Earnings problems not the only thing hurting stocks. Hussman argues that weak balance sheets are another big negative.
The Market Climate remains on a Warning condition here. It is an absolutely open question as to whether or not the market will recruit favorable trend
uniformity in the weeks ahead. We make no forecast in that regard. If the market does so, we would expect to reduce our hedge by as much as 40%, still
leaving the majority of our holdings fully hedged, but taking a moderate speculative exposure to the market risk inherent in the favorably valued stocks we
already own.
Specifically, we currently hold a fully invested position in about 100 stocks that we believe exhibit some combination of favorable valuation and market
action (price-volume characteristics that convey persistent accumulation by other market participants). Those stocks have two sources of fluctuation. In
part, they fluctuate due to overall market fluctuations, and they fluctuate due to characteristics specific to those individual companies. When we are fully
hedged, we are willing to take the company specific risk, but attempt to neutralize the market risk of those stocks. When we lift a portion of our hedges,
it isn't necessarily a statement that we "like" the overall market. It simply means that we are willing to take more of the market risk inherent in stocks we
already own. Subtle distinction, but important, because a fully invested position in our favored stocks, leaving 40% unhedged, is a dramatically different
position than simply being 40% invested in some market index.
For now, we remain fully hedged. My opinion is that this market is far more extended than most investors seem to imagine. While we've actually had
some opportunities to increase our exposure to a few technology stocks (we still won't touch Cisco because we don't trust its management), the broad
market is actually more overextended than it was at the 2000 peak. We don't trade on opinion, of course, but we're comfortable with a full hedge here.
With regard to the big picture, probably the best phrase to describe both the economy and the markets is this: delayed recognition of impairment. What
we have is a situation where the fundamentals, particularly in terms of balance sheets, are terrible. But there are mechanisms at work to delay the
recognition of this impairment.
In the housing market, for example, balance sheets continue to deteriorate. Mortgage debt has soared to record levels relative to household income.
Sub-prime defaults are spiking higher. And home owners have withdrawn so much cash when they refinance that equity as a percentage of total home
value is now less than 55%, compared to 70% little more than a decade ago. But homeowners are focused on the nominal interest rate on mortgages, which
is fairly low, failing to understand that with inflation low, the real interest rate, and thus the real burden of mortgages in terms of purchasing power, has
rarely been higher on a historical basis. It is that burden that eventually shows up in default rates.
In the banking sector, the past several years have seen a dramatic increase in securitized loans. What happens here is that banks make loans, package
them into a security, and then sell them off on the bond market. As a result, these loans go off of the balance sheet, and if they fail, they don't show up in
the banking statistics. As Charles Peabody notes in Kate Welling's excellent Welling@Weeden, "a lot of these structured products are sitting out there
with significantly impaired values - CLOs or CBOs or CDOs, collateralized loan obligations of one flavor or another. Essentially, that's what PNC had
created with their special purpose entity, for instance. But as assets become impaired in those vehicles, they're not recognized immediately in the P&L or in
the equity accounts of these banking organizations. Eventually, these CLOs will be renamed CLOWNs, for 'collateralized loan obligations worth
nothing.'"
Moving on to the corporate sector, the Wall Street Journal ran a chart on April 4th, showing how dramatically tangible assets have declined in recent
years as a percent of all business assets. Corporate balance sheets are increasingly built on intangibles and goodwill that can be highly subjective.
In effect, the stock market and the economy are built on increasingly fragile balance sheets - questionable assets on one side, huge debt on the other.
Confidence is based not on underlying asset values, but on the trend of income and reported cash flows. The problem is that as long as these reports are
upbeat, investors refuse to look deeper. This lack of vigilance results in a time lag between impairment of assets and the recognition of this impairment in
market prices. It is this lag - this air - that many stocks are trading on here.
With an active slate of earnings reports due this week, investors will undoubtedly be urged to focus their attention on operating earnings and cash flow
once again. This is really a request to ignore the balance sheet.
Take for example the argument that strong cash flow indicates "high quality" earnings. When people talk about "cash flow" this way, they're not talking
about cash flow = net earnings + depreciation, depletion and amortization. Financial statements don't even include that number. When people talk about
cash flow being an indicator of earnings quality, they're talking about the first figure on the Statement of Cash Flows: "Net Cash Provided by Operating
Activities."
Now in theory, if you're reporting earnings and you can show the cash in your hot little fist, then yes, the earnings report can probably be taken at face
value. But net cash provided by operating activities doesn't show this at all. Most of this cash disappears as unspecified "investments" and other uses of
cash flow that make it unclear that the cash flow was ever legitimate in the first place. Often these "investments" are simply expenses that have been
purposely misclassified. The investments are then written off later as "extraordinary losses", keeping them entirely out of the calculation of operating
earnings, and allowing the game to continue.
Much of this can be demonstrated by analyzing the financial statements of a randomly selected company. Let's see. Oh, here's one. Enron.
In its 2000 annual report, Enron reported strong net income, and backed it up with "Net cash provided by operating activities" of $4.779 billion. Now, few
reading the report knew of the accounting fiasco underneath this company. Nor did they have to. The funky cash flow number was enough.
See, if you go over to the balance sheet and the footnotes, you discover the source of much of this "cash flow." From 1999 to 2000, Enron's receivables
roughly tripled, increasing by $8.203 billion. Payables shot up by $7.167 billion, the company ran off $1.336 billion in inventories, and it otherwise ran
down its working capital (net short term assets) by 1.469 billion. Now, anything that allows Enron to hold onto more cash (including deterioration in the
timeliness of payments, depleted inventories, and reduced working capital) boosts "Net cash provided by operating activities." For instance, the increase in
payables means that Enron owed others $7.167 billion that had not yet been paid out of the cash account. That's actually booked as a "source" of cash
flow, as is the rundown in inventory (since no cash had to be laid out to obtain the energy that was sold). In all, these "changes in components of working
capital" added 7.167 + 1.336 + 1.469 - 8.203 = $1.769 billion to Enron's year 2000 "cash flow". Nice.
Any risk-averse investor would be put off by that big jump in receivables, as well as the six-fold increase in "assets from price risk management activities"
from $2.21 billion to $12.01 billion, a corresponding surge in similarly-named liabilities, and an absence of discussion of what these "activities" actually
entailed. In short, you didn't even need to know that there were accounting irregularities. The published financial report, as it stood, was bad enough.
Bad enough for anyone willing to look past the garbage about beating analyst expectations and "huge cash flow." You're going to hear more of that
garbage this week. So be prepared to go to the web sites of the companies, and actually look at the reports - particularly the balance sheet and the statement
of cash flows.
In general, you want to look for 1) big jumps in receivables - an indication that customers aren't paying in a timely manner, 2) big jumps in payables - an
indication that cash flow is larger than it would otherwise be, and the company may be strapped for cash, 3) big jumps in inventories - an indication that
products aren't selling, 4) big declines in inventories - an indication that cash flow from operations is higher than it would otherwise be, 5) huge numbers in
any category labeled "other", 6) footnotes about option costs and associated tax deductions - figures that often reveal that option grants actually exceeded
net income, 7) notes about "accounting changes" - always ask "Why?", and 8) four paragraphs in the auditor's opinion rather than three - the fourth
paragraph (which would occur after the one saying "In our opinion..." may be nothing of importance, but it can sometimes contain information about some
aspect of the financial report that caused fights between the auditors and management.
Should be an interesting week. |
