Here comes the big profit lie

January 6, 2012: 5:00 AM ET

Wall Street expects corporate miracles in 2012, and that means trouble.

By Geoff Colvin, senior editor-at-large

FORTUNE -- Brace yourself for an increase in stupid, misleading, or illegal action by U.S. companies. The trend is inevitable. In fact, odds are it's already under way.

The problem is an old one, but we haven't seen it in a while, and memories are short. It's profit expectations -- they're insanely optimistic. Companies and the Wall Street analysts who follow them are forecasting profit increases that make Pollyanna look like Nouriel Roubini, which is not a pleasant image to contemplate. As managers strive desperately to make their impossible numbers, some will go astray. When reality catches up with them, investors will suffer. We saw it in 2006 and 2007, when analysts expected the global economic boom to go on forever. We saw it at a historic scale in the late '90s.

Now analysts and companies are projecting that after rising at rates of over 30% a year, profit growth will moderate -- not a blinding flash of insight given America's creeping economy, slowing growth in Asia, and potential cataclysm in Europe. Nonetheless, even in that profit-hostile environment, they're still forecasting strong, double-digit profit growth next year.

It makes no sense. Corporate profits as a percent of GDP are near their post-World War II high of about 10%, which was reached at the apex of the last boom. Are they really going to gallop ahead from that level? Their postwar average is about 6% of GDP. Long term, profits can't grow faster than the economy. Of course some of those profits come from regions growing much faster than the struggling West, but that provides little comfort. The World Bank's forecast of 2012 world GDP growth is all of 3.6%. Yet analysts surveyed by Thomson Reuters expect S&P 500 profits to grow 10% next year.

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It's not that the analysts are oblivious. It's that they're forecasting profits for individual companies, not for the whole market, and they still tend to fall in love with the companies they're covering. They also still rely heavily on guidance from those companies. So they repeatedly fool themselves into believing that even if the economy is going nowhere, the company they're analyzing will blow the doors off. And occasionally they'll be right. The result is that individually they think they're being reasonable, yet collectively they're nuts.

Managers get punished harshly for failing to meet expectations, even unrealistic ones, so in growing numbers they'll try to hit their targets by doing things they shouldn't. Think of them in three categories:

Stupid: The easiest way to hit profit targets is to cut expenses. Trouble is, many of the expenses that managers most frequently cut -- R&D, marketing, and employee training -- are expenses only under accounting rules; they're actually investments that pay off later. Unfortunately for those managers, investors aren't as clueless as they think. Research shows that markets whack the stocks of companies that cut today's costs in ways that hurt tomorrow's performance.

Misleading: Worse than misguided slashing, because it's harder to detect, is playing the accounting rules like a fiddle. Think of Enron's special purpose entities, which enabled it to increase profits through outfits in which it owned only a 3% stake.

Illegal: Various federal crimes can boost earnings impressively. HealthSouth (HLS) fraudulently adjusted its estimates of how much it would collect from customers; five CFOs went to prison. Capitalizing expenses makes costs magically disappear; that's what WorldCom did in a bigger way than any company before or since.

All those moves were committed by managers trying to meet profit expectations that couldn't be reached responsibly. Companies can at least reduce the temptation by refusing to make forecasts of their own, but for most the prospect of publicly dialing down expectations is just too painful. So the expectations live on, and managers keep trying to meet them. Most harmfully, many investors believe them -- even when, as now, they're clearly in fantasyland.

This article is from the January 16, 2012 issue of Fortune.

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