Posted on 07/12/2002 7:40:13 AM PDT by CutMyTaxes
By focusing too much attention on the nuts and bolts of accounting, Democrats threaten to undermine real economic activity.
My professional career and management of my personal assets for the last thirty-seven years has been focused on investing non-consumption assets for the purposes of earning a net return on the investment.
Two ways you get a return off investment assets: One way is that the investment earns income you receive as an investor (net cash flow from net income of direct investments; dividends on common stock); the other way is that the value of the investment goes up and there is a regular trading market for the investment asset (common stock). The increase in value return is usually more difficult to measure: Did the stock go up because it retained income; or did it go up because there is so much investment money out there chasing investment assets that people were simply willing to pay more for it--and will that trend continue in the future or reverse.
Now when you focus on the market for common stocks which is what you are really addressing, over the last fifteen years, maybe twenty, the second kind of return has been primary and most suspect--under current conditions, whatever you may believe about earnings, and statement numbers, we are never again in either my lifetime or probably yours, going to see an environment where stocks go up ten percent a year because the speculative value resulting from the willingness of buyers to pay more because they have to buy something goes up.
So what you have to see to restore a sound investment climate is where you can look at common stocks as earning a return, a good part of which they distribute to shareholders as dividends so that the shareholder can look to 5% which is real because it is dividend cash in his pocket and another 5% which is increase in the price of the stock because the corporation retained the income and used it to increase its earning capacity. Both returns are dependent on actual earnings by the corporation.
Problem is with these numbers. Its not just Democrats who have finally waked up to the fact that public corporations have been telling the market they made more money than they actually made. A usually reasonable price for a public stock is somewhere in the range of a price earnings ratio of 15-19 in an expanding economy. Multiples go up because people are making poor speculative decisions, encouraging overstatement of earnings which drives true multiples up further.
Current S & P is probably selling at somewhere around 30+ times trailing published earnings (not the 22 announced Wednesday). Further, if you take those earnings and adjust them to some semblance of reality, S & P is really selling at 50-60 times true trailing earnings under circumstances where the economy is shrinking. So the real looking carefully at the numbers is important to everyone including Democrats.
The implications of this arithmetic are that stock prices are going to go a long way down from here--my guess is 1200 on the Dow; 100 on the S & P. Where, by the time we get there, we will be looking at multiples around ten times real trailing twelve months earnings (partly because real earnings are going down also).
What can Democrats (and Republicans) do about this? Permit deduction of dividends for tax purposes; reform the tax system to encourage capital formation and investment (even by rich capitalists).
Current S & P is probably selling at somewhere around 30+ times trailing published earnings (not the 22 announced Wednesday).
How exactly do you calculate this, or is this an educated guess based on your experience with announced earnings?
Further, if you take those earnings and adjust them to some semblance of reality, S & P is really selling at 50-60 times true trailing earnings under circumstances where the economy is shrinking.
Please explain further, if you will.
The implications of this arithmetic are that stock prices are going to go a long way down from here--my guess is 1200 on the Dow; 100 on the S & P.
This seems awfully bearish. Dow 1,200 predates Reagan...
The news release that appeared the other day about the S & P multiple was based on released earnings--call those "above the line" earnings. There is a problem with those earnings because companies have fudged things like booking expenses to capital costs; fudged inventory valuations; fudged income numbers--by taking income in as gross income that is really not yet earned income at all. So the above the line number which the analysts and media would like to focus us on is really a little phony itself.
Because the above the line number overstates income because management has inflated income by using these devices. Although the how much is in fact a judgment call on my part, I have tended to view the above the line number as less inflated--as we see these new reports on a company by company basis and see how much inflation there really is, my current judgment is that even the above the line number is more inflated than I have previously thought--and thus current prices are a higher multiple of trailing twelve months earnings that I have previously judged.
Then you get to the next issue. There are historical theoretical accounting justifications for putting some charges below the line--they are extraordinary and detract from the meaningful nature of the reported earnings. Well and good although what really counts for the investor is how much the company is really producing in earnings that are cash that can be used to get to the shareholder's pocket.
That "extraordinary" concept in the modern world has been inflated all out of proportion to reality. That's bad--for two reasons: It means you can't compare last years earnings and year before last's earnings with this years earnings because the earlier earnings were more realistic--they are not comparable; and, second, and worse, you can't tell what kind of an investment you are making because you can't tell how much it is going to earn. All of the companies I follow (except Berkshire Hathaway and some of the Gold companies) have increasing amounts of below the line items and when I look at them, I think they exert a continuing impact on continuing operations.
I have several companies I have converted from 25-30 reported PE's to 65-70 PE's by doing my own restatements so I think the practice is sufficiently common that my judgment of a general overstatement resulting in a PE of 50-60 is probably fair.
I don't know that everyone would be familiar with a scatter chart--it is a chart that presents each piece of data as a dot on the sheet of paper. Prechter published a scatter chart of PE's based on media earnings ("above the line") for the last two hundred years. All of the years before 1990 are in a 1 1/2" x 2 1/2" square in the bottom left hand corner of the 8 1/2 x 11 " page; all of the 1990's are up in the upper right hand corner--even the overstated media earnings result in outrageous prices.
If you get prices back to reasonable High multiples, you still get the Dow Industrials in the 4000 range--and you should not get high multiples because the economy is in the incipient stages of a significant contraction.
Sure, my forecast gets back to Reagan--1981-82 to be exact; and interestingly enough, that is when multiples began to be excessive. But if Reagan had remained President; had been able to enact some version of his Tax Reform package (known as Treasury I in 1985), those multiples would have been justified because we would have had a prolonged substantive economic expansion of historical magnititude of which we would not yet be seeing the end.
Didn't happen. We elected Bush I who raised taxes; we elected Clinton who raised taxes a lot; and Clinton-Greenspan then pursued monetary policies designed to keep the appearance of a stock market and then real estate expansion going long after the end of the economic expansion (a bubble); the end result is that after the economic expansion engendered by Volker and Reagan 1986 tax policies is exhausted, the bubble is in the process of deflating.
The 1200 Dow forecast is not mine it is Prechter's and it is a reasonable estimate based on where multiples go at the end of the contraction. I don't think Prechter has an S & P forecast but my 96 S & P is based on the same kind of analysis--what kind of a multiple do you get at the bottom of the barrel and what do you think is left in the way of earnings.
The government's tools to resist this kind of trend are much bigger now than they were in 1932--I don't think they will get a positive result; but maybe I am mistaken. I think they will have lots of excuses like terrorist activity and crooked managment on which to blame their failure.
Anyway, in the recent and ongoing contraction in Japan, one of the faulty underpinnings was the overvaluation of company P/E's. Was this accounting fraud (yes, as you describe it, it all seems like variations of fraud to me) as common in Japan, or is this occurrence largely an American phenomenon?
I realize Japan has an entirely separate can of worms, like government intervention and protection in nearly every sector. But, regarding the valuation of earnings, do they account for themselves in the same manner?
Many of these companies are international (God forbid, global) ;). These accounting irregularities will also impact other international issues as these same companies later try to obtain additional lines of credit from banks abroad.
None of these behaviors bode well for us going forward at all. It is a bit scary.
To be honest and perhaps a bit blunt, I hope you are pessimistic.
I have been in a number of meetings where accountants and management are deciding how to present something in the financial statements. An in fact, lots of times, personal greed on the part of some of the participants is a factor; sometimes the independent accountant is thinking about his new $125000 Porsche that he probably can't afford if he loses this client. Maybe these guys don't even think about the direct connection between the Porsche or the new house to the matter at issue; but they can think of creative arguments why its ok to do it this way and sometimes they are pretty forceful in holding their position.
I have been the wicked Godfather in some of those meetings; and lost some of those arguments. But facts are that if you sat these guys down in a deposition right there where the facts are before everybody, they probably can still make the argument what they are doing is a reasonable business judgment on the facts presented.
Japan is different in many respects. But there are similiarities. I don't think you make a reasonable deal at ten times earnings an equally reasonable deal at fifteen or twenty because you move it to Japan. What's different in Japan is that the government has used levers of monetary and fiscal policy to keep appearances up solely for the sake of keeping appearances which our government has never before used--and which our government does not admit to useing here today which maybe they are.
End result however is that this stuff is all real substance--trying to get people to belive that the ecnomy or the stock market are really going up when they are really going down in my view is counterproductive--we are better off getting to and dealing with reality that continuing to try to kid ourselves.
At the end of the day, people are going to start investing money in equities again when it makes reasonable economic sense to do so and probably not before. A short term rally in the US Stock market is coming in the second half of July but the real sell off will come in September-November.
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