SERIOUS MONEY:Many investors believe a profit recovery is on the way, but their optimism may prove misguided, writes CHARLIE FELL

HOLLYWOOD'S VERSION of The Wizard of Ozpremiered on this day in 1939.

Judy Garland's portrayal of Dorothy propelled her to stardom, not only for her acting abilities but also for her memorable rendition of Over the Rainbow. As she famously sings: "Somewhere, over the rainbow, way up high, there's a land that I heard of once in a lullaby."

Fairytales are not confined to Hollywood, however. The recent earnings reporting season has resulted in investors on Wall Street reaching “beyond the rainbow” where “happy little bluebirds fly”. Observers could be forgiven for thinking investors, like Garland, have developed an unhealthy appetite for “happy” pills in their search for good news.

Completion of the second-quarter earnings season should see corporate profits drop 19 per cent year-on-year. While this represents a vast improvement from the almost 40 per cent fall during the first three months of the year, the cumulative decline in earnings per share since the profit cycle peaked in the second quarter of 2006 ranks among the worst downturns of the past century.

Those fictional operating numbers, which exclude all the bad stuff, have more than halved over the past two years – and are exceeded only by the savage declines that accompanied the first World War and the Great Depression. The 90 per cent drop in reported earnings over the past eight quarters is the largest since record-keeping began more than a century ago.

Investors found reasons to be cheerful, however, as roughly three-quarters of the companies in the SP 500 beat expectations, the largest margin of outperformance since Thomson Financial began keeping records in 1994.

Furthermore, following three quarters in which the number of companies guiding analyst estimates lower vastly exceeded the number guiding estimates higher, the trend has reversed. The senior management of 45 companies raised guidance during the reporting season, against just 13 who did so two quarters ago, while 30 lowered guidance, down sharply from 79 six months ago.

The trends underlying the current earnings season are positive. But digging below the surface reveals that the upside surprise to low-ball estimates is explained by an intense focus on cost containment. Revenues disappointed once again and registered a double-digit percentage decline year-on-year for the third consecutive quarter. But the merchants of blue-sky thinking have dismissed the fact that corporate America cannot cost-cut its way to prosperity and have pencilled in a sharp rebound in profitability for the remainder of 2009 and beyond. They were wrong before and it is likely they will be again.

The downside to aggressive cost containment is that it adversely affects the final demand upon which robust earnings growth depends. Aggressive wage cuts and widespread layoffs have resulted in employee compensation dropping to just 44 per cent of gross domestic product.

Pretax household income dropped 3.4 per cent year-on-year in June and little relief is in sight with the average work week close to a record low and the unemployment rate almost 4½ percentage points above potential.

Although household debt fell for the first time on record in the first quarter, it is still climbing relative to personal income, at 115 per cent compared to 78 per cent a decade ago. And while the household debt-service ratio of disposable income has inched lower due to the fall in interest rates, it is still near record highs of 13½ per cent.

The consumer is simply not in a position to be the engine of recovery from the current recession and the emergence of a robust earnings expansion in the absence of a fully participating consumer is unheard of since the second World War.

The corporate sector’s fortunes are inextricably linked to the economic cycle and the impending recovery will not be sufficiently robust to sustain a marked rebound in profitability.

The manufacturing industry is already drowning in excess capacity with utilisation rates below 65 per cent. Modest economic growth in the year ahead will do little to eliminate the surplus and pricing power will remain largely absent.

Despite the perma-bulls’ protestations to the contrary, inventories remain excessive when viewed against the unprecedented 18 per cent decline in sales.

The 8 per cent year-on-year drop in inventories barely exceeds that seen at the bottom of the mild recession in 2001. It is thus clear that price discounting will remain a consistent feature of the business environment.

The second-quarter earnings season is almost complete and investors have interpreted the upside surprise as evidence that a V-shaped profit recovery is imminent. But revenues continue to disappoint and nominal economic growth in the year ahead is likely to run at roughly half the rate that produced the earnings recovery in 2003.

Investors would be well advised the heed the words of Garland when she quipped that “behind every cloud is another cloud”.