Don't Get Fooled Again
We?ll be fighting in the streets
With our children at our feet
And the morals that they worship will be gone
And the men who spurred us on
Sit in judgment of all wrong
They decide and the shotgun sings the song?.
Just like yesterday
Then I?ll get on my knees and pray
We don?t get fooled again
~ The Who ~
For those who are worried, I?m not getting into the music business. Nor am I joining a rock-n-roll band. However, the lyrics of this song sung by The Who resonated in my ear as I thought of this quarter?s earnings season. Each quarter Wall Street and companies play the earnings game, a quarterly entertainment designed to thrill the masses. The actors are the same and so are the lines. Wall Street, major corporations and the media give their performance with much aplomb and certainty. The plot is always the same. Analysts lower earnings estimates, companies easily beat them and investors respond enthusiastically by bidding up shares. Nobody looks behind the stage or examines the numbers. In a world of make believe, the lines are accepted for what they are. The numbers always look good and companies always beat estimates. Just like a Hollywood movie there is always a happy ending.
This quarter will be different. There is a lot riding on the numbers. After promising a second-half recovery for the last four years, it is time to deliver. Stocks have exploded since their October lows of last year based on an economic recovery that is finally expected to take root and deliver spectacular earnings. In anticipation of this occurrence investors, both institutional and individual, have been bidding up shares all year long. So far there is nothing to show for it but expanding PE multiples. Investors have increasingly been willing to overpay for earnings that are of lower quality and less consistent. Earnings have risen year-over-year, but not by much. Since Q1 they have actually been declining and are expected to fall for the remainder of this year. You wouldn?t know this of course by following the headlines. The numbers always look good, if not spectacular. Pro forma earnings have been rising; while real earnings have been declining quarter-over-quarter. The difference between GAAP and CRAP is still as wide as the Grand Canyon. There are also widening differences between what companies report to shareholders and what they report to the IRS. This is visible in the two graphs below that show no improvement between real numbers and the fantasy numbers that analysts, anchors and company pitchmen give in press conferences.
Playing the Earnings Game
What happens each quarter is predictable and generally follows a sequence of events that give little clue as to the true underlying condition of corporate profits. Yes, companies are beating the numbers, but beating those numbers has gotten a lot easier. The way this game is played is very easy to follow. There are three parts to the game.
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Deliver a track record of consistent earnings growth
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Manage earnings expectations carefully
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Slightly beat earnings estimates
If managers play the game well, they will be rewarded by seeing the price of their shares rise, making their stock options worth more. Nobody ever factors in the cost of options, so large options grants can be ignored. The recent rally has made playing the earnings game easy again just like the good ole days of the 90?s. You look for earnings headlines in the paper, looking out for a company that surprises on the upside. If the surprise is followed by an analyst?s recommendation or a glitzy story on a cable channel, you know you?re onto something. You may want to check out to see if things are as rosy as pitchmen are saying by visiting an online message board to find out what other investors are saying. But that isn?t where the real story is buried. The real story is in the company?s 10-Q report filed with the SEC. However, that information won?t be available for weeks and months, long after the company?s press release. By then everyone will have forgotten this quarter's press release and move on to other things. The less you know, the better off you will be in this rally. This is a market driven by liquidity and momentum and not fundamentals. This fact is clear by judging what has done well this year. Those stocks that are losing money are going up twice as fast as those companies that are actually making a profit. Companies with deteriorating balance sheets, declining earnings, and poor quality of earnings have become this rally?s market leaders.
Lowry?s investors services reports that buying enthusiasm has shifted decisively into mid-cap and small cap stocks. There is a renewed phase of momentum investing that has taken over the market led by large institutional investors. Large institutions are ignoring liquidity considerations and instead have chosen to invest in higher risk small cap stocks in an effort to gain instant gratification. The buying power of institutions is enough fuel to drive small cap prices higher. The only problem for these large buyers will be their exit strategy. The same will hold true for the individual investor. Investors will have to be quick of hand to call the top--and more importantly--exit quietly before the herd makes a mad dash for the exit gates at the same time.
The Inside Story
Despite the gains in this year?s speculative stocks reflected by the lead of the NASDAQ over the S&P 500 and the Dow, fundamentals always win out in the end. Perhaps that is what insider selling is telling us. Who do you think has the most reliable information as to how well the company is actually doing? The insiders or mad hat investors who are chasing returns? Despite inside knowledge the individual investor can have access to the same information if he or she is prepared to do some homework. The information is there, buried in the company 10-Q report and especially in the footnotes. The footnotes tell the story behind the story and are truly critical in understanding a company?s true health. The companies would prefer that you don?t read them. Wall Street would prefer that you ignore them, because it may cast a doubt on their perpetual story that it is always a good time to be buying stocks. The footnotes, along with Management?s Discussion and Analysis, should be a must read for investor.
Things have become more complicated and companies are required to disclose more today as a result of Sarbanes-Oxley. Investors are given more information today as the number of pages devoted to footnotes has doubled in the past six years. As complicated as understanding accounting has become, there are a few simple guidelines that investors can follow to avoid being fooled. You have to understand that the quality of earnings has deteriorated over the last decade and what you hear today isn?t necessarily what you get. Companies have become adept at manipulating earnings and whitewashing all the bad stuff. Most investors are intimidated by numbers, but you don?t have to be a CPA or an expert in finance to understand them. There are a few simple rules to follow and you will eventually get the hang of it. Once you begin to practice and understand the importance of these reports, you are not likely to get fooled again.
Understanding Gimmickry
Rule number one is if after reading the 10-K or 10-Q, you still don?t understand it, chances are that the company is trying to confuse you. If you can?t understand what the company does or the footnotes aren?t understandable, avoid investing. The second rule is to look at the company?s footnote on income taxes. It reveals the difference between a company?s reported earnings and its tax earnings. The wider the gap, the greater the chance is that the company is using creative accounting to manipulate earnings. There is a lot of that going on today as reflected in the earnings gaps between pro forma earnings and GAAP earnings as well as reported and taxable earnings. The gap is reflected in the graphs at the top of today?s update. Some of the more common red flags to watch out for are highlighted below.
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Change in accounting policy
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Big differences between pro forma earnings and net income
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Taking special charges quarter-to-quarter
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Shrinking business segments for no reported reason
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Earnings that are growing faster than cash flow
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Opaque income and expense statements
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Limited disclosure on derivatives (a ticking time bomb)
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Large stock option grants
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Synthetic leases
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Off balance sheet debt
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Unrealistic pension return assumptions
The greatest way to discover if there is a problem at a company or if management is legally manipulating earnings is to examine the company?s income and cash flow statements. You should look to see if earnings are rising faster than cash from operations. If income is rising faster than cash flows, this means that company accruals are getting larger and larger. This should make you suspicious of company accounting decisions. Firms with large accruals are more likely to suffer large write-offs in the future. These large write downs are often referred to euphemistically. Not all companies that have large accruals are manipulating earnings, but those that do always have large accruals.
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Big Write-Offs |
| Acquisition Charge |
| Amortization of Intangibles |
| Goodwill Amortization |
| Impairment Charge |
| Nonrecurring Charge |
| Research & Development Charge |
| Restructuring Charge |
| Stock Compensation |
| Workforce-Related Charge |
| Write-Down |
| Write-Off |
Perhaps the easiest thing for an investor to do is to keep your analysis simple. If there are too many footnotes and you can?t understand them, then the company usually doesn?t want you to understand what they are actually doing. You should look no further and avoid making an investment. The second thing to look for is a wide gap between the company CRAP numbers or pro forma earnings and what they actually report on the bottom line. If the gulf is wide, stay clear. Finally a widening gap between net income and cash from operations tells you that trouble is lurking around the corner or that management is manipulating earnings. Avoid it at all costs unless you really understand the company big picture. Remember, it?s your money.
I have highlighted a few important points that will hopefully keep investors from getting fooled again this quarter. It is my opinion that the management of companies and Wall Street analysts are setting up investors to get hosed again. What goes widely reported as earnings today and what actually gets inked on the bottom line is widening again instead of narrowing. This widening gap is one reason why I believe insiders are selling in record numbers. They own stock options and know what the real earnings story is which is why I believe they are selling. You don?t dump your stock, if the company?s business prospects are improving.
Déjà Vu
Another forgotten part of investing today is looking at value. I?ve seen everything that you can imagine used as an explanation to sell the public an overvalued equity. Today is so reminiscent of 1999 that it is indeed remarkable. Back in 1999 you had the NASDAQ outperforming the S&P 500 as you do today.
You also had an acceleration of insider selling as you also do today. Likewise, valuations are at levels that normally presage severe corrections. The S&P 500 currently is selling at 29 times trailing earnings. If you include expenses such as stock option expense, unrealized gains/losses from hedging activities, pension and post-employment expense, a reversal of prior year charges, merger and acquisition related expenses, and goodwill impairment charges as S&P does with its core earnings, then the S&P 500 is selling at 44 times earnings. A graph of the PE multiple of the S&P shows a massive head and shoulder pattern that is hovering right at the neckline. One can only wonder what will happen when that neckline is broken.
In a similar fashion, the market leadership in 1999 was more speculative issues as they are today. Bidding up those shares were giddy investors. Well, the day traders and the momentum investors have returned back to the markets and are operating in full force. The tech stocks have become this year?s favorite investment sector even though earnings for this sector are far from spectacular. Investors are bidding up shares as if another long-run secular bull market is in force rather than a cyclical bull within a secular bear market. The double-digit growth days for the tech sector are gone, but investors are acting as if they never went away. The return of day traders and margin investing should give one pause before chasing stocks. Investors are ignoring the warnings and instead are acting with complete abandon, oblivious to the risks they are taking. This puts in play--from a Dow Theory perspective--the perfect set up for the next stage of the bear market to unfold where the greatest damage to stocks is done. Robert Rhea warned of this danger when he wrote his invaluable book, ?The Dow Theory.? In writing on secondary movements within a bear market Rhea warns investors as follows:
Bear markets seem to be divided into three phases: the first being the abandonment of hopes upon which the final uprush of the preceding bull market was predicted; the second, the reflection of decreased earnings power and reductions of dividends, and the third representing distress liquidation of securities which must be sold to meet living expenses. Each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market?.
Several things well worth remembering are contained in the following excerpt from an editorial appearing in 1921: on Dow?s old theory? the secondary rallies in a bear market are sudden and rapid, conspicuously so in the recovery after an actual panic break?
A secondary rally in a bear market, as the averages for many years past show with curious uniformity, is followed by the making of a line which thoroughly tests the public absorption power. On a serious break there is always serious buying in support, to protect weak accounts too large to be liquidated, and this stock is fed out on recover?.
Long experience, which can be verified from the averages, teaches that in a broad bull movement, of a kind that lasts over a year or more, the advance looks slow compared to the sharpness of the occasional reactions. In the same way, in a bear market, sharp recoveries are in order.
A reading of the Dow?s great theorists should be a must reading for today?s investor who feels that the rules no longer apply. We are in the latter stages of a secondary reaction or recovery from a bear market low. The fact that valuations remain this high and that investor sentiment remains this bullish should be taken as a contrary indicator and warning that the primary force of the bear market will once again reassert itself. If this rally continues, it will take place next in the blue chips. As the graph of relative performance of the NASDAQ and the S&P indicates, the NASDAQ should begin to reverse course and blue chips should move into ascendancy if this rally has any power left to it.
In summary, what can an investor do given the poor quality of earnings and high valuations for stocks today? The answer to that question is simple: know and understand what it is you?re buying and watch what you pay for it. It is that simple. If you jump on board and buy a stock and overpay for it, you in effect are speculating and playing the greater fool theory. Just make certain you aren?t the last fool. Doesn?t it make more sense to invest your money in the primary trend of the market which is in ?things? or commodities as the value of paper assets are inflated away?
The greatest surprises this quarter are going to come from the energy and the precious metals sectors because that is where expectations are the lowest. That is also where the primary trend of the market lies. It would surprise most investors to learn that the HUI has kept pace with the NASDAQ this year or that the price of high quality junior mining companies are up two, three, and fourfold this year. You can trade the secondary rallies or stay long the primary trend. It seems to me that investors would be far safer staying with the primary trend of the market rather than trying to constantly trade the secondary reactions. It is much easier to get fooled by secondary reactions than it is the primary trend. If you are playing the secondaries, just make sure you don?t get fooled again.
Today?s Market
Stocks rose today for the fourth consecutive session following Friday?s flag pole rally. Volume was extremely light following Friday?s miracle in the futures pit. Volume on the NYSE barely hit a billion shares, 25 percent below its three-month daily average. Analysts are expecting earnings to increase by 16% this quarter according to the latest Thomson Financial poll. Q4 profits are projected to climb by more than 22%. Investors will get their first glimpse at earnings this week when 14 S&P 500 companies release their results. Alcoa reports tomorrow and Yahoo will report on Wednesday. Investors are expecting big things from Yahoo this quarter. Revenue is expected to soar by 36 percent this quarter. Heaven knows what the earnings numbers are since Yahoo! uses pro forma numbers as do most analysts who follow the stock. Nonetheless, Chuck Hill of Thomson First Call expects a robust quarter.
The dollar lost ground today against most major currencies and bond prices recovered somewhat after two sessions of big declines. Gold prices also snapped back. Technology issues were followed by financials and energy.
Market breadth was positive by 21-11 on the NYSE and by 20-11 on the NASDAQ. The VIX was unchanged up only .01 to close at 19.51 while the VXN rose .22 to 29.42.
© 2003 Jim Puplava
October 6, 2003
Charts courtesy of: Bigcharts.com & stockcharts.com
