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Today's Market WrapUp  04.30.2003  Mon  Tue  Wed  Thu  Fri  Puplava Archive

Nothing Has Changed
BY JAMES J. PUPLAVA, CFP

Earlier this week with too much fanfare the government announced a major settlement with Wall Street firms over conflicts of interest. The markets took that to mean it was much safer for investors because Wall Street research would now be more objective. The reforms reached as a result of the settlement included the well-publicized effort to rebuild a Chinese wall separating analysts from the investment banking side of the business. Most experts believe the reforms will do very little to change how Wall Street operates. What investors will now get is at least open disclosure to potential conflicts of interest. The majority of recommendations coming from the Street are still buy recommendations. How often do you hear a firm recommend investors sell a stock? In fairness to the Street, Zack's Investment Research reported that Wall Street sell recommendations have risen from 2 percent to 10 percent, the highest on record.

However, the biggest problem on the Street is that analysts and firms still need to sell stocks, which is one reason they always taught the fact that stocks are cheap and always a buy when they know differently. The widespread use of pro forma or CRAP numbers is abusive. It gives investors the impression that earnings are great and stocks are always a bargain. It is easier to recommend buys when you are using bogus or fictitious forward earnings numbers. Does anyone really believe that trailing earnings for the S&P 500 of $27.59 will grow by over 80% by yearend to $48-$50? And speaking of stocks being cheap, how do analysts justify P/E multiples of 27 on the Dow, 33 on the S&P 500, and a negative P/E on the Nasdaq as cheap? Those P/E multiples translate into an earnings yield of 3.69% on the Dow and 2.20% on the S&P 500. Do analysts really think when earnings yields are less than 10-year Treasury notes that stocks are cheap?

Better yet -- are dividend yields that are less than 2% for the S&P 500 and only 2.37% for the Dow? As shown in this graph from of the S&P over the last eight decades, most of the return from equities came from dividends. Dividend yields at one time were in the range of 6-7 percent. It was when dividend yields got this high because of a bear market that the subsequent decade produced higher returns for investors. With dividend yields only in the 1.8-2.3 range the returns going forward will be a lot less for investors.

Another thing that hasn't changed in this bear market is the bubble mindset has never left the market. In almost every bear market rally since this bear market began investors rush back to bid up shares of the last bull market leaders. Shares of Internet stocks, and tech stocks in general have now been bid up to ridiculous prices. The simple fact that fund managers are selling off shares of Barnes& Noble and Borders at 10-12 times earnings and buying shares of Amazon.com, which has no earnings and is paying 12 times the price for pro forma profits, encapsulates it all. In short, the bubble has never left; it is still with us and is manifested in valuation metrics within the tech sector.

Last, year’s slide in the stock market was blamed on corporate malfeasance. The accounting scandals and the revelation that the 90's earnings miracle was fiction caused widespread disillusion with investors. The fines and the photo ops of regulators arresting high profile execs from these companies was supposed to assuage the anger of investors who have been mislead by company CEO's and the analysts that recommended their stocks. While the accounting scandals have receded in the background, they are still out there, and the pro forma charade has yet to be addressed. Analysts, anchors, and company PR spokespeople should be required to report earnings on a GAAP basis versus CRAP* earnings. Until that happens, investors will be given false and bogus numbers that are meaningless. As I mentioned earlier this week, I have yet to find an investment book that recommends that investors make their purchase decisions on a company meeting or beating estimates. The estimates are constantly changed and tinkered with until they are lowered to a point that companies beat them. Beating or meeting estimates tells you nothing about how well the company is doing. Year-over-year comparisons and trend analysis is more helpful.

We still have the issue of debt that is included or reported on the balance sheet. What does it say when companies have more debt that is off their balance sheet than what is reported on the balance sheet? This hideous practice still exists and money center banks still provide off balance sheet financing. The SEC is looking into a proposal that would require companies to disclose the debt in either their footnotes, or better yet to put it back on the balance sheet where it belongs.

A final issue that that has not been resolved is the accounting for stock options and CEO pay. This issue will be resolved by the end of the year. However, CEO pay has not changed. Boards of directors are still awarding large pay and compensation packages that are way out of line with job performance. I'm not a socialist, so I don't object to someone making big bucks. What I do object to is when it is hidden and not disclosed openly, and when it is way out of proportion to job performance. I don't believe CEO's should be paid enormous salaries when the earnings of the company are down or the company stock has performed miserably. The following table from the April issue of Fortune will illustrate the point.

The list above is just a sample of some of the obvious egregious paychecks given to CEO's with either declining company fundamentals or declining stock prices. The boards of directors of these companies have forgotten the fact that it is the shareholders who own the company. The CEO should be a steward of shareholder money. Looking at the compensation packages of some of these CEOs, it becomes obvious the company is being run for the benefit of management. In contrast to the high salaries listed above with poor job performance, Tom Siebel of Siebel Systems only received $1 last year after his company stock lost 73%. Warren Buffett's salary was only $296,000 with Berkshire stock down 3.8%.

Top executives are still fleecing shareholders with compensation packages that are way out of proportion with job performance. I don't mind seeing a CEO get multiple millions when he or she is doing a good job managing the company, profits are growing, and share price is rising. However, since most of their compensation package comes in the form of restricted stock and stock options, there is always the conflict of interest to cook the books or make what is going on in the company sound much better than it actually is. These packages also include pension plans that border on the absurd. Mike Armstrong, after doing a horrible job at AT&T taking the company on a debt and acquisition binge, and decimating the company balance sheet with losses and writedowns, will receive the equivalent of $17.4 million in pension benefits after five years of nearly ruining the company. In summary, there doesn't seem to be any accountability between the board of directors and the compensation packages that they award to company CEOs and upper management. The concept of shareholders actually owning the company, and CEOs are stewards of this money, has almost been lost in corporate America. When you find honesty, integrity, and accountability, it is rare.

Today's Market

Back to today's markets, it was a rough day for the financial markets swinging between gains and losses all day before closing on a negative note. Weighing on the markets was the slide in the dollar. Also contributing to the day's decline was Alan Greenspan, who sounded less than sanguine in his testimony before Congress this morning. On top of that, analysts are busy cutting their CRAP* earnings estimates for the second half of the year. Remember, CRAP estimates have risen this quarter; while GAAP earnings have actually declined. Talk about a world of make believe, analysts are still forecasting that tech earnings will rise by 53 percent in the third quarter and by 27 percent in the fourth quarter. All of the pro forma or CRAP earnings estimates are backend loaded this year as they have been the last four years. Ken Perkins at First Call, which tracks analysts’ estimates, sees no catalyst out there that will ever produce this fiction. In fact, analysts are thinking the same way that they have thought the last three years. They have failed to account for the glut in capacity or the fierce price competition that is undercutting margins and sales prices.

According to First Call, we are exactly where we were last year at this time when analysts were forecasting pro forma earnings gains of 132% for Q3 and Q4 of 2002. Even at the beginning of Q3 last year, Wall Street expected profit gains of 118% for Q3 and 64% for Q4 of 2002. Many feel that Wall Street has become more reasonable in their estimates, but we are still dealing with CRAP estimates and not GAAP estimates. We are still in la la land. This brings me to my conclusion that nothing has changed over the last year. Valuations are still at bubble levels, fund managers are still chasing the last bubble, accounting scandals are still with us, and CEO's continue to fleece shareholders with the issuance of generous stock options despite dismal performance. Analysts and anchors continue to mislead investors with reporting and using pro forma numbers instead of GAAP numbers. And the myth of the second half recovery is with us for the fourth year. Even more amazing is that investors and managers actually still believe it. Even more ludicrous is the recovery scenario, which bears repeating.

Source: BCA Research, BCA Daily Insights April 30, 2003

1. Companies increase profits by cutting costs.

2. Cutting costs means firing more workers. Half a million workers have been fired in the last two months alone.

3. To further trim costs companies shut down plants and service centers here in the US, and moved them overseas.

4. Fired workers go deeper into debt by funding consumption with credit card debt or extracting more equity out of their homes.

5. Consumers then take this borrowed money and spend it on foreign goods driving up the trade deficit.

6. The government in turn prints oceans of money, the Fed actively monetizes debt to keep rates low, and the government goes in to the capital markets to fund rising budget deficits.

7. We then proclaim that we want a strong dollar policy as the dollar sinks.

No wonder Mr. Greenspan is less then sanguine. (The Chicago Purchasing Mangers Index declined in April indicating that manufacturing activity is declining in the region.) He is trying to prop up multiple bubbles that are all in danger of bursting. The green thumb no longer seems to have its magic. Given the logic above, investors have become euphoric; investment advisors have turned decidedly bullish as reflected in the VIX and the VXN, and the little guy is creeping back into the market. It all looks like a turning point to me as reflected in Tim Wood's editorial. Maybe that is why the shorts have been busy covering their gold short positions in gold stocks over the last month. They have yet to cover most of their silver shorts and will have difficulty doing so without driving up prices since the float is so thin.

Volume hit 1.6 billion shares on the NYSE and 1.5 billion on the Nasdaq. On the Big Board advancing issues beat out declining issues by a 19-13 margin and by 18-14 on the Nasdaq. The VIX edged up by .24 to 23.77 and the VXN barely budged by .09 to 32.67.

Copyright © 2003 Jim Puplava
April 30, 2003
Chart courtesy of www.bcaresearch.com 

* CRAP = Cloudy Reporting Accounting Principles

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