Carl Swenlin
November 17, 2001
FUNDAMENTAL OBSESSIONS: It can be demonstrated that market price movement will often anticipate turns in trailing earnings. This is not because the market can see the future, rather it is because earnings information is reported informally in advance of earnings actually being officially "booked"; therefore, the market responds to what is known and anticipates confirmation and continuation of positive or negative earnings news before the official earnings turn begins to show on the chart.
We are currently being told that the market "sees" a "V-shaped" economic recovery early next year and is therefore anticipating an earnings recovery. The problem with this assertion is that there is virtually no evidence to support it, so exactly what is the market seeing? I think it is seeing the world through the same rose-colored glasses that got us into this valuation bubble in the first place.
On Thursday the S&P 500 was at 1142.26 and had a P/E of about 31. To return the S&P to fair value (P/E = 15) would require a price decline to 551.00, or for earnings to double, or some combination of the two. To assume that prices will continue to rise while earnings deteriorate or go flat, is irrational. I repeat once more, in the last 60 years there has never been a case where a bear market has ended with valuations at record highs. Bear markets are supposed to correct this kind of excess. So far, this one has not.
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PRO FORMA FOLLIES
Pro forma earnings reporting is a practice that has virtually no standards whatsoever, and is designed to mislead investors as to the true financial standing of the company. Using this increasingly popular deceit a company presents their financial status in a way that presents the best picture by leaving out items that reduce earnings or by inflating revenue. Alan Newman (Crosscurrens; crosscurrents.net) quoted from Yahoo's October 10 earnings announcement as a recent example: "On an operating basis, excluding a range of costs, the company reported a small profit of $8.4 million, or one cent per share." Alan retorts: "Yahoo's pro forma 'profit' actually excludes depreciation, amortization, payroll taxes on option exercises, investment gains and losses, stock compensation expenses, and acquisition related and restructuring costs."
I think I get it. To make a profit we just keep pulling out expenses until income minus expenses equals a positive number. Gee, I wonder how many companies went bankrupt not knowing how easy it is to make a profit. Actually, if you or I were to apply for a mortgage using "pro forma" personal financial data, we would be risking jail time.
According to a Reuters article, the SEC and Standard & Poors are starting to take notice of this scandal. In fact it is a scandal that they haven't done something before now, but at least they are beginning to recognize their own responsibility (liability?).
The article states, "'If what's in a press release is materially misleading ... then we can charge them,' said Niemeier [chief accountant for the SEC]. For example, if a firm claims it posted a rise in operating results by excluding certain items that it didn't make clear to investors when its results were actually down, the agency could take action against the firm."
Hello?!! Reporting a profit when in fact you have a loss is not misleading? The SEC's inaction regarding this practice proves once again that the SEC is an extension of Wall Street, not Washington. And, regardless of the hawkish nature of the above quote, the SEC has in fact not decided what action it will take, or if it will take action at all!
Ratings and reporting agencies have been just as bad, but at least Standard & Poors is moving in the right direction saying that "it now will treat frequently excluded items such as restructuring charges, stock option expenses, and write-downs from ongoing operations as part of a company's operating earnings." Hooray!
In contract, First Call says it will continue to use the pro forma analysis for estimating earnings. I can see why they would want to maintain a consistency in their methodology, and they are not using their results to rate companies and have no fiduciary responsibility per se, but we can only hope that they will migrate back to truthful reporting based on generally accepted accounting principals (GAAP), the standard used in the past.
Pressure for the SEC to act probably will not be as heavy a we might think. The equity bubble is still deflating, and it is likely that political pressure will be applied in the opposite direction -- don't do anything to shake the confidence of the gullible public. The object of almost everyone, particularly the public, is to keep the bubble inflated, and the key to keeping a bubble inflated is to keep the manic participants away from any fragment of reality. |
