The Earnings Game and Other Bull Markets (The Silver Streak)
By James J Puplava CFP, July 28, 2003
We are now at halftime for Q2 earnings. As usual companies have beat estimates. There is nothing new there because that is the way the game is played. Company's lower guidance, analyst's lower estimates, and then companies report actual results that beat forecasts. You would never really have a good handle on things if you listened only to financial reports coming from the financial media. "Times are good and getting better" and "This is a new bull market" are constant mantras repeated every day and every week. The bulls site rising stock prices as evidence that a new bull market has begun in stocks. There is another bull market going on that nobody talks about that I will get to in a moment. For now I want to cover the earnings story since that is the topic d'jour. Earnings look good as long as you don't ask questions.
The recent rally in stocks since the end of Gulf War II has been based on expectations for an earnings rebound. The simple fact is that year-over-year earnings have improved, but that isn't saying much. A year ago with accounting scandals, goodwill write downs and other restructuring charges, earnings were pretty lousy. Since then they have improved as companies have taken deliberate action to stave off cash drains due to lack of pricing power which has led to lower profit margins. Now that over 60 percent of all S&P 500 companies have reported earnings, we are getting a better picture of the way things could shape up for the rest of the year.
To start out, earnings for S&P companies have risen over 8 percent from a year ago. That has topped analysts' estimates of 5.3 percent. This is the bull story that you hear almost daily, "earnings are beating estimates." These numbers sound good only if you forget that at the beginning of the year Q2 estimates were supposed to rise 11 percent. After Q1 results were reported, analysts slashed estimates by more than half to the now present 5.3 percent number. By lowering estimates to a level this low, Wall Street gave companies a wide swath in which to easily beat the numbers. Yes, companies were able to beat expectations, but only because those expectations were lowered dramatically. So the good news is that companies are beating estimates, but only because those estimates keep moving lower.
The next question is how companies are improving earnings. Is the improvement coming from higher top line sales growth and higher margins which would indicate an improvement in the earnings environment? Unfortunately the answer to both questions is no.
An analysis of earnings indicates that, like the previous five quarters, the improvement in earnings is mainly coming from cost cutting. Top line growth has been hard to come by so companies are still relying on cost cutting to improve their profits. In addition to cost cutting another enhancement to earnings this quarter has come from a declining dollar which has made overseas earnings more valuable when translated into domestic dollars. Foreign currency gains added about 2-3 percentage points to profits this quarter. Without them companies would have reported earnings at the lower estimated number of 5 percent. On a trade weighted basis the dollar has fallen 9 percent since reaching its peak back in February of last year. Since the dollar is expected to decline even further, currency gains remain one of the bright spots on the earnings front.
Finally the issue of earnings quality isn't addressed adequately in company press conferences or by media coverage. In the words of UBS analyst David Bianco, "In our view, the quality of earnings for the S&P 500 from an accounting standpoint is the worst it has been in more than a decade."
Companies still routinely exclude stock option expense which overinflates income. In addition to stock option expense they also overstate earnings by overinflating returns on pension investments. Many company pension plans have been losing money while their pension assumptions remain positive.
The gulf between pro forma earnings (C.R.A.P. - cloudy reporting accounting principles) and real earnings (GAAP - generally accepted accounting principles) keeps getting larger. Last year GAAP earnings for the S&P 500 were $28. The pro forma numbers used by Wall Street and the financial media was $47.26. We are seeing growth rates in pro forma earnings that veer far away from actual earnings numbers according to GAAP. There is also a widening canyon between the operating numbers used by analysts and anchors and those reported to the government and used in the national income accounts.
We are still dealing with bogus numbers, a fact that is starting to get the attention of foreign investors that the U.S. markets are no longer clean. Last week the Financial Times ran an article on the rigging of the U.S. markets. It may be one reason that many foreign entities are pulling out of the U.S. We once were considered to be the model that other markets strived for; now we have become the one they try to avoid. Over the weekend the ECB recommended that all of its member central banks dump all of their holdings of Freddie Mac and Fannie Mae due to accounting irregularities. Freddie Mac is currently under investigation by the SEC and federal prosecutors after understating earnings by $4.5 billion leading to the resignation of the firm's top three execs. Foreign institutions and governments are now starting to pay more attention to accounting issues and earnings quality. The constant accounting scandals are starting to get everyone's attention overseas, even though they are ignored by investors domestically.
There is a lot riding in this market on a second half recovery. There are big expectations for earnings in Q2 & Q4, especially in the tech sector. There is nothing reported, at least so far that would support these expectations. This means at some point, either in September if not before, when companies start confessing Q3 results a serious realignment of expectations is going to take place. Unless the dollar plunges rapidly enough to impact earnings through currency gains it is hard to see where the next earnings catalyst will come from. Wall Street's credibility is now at stake. The Street has been predicting a second half recovery for four years now. Now it is time to pony up and deliver or face a severe retraction. The recent rally has gotten way ahead of even the most optimistic expectations with stocks now sporting bubble valuation in almost all indexes. As of the close today the Dow is selling at 30X trailing earnings, the S&P 500 trades at 29X 12 month profits, and the Nasdaq 100 is selling at 233 times trailing profits. That is a market that is priced for years of perfection when none actually exists.
The Silver Streak
There is another bull in town that is starting to get investors attention which is the precious metals and energy markets. Gold is in a new bull market and has been recently joined by silver. Silver has risen more than 10 percent in seven trading days last week and was up another $.12 today to close at $5.195. That price increase has moved up with increased volume to hit $5.20 intraday. This has gotten the attention of many precious metals bulls. Up until now silver has failed to confirm the new bull market in gold. Just as in Dow Theory the Transports and Industrials must confirm each other, it is the same in the precious metals markets where silver is an important confirmation of gold.
Many silver bulls, I include myself as one of them, believe that the upside potential in silver is enormous. James Turk, editor of the Freemarket Gold & Money Report, thinks that silver could hit $6.45 by September. I personally believe that silver could actually go much higher. The reason is that there isn't much of it around and what there is has been shorted heavily. Large monster short positions on the COMEX have kept silver suppressed now for more than a decade. As I wrote in my last Storm Update, "Silver, an Undervalued Asset Looking for a Catalyst", shorting silver has been a one-way trade. The shorts have controlled the silver market for far too long. They have shorted the bullion and they have shorted the stocks. As shown below, short positions in the silver stocks went up last month and are up substantially over the last year.
|SHORT POSITIONS IN PRECIOUS METALS STOCKS|
|Company||Q2 2002||Q3 2002||Q4 2002||June 2003||July 2003||% Mo||% Qtr|
|Golden Star Res.||61,330||122,991||198,991||798,811||1,271,142||+59.1||+1,202|
|Source: Nasdaq MarketData Short Interest Survey|
Part of the jump in silver stocks this last week (many are up over 30% in a week) is due to short covering. The shorts have kept prices suppressed and have afforded investors an opportunity to pick up the bullion and the shares at extremely depressed prices. This is just the beginning of a decade long bull market.
The best thing about this new bull market is that it is still in its formative stages. The press spends very little time talking about it; it isn't followed by Wall Street, few institutions have put money in it, and it is ignored by the investment public. That is how new bull markets begin. Institutions and the investment public are still foolishly chasing the last bull market bidding up the shares of tech companies and Internet shares to absurd levels again. Even though the mania returns to Wall Street the precious metals markets have soared and held up well during the recent stock market rally. Everyone is gloating over the double-digit returns in the NASDAQ this year. Small cap stocks are in again and have been among this year's top performer. However, you hear very little about small cap junior mining stocks which are also soaring. Some of these stocks are up 600-1000 percent over the last couple of years. If you want to talk about larger issues consider this point; the Amex Gold Index (HUI) is up 305% since January 2001. The hedged Philadelphia Gold & Silver Index (XAU) is up over 80% over that same period. Don't you think if tech stocks were up over 300%, it wouldn't be front page news?
It is a shame that Wall Street and the financial media continuously goad investors into overvalued tech stocks at a time that insiders are selling at record levels. It just proves the point that old bulls die slowly and new bulls emerge reluctantly. As gold and silver prices double, triple and quadruple, they will eventually catch on. In the meantime the astute investor has the opportunity to buy actual bullion (suggest paying cash and taking delivery) while prices remain cheap because of heavy shorting, manipulation and disbelief.
Keeping An Eye on Energy Too
Another bull market is also emerging in the energy sector. Despite the ending of major hostilities in Iraq, oil and natural gas prices remain stubbornly high. It will be years before Iraqi oil can successfully come on stream to relieve pricing pressures. In the meantime, OPEC will keep production under control which means higher oil prices are here to stay, especially as many countries have already reached peak production limits and are now in decline such as Britain�s North Sea.
A bullish picture is also starting to emerge on the natural gas front where experts now all agree the U.S. faces a short-term crisis. There are two camps when it comes to natural gas. There are the depletionists who believe that natural gas production will peak at 130/tcf year by 2030. The anti-depletionists believe that supplies will last throughout this century. What we do know is that annual average production growth rates have fallen in each decade. They were 3.52% from 1970-1980, 3.15% from 1980-1990, and 1.97% from 1990-2000. Furthermore, most of the bulk of the world's untapped gas resources remains in remote and isolated locations. This makes transportation costs a key issue in getting at available supplies. These remote locations are far away from major gas markets. Since many gas users such as the U.S. lack adequate infrastructure for handling transported gas (LNG) the hurdles for development are much greater. This is one reason why prices remain high. We are in the middle of summer, a time when gas prices are expected to fall because of weak demand due to nicer temperatures and new storage injections. Yet closing prices today at $4.70 are well above projected average prices for this year of $3.50.
While experts disagree over the future peak of natural gas production; they all agree that North America and Western Europe face near-term production peaks. This means the U.S. as it is in oil will become even further dependent on its future energy needs. According to the EIA in its 2003 International Energy Outlook, 71% of the world's gas reserves are in the Middle East and former Soviet Union. Russia and Iran account for 45% of the world's natural gas reserves. This bodes well for Middle Eastern nations that will become even more dominant in their control over the energy sector. With the major share of the world's oil, and now natural gas, the Middle East will become a more important balancer in meeting western countries' oil and natural gas needs. One of the pictures that I see emerging in this next decade is the growing importance of natural gas in meeting the world's energy needs. The three major plays of this decade are going to be in precious metals, energy and in water. Within the first two, silver and natural gas will become the best performers within those respective groups. We have been positioning our portfolios along these lines since the beginning of my Storm Series.
Back in today's markets, stocks had difficulty maintaining gains despite Wall Street upgrades of Disney and AT&T. The blue chip indexes were down while the NASDAQ pulled a rabbit out of the hat to end up in positive territory. Everything is on hold this week ahead of important economic reports. Tomorrow we get consumer confidence numbers. On Thursday we get an advance report on Q2 GDP and the jobs report. On Friday the markets will have to digest ISM manufacturing reports. Also weighing in on the markets has been the recent rise in interest rates. Today was no exception as bond prices plunged with the yield on the 10-year note rising to 4.305% and the yield on 30-year bonds rising to 5.23%. The bond markets lost ground on news of the Treasury's major debt calendar during the second half of the year. The Treasury will have to raise $230 billion to fund this year's deficit. The government reported that it will need to borrow $104 billion in the July-September period and $126 billion in the subsequent three months.
The rise in yields in some quarters is being attributed to comments made last week by Alan Greenspan and Governor Ben Bernanke. Both the Fed Chairman and Bernanke expressed optimism in the economy's recovery. Mr. Greenspan, known for his inability to spot bubbles, believes that economic growth next year could approach between 3.75- 4.75%. The Fed is doing all it can to reinflate the economy and the financial markets. It appears that Wall Street and investors believe the Fed will eventually prevail. However, for bond investors who bought 10-year notes last month at their low point, now sit on losses of almost 9%. We have now done in one month what it took almost six months to do in 1994, the last time we has a bond market crisis.
Fed officials are still sticking to their robust economic forecast with Federal Reserve Bank President of Chicago, Michael Moskow, saying that tax cuts, productivity gains and the lowest interest rates since 1958 are going to give us a robust economy in the second half of the year. The Fed's message for the second half of this year is "robust growth without inflation."
Wall Street analysts believe that bond yields can continue to rise without much impact on the stock market because of robust pro forma earnings growth now projected to grow at 13.1 percent for Q3 and 21.6 percent for Q4. What the real numbers will be is anyone's guess.
Volume trimmed back to 1.28 billion shares on the NYSE and 1.53 billion on the Nasdaq. Market breadth was negative by 18-15 on the Big Board and positive by 19-12 on the Nasdaq. The VIX edged lower by .01 to 19.93 and the VXN rose .36 to 30.40.
* FULL DISCLOSURE * The author, James J. Puplava, owns silver and gold bullion & equities as well as foreign government bonds for client and personal accounts.
Graphic Source: www.StockCharts.com and Wall Street Journal
© 2003 James Puplava