Beware Earnings as F.O.E.

Earnings reports and earnings season every quarter are times when the market responds to impressions rather than researched information.  Too a large extent the public cannot be entirely blamed, because they are relying on news reports and financial information from the companies.  In as much as these do not reflect the underlying tax accounting manipulations, real cash flow, the types of cash, and other legal legerdemain that constitute forward operating earnings (FOE), the information being publicly passed and digested does not give a reliable value of the security or the market as a whole.

John Hussman has written about the problem of forward operating earnings on many occasions in his weekly commentaries.  On July 19, he discussed how dividends are not properly taxed and this leads to companies to report earnings and then waste the "...retained earnings on speculative acquisitions and incentive compensation to insiders...".  He then went on to discuss how he warns investors to be skeptical of valuation metrics built on forward operating earnings as they are estimates of next year earnings but omit a whole range of charges such as bad investments, loan losses, restructuring charges, etc.  This generates statistically distorted and overly optimistic projections as substantiated by historical data.  He then illustrates how Tobin's q ratio, which is based on comparing market value to replacement cost, as advocated by Andrew Smithers and Schiller's CAPE, which is based on the ten year average of actual net (not operating) earnings provide consistently comparable valuations.  "Ultimately, the value of any security is the properly discounted stream of cash flows that the security will deliver into the hands of the investor over time."  Net earnings not operating earnings are the important and more accurate information.  "...net earnings represent the only amounts that investors can hope to obtain, and then only if the net earnings are distributed as dividends or invested in productive activities that don't get written off later."

On August 2, 2010, Hussman continued his concern with the increasingly careless use of operating earnings as a misleading measure of stock valuation.  "The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation."  Analysts tend to treat these hypothetical operating earnings to create forecasts "... as if they are distributable cash flows. Unfortunately, operating earnings exclude a whole range of charges that may not occur on an annual basis, but are legitimate costs and losses incurred as part of the ordinary course of business. Meanwhile, operating earnings often include a benefit from those very same "extraordinary" sources - provided they make positive contributions (witness the large boost to the operating earnings of major banks this quarter, resulting from the reduction in reserves for future loan losses)."

On August 9th, Hussman repeated the importance to the investor of being able to properly assess stock valuations.  He then continues with warning investors to not believe that cash on the balance sheet could "... suddenly be used, in aggregate, for new investments and capital spending." Often, this cash is in the form of loans to the government or private companies in the form of T bills and commercial paper.  Consequently, these investment savings are not available to spend.  These marketable securities are someone's liabilities.  Often, cash is the result of the issuance of corporate debt.  You cannot look at cash assets and ignore liabilities in national and global balance sheet of all assets and liabilities; what affects one side of the balance sheet effects the other side of the economic balance sheet of all corporations, individuals, and government.

When you look at market valuation and the value of a security, you need to dig into the actual detailed financial information and historical data and use that data in a rigorous model that yields information and not forecasts.  Too many market pundits will cry earnings and pronounce them as positive or negative based on summaries and estimates of forward operating earnings when they should be focused on net earnings, in what form cash is held, liabilities, and the use of earnings.  Too often market talk about earnings is the shot used to stampede the herd.  Often, market commentators have vested positions in how the market moves or, worse, political motives in forming public opinion.







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Revisionist GDP Numbers

On July 31st we reported the 2010 Q2 GDP numbers of 2.4%, of which 1.05% was from increase or rebuild of inventory and only 1.3% actual demand growth.  Of more concern, Q1 2010 was revised from 2.7% to 3.7%, which included a substantially revised inventory rebuild of 2.64%.  At the same time each quarter of 2007, 2008, and 2009 were also revised indicating the recession was worse then we were led to believe.

What Q2 2010 showed was spending needs to pick up, which is unlikely, and too much consumer and business spending go to imports.  Personal consumption expenditures (PCE) of 1.6% in Q2 slowed from 1.9% in Q1.

Q3 2010 will need to grow 3.4% to get to pre-recession levels.  With the economy slowing, unemployment growing, and housing prices (new existing home sales will be out August 24th) and inventory trending down that is not going to happen.  The July 30 Consumer Metrics Commentary on the GDP numbers shows the problem of the inventory rebuild number in the GDP going forward.  It should be noted that the GDP methodology used in the United States is completely different from that used by any other country, because the United States since 1980 has used a hedonic price index to adjust GDP numbers for a subjective value attempting to determine the economic growth from innovation, such as the economic growth from computers being replaced by more powerful computers.

With economic data for the last several months being mixed and beginning to show not only a slow down but the possibilities of contraction, analysts from various sources have been pouring over how the Q2 2010 GDP number might be revised on Friday, August 27th, and opining that it will be revised down to 1.9%, 1.4%, or even an extreme 1.0%.  With eyes around the world, particularly Europe, watching the United States for signs of recovery or slowing growth portending a possible near future contraction, the revision could have fear-confidence repercussions globally.  October Q3 GDP reports could begin to show contraction again in some European countries which have been expanding on tax increases, like Spain.  Will the fear-confidence factor grow into a sharp market correction?

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SEC Comment on the Fiduciary Problem

In the United States the financial services industry and the many associations which represent its salespeople, such as the CFP Board, have been pressing for an amorphous financial standard which would apply to all advisors without respect to how many conflicts of interest they have.  An actual discussion of true fiduciary duty is not allowed on the table, because fiduciary duty does not allow any conflicts of interest.  Even with the financial standard smoke screen, the salespeople protest they cannot understand what it is and how it could be applied and the public needs to practice caveat emptor.  Present securities law, rules, and regulations favor salespeople over fiduciary advisors and purposefully confuse the public as to who is who and what they do.

The new financial reform legislation which passed Congress kicked the fiduciary question down the street and required the SEC to study what, if any, fiduciary requirements should be placed on salespeople, advisors who sale, and advisors who do not sale (this later category is not a popular subject on Wall Street or in insurance companies).  Comment on this subject ends August 30 and you can read comments on file here.  The transparency of designations which clearly communicate to the public who is who and the level of fiduciary responsibility or actual fiduciary duty are long overdue.  Even the associations confuse the issue.  For instance, NAPFA holds itself out as an association of fee only advisors, but the majority of its members are salespeople who appear to provide the bulk of the association's revenue.  Besides an initial and annual membership fee, the requirement to become a fee only advisor member includes submitting a fictional financial plan consistent with the example plan sent to prospective members.  How hard can that be?  Yet, many lazy news organizations and writers fail to do the research and think this is the source for fee only advisors, when it actually has a very small percentage of actual fee only advisors as members.  A clear SEC designation would clear this mess up and make a lot of these self-serving associations redundant.

I have previously written on the need for a two years master's degree program for fiduciary advisors and have been working on a curriculum program.

Here is the comment I sent the SEC:

SEC

Comments on File 4-606

In the United Kingdom, Canada, and Australia it is now illegal to give financial advice and sell products and the regulations being phased in, because the two activities are ethically incompatible.

In the United States, the discussion of true fiduciary duty in which there are no conflicts of interest, as above, has not been publicly allowed, as salespeople and the organizations and associations which represent them are committed to the existence of "unavoidable" conflicts of interest and the promotion of a "fiduciary standard" which would put wolves in sheep’s clothing and continue the confusion of the public as to who is who as a commissioned advisor, fee-based, or fee-only. In fact current SEC law and rules and regulations allow financial advisors, with Broker-Dealer relationships, and advisors who accept fees from sources other than clients and/or soft money or services from a Broker-Dealer to legally call themselves fee only advisors. This confusion is purposeful and serves the best interests of salespeople.

I have previously published, prior to the passage of the new financial reform bill, a criticism of the current regulatory process and need for clear designations under the title of "Fiduciary Responsibility vs. Fiduciary Duty" which was published nationally by Advisor Perspectives

and also here.  It is time for public transparency, clearly delineated advisor definitions, and appropriate fiduciary responsibility salesmen and conflicted advisers distinguished from the fiduciary duty of a true fee only advisor with no conflicts of interest.

That article reads as follows:

     

I included the text of the "Fiduciary Responsibility vs Fiduciary Duty" article above as the SEC comments page recognizes no links in my comment.

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Yves Smith Interview

On the 7/31/2010 Radio Show, we had the opportunity to have Yves Smith as a guest.  Yves Smith is the author of ECONNED, which is one of the best books on the financial crisis, because it covers the economic thinking which led up to the financial crisis as well as how Wall Street greed proceeded at high speed towards the crisis and how government failed in its regulatory duties before and after.  Yves Smith is also the creator of the blog naked capitalism.

Here is the link to the RSS feed for The Pursuit of Financial Happiness which you can past into your preferred reader:

http://www.stationcaster.com/stations/wmay/rss/?c=336


 Here is the actual podcast of the Yves Smith guest appearance.

The Pursuit of Financial Happiness radio show podcasts are also available free on iTunes, but you need to go to the Advanced tab at the top of  iTunes and then select Add Subscription and past the above RSS feed in order to get a current list of shows, because iTunes takes its time adding shows from the RSS feed and just subscribing to the show itself in iTunes' Podcasts will not get you a current list of podcasts.

UPDATE: 1 June 2015
The radio station link is no longer any good.  Here is a good link:


http://www.mjscpaplan.com/podcasts/Interview_w_Yves_Smith.mp3



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Does the Media Understand Economic Statistics - Housing?

On Monday, July 26, the media made much of  June New Home Sales going up 23.6% with inventory decreasing from 9.6 months to 7.6 months and it seemingly effected the stock market which went up 100.81 points on the Dow.  Unfortunately, the June sales looked so good, because the May sales were substantially revised down.

June existing home sales and June housing starts were also down in reports from the prior week.

On July 28th, the Fed Beige Report came out and indicated sluggish housing sales, a decline in housing starts, and a struggling commercial real estate market.

When reading news articles, you need to dig for as complete information as possible in order to understand what the data really means.

The home ownership rate fell to 66.9% which is the lowest level since 1999.  While the Case-Schiller Housing Price Index showed a May increase in prices, the data is actually indicating that prices are probably starting to decline, although those results may not show up in the Case-Schiller for months.

Negative home equity is still at 4.1 million homeowners with more than 50% negative and 5 million with 20-50% negative equity, although the number has declined from its 2009 peak.  Banks are holding foreclosed and repossessed properties on their books rather than try to sell them in this market and to procrastinate in writing down the value of the repossessed homes on their books.

On Monday, July 26, did the stock market react rationally to housing data or did it just hear what it wanted to hear?


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What Have I Been Doing

I have been very deficient in making posts and I wish to apologize.  It is my intent to always attempt to make regular and hopefully daily posts.  However, many of my posts require significant research and organization and then hours to actually write.  The "Leftovers" posts from the Radio Show take 2-3 hours minimum. 

Since April I have been heavily involved in research on the European Credit Crisis looking at not just the countries but the banks in the countries, the ECB, the EU, the eurozone, account imbalances within the eurozone, the monetary and fiscal structure of the eurozone, interbank lending, country and bank exposure to deficit countries encountering credit confidence problems, interbank lending, liquidity issues, and trying to identify trends and the reasons effective solutions were or were not emerging. 

The European Credit Crisis is now at a lull, but credit and liquidity issues remain and they present potentially global ramifications, particularly as China and India attempt to control inflation internally, China attempts to control its real estate bubble, and political internal pressures build within France, Germany, the UK, Greece, not to mention India, China (a major competitor with Germany for the export market), and other countries.  In the meantime, Russia has been exerting its energy muscle to build relationships within the EU and eurozone to benefit its own economic interests which could eventually put enormous pressure on NATO.

Professionally, I have had to get Quarterly investment management reports out and otherwise earn a living.

I have almost 20 articles outlined and/or researched and waiting for the hours to write them.  Although I have not been posting, I still spend significant hours during normal sleeping hours working and doing research.  One article on Germany and how its history is consistent with the current Credit Crisis has been ready to write for over three weeks and will undoubtedly be relatively long while still concise.  I have another I want to do as soon as possible on Spain and its importance in how the European Credit Crisis winds down or proceeds.  I have at least two more planned and researched on the Pan-European Credit Crisis.  I have another on The Great Moderation as the Great Enabler.  I have one planned on China and its currency.  I have another on rethinking macro policy; another on wages, aggregate demand, and unemployment.

I intend to post all Leftovers from the Radio Show even though I am a half box behind in getting it done, because I think it is important to see how the data and facts have evolved.  When I get commentaries on the market from various sources, I like to read them and then hold them for at least a month and then read them again.  It can be very insightful.

I intend to make it worthwhile to check this Blog on a regular and, hopefully, a daily basis.

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Leftovers -- Radio Show 5/22/2010

Bank analyst, Meredith Whitney, said investors should avoid bank stocks at all costs.  In the second half of 2010, she expects job losses and a housing double dip.  The drop in reported credit card delinquencies was actually the result of new credit card rules which took effect earlier this year.  She thinks the financial reform bill will "be very bad" for banks".

When it comes to credit cards, the banks are gaming the payments, because, under the new laws which were designed to appear to protect consumers from self-serving billing practices, only the amount of the payment in excess of the minimum must be applied to higher rate balances.  The minimum payment is applied by the banks to lower interest rate balances first.

Elizabeth Warren continues to argue that the loopholes in financial reform which allow the big interstate banks to escape tougher state laws and rules on banks and credit unions create unfair competition, a destruction of a level playing field, and subjects consumers to higher interest rates if not usury.  Senator Whitehouse's amendment would close these loopholes and make big banks subject to stronger state laws if they want to do business in those states.

Another financial reform amendment by Senator Durbin would require credit card companies to cease charging transaction fees if the business also accepts debit cards.  This will help businesses, but it is expected the credit card companies will pass the lost transaction fees in higher card fees to credit card holders.

April CPI went down one-tenth just as it went up one-tenth in March for an annual inflation rate of 2.2%.  Core inflation was unchanged at .9%.  Using the 1980's calculation for inflation, inflation would be approximately 9.5-9.6%.  Using the 1990's calculation for inflation, inflation would be approximately 5.5%.

In the April meeting minutes of the Federal Open Market Committee meeting of the Federal Reserve, it was observed that business conditions are improving but most anticipated the pick up in output would be slower relative to past recoveries.  It is unlikely that consumer spending will be driving economic recovery and the savings rate has dropped.  The housing market appeared to have stalled.  Commercial real estate activity continued to to fall on deteriorating fundamentals.  Small businesses continue to have continuing difficulty in obtaining bank loans.  Small and regional banks are vulnerable to commercial real estate loans.  If European countries expand fiscal consolidation (cut deficits), the result would likely be slower growth in in Europe and a weaker global economy.  As I have noted on several occasions, and as one participant in the FOMC commented, core inflation appears to have been held down in recent quarters by unusually slow increases in the price index for shelter (its composition was changed)  and the recent behavior of core inflation might be a misleading indicator of the underlying inflation trend.  While inflation remains low to flat, expectations of inflation are increasing among market participants.  Again Mr. Hoenig was the sole dissenting vote on "exceptionally low levels of the federal funds rate  for an extended period", because he fears it will lead to a build up of future financial imbalances increasing the risks of longer run macroeconomic and financial stability and limit the FOMC's flexibility in when and how it begins to raise rates.

David Beckworth has concluded that a current high unemployment is not cyclical but structural, which means there are thousands of jobs which are permanently gone and will never be refilled.  In my opinion, this also means those unemployed over 55 years old will particularly have a hard time find comparable work or comparable pay to their former jobs.

The SEC suspects ETFs fueled the May 6th drop.  ETFs accounted for 70% of the securities that fell 60% or more from their price at 2:40 P.M.  Bond ETFs did not see sharp drops.  Many of the trades involved stub quotes or place holders (one cent) as the result of computer programs.

John Hussman in his weekly commentary is concerned that the ECB's pledge to buy sovereign bonds from European banks will place weak assets on their balance sheet just as the Fed did with toxic mortgage backed assets.  I personally do not think they are comparable assets.  Hussman sees monetary policy as being only as good as fiscal policy.  Unfortunately, the eurozone has removed monetary policy from its member nations control and the Stability and Growth Pact has significantly crippled member nations' fiscal policy applications consistent with internal economic needs.  Hussman is also ignoring the current account imbalances within the eurozone.  He believes that without a central taxing authority, the eurozone lacks the ability to control deficits.  Consequently, he thinks Greece will have to restructure debt, but he is ignoring that the IMF/EU bailout forbids restructuring.  He actually thinks Greece and other countries will pull out of the euro, but he is not acknowledging that that would require withdrawal from the European Union in totality, which is very unlikely and difficult to happen.  He sees tepid wage growth for the next several years and inflation not being a factor until the last half of this decade.

Congress will be considering a mish-mash conglomerative bill which includes several diverse issues: a 30 day extension of jobless benefits, retroactive reinstatement of expired tax cuts, summer jobs, police and teacher jobs, and increased taxes on investment fund managers from 15% capital gains to 35% as well as other oil barrel tax, a three year delay in Medicare payment cuts to doctors, etc.  These bills are designed to have a little something for each party and often end up either mired in controversy.or whisked by the wind.

Hundreds of cases have been referred to the Justice Department over several years involving bid rigging of municipal bond sales by financial advisors and traders, including banks.  This also involved the sell of interest rate swaps to local governments that backfired.  The process was pervasive and may have involved many, if not most, of the largest banks.

Pinalto, Cleveland Fed President, sees a gradual recovery and low inflation.  She sees high unemployment and overwhelming cautiousness by consumers and businesses as a major impediment ("headwind") to recovery.  Kohn, Fed vice-chairman, sees keeping future price expectations intact as vital with interest rates are very low.  Unanchored expectation would be risky and far too costly.  He addressed the uncertainty of determining proper price stability, asset bubbles, asset purchases and sells, and balancing financial stability.  Dudley, New York Fed President, said the recovery will not be robust, household deleveraging started last year, and the transitory inventory boost to GDP is over.  Tarullo, Fed Board Governor, in Congressional testimony said the European credit crisis could spill over and cause U.S. bank losses on credit exposures.

The passage of the Senate financial reform bill has a variety of winners and losers, but it is going to Conference Committee with the vastly different House version and in conference committee anything can happen and a bill could emerge which is vastly different from the two which went into Conference Committee.  You can expect many amendments which were not debated publicly and the bank and financial services lobbyists will have their knives out and counter attacks washing across the Conference Committee like the waves of the ocean.

Economic information we did not get to on the show:

The IMF said the European Union fiscal tightening will slow recovery.

The new UK government will cut $8.75 billion in spending.

Japanese core machinery orders were up 5.4% in March.

EU plans hedge fund crack down with rules to control pay and borrowing as well as force disclosure of investing information.  Some think this will discriminate against U.S. hedge funds and other none EU funds.

Germany unilaterally and without consultation with other EU countries banned short selling of equities and sovereign debt swaps.  It had negative effect on the markets, but it is essentially meaningless without action by other countries as the trades will just be executed in other foreign markets.

Eurozone CPI was up .5% in April on rising energy prices.  CPI was up 1.5% vs year ago.

UK CPI was up 3.7% April vs year ago with higher food and tobacco/alcohol taxes.

Chinese CPI is expected by the government to rise 3% vs year ago in May and June.

Dubai World reached a tentative agreement with creditors to restructure $28.5 billion in liabilities.

Japan's economy grew 4.5% (expected 5.4%).

Spain's lar4gest union may call for a general strike.

Greek demonstrations were mild after last week's violence,


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