Puplava Nails it again!
Wednesday's Stock Market WrapUp
S&P Goes All-American
In writing today’s commentary there were no shortages of topics to write about, so I will start with a few of the morning's headlines and digress from there. Standard & Poor’s, the keeper of the S&P 500 Index, made their largest change in several years to the index. S&P dropped the listing of seven foreign stocks and has now decided to make the index all-American. The seven foreign companies dropped had a market value of $19.8 billion. The companies that will replace them will have a market value of $16.8 billion. The difference of $3 billion will have to be spread out over the remaining 473 companies in the index. David M. Blitzer, chairman of S&P’s Index committee said, “When the dust settles, the index funds will buy a little bit more of the other 493 stocks in the index.”
Many of the companies removed were natural resource companies such as Royal Dutch Petroleum, Barrick Gold and Placer Dome. The changes will sharply reduce the representation of gold stocks in the S&P 500, removing two of the three gold stocks in the index. The only gold stock left is Newmont. The removal of Royal Dutch also reduces the representation of oil in the index. Deleting these companies removes some the best performing companies within the index and replaces them with financial companies. The S&P committee did not apply the same logic to the 10 companies in the index that are based out of the Bahamas such as Tyco International or Carnival which is based in Panama.
One has to wonder about the wisdom of such an approach, especially at a time when gold shares have been outperforming the major indexes over the last two years, a time when the CRB index of commodities is moving to new highs, the price of oil is rising along with gold and silver you have the removal of commodity based companies from the index. You also have mutual fund companies like Vanguard closing down its gold fund to new shareholders and Fidelity selling off shares of gold companies.
The companies that are replacing the natural resource companies are Goldman Sachs, Ebay, UPS, Prudential Financial, Principal Financial Group, SunGard Data Systems Inc., and Electronic Arts. One can only imagine what this will do for the real P/E ratio of the S&P 500. Ebay sells at 140 times earnings, Electronic Arts trades at 90 times earnings, and UPS trades at a multiple of 30.
S&P hopes the changes will generate some more buying power for the S&P with nearly $1 trillion in index funds and many more funds acting as closet index funds. It is almost as if the financial industry wants to generate an artificial rally. If the indexes don’t rally on their own, perhaps reengineering the index will help. Let's not forget that P/E multiples computed for the S&P 500 are also artificial since they aren’t computed on the net income figures of the companies. The P/E multiple is now based on a variation of pro forma earnings. Why stop with that? Maybe in the future we will see pro forma prices calculated by a computer in much the same way that the value of OTC derivatives are computed. We now have pro forma earnings, pro forma economic numbers, and pro forma media reporting. Why not have pro forma prices as well? We already live in a land of make believe. Why not carry it to its full conclusion? We could turn the financial markets into an investor theme park of make believe in much of the same way as Disneyland. Come to think of it, this may be much easier done than originally thought since Disney owns CNBC.
Discredit and Credit - Whew!
In today’s scandal sheet, the U.S. attorney’s office has opened criminal investigations into Qwest Communications. Two U.S. lawmakers have looked into whether Salomon Smith Barney and Citigroup let officials of WorldCom buy into IPO’s underwritten by both companies. A letter was sent to Salomon analysts Jack Grubman. Lawmaker’s criticized Grubman yesterday saying his relationship with Ebbers made the analyst unwilling to question WorldCom’s finances.
On the financial front the credit binge of recent years is leading to more bankruptcies and more bank loan loss charges. Today Sun Trust, one of the nation's top ten banks, said its profits would fall 1 percent in this quarter as the bank increased its loan loss reserves by 15 percent. The bank wrote off $16.3 million from losses in Enron. The bank is owed $76 million by bankrupt Adelphia Communications. The bank also wrote off $83 million in commercial loans, which was three times the amount written off in the same quarter a year ago. Sun Trust's disclosure today follows a drop in profits of 9.7 percent last quarter because of a rise in bad loans.
In other credit news the FDIC, which seized the assets of NextCard, the Internet bank credit card company, told 800,000 credit card holders on Wednesday that their credit cards would become worthless. The federal regulators closed all accounts as a result of the on-line credit card issuer’s financial failure. Today it we saw news that more states are reporting an increase in bankruptcies. The state of Arizona reports that bankruptcy filings are up by 10 percent this year. State officials say that lenient bankruptcy laws, mounting personal debt, and a sluggish economy are behind the increase in bankruptcy filings.
The growing number of bankruptcy filings and the mounting corporate bond defaults are due to set new records. Even though bankruptcy filings are up, consumers continue to add more debt at record levels. Economists hail this as an unmistakable sign of consumer confidence in the economy. There is something wrong here with this kind of thinking. Economists and analysts are basing their recovery assumptions on the consumer’s ability to add more debt and spend. The consumer is already over burdened by too much debt -- yet the financial system and government officials are urging the consumer to take on more debt. This is a house of cards that is waiting for a catalyst to tumble. And here we have the S&P 500 adding more financial companies to its index today! This is the problem with the financial markets and with the economy -- it is all based on debt. The assumptions are that companies will borrow more money, consumers will go deeper into debt, the government will continue to deficit spend, and foreigners will continue to lend us money. It is simply amazing that very few people on Wall Street and in Washington see the danger in all of this.
Getting back to the credibility of our financial system, a new report given to Congress today by Weiss ratings showed that nine out of ten public companies found to have had accounting irregularities received a clean bill of health from their auditors. The failure to spot these accounting problems cost shareholders $1.3 trillion in wealth. The Weiss Report titled “ The Worsening Crisis of Confidence on Wall Street: The role of Auditing Firms” points out that only PricewaterhouseCoopers issued any warning. The other firms Arthur Andersen, Deloitte & Touché, Ernst & Young, KPMG and Tullis Taylor made no warnings at all. The Weiss Report also looked at 228 companies that filed for Chapter 11 bankruptcy between 1/1/01 and 6/30/02. The “Big Five” auditing firms performed audits on 194 of the 228 companies studied. Weiss says that 42 percent of the companies that went under were given a clean bill of health. Weiss says that KPMG had the worst track record. Weiss urged Congress to pass the” Public Accounting Reform and Investor Protection Act of 2002” without weakening amendments.
As I have written so many times over the years, the accounting system has become so complex that investors need the skills of a forensic pathologists and the investigative intuition of Sherlock Holmes. The numbers are opaque, the footnotes confusing and laborious. I spent the holiday weekend examining one company whose annual report was primarily made up of footnotes. It wasn’t clear what their numbers were nor did management have a good explanation of the numbers or the direction of the company. I concluded that if the company didn’t understand their own business, that the accountants didn’t understand it either. I wondered what it was that so enamored the company with Wall Street.
I believe that unless the financial industry can agree on some kind of standard that most investors and the auditors can understand, the whole system is bound to implode. The system we now have borders on the absurd. Numbers no longer have any meaning to them. You simply can’t take them at face value. The present trend with Wall Street, the financial media and the companies they follow and report on, is go with whatever looks good. Companies seem to be saying don’t look at our actual results, instead look at our hypothetical numbers which make us look good. Unfortunately, the analysts and the media and the rating agencies go along with it. That is how bad it has gotten that Barron’s and Standard & Poor’s no longer report financial ratios such as P/E multiples on bottom line numbers. We now have about five variations of pro forma numbers that are used to report on earnings. Today's investor doesn't have a clue as to which numbers reported represent the real numbers.
Today's Market
There was heavy selling everywhere in the markets today. Even defensive areas like utilities got hit hard. Drug issues continue to get pounded with Merck hitting a five-year low. Within the Dow only two of its components McDonalds and Procter & Gamble were on the plus side. Today’s winners were confined to the precious metals sector. Volume was heavy approaching 1.78 billion on the NYSE and 1.84 billion on the Nasdaq. Market breath was very decidedly negative by 24-8 on the New York Exchange and by 24-11 on the Nasdaq.
Overseas Markets
European stocks fell, led by banks such as BNP Paribas SA and Commerzbank AG, after Goldman, Sachs & Co. said lower share prices may crimp revenue at some of the region's biggest lenders. Munich Re dropped after pumping $2 billion into its U.S. unit. The Dow Jones Stoxx 50 Index shed 3.6 percent to 2925.91
Asian stocks fell after Merrill Lynch & Co. cut its 2003 forecast for worldwide capital spending by the semiconductor industry. Samsung Electronics Co. and Tokyo Electron Ltd. paced the drop. Japan's Nikkei 225 stock average slid 1.9 percent, while Taiwan's TWSE Index slumped 2.4 percent.
© Copyright Jim Puplava, July 10, 2002
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