Weekday Commentary from Jim Puplava
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The Next Bubble to Burst
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Market WrapUp for the Week
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Tuesday, October 15, 2002
Earnings Perception
In the financial markets perception is everything. What can be perceived can be believed, if only for a short while. Today was no exception. The market shot up at the opening bell on news that earnings exceeded expectations. The general view mouthed throughout the day was that earnings are coming in much better than expected, and that companies have turned the corner. The Dow shot up several hundred points at the opening bell and reporters hailed the surge as sign that we have finally hit bottom. It is now time to get on with the recovery. Analysts and anchors were telling investors that this is the “real thing,” and a sustainable rally. Nothing could be further from the truth. The plain fact is this is nothing more than a tradable rally following many of the same characteristics of the summer rally that fizzled. For money managers who have been losing this year and the last three years, they are now forced back into stocks, which was the original intention of the intervention that helped to trigger it.
Earnings reports coming in from Citigroup and Bank of America got things started. Other reports from GM beat the Street and investors seemed to ignore the losses reported by Delta. The airlines are basket cases requiring government intervention to save them from bankruptcy. Costs are rising due to higher energy prices and rising labor costs. Air traffic is down in both the number of flights and the miles flown by passengers. The airlines are losing big money that keeps widening by the quarter and have now been forced to postpone taking delivery of jets ordered to modernize their fleet.
As far as the banks were concerned, Citigroup reported net income that rose 23% during the third quarter. Part of that gain was attributable to a $1.1 billion sale that generated a pretax gain of $830 million on the sale of its Park Avenue headquarters on September 25th. Without this gain, income growth would have been 13% versus 23%. The income gains came mainly from its mortgage and credit card divisions, the two areas most susceptible to an economic downturn if consumers retrench on their spending. Credit card earnings rose 21% as the spread between the costs of funds and what they charge borrowers rose to 11.09% from 10.93%. The bulk of the banks’ earnings are coming from the bubble in mortgages and consumption.
Other areas of the bank aren’t doing as well. At the brokerage division, Salomon Smith Barney earnings fell 7% as merger revenues and investment-banking fees fell sharply. The investment-banking unit dropped down to 10th place. Non-performing loans rose to $4.8 billion, or 3.5% of all loans to companies. The lending division more than tripled the size of its pool for bad loans to $710 million as the bank wrote off bad loans to Argentina and telecom companies. The company is seeking greater collateral from corporate borrowers.
Bank America, the biggest consumer bank, said profits almost tripled, driven by mortgages and credit cards. The bank’s investment banking business fell 18%. Bank America, like other money center banks, is making most of its money from lending to debt strapped consumers. The drop in short term interest rates has widened the lending spreads between what a bank pays its depositors and what it charges consumers to borrow. The trend in most bank lending and what banks are paying for funds has dropped precipitously with 11 rate cuts, while what they are able to charge to borrow remains high. Many consumers run up their credit card debt and then pay it off with equity extracted out of their homes through mortgage refinancing.
The excitement over Fannie Mae’s third quarter earnings is less than to be desired. Q3 earnings fell 19% as the largest buyer of mortgages had an unrealizable loss in the value of its derivative portfolio. The financial entities net income fell to $994.3 million from $1.23 billion a year ago. Analysts say that if you exclude the loss from derivatives, the mortgage lenders earnings actually rose 18%. Fannie Mae dismissed the derivative loss as irrelevant since they believe their only real exposure to derivative losses is in the event of a counterparty failure.
General Motors
At General Motors, investors got excited over the automakers hypothetical earnings of $615 million. The auto company’s actual earnings were a much different story. Losses actually doubled to $804 million after the company wrote down the value of its investment in Fiat Auto by $1.37 billion. The spin was that if you exclude certain expenses, results exceeded analyst estimates. GM shares have lost half of their value due to three trends:
1) Discounts and zero percent loans are hurting profit margins.
2) Additional write downs of investments that have turned sour.
3) Underfunded pension liabilities.
The company has experienced a negative 10% return on its pension-fund assets in the first nine months of this year. This will force the company to make an additional $1 billion in pension contributions in 2003. This is a company whose growth, activity, debt, and profitability are deteriorating as reflected in the table below.
GM's Financial Physical
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1997 |
1998 |
1999 |
2000 |
2001 |
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Gross Margin |
21.9% |
22.5% |
24.2% |
21.1% |
18.9% |
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Pretax Margin |
4.6% |
3.2% |
5.2% |
3.7% |
0.8% |
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Profit Margin |
4.0% |
2.0% |
3.6% |
2.4% |
0.3% |
|
Return on Assets |
2.9% |
1.2% |
2.3% |
1.5% |
0.5% |
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Return on Equity |
32.3% |
17.8% |
33.2% |
17.0% |
2.0% |
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Return on Capital |
10.8% |
6.0% |
7.7% |
6.5% |
2.4% |
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Debt of Assets |
40.14% |
47.1% |
47.9% |
47.7% |
51.3% |
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LT Debt/Com Equity |
531.4% |
771.2% |
637.9% |
479.4% |
843.4% |
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Lt Debt/T Capital |
37.7% |
87.0% |
84.7% |
37.4% |
56.0% |
Intel
In the case of Intel, which announced earnings after the market closed, profit margins and returns on capital have declined steadily in this economic downturn. Intel’s CEO Craig Barrett has tried to turn things around without success. The company has come out with faster processors finding it reducing prices quickly to move inventory. There is a capital-spending slump by business that is inhibiting spending on personal computers. With the economic rebound fading, manufacturing slowing, and consumer confidence waning, faster and more powerful chips have failed to jump start sales. Intel reported net income rose as acquisition costs dropped. Sales fell from $6.55 billion to $6.50 billion. The company warned that fourth quarter sales will be less than a year ago ranging from $6.5 to $6.9 billion compared to close to $7 billion last year. The company said just the opposite of what analysts wanted to hear. There will be no rebound in PC’s until the economy improves. Profits would have been $768 million if certain costs were excluded. Shares of Intel fell 14% in after hours trading, and have fallen close to 50% this year. More importantly than disappointing third quarter results was what Intel said about the fourth quarter: there won’t be a rebound in sales and profits.
Intel
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1997 |
1998 |
1999 |
2000 |
2001 |
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Gross Margin |
60.3% |
53.8% |
59.7% |
62.5% |
49.2% |
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Operating Margin |
39.4% |
32.3% |
34.6% |
31.2% |
9.3% |
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Pretax Margin |
43.5% |
34.8% |
38.2% |
44.9% |
8.3% |
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Profit Margin |
27.7% |
23.1% |
24.9% |
31.2% |
4.9% |
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Return on Assets |
26.4% |
20.1% |
19.4% |
23.0% |
2.8% |
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Return on Equity |
38.4% |
28.4% |
26.2% |
30.2% |
3.5% |
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Return on Capital |
36.6% |
27.5% |
25.3% |
29.3% |
3.5% |
Other Company Reports
If there was a real profit story today it was in the drug sector where Johnson & Johnson and Forrest Labs reported higher profits due to increased sales from arthritic and depression drugs. Both companies are benefiting from a lack of generic competition for its top products. J&J’s pharmaceutical business is firing on all cylinders. But J&J and Forrest may be the exception. Estimates for the third quarter on 31 pharmaceutical companies is expected to show that earnings declined by 5% during the quarter. About $40 billion in sales of drugs will come off patent between 2000 and 2005. Top selling drugs will then become subject to competition from lower priced generics, which are often times half the price of regular drugs.
Wall Street and the media are fortunate in the fact most investors don’t know how to read financial statements. Concerning this matter, it is doubtful whether anchors understand how to read them as well. If you watch the cable channels they are always hyping one sector or another or calling for a market bottom. Up until the events of September 11th, investors were never told that we were in a bear market or that the economy was in recession. After 9-11 it became permissible to talk about the bear market and a recession. We were told it was brief when in fact it was later altered to extend a full three quarters. As with so many economic reports when they are revised lower, the news goes unreported. Initial estimates, which paint a far better picture, make the headlines with much fanfare. When they are revised lower the story is buried in the back pages.
S&P News
Standard & Poor’s announced today an important new governance initiative designed for companies and investment markets. The new service will provide investors with corporate governance scores. It will alert investors to how well US and other companies perform the basic task of fully disclosing information to investors. In a white paper, “Global Transparency and Disclosure: Overview of methodology and Study Results-United States,” S&P highlights the difference between annual report disclosure by US companies and the disclosure provided in written documents (10-K) to the SEC. Perhaps a similar disclosure should also be required from reporters. It might be helpful for investors if the media in addition to reporting pro forma or CRAP numbers, they also reported the actual net income figures, how they were arrived at, and the trend. Instead of the daily drivel each day when we get these one-day or two-day wonders, more meaningful analysis would be more helpful. This would include a deeper look at the earnings numbers, reporting revised economic numbers and their trends, and what is happening to corporate balance sheets. The destruction of book value is the largest I’ve seen in my 23 years in the business. The bubble years of 1995-2000 produced billions if not trillions in malinvestments. Those malinvestments are now being written off which is why nobody discusses earnings according to GAAP anymore. The GAAP numbers reflect the writedowns where the CRAP numbers exclude them.
For investors looking at what has happened to book value gives you a measure of how well management has done with reinvested profits. After all, the profits belong to the shareholders. When profits aren’t distributed to investors in the form of a dividend they are kept by management for investment. It is only appropriate for investors to ask how well management has performed by examining what has happened to the value of those investments, which should be reflected in higher book values for the company. When companies misspend profits and make poor investments, book values shrink as companies write off poor investments as GM is doing today. Another measure that should be examined is the statement of cash flow to look at whether earnings are backed by cash. This alerts you to possible earnings management problems if cash is lining up with earnings over time. By paying significant dividends a company is ensuring investors that it has real earnings and cash to back up the dividend and not the fluff of bogus profits. There was a reason dividend increases lagged throughout the later 90’s; it was because earnings were being managed instead of grown.
The Technical Picture
Looking at the technical picture of the market, it now remains to be seen whether the markets can rally beyond a 3-4 day wonder streak, which is reminiscent of the late July rally. Technically speaking, the Dow may be about to form a double shoulder above its neckline that could lead to a further breakdown this year. Credit spreads keep widening as I’ve written about recently, and that doesn’t bode well for the markets. It tells me that systemic risks are growing spelling trouble down the road. Another feature of this market that doesn’t build confidence is these bear rallies are primarily made up of one-day wonders. Instead of a steady market that rises gradually, we get most of the rallies gains in a few days such as today. Then the market tapers off before resuming its downward trend. True, J&J and Citibank saw their earnings rise. But Citigroup’s earnings are very vulnerable to a spike in long-term interest rates and a falloff in consumer spending and borrowing. The fact that banks are lending aggressively into this housing market and making more loans to sub par borrowers doesn’t seem to raise an eyebrow with the financial press. The argument is that rising housing prices stand as collateral behind these aggressive loans. What happens if real estate prices fall? Then that collateral and the diminished equity that backs those loans don’t look as secure.
What has distinguished this recession from past recessions is the careless behavior of financial institutions as lenders, and consumers as borrowers. The consumer increased his debt load borrowing more money as debt levels soared, savings plummeted and spending multiplied. The consumer’s mantra has become “eat, drink, and be merry, for tomorrow we die.” What makes this recession different from others preceding it is the complete abandonment of sound financial principles. Banks have become more aggressive in their lending to consumers, especially with sub par borrowers. Consumers, on the other hand, have jettisoned savings and spending restraints in favor of a borrowing and spending binge. With the stock market no longer providing a cushion to net worth, homeowners are tapping into their home equity to pay bills and support consumption. None of this is healthy. It tells me that a day of reckoning is fast approaching. You can’t have general prosperity based on debt. Debt gave us the bubble, debt gave us a mild recession, debt gave us a feeble recovery, and debt will bring this market and economy to its knees. I have yet to discover any empire throughout history that has prospered on account of debt. In most cases the rise in unprecedented debt signaled the empire’s fall.
The Markets
The major averages had a large pop to the upside. The S&P 500 has risen 13.5% in four days, the biggest jump since October of 1974. The S&P 500 has had three rallies of 19% or more during this bear market before heading even lower. Despite the rallies, the S&P 500 is down 23% this year and is heading towards its third consecutive year of losses. This hasn’t happened since 1939-41. The four-day rally has added $1.14 trillion back in stock market wealth. Wall Street analysts are still busy lowering pro forma profit estimates, which have fallen to 5.2% this quarter. They have been lowered so much that you now have companies such as GM, which lost money by beating estimates.
This rally looks hollow just like July’s. The only thing going for it at the moment is short-term momentum, a lot of hype and balderdash, and wishful thinking on the part of fund managers who have been losing investor capital for three years. Most of this rally has come from short covering and institutional funds trying to bolster losing performance. The pattern of these three bear market rallies has been as written on Friday:
The Four-Step Rally Process
Phase 1 One-two-three-day rallies, sparked by intervention at key support levels.
Phase 2 Short covering drives violent upside surge in indexes.
Phase 3 Day traders come in and increase short-term momentum.
Phase 4 John Q comes in at end of rally after uptrend has run out.
I call it the “rope a dope.” Suckers are lured into stocks just before the bad news clobbers the market and takes it down to lower levels. I refer readers to James Sinclair’s VIP for today, which features long-term chart patterns that don’t bode well for this market. Gold on the other hand looks much different. It would be nice to see the media report and show graphs of gold over the last twelve months instead of just talking it down. If you look at Barron’s and the Wall Street Journal’s quarterly mutual fund performance, gold and short funds dominate each quarters’ performance. Yet very little is said about them. When markets are falling and gold is rising, we get to watch cable anchors go through physical workouts. Television is an entertainment medium, designed more to entertain rather than to inform. Otherwise, we wouldn’t be getting so many ridiculous stories as to why stocks rose on improving fundamentals when in fact they have deteriorated. This is another tradable rally and nothing more as a result from oversold conditions in the market. Trade if you are able to; otherwise stay out or go short before the storm’s next fury hits. Keep your eye on the bond market, which may be the next bubble to burst. The bond market got hammered hard today with long-term bonds losing as much as 2%. A rise in the 10-year note and 30-year bond could put an end to the refi game that has kept the real estate markets strong and personal consumption high. The 10-year rate is back over 4% and the 30-year bond is heading back over 5%.
Look at individual sectors today. All sectors were in the green except gold, which sold off. Tech stocks rallied despite poor results from Intel and warnings about the fourth quarter. Chip and hardware stocks performed well along with airlines, banks, biotech and auto shares. First Call is worried that “significant further negative pre-announcements” for the fourth quarter are very likely. Then there is 2003, which isn’t looking much better. Capital spending isn’t picking up and the industrial sector is heading back into recession. Next year companies will face significant pension contributions that will eat into earnings as pension fund returns fall far below estimates made in pension plan assumptions.
Volume came in at 1.84 billion shares on the big board and 1.99 billion on the Nasdaq. It was mainly institutional buying that drove the markets this morning. Advancing issues outdistanced declining issues by a 24-8 margin on the big board and by 25-8 on the Nasdaq.
Overseas Markets
European stocks surged, sending the Dow Jones Stoxx 50 Index to its biggest one-day gain in four years. Royal Philips Electronics jumped after its third-quarter loss narrowed, and LVMH advanced after reporting higher sales. The Stoxx 50 climbed 6.3% to 2585.73. All eight major European markets were up during today’s trading.
Asian stocks rallied after a gain in U.S. equities raised optimism that earnings at exporters such as Sony Corp. will improve. Japan's Nikkei 225 Stock Average rose 3.6% to 8836.73. Taiwan Semiconductor Manufacturing Co. led the TWSE Index's 5.6% surge, its biggest in more than 10 months, and Hong Kong's Hang Seng Index soared 4.1%, its biggest gain in 12 months.
© Copyright Jim Puplava, October 15, 2002