Weekday Commentary from Jim Puplava
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P-P-T To The Rescue!
Ned W. Schmidt |
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Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Wednesday's Stock Market WrapUp
No Trust in Financial Statements
Last fall I took a graduate course in forensic accounting. I felt at the time that companies were getting too creative in the way the books were cooked and felt it was time for another refresher course. As we went through each chapter of the course, I remember my professor saying, "You can’t take any number on the financial statement at face value." It didn’t matter whether you were looking at the income statement, the balance sheet, or the statement of cash flows. You started with the footnotes and rebuilt all of the financial statements -- only then could you look at truly analyzing the company. Each week the thesis was, "You can’t trust the numbers." Distrust and then verify became the new "modus operandi" in financial accounting.
I thought at the time how sad it was that you could no longer trust the financial statements. What good were financial numbers if they were designed to obfuscate the truth? We then found out you could no longer trust the accountants. It was another sad chapter when the keepers of the books were no longer trustworthy. The accounting scandals were followed by Wall Street analysts’ scandals -- which was nothing new. Anyone with experience in the business never would believe the ridiculous reports that came out in the late 90’s showing that stocks were in a new era and therefore deserved different valuations. That claptrap was designed for public consumption. Anyone with experience knew better.
Scandal du jour
Today we now have to deal with WorldCom, which hid $3.9 billion in costs that helped to boost profits. The company will now be forced to cut 17,000 jobs and try to persuade banks, such as J.P. Morgan and Citicorp, to extend $5 billion in new credit. What WorldCom did is no different from what the government has been doing for years with the GDP numbers. WorldCom capitalized costs instead of expensing them. By capitalizing costs, they showed up on the balance sheet rather than as expenses on the income statement. This is no different than what the Bureau of Economic Analysis does when it includes software as a capital expenditure instead of an expense. It over-inflates GDP numbers in the same way WorldCom inflated its profit numbers. The use of hedonic indexing and software capitalization has over-inflated the GDP numbers for years. As I wrote in my Perfect Storm Series, this created the false impression during the later 90’s that the economy was growing much faster and was more productive than actually reported. So why should we be surprised at what WorldCom did? The government is still doing the very same thing in the way it treats software and computer technology sales. In the case of hedonic indexing, it is over-inflating sales.
The latest WorldCom scandal is one more example of the 1990’s myth of a new paradigm. At least in the 80’s the numbers were a bit more real. We were actually making things. In the 90’s, most of the profits at the corporate level and the economic numbers are proving more and more to be a mirage--a figment of the imagination--developed with creative accounting on the part of corporate accountants and government statisticians.
What these recent financial revelations and the Washington scandals of the 1990’s point to is this: we are a society badly in need of a moral compass. Unfortunately, integrity, moral principles, righteousness and truthfulness cannot be legislated. There are either innately held as core beliefs, or they are not held at all. With ethics and moral integrity no longer held in high regard, or disparaged as they were in the 90’s, we should not be surprised at the daily headlines. We have moved as a society away from any moral beliefs. Holding religious convictions or believing in right or wrong is discouraged. Even on a day such as this, the San Francisco Federal Appeals Court struck down the law that inserted "under God" into the Pledge of Allegiance, ruling that the phrase violates the rights of impressionable schoolchildren. The courts ruled in favor of Michael Newdow, an atheist, who believed the pledge interfered with his right to direct religious education.
Apparently the belief in God was offensive to an atheist and the courts have now denied that right to others. The majority of Americans hold a belief in God. America is about freedom of religion. There are many faiths in this land that believe in a higher being. Belief in a religion normally inculcates one with a moral belief system -- a belief system that teaches one there are rights and there are wrongs. When we work as diligently as we are now through our court system to remove all beliefs or mention of God, then we are going to have more Enron’s, Global Crossing’s, and now WorldCom’s. When people are brought up to believe in no moral absolutes, then whatever you can get away with or whatever makes you feel good will only lead us into greater moral decay. In the words of Frederick Douglas, "The life of the nation is secure only while the nation is honest, truthful, and virtuous."
Today’s Market
In today’s market it appears obvious that the PPT was hard at work. I was literally having a conversation with someone when I looked up on my screen and watched the markets move from new benchmark lows into positive territory. The daily chart of the Dow Industrials looked like a NASA space launch and it was occurring in real time as I watched the numbers climb from the negative to the positive in a matter of a few minutes. It reminded me of a trip I took last year on a nuclear submarine when the ship’s captain took us from depths of 750 feet to 100 feet in a few minutes. I recall watching the depth meter on the con as the numbers quickly rolled up. I had that exact experience today. The gentleman I was talking to was a credit analyst and his screen was tuned into the same chart. It was a heroic effort that took the markets from the depths of the abyss. At the end of the day, however, it failed. The Dow and the S&P 500 both finished in negative territory while the Nasdaq managed a tiny gain.
It now appears necessary to intervene in the financial markets, the currency markets, the commodity markets, and into our credit system to keep things functioning. History teaches us that all intervention fails and that the markets eventually win out in the end. Intervention simply postpones the inevitable and creates new distortions.
Watch for Other Developments
As a new financial scandal hit the airwaves and as the dollar fell overseas, there was a war going on in the gold markets. Gold was rising as investors sought shelter against the coming storm. It became necessary to suppress its price. With all of the negatives of the economy, the stock markets, credit system, and the dollar all imploding, it has become harder and harder to keep the sheep corralled, and a few are leaving the pen. The rest of them are spooked. The next big scandal, and I really mean "big," is going to make the Enron’s, Global Crossing’s, and the WorldCom’s look like venial sins. This scandal, which is now being talked about around the globe, is the coming "gold scandal." This scandal involves the suppression of gold and silver prices by bullion banks, hedge funds, and some of the gold industry. Right now the notional value of gold derivatives is close to $280 billion. It is taking larger amounts of derivatives to keep the price suppressed. At some point that will no longer be possible; the markets are much bigger than the short sellers. More and more sophisticated investors and governments are becoming aware of the short seller’s predicament.
Rather than belabor this issue here, I would encourage reading the recent editorials by James Sinclair & Harry Schultz posted on this site. They explain the dangers much more succinctly. I would also recommend reading my Storm Updates, Rogue Waves & Standard Deviations Part 1 and Part 2, for more information on this danger. Suffice to say when this next scandal envelopes the markets, it is going to take down some big financial institutions with it. The financial markets will reverberate for years in its aftermath.
Other Market News
Back in the financial markets, WorldCom took center stage. But there were other scandals and wrong doings that continue to make headlines. An affiliate of the accounting firm, Ernst & Young, was fined $400,000 by the SEC for compromising the independence of its audits. Tyco’s Ex-CEO Kozlowski faces new charges of evidence tampering in a tax case. Qwest shares plunged 57% after regulators said the company would be forced to restate its financial results, and shares of Martha Stewart Living continue to fall on insider trading concerns.
These scandals overshadowed the Fed meeting and positive economic data. In many ways, the Fed has now become irrelevant other than its ability to monetize financial assets through intervention in the financial markets. Even today’s news on the housing bubble, which is still inflating with record new home sales, failed to garner attention. The media loves a good scandal and now they have many from which to choose. Maybe Hollywood will come out with a new hit show like the "Sopranos" and call it the "Accountants," or maybe it will be another series such as "Dallas" with an evil and corrupt CEO. Another suggestion might be to televise the hearings of Martha Stewart, Dennis Kozlowski, Bernie Ebbers, or maybe a few of the celebrity analysts of the Internet and telecom boom. It is hard to believe that a Salomon Smith Barney’s chief telecom analyst cut his rating on WorldCom to "under-perform" on Monday. This same analyst has maintained a "buy" recommendation on WorldCom from April 1997 through April of this year. His last under-perform rating was issued on Winstar Communications a day before it went bankrupt.
The comeback in stocks today was being spun as a positive as a result of the Fed standing pat on short-term interest rates. It was a day punctuated by sharp downdrafts that were miraculously followed by sharp explosive rallies. It was one of the heaviest trading days of the year. Volume on the NYSE came in at 1.99 billion and 2.06 billion on the Nasdaq. Despite efforts to resuscitate the major indexes, market breadth was decidedly negative by 19 to 13 on the big board and by 21 to 14 on the Nasdaq. There was red everywhere, especially in financial and banking stocks. With a possible WorldCom default and problems in Brazil, shares in J.P. Morgan Chase and Citigroup were among the Dow’s biggest decliners. These two banks are in all of the wrong places. They are also bullion banks that are involved in the huge short position in gold. It is the growing sense that these banks may be heading into trouble, causing investors to dump bank stocks, especially the big New York banks. Despite the fears over WorldCom, the bulk of their debt is in bonds; it will be investors and holders of bond mutual funds that bare the brunt of WorldCom’s pain.
The events of today may get us closer to the capitulation phase of the market. To get us to the next phase, it may take a bit of confidence building, which Wall Street and the financial media are so good at. I fully expect, devoid of any further major scandals, and barring unforeseen terrorist events, that by next month headlines will be filled with stories of companies beating analysts’ estimates. The Fed will do its part to prop up the markets. They did their part today by saying they aren’t even close to raising interest rates. What I suspect will happen as a result of this week’s meeting of the G-8 is a concerted attempt by central banks to reinflate the economy and financial markets, which means we will have stagflation.
Overseas Markets
European stocks dropped after WorldCom Inc. said it fabricated profit by misreporting $3.9 billion of expenses, shaking investor confidence in corporate accounting. The Dow Jones Stoxx 50 Index slumped 2.2% to 2906.60 points, taking this year's drop to 22%. All eight major European markets were down during today’s trading.
Asian stocks declined after WorldCom Inc. misstated $3.9 billion in expenses, renewing concern U.S. accounting problems will undermine a recovery in the region's largest export market. Japan's Nikkei 225 stock average slid 4%, its biggest slide in nine months.
Bonds Today
Government bonds rallied heartily across the board as investors searched for a safe haven. The 10-year Treasury note rallied 19/32 to yield 4.74% while the 30-year government bond flew 14/32 to yield 5.43%.
In economic news, May durable goods orders rose 0.6%, more than the expected 0.3% increase. The housing market remained with May new home sales up a whopping 8.1% to 1.03 million. Thursday will see the release of weekly initial claims, the final revision to first quarter gross domestic product and the minutes of the May 7 FOMC meeting.
© Copyright Jim Puplava, June 26, 2002