Blinded By Glitter
By James J Puplava CFP, June 11, 2003
First it was Intel, then it was Motorola. Yesterday it was Nokia, today it was Texas Instruments. We are now in the earnings confession season, and like previous quarters, the warnings are starting to accelerate. Although GAAP and operating earnings (CRAP*) are expected to be up year-over-year this quarter, estimates are falling this quarter and for the remainder of the year. According to estimates made by S&P GAAP, earnings are trending as follows:
|Q1||$ 9.19||Q1||$ 11.19|
As you can see from the estimates and comparisons at the right, the earnings trend is an improvement from last year. However, recent estimates are trending lower as more companies have issued warnings. If there is going to be a second-half recovery, it hasn't shown up in earnings estimates nor has any guidance been given by companies when they warn or report. The sizzle or the spin is that things have improved. This is true. If you look at where earnings are this year compared to where they were last year, there has been a definite improvement. That is the good news. The bad news is that most of this improvement has come from cost cutting. This has meant laying-off more workers.
Now earnings are starting to stall again as companies come up against the headwinds of rising benefit costs in the form of higher wages and labor costs, that are growing faster than productivity, and higher medical and pension costs. Margins, profits, and cash flow have started to flatten if not decline as costs rise faster than the ability of companies to raise prices. This is one reason companies have been issuing warnings and why earnings estimates have come down as shown above for S&P companies.
Wall Street is selling the sizzle without the steak.
The story this year like last year is the belief in a second-half recovery. If there is a recovery out there, it isn't showing up in earnings, nor is it audible at company press conferences. The hype coming from Wall Street and the financial media, and what companies are actually reporting is wide enough to fly a 747 through it. In addition, there is no mention of just how expensive stocks have become in relation to earnings. I know many on the Street believe that we are in another new era where earnings don't matter earnings, that is, of the traditional kind as represented by GAAP. The Street prefers to look only at the movement of prices. If you insist on some metric of value, then they quickly refer to the CRAP numbers, which make stocks appear less overvalued. But numbers are what they are and you can use any numbers you prefer. I was shocked the other day when an analyst on bubble vision used 2007 estimates to justify a P/E of over 100 for an Internet stock. In fact, I've noticed that reference to 2004 and 2005 earnings are now being used on a regular basis.
What galls me is this: if analysts can't predict with any degree of accuracy where earnings are going to be next quarter, what confidence should investors have that their forecasts for 2004 or 2007 are going to be any more accurate? The only improvement that we see in earnings is with the CRAP estimates listed below.
|2003 Pro Forma Estimates (CRAP)|
The CRAP estimates remain high, which is why Wall Street uses them. These aren't the numbers that get reported on the financial statements sent into the SEC, nor are they the official numbers inked in the company's annual report. But for now investors are buying the glitter, not the facts. What continues to amaze me is after taking devastating losses on stocks after the technology bubble burst, investors and I include professionals in this category continue to chase after stocks with no earnings, declining earnings or major losses. This trend has carried into the markets in a major fashion. The biggest performers this year have been the following:
- Stocks whose earnings have declined over the past two years.
- Stocks with operating losses over the last 12 months.
- Stocks whose earnings are unpredictable and erratic.
- Stocks with negative analysts' earnings revisions.
- Companies whose balance sheets are deteriorating and whose profit margins are falling.
At first these statistics may be appalling, but I assure you they are consistent. When you invest in a market where CRAP earnings have become the new standard, it is only natural that the CRAP companies would outperform the GAAP companies. This is a market where glitter sells and facts don't matter. I find it more remarkable that after taking a shearing these last three years, investors have fallen into
What is even more remarkable is the ability of the markets to rally suddenly in the futures pit after bad news is reported. It doesn't matter what the news is; when the market starts going down upon the release of bad news, the market always rallies beginning first in the futures pits. Yesterday the markets started to weaken again when reporters said that a large unknown buyer started buying heavily in the futures pits. Markets always rally consistently after a few down days, almost as if some invisible hand has put a floor underneath the markets. Weakening economic reports, disappointing earnings, layoffs, rising energy prices, mushrooming consumer debt levels, skyrocketing budget deficits, record trade deficits and a falling dollar are accompanied by rallies in the stock and bond markets. The worse the economic news becomes, the better the markets perform. The US has the lowest savings rate, the highest trade deficit and some of the highest debt levels of any of the G8 countries. Yet it enjoys the lowest interest rate out of any of the major G8 countries with the exception of Japan.
What has become predictable is that if the markets sell off sharply, in one or two days a major rally will follow beginning with a large buyer showing up in the futures pit buying futures at any price. If a bad economic report comes out such as a jump in the unemployment rate the markets are sure to rally. If a major accounting scandal surfaces such as today's announcement by the SEC of a formal criminal probe into the accounting practices of Freddie Mac the markets will rally. If a company warns that sales or earnings will be less than expected, the markets will rally if not that day, then assuredly the next day. If there is a terrorist attack or a geopolitical event, the markets rally. The invisible hand makes sure that no matter the economic, earnings or political news, there is always an unknown buyer willing to step up to the plate and buy S&P futures at prop-up prices. Adam Smith always talked about the virtues of the invisible hand at work in the market place. We are truly blessed to have an invisible hand at work in our financial markets.
The Pro Forma Economy
Speaking of other works of fiction, I'm always amazed at how new and improved statistical measures used by government statisticians continue to make the economy improve. Just recently, although the unemployment rate went up again last month to a nine-year high, new statistical measures made the previous month's job losses of 48,000 completely disappear. Our GDP numbers are becoming one of the 7 Wonders of the World. We are able to translate a nominal improvement in technology sales into hundreds of billions of dollars of new GDP. Nobody actually received these new inflated statistical dollars not the manufacturer, nor the retailer of these goods but they still showed up in the GDP numbers.
You may also be surprised to find out that one reason inflation levels have remained low while the prices you pay for things keeps going up is due to statistical tinkering as well. Quality improvements in products such as automobiles are used to reduce the price of the car. The car price actually went up, but this price increase is not included in the way we compute inflation. We also use other statistical measures to improve GDP. The government imputes a hypothetical value from rent, if you own a home, and adds that to GDP. They also include imputed income from free checking accounts and add that to GDP. Now they are studying the value of domestic chores performed around the home for their beneficial inclusion to enhance GDP. If you mow your lawn, clean your home, take out the garbage, wash your windows or car, or baby-sit your kids, these are services performed that save you money. If you didn't perform these services yourself, you would have to hire someone else to perform them for you. Therefore, to government statisticians, they have hypothetical GDP value.
The Perpetual Bull Market
Some day in the future we could have an economy that is always improving, where job losses never take place and where there is never any inflation, thanks to the wonders of pro forma accounting and statistics. By simply mowing your lawn twice a week, taking out the garbage every day instead of once a week, we could expand GDP indefinitely. Seasonal adjustments could then be used to eliminate unemployment. If companies lay off more workers, simply adjust them seasonally and send these unemployed workers to statistical heaven. We could then use hedonic adjustments to enhance all production numbers and services. Thus, in the future, our economic well being will be based on borrowing money, spending it and trading paper assets for extra income. The more credit that the Fed injects into the economy, the more added credit could be used to create and inflate various asset bubbles. We could have constant rising stock markets, rising real estate prices and rising commodity prices. This wouldn't be known as inflation. The proper term would be "bull" markets and they would be perpetual. We would then become a nation that borrows, spends, and trades for a living.
Back at asset Disneyland, the markets went down at the opening. Then they began to rally first in the futures pit as the invisible hand was at work again and then rallied in flagpole fashion the rest of the day. (See chart above.) The markets simply ignored warnings coming from Texas Instruments and the formal announcement by the government of a criminal and securities probe into accounting practices at Freddie Mac. The top three officers at Freddie Mac were fired in the midst of an audit. The speed of the criminal investigation into Freddie reflects the seriousness of the charges. Congress is now planning a hearing on Freddie Mac's accounting. And by the way, both Freddie and Fannie own or guarantee 42% of the $6 trillion mortgage market.
What the markets focused on instead was a Merrill Lynch report that said IBM won't be harmed by the government's probe into the company's accounting practices. The market rallied further in flagpole fashion after the Fed announced the results of its latest Beige Book on economic conditions. The Fed reported that the U.S. economy continued to grow at a "sub-par" pace since April despite the lowest interest rates in half a century. A Wall Street money manager stated that the actions of the markets to continue to rally on worsening economic and financial news is a sign that we are definitely in a new bull market. The markets continue to go up, notwithstanding the work of the invisible hand, over optimism that the Fed will once again cut interest rates this month and flood the economy and the financial system with more credit.
IBM was the biggest contributor to the Dow's advance following the statement from Merrill Lynch that the government's probe into how the company accounts for its sales won't hurt the stock. The only stocks hurt today were chip stocks. Companies within the sector continue to report lower sales or profits. The Semiconductor Industry Association dropped its 2003 growth targets to 10.1 percent from a former range of 10-15 percent. Next year's target of 22.8% growth has also been reduced to 16%. Futures on the Chicago Mercantile Exchange rose 10.50 to 997.20.
Volume came in at 1.5 billion on the Big Board and it hit 1.9 billion on the NASDAQ. Volume on the NASDAQ has improved considerably indicating the little guy is coming back into the market in addition to speculators. Advancing issues outdistanced decliners by a 24-9 margin on the NYSE and by a 19-13 margin on the NASDAQ. The VIX barely budged by .01 to close out at 22.12; while the VXN edged lower by .26 to 33.74.
* CRAP is an acronym for Cloudy Reporting Account Principles.
Charts courtesy of www.stockcharts.com
© 2003 James Puplava