By Tim Price
Published: August 25 2009 (Financial Times)
What kind of a financial crisis are you having? If you are a graduating student, good luck with the job hunt. If you are a banker or an economist still in employment, you are probably keeping your head down while you count the bonus that your fellow taxpayers have so generously if involuntarily gifted you. If an otherwise blameless investor, you are probably wondering why you are being penalised with such derisory deposit rates and whether you should be jumping on to the equity market rally instead.
That might be dangerous. Headline equity index returns, year to date, are desperately misleading. There is, in fact, a two-tier market in operation: speculative (or, more politely, “growth”) stocks, which have done fantastically, and everything else. Industrial metals and mining stocks are one of the best-performing sectors internationally – not a little surprising, given that the global recovery has yet to be sustainably confirmed; energy and utilities sector stocks, along with plenty of other classic defensives, have largely been a washout. (They may yet have their day.)
And an analysis of the Altman Z Score, which assesses the likelihood of corporate insolvency by comparing various balance sheet measures, shows that the frankly flakiest companies have seen their shares hugely outperform the rest of the market even as their capital strength deteriorates. In short, this has been a rally driven by junk.
But then what should we expect, when governments and their nominally independent central bank associates have conspired to manipulate prices throughout the capital asset structure, primarily to bail out banks that are conspicuously unfit for purpose? We are now trapped within a global parody of free markets.
Within this parody, governments redirect a waterfall of capital towards the banks. The banks then “invest” this in effect free money in what looks suspiciously like securities speculation and property lending. Meet the new bank: same as the old bank. And while the sums “borrowed” from future taxpayers as economic stimulus have been extraordinary in the west, they are not even the largest. Relative to gross domestic product, as fund managers Eric Sprott and David Franklin point out, China has been busily stimulating its economy more than anyone – injecting the equivalent of fully 64 per cent of its first half 2008 GDP during the first half of 2009. That is the equivalent of buying 122 Ford Class aircraft carriers costing $8.1bn each.
Some questions now deserve to be answered. With credit provision in full-scale withdrawal, does it really make sense to be contemplating bank stocks as investments, not least given the messy governmental scrutiny at work in the sector? And if private sector credit availability is set for broad retreat throughout the Anglo-Saxon economies, how on earth can our nascent economic recovery be described as anything other than pale, sickly and fragile? Equity markets have rallied nicely from their lows, but a degree of realism is surely in order.
The banking sector profits of recent years were never sustainable, inasmuch as they were built on the sandy foundations of leverage. Corporations and households around the world are now urgently paying down debt and rebuilding their balance sheets. They are, in short, battening down the hatches in preparation for a nuclear winter. There is little credit to spare for that diminished crowd with the appetite to take it on. Those are not conditions conducive to a robust recovery, far less to a new boom.
So for those chasing the rally: what, precisely, is your endgame? Perhaps you see extraordinary levels of government indebtedness miraculously evaporating amid new economic expansion, even as taxes rise. Perhaps you see ailing, cash-hoarding banks mysteriously opening the lending taps for the next wave of entrepreneurs. Or perhaps you are looking at the future through the hugely distorting prism of the recent credit bubble. Years of massive misallocation of capital cannot be followed by effortless recovery.
Wednesday, August 26, 2009
Thursday, August 13, 2009
Alternative yardsticks for US earnings tell different stories
Paul Marson is chief investment officer of Lombard Odier. He wrote the following article in today's Financial Times (8/13/2009). It is worth the read because it explains the irrationality behind the financial markets these days. Make no mistake, the upward turn in the market since early March has been propelled by factious perceptions. "Green shoots" are nothing more than code words by politicians and other central economic planners to replace the reality of our situation. The "green shoots" they talk about are merely the consequence of massive fiscal and monetary inflation; they are temporary. In this environment, of course firms are going to report "earnings." Yet, few recognize that these numbers have been massaged and twisted in such a way that value estimates are difficult to ascertain. Against this backdrop, Mr. Marson provides some insigthful comments. Here it is...enjoy.
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The US second-quarter earnings season is now ending, apparently on a good note as nearly three-quarters of US companies have beaten consensus expectations. But a closer look at these earnings shows there is cause to be more cautious about the health of corporate America than the headline numbers would suggest. The cloud of euphoria that followed recent results had more to do with extraordinarily low expectations than to any meaningful and lasting improvement in prospects, which still require a rapid recovery in economic activity. This suggests the recent equity rally off the back of these results is overdone.
Every quarter, US companies publish their results under the defined US GAAP accounting rules. These results are labelled "reported earnings". However, the most commonly looked at form of earnings are adjusted "operating earnings" on which companies prefer to focus as they consider these better capture the underlying trend in activity. Adjusted operating earnings exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill right downs and other write-offs. While reported earnings are based on strict accounting rules, adjusted operating earnings are at the discretion of companies because there is no defined set of exclusions. Neither measure is perfect but with adjusted operating earnings, exclusions are currently so large that information about the true state of companies (and therefore the market as a whole) is being excluded.
These exclusions have reached the level where the gap between adjusted operating earnings and reported earnings is so wide that they deliver different messages on the state of US corporates.
There is plenty of evidence to show that the exclusions in adjusted operating earnings are not one-off or non-recurring items. Often they contain useful information pointing to weaker cash flows ahead. Messrs Doyle, Lundholm, Soliman, in their "Predictive value of expenses excluded from pro forma earnings" 2003 study found that the three-year return for companies in the top decile of "other exclusions" is 23 per cent lower than for those in the bottom decile for exclusions. One dollar of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.
Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor's is $7.2 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are $61.2, down 34 per cent from the 2007 peak. This $54 gap is a record.
How has this come about? Much of the difference between adjusted operating earnings and reported earnings is caused by massive writedowns in the financial sector. However, outside the financial sectors write-offs are also at record highs as corporates are eager to toss out impaired assets during periods of stress.
Furthermore, when looking at adjusted operating earnings, it seems that most US corporates managed to beat their analyst estimates thanks to production and job cuts.
There is no doubt that strong earnings numbers several years ago reflected extraordinarily high, debt-fuelled margins that are difficult to imagine again, particularly in a deleveraging and deflating economy. Investors should not expect a rebound in earnings or profitability and certainly not to previous elevated levels. Why? Because earnings growth must entail some combination of increased profit margins, rising turnover or greater leverage. Increased leverage is currently unacceptable to managements and investors alike. Wider profit margins and higher turnover may be achievable in the short term, but are much less attainable in a deleveraging cycle.
Those assessing the health of corporate America seem to be assuming a substantial, and above normal, recovery in reported earnings, alongside a return to above-trend GDP growth over the next 12 months. They are in danger of looking at the prospects for economic recovery, revising earnings expectations higher, but without considering how this might happen. In the meantime, the elephantine gap between adjusted operating earnings and reported earnings sits quietly in the room.
======================================
The US second-quarter earnings season is now ending, apparently on a good note as nearly three-quarters of US companies have beaten consensus expectations. But a closer look at these earnings shows there is cause to be more cautious about the health of corporate America than the headline numbers would suggest. The cloud of euphoria that followed recent results had more to do with extraordinarily low expectations than to any meaningful and lasting improvement in prospects, which still require a rapid recovery in economic activity. This suggests the recent equity rally off the back of these results is overdone.
Every quarter, US companies publish their results under the defined US GAAP accounting rules. These results are labelled "reported earnings". However, the most commonly looked at form of earnings are adjusted "operating earnings" on which companies prefer to focus as they consider these better capture the underlying trend in activity. Adjusted operating earnings exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill right downs and other write-offs. While reported earnings are based on strict accounting rules, adjusted operating earnings are at the discretion of companies because there is no defined set of exclusions. Neither measure is perfect but with adjusted operating earnings, exclusions are currently so large that information about the true state of companies (and therefore the market as a whole) is being excluded.
These exclusions have reached the level where the gap between adjusted operating earnings and reported earnings is so wide that they deliver different messages on the state of US corporates.
There is plenty of evidence to show that the exclusions in adjusted operating earnings are not one-off or non-recurring items. Often they contain useful information pointing to weaker cash flows ahead. Messrs Doyle, Lundholm, Soliman, in their "Predictive value of expenses excluded from pro forma earnings" 2003 study found that the three-year return for companies in the top decile of "other exclusions" is 23 per cent lower than for those in the bottom decile for exclusions. One dollar of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.
Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor's is $7.2 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are $61.2, down 34 per cent from the 2007 peak. This $54 gap is a record.
How has this come about? Much of the difference between adjusted operating earnings and reported earnings is caused by massive writedowns in the financial sector. However, outside the financial sectors write-offs are also at record highs as corporates are eager to toss out impaired assets during periods of stress.
Furthermore, when looking at adjusted operating earnings, it seems that most US corporates managed to beat their analyst estimates thanks to production and job cuts.
There is no doubt that strong earnings numbers several years ago reflected extraordinarily high, debt-fuelled margins that are difficult to imagine again, particularly in a deleveraging and deflating economy. Investors should not expect a rebound in earnings or profitability and certainly not to previous elevated levels. Why? Because earnings growth must entail some combination of increased profit margins, rising turnover or greater leverage. Increased leverage is currently unacceptable to managements and investors alike. Wider profit margins and higher turnover may be achievable in the short term, but are much less attainable in a deleveraging cycle.
Those assessing the health of corporate America seem to be assuming a substantial, and above normal, recovery in reported earnings, alongside a return to above-trend GDP growth over the next 12 months. They are in danger of looking at the prospects for economic recovery, revising earnings expectations higher, but without considering how this might happen. In the meantime, the elephantine gap between adjusted operating earnings and reported earnings sits quietly in the room.
Monday, August 3, 2009
Read between the lines and know the real facts, or risk being deceived
By Marty Chenard
It is now August. Many are guessing that the 4th. Quarter will see a positive GDP number this year. The market appears to be factoring in that possibility. Will it really be possible to generate a positive GDP?
Second Quarter earnings results can now be given some thought. Here is what happened on the S&P 500:- Almost 61% of the S&P 500 beat their estimates. - 35.5% did better than last year's earnings per share.- Almost 25% had sales ahead of last year's.- 75% reported lower sales.
It is hard to find fault with the improvement in earnings per share ... but the fine print says: "75% had lower sales, but 61% beat their estimates."
So ... 60 out of every 100 companies beat their estimates ... but 75 out of every 100 had lower sales? How does one have lower sales but beat estimates?
You could do it by under estimating future expectations. In this way, what would normally be a bad result, looks good because you did better than the worse result that you reported "could happen".
Okay, so how could you have lower sales, but better earnings? You would have to cut costs ... cut inventories, layoff, reduce expenses, etc. That works the first time around ... the second time around is very difficult to cut as much on a percentage basis. So, the salvation will have to be an increase in sales during the current and future quarters.
That's the rub. The economy needs an increase in spending by consumer and business end users. We are getting some increases due to government stimulus programs. That can't go on forever without the consumer taking back the spending reins ... or our government will go bankrupt, the Dollar will fall, and interest rates will go up.
So, now we need the real thing ... increased spending by the consumer. We need an increase in demand because people can afford it, not because the government gave a consumer a $4,500 credit so he could buy a car. Christmas is not that far away, and the government will not be giving any consumer subsidies out for buying clothes, appliances, pots & pans.
So, as an investor, that's what you want to be watching for: Reports that indicate consumers and businesses are increasing their spending levels. Recent earning estimates are turning up slightly ... that's a good thing. It would be nice if "lots of increased spending" could happen without big increases in debt levels, because all of the excess debt and leverage has not been wrung out of the system yet.
If all goes well, and positive expectations bear fruit, then we will see forward economic progress. But, if GDP remains negative in Q4 along with weak consumer spending appears during the holidays, then the market will have a confidence retraction bringing things back to where the true balance is.
Although some earning estimates have turned slightly up, sales have not moved from declining to "increasing". The progress we are making is one of "getting less worse", and granted ... that has to happen first before we get to where things are "good". For now, don't mix the two ... getting less worse is different than getting better, and less worse is economically a lot different than getting better.
Be open minded and consider the real "comparative conditions" relative to time ... sometimes the media tries to "headline" the news to make things look better than they really are.
Take Financials for example. Some media sources have excitedly reported that " Financials are up 273% from the Second Quarter of 2008". Well, the 2nd. quarter of 2008 was negative, so what did the media really mean? Did that 273% improvement mean that things were in the positive ... or almost positive, or in the negative?
Here is what they could have said, if the media had wanted to use a different time-frame for the same result: They could have said that, "Financials were down 83% from the 2nd. quarter of 2007".
Was it misleading to make things appear as if they were wonderful? Or, was it a good thing to show the optimistic side? Our thinking is that "enough of the numbers should be reported so that someone really understands what is going on". If a person gains 30 pounds, is that good or bad? To answer the question you need to know what their ideal weight should be and how much they weighted before losing 30 pounds. Depending on the answer, they could be grossly over weight, underweight, or just right.
It is now August. Many are guessing that the 4th. Quarter will see a positive GDP number this year. The market appears to be factoring in that possibility. Will it really be possible to generate a positive GDP?
Second Quarter earnings results can now be given some thought. Here is what happened on the S&P 500:- Almost 61% of the S&P 500 beat their estimates. - 35.5% did better than last year's earnings per share.- Almost 25% had sales ahead of last year's.- 75% reported lower sales.
It is hard to find fault with the improvement in earnings per share ... but the fine print says: "75% had lower sales, but 61% beat their estimates."
So ... 60 out of every 100 companies beat their estimates ... but 75 out of every 100 had lower sales? How does one have lower sales but beat estimates?
You could do it by under estimating future expectations. In this way, what would normally be a bad result, looks good because you did better than the worse result that you reported "could happen".
Okay, so how could you have lower sales, but better earnings? You would have to cut costs ... cut inventories, layoff, reduce expenses, etc. That works the first time around ... the second time around is very difficult to cut as much on a percentage basis. So, the salvation will have to be an increase in sales during the current and future quarters.
That's the rub. The economy needs an increase in spending by consumer and business end users. We are getting some increases due to government stimulus programs. That can't go on forever without the consumer taking back the spending reins ... or our government will go bankrupt, the Dollar will fall, and interest rates will go up.
So, now we need the real thing ... increased spending by the consumer. We need an increase in demand because people can afford it, not because the government gave a consumer a $4,500 credit so he could buy a car. Christmas is not that far away, and the government will not be giving any consumer subsidies out for buying clothes, appliances, pots & pans.
So, as an investor, that's what you want to be watching for: Reports that indicate consumers and businesses are increasing their spending levels. Recent earning estimates are turning up slightly ... that's a good thing. It would be nice if "lots of increased spending" could happen without big increases in debt levels, because all of the excess debt and leverage has not been wrung out of the system yet.
If all goes well, and positive expectations bear fruit, then we will see forward economic progress. But, if GDP remains negative in Q4 along with weak consumer spending appears during the holidays, then the market will have a confidence retraction bringing things back to where the true balance is.
Although some earning estimates have turned slightly up, sales have not moved from declining to "increasing". The progress we are making is one of "getting less worse", and granted ... that has to happen first before we get to where things are "good". For now, don't mix the two ... getting less worse is different than getting better, and less worse is economically a lot different than getting better.
Be open minded and consider the real "comparative conditions" relative to time ... sometimes the media tries to "headline" the news to make things look better than they really are.
Take Financials for example. Some media sources have excitedly reported that " Financials are up 273% from the Second Quarter of 2008". Well, the 2nd. quarter of 2008 was negative, so what did the media really mean? Did that 273% improvement mean that things were in the positive ... or almost positive, or in the negative?
Here is what they could have said, if the media had wanted to use a different time-frame for the same result: They could have said that, "Financials were down 83% from the 2nd. quarter of 2007".
Was it misleading to make things appear as if they were wonderful? Or, was it a good thing to show the optimistic side? Our thinking is that "enough of the numbers should be reported so that someone really understands what is going on". If a person gains 30 pounds, is that good or bad? To answer the question you need to know what their ideal weight should be and how much they weighted before losing 30 pounds. Depending on the answer, they could be grossly over weight, underweight, or just right.
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