Weekday Commentary from Jim Puplava
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Storm Watch Update 3/22
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Jim Puplava's NEW Perspectives Series Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday 3/22
Wednesday's Stock Market WrapUp
A Crisis of Confidence
There are many famous quotes that describe today’s economic and financial environment. Perhaps you have heard of many of them. The obvious one is "Figures lie and liars figure." Winston Churchill once said, "There are a terrible lot of lies going around the world, and the worst of it is half of them are true." There is even a book out by there called, How to Lie With Statistics by Darrell Huff. Unfortunately, we live at a time when numbers, facts, and statistics can no longer be taken at face value, especially today when looking at economic and financial numbers. It doesn’t matter whether you are looking at economic or earnings reports coming from corporations and Wall Street analysts. A crisis of confidence or a lack of trust in our government and financial institutions is the number one crisis now facing the financial markets.
Like so many myths, the reported profit miracle of the 1990’s is now turning out to be a mirage as more companies confess their sins of earnings manipulation. Ever since the Enron scandal and the advent of a bear market, the investment public, and belatedly the government, is now starting to pay attention to the way profits are reported. What has been discovered is over 30% of exchange listed companies are now suspect of manipulating their earnings. The greatest way to track this discrepancy between what companies report to the public and what is parroted by the boobheads on networks, is earnings differ greatly from what is reported as actual cash from operations. Under most normal circumstances the two numbers, earnings and cash flow from operations, should be in sync. We have many large well-known companies from GM, AOL, Intel, to IBM reporting one figure as pro forma income or profit, and another figure as net income according to GAAP. At one time the U.S. accounting system was considered to be the standard that all other countries aspired to. This is no longer the case.
With stock options as the main form of compensation for top executives, top management created incentives for itself to manipulate earnings in an effort to move stock prices higher. The abuses that were created through the issuance of stock options are now making front page headlines in the financial press. It is widespread practice to put top management at odds with shareholders. This, I believe, is partially responsible for many of the abuses seen today. We’ve seen top executives, such as Disney’s Michael Eisner, receive a salary of $5.7 million and additional compensation in the form of stock options worth $569 million, almost one-third of Disney’s income in the year they were issued.
Abuse of Stock Options
It is this abuse in the issuance of stock options that is now on the agenda in Washington, and companies are going all out to preserve this privilege that has raped shareholders. Sadly, they are able to influence key senators, such as Joseph Lieberman, who will work against reform of this abuse to the detriment of shareholders. Lieberman stopped the last attempt at reform in 1994. This same senator leads a committee now investigating Enron. While Washington treats Enron as an energy issue, they are missing out on the larger picture, which is the perilous state of our financial system caused by derivatives. While monitoring individual companies, they ignore the much larger issue of derivatives, especially the derivative books of the nation’s seven largest banks that look and act more like hedge funds.
It would be one thing if all investors had to contend with was corporate earnings. While the financial press and Washington are caught up with monitoring the books of corporations, no one is monitoring the government’s books. When it comes to economic numbers, the government’s books can be just as manipulative. For example, we now find ourselves having to increase the national debt limits again after raising the limits by half a trillion back in 1997. For the last five years all you have heard is the government was running a surplus. How can a government run a surplus when its outstanding debt has increased by $500 billion over that same period of time? We are now talking about increasing the national debt limit by $750 billion when, in fact, we are still talking about surpluses over this next decade.
Unemployment
Another example of this malarkey is the way the unemployment numbers are reported. Last month the government reported the unemployment rate fell in February from 5.6% in January to 5.5% in February. Those numbers are seasonally adjusted (manipulated). This number surprised the financial markets helping to trigger a rally in stocks as another sign the economy was improving. This lower unemployment report stood in stark contrast to daily headlines of continual job cuts being announced by major corporations. The actual numbers unadjusted portrayed a different picture. The unadjusted unemployment rate was 6.1% instead of the widely reported 5.5%. In February, according the Bureau of Labor Statistics, 266 metropolitan areas recorded higher unemployment rates than a year ago. There were 40 areas that had lower rates, and 16 areas where unemployment rates were unchanged. There were at least 10 metropolitan areas with unemployment rates as high as 10%. At least 25% of the metropolitan areas reporting had unemployment rates of 6.5%, with California reporting the five highest recorded unemployment areas ranging from 18.2% in the Merced area, 17.8% in the Visalia-Tulare-Porterville area, and 15.7% in Fresno. The San Jose region, home to Silicon Valley, reported the highest year-over-year jump in unemployment jumping 5.5 percentage points.
These unadjusted numbers paint a different picture of the economy from the numbers widely reported in the financial press. It’s the same for the GDP numbers, which are statistically massaged. The growth rate in GDP during the fourth quarter was entirely due to government spending. The private sector of the economy actually contracted. The point that should be made is the unadjusted unemployment numbers reflect more of what is actually going on in the economy and line up better with what companies are doing to their payrolls. What investors need to understand looking at the financial markets or the economy is that there are several sets of books to look at if you want to find out the real story. What is given out for public consumption isn’t the same information insiders are using to make key investment decisions. If you want to play against the big boys, you better be using the same information if you hope to compete and win.
SEC Probes
Adelphia Communications and Williams Cos. saw their stock prices crater after it was announced the SEC is probing into their accounting practices. These two companies join the list of numerous other companies now getting a closer look from the securities monitoring agency. While the government is looking into earnings manipulation, they are ignoring an even greater danger with derivatives. The large New York banks and GSE’s, such as Freddie and Fannie, are expanding their derivative book at a double-digit rate. Many of the nation’s top financial companies are beginning to look and operate more like hedge funds. In the future, we could see many Enron style bankruptcies, but on an even larger scale.
Earnings Numbers
Looking at the earnings numbers for this quarter and next, First Call is already raising the earnings downturn for the first quarter and lowering the earnings gains for the second quarter. The current consensus, which changes every week, is that profits for the S&P 500 companies fell 9% during the first quarter and are now expected to grow by only 8.7% during the second quarter. These earnings numbers aren’t GAAP numbers. The earnings gains for the second quarter are pro forma numbers according to CRAP accounting principles. After what analysts are hearing from companies this quarter, expectations are rapidly being ratcheted down from what was once projected at the beginning of the year. Earnings expectations are becoming a bit more realistic, especially with weaker economics reported on almost a daily basis. Today, the Institute for Supply Management’s service index for non-manufacturing fell to 57.3 from 58.7 in February.
Middle East Tension
Tensions in the Middle East have put the markets on edge. Since the breakdown of peace talks on March 21 between Israel and the Palestinians, trading volume has fallen dramatically on the New York Stock Exchange. It is very difficult for Wall Street’s infamous spin machine to galvanize investors when they see scenes of war on television each night. A widely reported story today divulged that Arafat has approved plans by Fatah, Hamas, and Islamic Jihad to send at least 30 suicide bombers to Jerusalem. Jerusalem has been targeted by Arafat because of his desire to turn it into the capital for a Palestinian State. Since the peace talks broke down in September, over 415 Israelis have been killed in the 18-month long conflict. Of the 415 Israelis killed, 127 have been killed by suicide bombers in the last month. Many of the victims were women and children.
It has been difficult for investors to focus on anything else except war, profit losses or accounting scandals, none of which are confidence builders. The media has been unable to explain the war or the conflict in a way that makes it understandable. The media wants more diplomacy, but diplomacy hasn’t worked for the last decade. We are now seeing what Karl von Clausewitz once called the true nature of war which is, "War is nothing but the continuation of policy with other means." War can be either limited or absolute, depending on the grand strategy of the state. Total victory can only be achieved through attack. Arafat began the attacks in September of 2000. Now he faces Israel’s response. The Israelis now realize the best diplomacy is on the battlefield and not at the negotiating table. It is only when one side loses that it is most willing to negotiate. This understanding of war and politics is misunderstood by the media.
A much larger battle is just around the corner with the approaching attack against the terrorist state of Saddam Hussein. The U.S. is rapidly building up its presence in the Gulf in preparation for war. This is one of the reasons why the markets are so unsettled. In times of war, anything is possible because there are so many unknowns. It is this uncertainty that weighs on the markets.
The markets fell for the fourth consecutive day as earnings warnings and Middle East tensions spurred a selling exodus out of stocks. There was no refuge anywhere today, not even in gold or oil. Just about every sector saw red. The Dow lost 115 points with only three out of the Dow’s 30 stocks rising. The technology sector is imploding with software stocks getting hammered for the third straight day after profit warnings came from key companies. Goldman Sachs’ upgrade of its earnings forecast failed to inspire investors. Goldman Sachs estimates are adjusted for depreciation and inventory adjustments. Volume was once again light with 1.2 million shares on the NYSE and 1.72 billion shares trading on the Nasdaq. Market breadth has been steadily falling and was negative today by 20 to 12 on the NYSE and by 21 to 14 on the Nasdaq.
Treasury Market
Bond prices closed significantly higher as stock prices got pummeled. Fixed income securities rallied as investors sought a safe haven from the tech rout in the stock market and mounting violence in the Middle East. The 10-year Treasury note advanced 15/32 to yield 5.28% and the 30-year government bond rose 18/32 to yield 5.72%.
Overseas Market
European bank and insurance stocks including Prudential, Zurich Financial Services and Lloyds TSB Group rose as the prospect of interest-rate rises receded. SAP, Ericsson and other software and phone equipment companies fell on concern about the outlook for profits. The Dow Jones Stoxx 50 Index fell for the second day, shedding 2.83 points, or 0.1% to 3663.84. The yield on benchmark German bonds dropped to a two-week low on expectations the European Central Bank will wait for more signs economic growth is rebounding before raising interest rates. Four of the eight major European markets were down during today's trading sessions.
Japan's Nikkei 225 stock average rose as public pension funds began using 1.7 trillion yen ($12.8 billion) in money allotted this year to buy Kyocera Corp. and other companies with large weightings. The Nikkei rose 1.8% to 11,400.71, erasing an earlier 1.5% loss sparked by a drop in the Nasdaq Composite Index.
© Copyright, Jim Puplava, April 3, 2002