. Admittedly, weaker profits could make companies even more fearful about expanding, but given that the decline reflects slumping sales from overseas markets, it could also put new pressures on companies to find new ways to grow at home.
Economists worry that lousy corporate profits could send the economy into a full-fledged recession. It's still unclear if the latest decline in earnings will be the first of many, similar to the past two recessions, or if we will see a repeat of 1998, when the economy continued to grow even as corporate profits fell sharply. The pinch came amid rising labor costs and the inability of manufacturing companies to raise prices on its products in the face of stiff competition from abroad.
To be sure, the relationship between profits and GDP growth is not always clear cut and just because earnings fall doesn't mean the economy will follow suit. During the 2007 financial crisis, corporate profits fell in tandem with employment. But in the years following the end of the recession, profits quickly rebounded as many companies cut costs and expanded into emerging markets for growth.
Weak earnings could also send the stock market spiraling downward. This would spell bad news to shareholders in a year when some expect stronger dividend payouts. But as Paul Lim of Money Magazine pointed out recently, the fall in earnings might not drive stocks down as much as some think.
Profits influence the stock market's performance, but primarily in the long-term. Using the past as a guide, Lim argues that there's no direct correlation between earnings growth and stock price movements. Since 1938, eight of the 16 best years for stocks have coincided with declines in corporate earnings. What's more, profits rose in 13 of the 16 worst years for stocks -- further illustrating that earnings aren't a predictor of stock performance and, in fact, it just might be the other way around. There may actually be an upside to slower profits.
As corporate earnings rebounded, and then soared, over the past two years, companies remained reluctant to hire or invest more. Executives continued building record levels of cash reserves, claiming the economy looked too uncertain to justify the costs of more hiring and investing at home. Instead, many banked on sales overseas, particularly in emerging markets including those in China, Brazil and India. However, the latest earnings decline suggest that this strategy can only take companies so far.
Whereas profits from businesses at home rose at a seasonally adjusted annual rate of $41.7 billion in the first quarter, profits from the rest of the world surprisingly dropped $48.1 billion as Europe's ongoing debt crisis worsens and as China and India's economy slows down. If this continues, executives will need to re-evaluate their growth strategies, at least in the short-term. And the relatively better performance at home is reason enough for companies to consider investing more in the U.S. economy.