Dumb and Dumber

By James J Puplava CFP, April 23, 2003

Nobody ever said that the markets or investors have to act rationally. Markets often move on emotion, respond to hype, or periodically erupt in a bout of irrational exuberance. That is certainly the case today. There is nothing fundamental in the economy, earnings, or in the geopolitical sphere that would justify today's bout of irrational exuberance. In fact, it is a perfect example of the moral hazard at work. The message from the Fed seems to be "go ahead and speculate because we will provide the economy with cheap and abundant credit, make sure markets are kept liquid, monetize debt and intervene when necessary to keep the financial markets functioning." The Fed has on numerous occasions reminded the financial markets that even if interest rates go to zero they still have plenty of tricks left to

The disconnect between Wall Street and Main Street has never been this wide. On Main Street workers, households and families go deeper into debt each month to pay their bills. The cost of everything they need is going up like food, water, utilities, medical bills, insurance premiums, gasoline, school tuition, and rent. At the same time, the cost of things they don't need such as new computers, new cars, DVD players, cell phones, and video game players are going down.

For the last few weeks, earnings reports have come pouring in. Companies are beating estimates. However, one has to ask what are estimates? Do they really mean anything when they are constantly massaged and adjusted lower to the point that companies actually meet or exceed them? As far as earnings go, an investor never knows what they are going to get when companies, analysts, or anchors report them. Earnings now come in different varieties with various expenses, charges, and writedowns routinely excluded from them. Most investors are unaware that the typical earnings reported each week that beat estimates aren't the real thing. They are pro forma numbers given by companies to analysts that typically report profits in a way that makes the company look good. They are not earnings that meet GAAP (generally accepted accounting principals) requirements. Companies are still required to file earnings reports with the SEC according to GAAP principles. However, these are not the numbers that analysts, anchors, or company PR people use in press conferences. The numbers given out by the media and Wall Street pitchmen are the pro forma numbers that in most cases exclude large expenses and write-offs.

In addition to pro forma numbers, there are no standard benchmarks for reporting even within the same industry, so when you hear an earnings report from one company and then hear another report from another company in the same industry, you are often hearing numbers that compare apples and oranges to radishes. Most companies still don't account for stock options. This practice is most prevalent within the tech industry. What's more, many companies are now starting to bury announced layoffs of workers in their press releases. Obviously, you can't report pro forma earnings and portray that things are going well when you continue to lay off more workers.

Given what I have seen in examining the earnings reports that have accompanied press releases, I have seen nothing that would justify the absurd valuations in the tech sector. At least in the mania stage of the late bull market companies routinely reported higher profits each quarter. Granted, these numbers were later proven fictional or phony, if not fraudulent. At least an investor, at the time not knowing that the numbers were fraudulent, might have had a justification for paying a higher price for what appeared to be growing earnings. Looking back in retrospect, we now know that earnings actually peaked in 1997. The advance in the indexes in 1998 and 1999 were the product of investor willingness to pay higher multiples for the same dollar of earnings.

That is certainly not the case today. Investors have been forewarned because of last year's accounting scandals that caveat emptor should be the standard practice when investing today. At a recent staff meeting with my investment team a member commented that what is different at our firm is that we don't believe what we read or hear. We spend a lot of time chasing down stories and verifying facts either with company officials, competitors in the business or with actual SEC numbers, a habit that has been honed and polished after developing a healthy degree of skepticism learned over the years through mistakes. The individual investor should be developing the same degree of skepticism now in spades. In my entire 24 years in the business, not counting three spent as an accountant, I have never seen this much hype, spin, untruth and balderdash in my entire career. I sometimes wake up and wonder if I'm living on the same planet.

This is especially true when I hear press releases coming out of the tech sector and then read the actual financial reports. What I hear on cable news channels and in various financial publications is mostly spin. Financial anchors and reporters have simply become a form of entertainment or cheerleaders for Wall Street. Last Friday Nokia's earnings report was a good example. After watching a giddy and giggly anchor announce that Nokia beat Street expectations triggering a rally in the markets, I expected to arrive at my office and read a very bullish earnings report. Instead, I read the following:

* The gain in earnings came from an accounting change in revaluing receivables by $226 million Euros.
* Without the accounting change, earnings would have been down by 13%.
* Margins fell from 24.4% in Q4 to 23.5% in Q1.
* Total sales will grow at a slower pace going forward.
* Motorola surpassed the company in mobile phone sales in the US.
* The company will trim 1,800 jobs at its network unit to help trim losses.
* Networking had a Q1 operating loss of $127 million Euros with sales sliding 15%.
* The company will take a $350-400 million Euro charge in Q2, slashing earnings by $0.05-0.06 a share to account for layoffs.
* Industry sales of mobile phones networks will drop 15% or more this year.

I would venture to say that the average cable viewer did not see this kind of report coming from cable reporters and anchors. There have been other reports coming from the likes of Microsoft, which only grew its earnings at less than 2% for the quarter, and guided earnings estimates lower in the quarters ahead. TI actually made money instead of losing it, but also reported that chip sales are running at the slowest pace in six months. Intel had lower earnings; Gateway struggles to survive and is laying off nearly 20% of its workforce. Palm, PeopleSoft, Sun Microsystems, CDW Computer Centers, electronic retailers Circuit City and Best Buys all missed estimates or reported losses. Furthermore, companies ranging from Nokia, Gateway, Applied Materials and Solectron are continuing to lay off workers after shedding workers last year.

The simple fact is that earnings aren't getting much better, there is still plenty of excess capacity, inventory channels are still building, companies lack pricing power and, as a result of lower margins and higher operating costs, are still firing workers. There is a definite difference between what is reported on cable channels and touted by Wall Street to actual conditions on Main Street. The two live in very separate worlds. One is fictional and the other is reality.

I have found most Fed officials, Wall Street economists, and cable TV anchors are clueless as to the shape of the future. How often do you hear stories about a second half recovery? This year is no different then the three years that preceded it. The earnings estimates are all backend loaded. The miracles, like previous miracles that never occurred, all take place in Q3& Q4 of this year. That way they can say that stocks are cheap when you look at forward earnings. Someone has yet to explain to me how we get from trailing earnings of $27 for the S&P 500 to yearend earnings of $48-50 by year end to give us an S&P that trades at 15 times forward earnings instead of the current 31 times earnings. Even then, the $27 figure doesn't include various expenses or core earnings, which are much lower. What I would like to know is what is going to become the catalyst this year that will give us an 80 percent increase in S&P 500 earnings?

Thank Goodness for Saddam & Osama

Looking at the current markets, I can't help from issuing a warning to those who are buying into this hype and spin. Nobody can begrudge Wall Street and cable TV from spinning the news. Wall Street is in the business of selling stocks and financial products. Cable TV needs to sell advertising and their advertisers are all in the financial business, so they have to say nice and positive things. The problem is that they aren't set up to sell hard assets or "things" which are in a new bull market. They are in the paper business. Perhaps when this bear market is over some of the paper they sell will be useful as wallpaper.

The point I would like to make here is that what is now going on in the financial markets is nothing more than a frenzied trading rally within the context of a larger bear market, which has yet to unfold. I say trading rally because that is all it is. If you are an experienced trader with tight stops and can control your emotions there is nothing wrong with trading these rallies. I have friends who are experienced traders and do well at actually trading. But they are disciplined and are cold as steel when it comes to making trading decisions; no emotions get in the way with these guys. They know they are speculating and they treat their trades in the same manner. They monitor their trades and exit from loss positions without any emotion, protecting their capital to come back and trade another day.

If, on the other hand, you spend less time making your investment decisions than you do shopping for new tires, you shouldn't be operating in this market. This market is full of hype and spin, aimed at keeping the average investor focused on anything else but the facts. The facts are terrible, so what you hear is the spin. Does anybody believe in a market that can go from double or triple digit losses to triple digit gains on the basis of a rumor of the capture of Saddam Hussein, Osama bin Laden, his brothers, cousins or whomever?

All I can say is thank goodness for these bad guys. They have saved this market from the depths of despair on numerous occasions generating miraculous flag pole rallies of redemption. Investor incredulity never ceases to amaze me. The market's ability to trade in triple digit bands, going from triple digit losses on bad news to triple digit gains based on rumors that we have captured evil villains, are right out of comic book fiction. Maybe in the future as the economic news and earnings news deteriorates these bungee jumping rallies will be attributed to Spiderman or Hulk sightings, or the appearance of Superman or Batman on Wall Street. Since earnings, actual economic reports or market valuations are no longer relevant, we can make up a completely new world of make believe. If the market goes down it is because of some new evil menace. What we then do is call on the bat phone or run ads on the cable channels calling for help from the Hulk or Spiderman.

At this point the reader should get my drift that what they see and hear each day is mostly fiction. Therefore, unless you are willing to invest long-term in the new emerging bull market in "things," or wait patiently for value plays to appear, one should stay out of this market unless you have mastered technical analysis, are experienced at applying it and can operate in this market completely void of emotion. What you don't want to get caught doing is playing Wall Street's game of dumb and dumber. The basic premise is that you buy something you are unfamiliar with at some ridiculous price. You buy based on the theory that there is another idiot standing directly behind you. The next idiot is even more gullible and willing to pay you even more, Caveat emptor!

Today's Market

Back at the casino, markets went negative and then closed positive by the end of the day. Kodak sent the markets down this morning by reporting second-quarter profits may drop as much as 29 percent. Cardinal Health reported lower revenues in the latest quarter. What rallied the markets into a frenzy is that AT&T reported a profit, thanks to a tax gain and some accounting changes that were favorable to the company. The company has
missed quarterly estimates for so many quarters that the fact they met estimates was cause for relief. The best part is that the company said going forward sales will decline by only 10 percent this year, which was better-than-expected. The company expects to do much better next quarter by paying salespeople extra commissions for stealing customers from rivals. The company is experiencing sales declines in all of its key business lines. Sales at AT&T's Internet service sector fell 1.6 percent. Consumer long-distance sales fell 18 percent. The news that got the markets excited is that the company is going back to is basic roots, which is a declining business. The company now feels that it can reasonably control the gradual erosion of its business to about 10 percent a year, which of course was much better than expected. After going on a $100 billion acquisition binge in the cable business that left the company saddled with heavy debt they have been exiting the cable business. The huge losses from this escapade has reduced shareholder equity by over 50 percent while increasing the company's debt by 26 percent. Wall Street thinks this is cause for celebration. They finally met their numbers.

This is something that is becoming all too familiar this quarter. After seeing profit warnings rise by almost three hundred percent this quarter, pro forma earnings numbers have been lowered so low that most companies are now exceeding them. This explains why there are so many warnings and so many companies beating estimates. Remember the Thomson First Call earnings estimates are pro forma numbers; not real earnings numbers. So we are still dealing with fictional numbers.

Another company that got the market juiced was Wyeth, the fourth largest drug maker. The company beat estimates by two pennies. The majority of their gain this quarter came from their sale of Amgen. Another relief to the markets is that the chief bubble maker himself, Alan Greenspan, agreed to stay on and serve another term as Fed Chairman. And speaking of the Fed, the markets seemed to ignore the Fed Beige Book released today indicating that the economy continued to slow down in March and early April. Half of the Fed districts reported weakening economic conditions. Consumer spending and sentiment was weak but the Fed blamed that on the war. The Beige Book also reported the labor markets remain weak. There was also mention of the SARS virus. The SARS virus may become the next scapegoat if things don't improve in the economy.

After the markets closed, Qualcomm reported profits that beat the Street. Excluding results from the company's QSI investment segment, the company was able to beat estimates by 2 pennies. A year ago the company reported pro forma profits of $0.20 versus the current quarter pro forma earnings of $0.38. Analysts have now upgraded the stock based on pro forma estimates this year of $1.38, which excludes losses from QSI.

Volume came in at 1.6 billion on the NYSE with advancing issues beating out losers. The VIX edged lower by .02 to 23.49 and the VXN fell .52 to 33.13.

Overseas Markets

European stocks rose, lifting the Dow Jones Stoxx 50 and 600 indexes to three-month highs amid optimism corporate profits are improving. Renault SA paced gains after its Nissan Motor Co. unit reported record earnings. The Stoxx 50 rose for a third day, adding 1.3 percent to 2368.78. The Stoxx 600 advanced 1.4 percent, with financial-services companies such as Aegon NV contributing two fifths of the gain. Benchmark indexes rose in all of the 17 Western European markets.

Japan's stock benchmarks rose, led by Fuji Photo Film Co. and other companies that rely on overseas sales, after U.S. corporate earnings boosted optimism the world's largest economy is recovering. The Topix index rose 0.2 percent to 789.35. The Nikkei 225 Stock Average was little changed, up 2.92 points at 7793.38.

Chart courtesy of StockCharts.com

James Puplava

© 2003 James Puplava

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James J. Puplava CFP
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