CRAP VERSUS GAAP
By listening to the financial experts, you would believe that all is going well in corporate America. Earnings are beating estimates, which should come as no surprise; they always do. That is because original earnings estimates have recently been adjusted lower just before actual results were reported. The improvement in earnings that the financial media and analysts are heralding has taken place only in the pro forma realm. According to S&P pro forma or CRAP (cloudy reporting accounting principles), earnings have increased from $11.96 to $12.39. However, actual earnings according to GAAP (generally accepted accounting principles) have moved slightly lower from $11.43 to $11.40. Therefore, the numbers you hear bandied about on the cable shows or in the financial press are CRAP numbers and not GAAP numbers. In other words, we are still dealing with fictional numbers or make believe numbers that don’t exist. These aren’t the numbers that companies use when they turn in their results to the SEC. The SEC requires GAAP numbers, not CRAP numbers so widely used by the financial media and Wall Street.
Today the markets were jubilant over the story that the SEC reached an agreement with ten Wall Street firms to pay $1.4 billion in fines for violating securities laws regarding conflicts of interest in Wall Street research. While this may be cause for celebration for investors, the fact is that Wall Street and the financial media still report CRAP earnings to the investment public. The alarming aspect about this practice is that it gives the allusion stocks are much cheaper than what they really appear to be. The widespread practice of using pro forma numbers is that it misstates actual earnings and distorts all measures of value used to evaluate stocks. Just as an informed consumer would check prices and base a decision to purchase an item on the best value or price, the same principle should be used to make investment decisions. How do you know what you are paying for or how well the business is doing if the numbers that you are given to evaluate the business is false?
As the chart from www.decisionpoint.com illustrates, stocks are still grossly overvalued when you look at real P/E ratios based on GAAP versus CRAP numbers. To put it bluntly P/E multiples are now higher than they were before the 1929 and 1987 crash. Buying stocks on the basis of beating estimates, estimates that are changed, adjusted, and manipulated just before earnings are reported is a dangerous way to make investment decisions. I can’t recall ever taking an investment course in graduate school, (I majored in accounting and finance) that ever recommended making a financial decision based on beating estimates, especially since the numbers are all bogus. It simply doesn’t wash. It is all part of a heroic effort being made by Wall Street to bring back investors into the market. Fund flows have been anemic and in a downtrend, which worries most brokerage firms. The actual charade of pro forma reporting is nothing more than filler time on what has become info financial shows. The analysts and the anchors now have something to talk about that sounds cheerful instead of the growing twin budget problems of the US and the lack of a real improvement in the financial numbers. After all, if things were this great on the earnings front, companies wouldn’t be firing workers and capex spending would be improving.
Few investors seem to be buying the concept that stocks are cheap and that things are actually getting better in the economy. The economic reports don’t say so. The GAAP numbers don’t either. Perhaps the greatest reality check for investors is between the growing layoffs that accompany each earnings report and the euphoria over the pro forma numbers. As mentioned last week, the layoffs are now starting to get buried in the press releases. You obviously can’t have a glowing pro forma report saying that things are really improving if you keep firing more workers.
Therefore, what can an investor do to protect themselves? One step would be to read one of several books listed below on understanding financial statements.
*How to Read a Financial Report, by John A. Tracy
*The Interpretation of Financial Statements, by Benjamin Graham
*Analysis of Financial Statements, by Leopold A. Bernstein
*The Financial Numbers Game: Detecting Creative Accounting Practices, by Charles W. Mulford
*Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Statements, by Spencer Meredith
The second step an investor can take to protect oneself from Wall Street hype and media spin is to visit the Standard & Poor’s website. They actually have a detailed spreadsheet they make available to the investment public. On this spread sheet you can find the real numbers, the spin numbers, and S&P’s core earnings numbers which actually do a better job than GAAP on analyzing market conditions from a more critical perspective. What you will then find is earnings that look more like the bar chart below taken from S&P’s spreadsheet and decisionpoint.com. Notice the vast difference between GAAP, CORE and CRAP or pro forma numbers. For the technicians out there you will see on the P/E graph up above a major head and shoulders pattern in the real P/E numbers in the first chart, another warning for the uninformed.
The above two web addresses should be bookmarked on your browser. Refer to them often when you hear the phony numbers given by analysts and anchors. Check the S&P spreadsheet with what is reported. What you will begin to see is what we see on a daily basis, which is a completely different world, one based on fact versus one based on fiction. The accounting books will also help you to read annual reports and what to look for when companies report numbers to the SEC. The www.edgar-online.com can also be helpful in finding the real numbers reported to the SEC as opposed to the spin and hype you hear on Wall Street and cable financial shows.
Osama/Saddam Indicator
Now as for the miracle rallies that seem to take place in the futures pit, I’ll leave that to this weekend’s radio show where my guest will be Nelson Hultberg. We will examine the concept of whether the PPT is fact or merely an urban legend. I never seem to be surprised at the market’s ability to stage a large rally based on bogus news or political events, especially as they seem to occur at key support or resistance levels, or when the market is breaking down. I have no problem with countertrend trading rallies in the market. They are a natural part of the process in either a bull or bear market. What I do have a problem with is in people that insist that they originate from a fundamental improvement in the economy and earnings, which simply does not exist. Of course, I also don’t believe in the Easter Bunny, the Tooth Fairy, or in Santa Claus, either.
I don’t wish to imply that every spike up in the major indexes is a result of the PPT. As I wrote in Dumb and Dumber last week, fund managers are also responsible for some of these rallies. Unable to make money by investing for their shareholders, fund managers have now resorted to the same investment philosophy as day traders. They are playing the momentum game in unison. Instead of investing, they are all chasing the same momentum stocks in what I call the usual suspects: the Ciscos, the Dells, the EMCs, Amazon.com, EBay and Yahoo. How else can you explain the selling of Barnes & Noble and Borders which actually make money and are selling at one-tenth the market value as an Amazon.com, which has yet to make a real profit and is selling at 104 times trailing earnings versus a P/E of 10 for Borders and 12 for Barnes & Noble?
Today's Market
Meanwhile back at the casino, the markets jumped at the opening bell after a large order in the futures pit. The reason for today’s flagpole rally was that investors were optimistic over earnings coming in much better than expected and beating analysts estimates. McDonald’s saw actual earnings decline but beat estimates, thanks to a currency gain due to a falling dollar. P&G’s sales and earnings gain came from a 3 percent gain due to a falling dollar and 2 percent due to acquisition and divestiture constrictions. These spurious gains helped to rally the markets, but the markets had already taken off in the futures pits where most of these gains seem to originate.
So far the bulk of the gains in earnings this quarter are coming from the energy and financial sectors. The financial sector is responsible for about 20 percent of this quarter’s earnings gain. The spin-doctors were hailing Q1 profit results as one of the best and fastest growth quarters since Q3 of 2000. Of course they are actually talking about CRAP numbers, not GAAP numbers. The GAAP numbers or real numbers are actually down as mentioned earlier. This is why it is so important for investors to go and read the real numbers at the S&P website. It will provide you with a reality check from the hype and spin coming from Wall Street.
The easiest way to think about the numbers you hear each day is that they are pro forma numbers. Pro forma numbers mean that something is missing and has been left out or omitted from earnings. Even on a day like today where companies such as P&G announced earnings that beat estimates, it was due to the exclusion of certain costs that P&G said that earnings would grow this quarter by 12 percent instead of 10 percent. The extra percent was due entirely to pro forma exclusions. A partial list of expenses left out in calculating pro forma profits is highlighted below.
* Goodwill impairment charges.
* Gains/losses from asset sales. They count them when they are gains and exclude them when they are losses.
* Pension gains. They simply don’t exist but are created through accounting assumptions.
* Employee stock option expense.
* Restructuring charges from plant closing and costs associated with firing workers.
* Writedowns of depreciable of depreciable or amortizable operating costs.
I could go on and on but suggest that the readers familiarize themselves with the core earnings concept at the S&P website to keep themselves out of the “spin zone.”
Financial shares were big winners today as investors rushed to buy shares of companies such as Citigroup, Merrill Lynch, and J.P. Morgan after they settled a record fine with the SEC for misleading investors through conflicts of interest between analyst’s recommendations and the investment banking divisions of the company. The agreement to pay a fine of $1.4 billion to the SEC was announced at a press conference in Washington. The investment bankers made more than $28 billion in underwriting fees while investors lost billions. It is a perfect example that white-collar crime pays.
Leading tech stocks higher today was shares of Cisco, which got a boost from analysts after one firm said that they expect the company to report earnings that will beat lower estimates. Wall Street, which expects S&P 500 earnings to rise to a range of $48-$50 by the end of the year, have back loaded all of their estimates to Q3 & Q4. The current projection would be a rise of 80 percent from where they stand now. The only way you get to $48-$50 earnings for the S&P 500 is to do so on a pro forma basis.
In after hours trading the Nasdaq 100 was down fractionally after Intuit said it would meet pro forma estimates. Sales were weaker than expected but will most likely beat estimates. As for profits, the only thing we know is that they will meet pro forma estimates. The company hasn’t revealed what will be excluded from actual numbers to arrive at Wall Streets pro forma target. Shares of Ariba rose in after hours trading after announcing the company will lose less than expected on a pro forma basis. Actual sales were slightly higher than expected. Altera reported that its revenue grew by 8 percent.
Overall, it was a triple digit gain for the Dow with the blue chip average actually gaining almost 200 points before falling back to a 165-point gain. Also helping the markets out was a government report that showed consumer income rose 0.1 percent in March, the first positive number in the index in three months. Meanwhile the economy is getting no encouragement on the capex front. McDonald’s announced that it would be reducing capex spending by $800 million in 2003. Chip stocks, which have been on a tear, recently are seeing orders improve but they are still down from where they were a year ago. Chip sales rose by 2.6 percent in March but are down 3.6 percent for the quarter compared to a year ago.
Volume came in at 1.27 billion on the NYSE. Market breadth was positive by 3-1. On the Nasdaq, breadth was positive by 2-1. Volume today was 7 percent below the three-month average. Volume, sentiment, and momentum indicators show that a top in the market is close at hand. The VIX, which fell .85 to 23.05, and the VXN, which dropped 1.02 to 32.68, are both at levels where corrections begin. Their rapid fall indicates widespread complacency in the markets. The McClellan Oscillator topped out last week. The frenzy in trading activity should be coming to an end shortly. The next things to watch for are the economic numbers. Wall Street believes now that the war is over the economy and earnings recover rapidly. We’ll have to wait and see. Suffice to say the Street isn’t confident enough to raise their pro forma numbers for Q2. Everything magically occurs in earnings in Q3 & Q4.
Overseas Markets
European stocks rose, buoyed by optimism the region's economy will benefit from oil prices at the lowest in more than five months. Siemens AG and Suez SA led the Dow Jones Stoxx 50 and 600 indexes to the biggest gains in three weeks. The Dow Jones Stoxx 50 Index rose for the first time in three days, adding 2.6 percent to 2350.61. The Stoxx 600 index advanced 2.3 percent. Banks such as HSBC Holdings Plc and Standard Chartered Plc accounted for more than a quarter of the increase. Benchmark indexes rose in 14 of 16 Western European markets open today, with the Greek exchange closed.
Japanese stocks fell as Sony Corp. tumbled by its daily limit for a second day. Sony, which last week reported losses that were wider than some analysts had forecast, led exporters lower after a report signaled a U.S. economic recovery is faltering. The Nikkei 225 Stock Average fell 1.2 percent to 7607.88. The Topix index lost 1.1 percent to 773.10 with Sony and other computer-related stocks accounting for almost a quarter of the drop.
Copyright © 2003 Jim Puplava
April 28, 2003
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