Weekday Commentary
from Jim Puplava
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Market WrapUp for the Week
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Wednesday, October 23, 2002
Anyone Can Jump Over a Pole If It's Low Enough
Nobody said the markets are rational in the short-term. The markets often move on emotion rather than fact. A good example is the recent rally in the major indexes from their October lows. Companies are now beating analysts’ estimates, but that is only after estimates were lowered so many times that companies were bound to beat them. It looks like Q3 pro forma profits will come in around 6%. That is a small cut above estimates of 5% the week before earnings began being reported. We started out the year at 30%, dropped down to 17% at the end of Q2, and then fell down to 5% a week before earnings were released. Earnings have been given as the main reason stocks have rallied because earnings came in much better than expected. This is hardly a distinction, given that the benchmark was revised so many times that eventually they would beat estimates.
Yet Q3 was an easy quarter to beat. The comparisons were made against last year’s Q3 when companies were taking big writeoffs. It was also a quarter characterized by the tragic events of September 11th. Going forward, the comparisons are going to be harder to beat, which is why so many companies have been cautious in their remarks for Q4 results. Nonetheless, Wall Street still has pro forma estimates of 17% for the last quarter of this year. Those estimates are still too high and will have to be reduced if analysts want results to look favorable. As those estimates come down, so will stock prices.
Pension Shortfall Looms Ahead
One factor that many on the Street aren’t talking to investors about is the major pension shortfall that is going to hammer earnings in Q4 and all of next year. Many companies got away with nominal contributions to pension plans in the 90’s due to rising stock prices. Just like consumers who quit saving during the 90’s because of rising stock prices, corporations quit contributing to pension plans. The stock market rose each year doing the savings for the companies. This made company earnings look much better. Corporations could forgo making contributions as the assets of the pension plan rose along with rising stock prices. That was the '90s; now we’re in a totally different environment. This is the 21st century where stocks have been declining double-digits for the last three years. According to pension analyst David Zion at CB First Boston, 360 companies in the S&P 500, who have defined benefit pension plans, could be underfunded by $243 billion at the end of this year. Company pension plans have 10% returns factored into their estimates. Instead of 10% returns, company pension plans have been losing over 10% a year. In 2001 the 50 largest companies in the US lost collectively $36 billion in their pension plans. However, by aggressive accounting assumptions made on the returns of their plans, these same companies recorded hypothetical gains of $54 billion versus an actual loss of $36 billion. According to CSFB, the typical pension plan went from being 7% overfunded in 2000 to 6% underfunded in 2001. That figure will rise even higher this year as result of the losses in the financial markets. CSFB estimates that S&P 500 companies will need to contribute $29 BILLION to pension plans next year. That $29 billion is going to be taken out of the corporate bottom line, which will be a drag on profits next year. It will also impact corporate plans for capital investment.
Big Blue May Be Singing The Pension Blues
IBM is typical of many companies facing this problem. IBM reported that profits fell 18% in the third quarter. The company helped to ignite a rally in the stock market by beating estimates. However, buried in IBM’s footnotes was about 10% of its pretax profits came from investment income earned by its employee pension fund. IBM has been losing money in its employee pension fund even though it has been reporting profits from pensions in its operating income. IBM has been using 10% returns in its pension assumptions. That assumption will no longer fly, given the actual losses in the plan. At the same time, IBM reported lower Q3 profits, the company also alerted the Street that it would have to divert $1.5 billion to its pension plan by year-end. That is $1.5 less for Q4 profits.
Pension shortfalls could have a major effect on company earnings, credit quality, and alter debt covenants, forcing the company to renegotiate debt at much higher rates. Unfounded pension liabilities caused Standard & Poor’s to lower GM’s credit quality because of a huge increase in pension liabilities. GM’s unfounded pension liabilities could grow to $23 billion by the end of the year.
Under current accounting conventions, if a pension plan is at least 90% underfunded, the shortfall can be spread over a 30-year period. However, if funding falls below 90%, companies have to make up the difference with larger cash contributions within three to five years. The list of blue chip companies currently underfunded makes up over 70% of the S&P 500. They range in blue chips such as IBM, GM, Boeing, DuPont, AMR Verizon, GE, and SBC.
Spinning Shortfalls & Writeoffs
How Wall Street will spin these shortfalls is anybody’s guess. I would suspect that we will exclude them as we do other restructuring charges and large writeoffs. This morning’s Wall Street Journal did a story about Household International. The company recently announced a settlement of $484 million to mollify allegations of predatory lending. The company will take a $333 million charge to earnings in Q3. The WSJ story is about how large writeoffs can often be ignored by investors to the detriment of their net worth. The article talked about how investors ignored a large $1 billion charge by Enron last fall. The announcement by Enron was just the beginning of a series of writeoffs and losses that would shortly bankrupt the company.
The problem with ignoring writeoffs is that it could come back to haunt you. An examination of the shares of AOL-Time Warner, JDS Uniphase, and Lucent are good examples of what happens to high-flying stocks once the writeoffs begin to flow. The book value and shareholder equity are destroyed in the process. Wall Street will tell you to ignore these numbers, but the markets are much smarter. The markets will adjust the stock price accordingly, reflecting the loss of shareholder equity. Companies, and analysts may be able to fool investors, but the pros know differently and will immediately sell the stock or short it, and bring down its value to closely reflect reality.
Today Lucent Technologies reported its 10th consecutive quarterly loss. Company sales fell again by 23% during the quarter. Lucent reported a loss of $2.81 billion for the quarter. The good news was that it beat estimates and had fewer losses than expected. Losses a year ago were $8.8 billion. Excluding charge offs, operating losses actually increased from 28 cents a year ago to 64 cents currently. The company has trimmed its payroll from 100,000 to around 35,000. Lucent will reduce its workforce by 10,000 by the end of 2003 and take another $4 billion in restructuring charges to do so. The company estimates it will have $2 billion left in cash at the end of next year. Many are now worried about the company’s survival. Consistent writeoffs are usually a harbinger of the future, so investors should be alert to when companies report consecutive charge offs. It usually portends difficulties or big trouble lies ahead.
Today's Market
The noonday recovery in stocks was all the more remarkable given the terrible earnings reports and losses that came out of companies today. AOL reported that it will restate sales over the past 2 years by $190 million. Amgen reported losses of $2.6 billion based on acquisition costs from mergers. AT&T Wireless posted a $2 billion loss due to writedowns and rising operating costs. The writedowns came from expenses reflecting declining asset values, including investments in other companies and licenses to carry calls. Operating costs rose by 50% during the quarter. The stock rose in after hours trading on account of a favorable interpretation of the company’s operating results. I après conference the company said if you back out expenses of $1.33 for impaired wireless assets, $882 million for investment losses, and take out miscellaneous other costs they would have made a profit of 4 cents a share. I would like to use the same methodology in computing my income taxes.
The markets staged a late day miracle recovery due to better-than-expected profit reports coming from Disney and Computer Associates. The major indexes were down nearly 2% by midday after Ely Lilly cut its earnings forecast. Stocks rose after analysts raised earnings projections for Disney and Computer Associates. Disney lost $158 million last year while earnings have declined steadily since 1997. Merrill Lynch raised Disney’s profit estimates to $0.70 from $0.65 for next year. AOL also jumped after disclosing it would have to restate sales, earnings and cash flow as a result of an in internal review of how the company accounted for certain advertising costs. AOL said that pretax cash flows for the period being restated would be $97 million lower. The stock rose on news that sales would rise 5% this year. AOL’s earnings fell from $0.24 cents a year ago to the current price of $0.19 cents. Revenue also fell short of estimates coming in at $9.32 billion versus forecasts for $9.98 billion.
While reported earnings looked bad or worsened, they beat most estimates, which became the real story. The late day rally was also attributed to favorable gibberish coming from Alan Greenspan on productivity for the US economy. Greenspan said that the country’s productivity is much better than it appears. In a separate report, the Fed’s Beige Book painted a bleaker picture of the US economy saying the economy remains sluggish in September and early October.
Ku-Chink! Upping the Down Numbers
All three major averages came back from the brink due to worsening earnings, but better-than-expected results. The NASDAQ has risen 9 out of the last 10 days on deteriorating sales and earnings news. The actual results are bad, but they aren’t as bad as the latest estimates refigured a week before they were reported. It is all part of the ritual earnings game played each quarter for investors. Companies don’t do as well, but are made to look better by beating estimates that are lowered continuously until companies actually beat them. Then the story becomes not how well the business is doing, but how well the company did against much lower estimates.
Up until last week individual investors weren’t buying. They were instead pulling their money out of equity funds at a high rate. The spin needs to get better, if the rally is to be maintained. Otherwise investors will lose faith and may even begin to capitulate, the last thing that Wall Street and fund managers want to see. Right now this is a game being played with other people’s money. It is fund managers buying shares and driving up their prices. Added to this game is short covering as the shorts are forced to cover their positions as share prices rise. That is the only reason this rally is taking place. It isn’t earnings, the economy, interest rates, or politics. There have been no new tax cuts or stimulus coming out of Washington other then preparations for war.
Market Internals
Volume on the NYSE came in at 1.53 billion and 1.55 billion on the Nasdaq. Market breadth was positive by 5 to 3 on the big board and by 5 to 3 on the Nasdaq. The VIX finished at 39.38 and the VXN closed down at 52.37. Market internals and momentum continue to decline.
Overseas Markets
European stocks fell after GlaxoSmithKline Plc's profit lagged forecasts and German lender HVB Group reported a loss. The Dow Jones Stoxx 50 Index declined for a fourth day, sliding 3.4%, the biggest loss this month, to 2486.17. All eight major European markets were down during today’s trading.
Taiwan's TWSE Index soared in its busiest trading day in six months on optimism growth in the semiconductor industry will rebound beginning next year. Taiwan Semiconductor Manufacturing Co. led gains after Chairman Morris Chang said demand will revive in the second quarter of 2003. The TWSE Index surged 4.6% to a five-week high. In other markets, Japan's Nikkei 225 Stock Average added 0.3%, led by Nissan Motor Co., on expectation the nation's third-largest automaker will say that first-half preliminary earnings increased.
Copyright © James J. Puplava
October 23, 2002
