Pro Forma Earnings vs. Real Earnings My scenario for the summer doldrums to be followed by a mid-summer rally is playing according to script. The stock market has been falling from its early May highs as doubts begin to surface over the earnings recovery forecasted by the Street. Companies are issuing pro forma guidance for the current quarter, but no guidance is given for the actual bottom line. As The Wall Street Journal reported today, "The two sets of numbers are related this way. Pro forma, or 'as if,' earnings appear to be more favorable than net income. That is because a wide range of business expenses considered normal under GAAP, such as restructuring charges, are typically excluded from the pro forma figures, while all manner of gains — such as asset sales are included." As the Journal points out, there are no standards for reporting pro forma numbers so it’s hard to predict exactly what you’re getting.
Most companies are now willing to give guidance on their pro forma numbers, but obfuscate the real earnings. Therefore, the earnings recovery Wall Street analysts are forecasting won’t be based on the bottom line. They will be pro forma fiction, which means the numbers are going to be whatever the analysts and the companies want them to be. This should follow the regular script for the upcoming quarterly earnings game. In the next few weeks, you should begin to hear the companies, that aren’t going to meet their numbers, start to report the bad news. This should keep a lid on any stock market gains and send stock prices even lower. As companies report the bad news, analysts will begin cutting their estimates to look smarter by the time the actual numbers are reported. They have already begun to lower their estimates. When the actual numbers get reported, the companies should come within a penny less or a penny more of forecast, with most companies beating their earnings targets.
This will spark a rally when a major company comes out with better numbers, such as GM in the Dow, or Applied Materials on the Nasdaq. Momentum traders will rush in, bidding up shares. Investors will dump their defensive issues, and the media will do their part in trumpeting the second half recovery scenario. The experts, economists, and all of the analysts will make their rounds on all of the financial shows and talk about the recovery that is on its way. They will sight companies beating estimates and the rise in stock prices as evidence to back their theories. It will be a fleeting moment of sunshine for the markets. Then reality will hit again, and another major down leg in stock prices will begin again.
The problems, as I have written in so many of these WrapUps, are debt, interest rates, and a lack of pricing ability. The debt levels and rising credit spreads are raising the cost of interest for most companies, and that fact alone is decimating the bottom line. There are also the huge impairment charges that still need to be written off as a result of billions of goodwill remaining on the balance sheet. The acquisition binge of the 1990’s still needs to unwind and is far from over. Most companies overpaid for the companies they bought and misspent shareholder assets through share dilution. The damage of overpaying for companies still has a long way to go. It is one reason we won’t be hearing bottom line numbers for many years. Without a real rise in corporate profits, there will be no capital spending boom to drive the economy. Business investment is funded by profits, which is why profit growth is so vital to fund future capital spending. Profits are what pay for this investment. Although profits in the short-term may improve from their lows, those improvements are coming from cost cutting and not top line growth. It is the top line that needs to start growing before companies shell out money for new equipment. There is no need to spend money on new plant and equipment with capacity utilization rates so low.
Wall Street on Trial - more ways that one This brings me back to the economic recovery and earnings scenario so widely believed in and promoted by analysts. It doesn’t look like the miracles are going to take place unless you look strictly at pro forma fiction. As the stock market hands investors their third year of consecutive losses, faith in Wall Street fiction is starting to wane. Just as investors lost faith in Wall Street following the Crash in 1929 with the depression that accompanied it, Wall Street is once again on trial. Investors and the general public are gradually losing faith in the financial system from the auditors and analysts, to the anchors that keep urging them to buy stock. The element of trust taken for granted by the Street no longer exists. There is a lot more skepticism, and politicians are ready to play into it. Investors have lost big money and they want a scapegoat; politicians are only too willing to play homage to investors’ anger. Never mind that the government has its own set of cooked books. It is a lot like putting the fox in charge of the hen house. When you see your local congressman grandstanding on accounting irregularities, just remember the government’s books are in even worse shape.
Housing Bubble Continues If investors’ enthusiasm for stocks is gradually eroding, that enthusiasm has found another avenue for adulation in real estate. The bubble in housing prices still continues as investors see a can’t-lose proposition. The National Association of Realtors reported existing home sales rose 7% in April to an annual pace of 5.79 million. With thirty-year fixed rate mortgages hovering around 7%, low interest rates are helping to prop up demand for housing. Many wonder how much further housing prices can rise or how much longer the bubble in housing can last. There is too much evidence suggesting home values are at unsustainable levels. Experts don’t believe the days of annual gains of 25% are foreseeable in the future, but neither do they see a downturn. Most feel that housing prices will just gradually cool off. Others believe new environmental policies restricting supply could provide an artificial support for high housing prices. They argue that when you restrict the supply of something and there is greater demand, the result is higher prices. However, historical evidence suggests that every recession produces a downturn in housing prices. This one has been different because of ample liquidity provided by the Fed, which lowered interest rates and made credit widely available.
But nothing lasts forever. The greatest limit to this argument is that consumer debt and continued job layoffs could put a dent in the demand for housing. Each month the government reports on personal income and spending. It shows consumer incomes are still going up, but not at a rate that supports spending. Last month personal income rose 0.3%; while spending rose 0.5%. This means that the consumer continues to go deeper into debt by borrowing money to support his lifestyle. You can’t continue to support spending habits with borrowed money. Eventually those debts are going to have to be repaid or cleansed from the credit system through default. At the present time, consumers are still spending money aided by refinancing and the boom in the price of their homes. I believe it is just a matter of time before this trend plays itself out. The question will then be, "What’s next?" Where will the pent up demand come from to help drive the economic growth rates that economists and analysts are predicting? The only one left is the government, which is spending money like never before. But there is a negative consequence to those budget and trade deficits, and that is what the declining dollar may be signaling.
Gold Still on the Rise If there was a bright spot in today’s market, it was once again found in the gold and silver sector. Wall Street and the media have done a wonderful job suppressing this story. Each week Barron’s reports a list of the week’s top ten performing mutual funds. They have all been precious metals funds. Other than reporting on them, nothing else is mentioned. Gold’s rise last week got only one paragraph. However, that hasn’t stopped gold’s relentless juggernaut. Today, futures traders bid the price of the yellow metal above $325 before it settled back at another high for the year at $324.10. Gold prices rose against the background of increasing tensions between India and Pakistan. This weekend Pakistan conducted missile tests and Pakistan’s President Pervez Musharraf vowed vigilance against India. Gold prices have reached another key resistance level at $325. At this level a lot of bullion banks and gold mining hedge books start to go negative. This will force short covering, which is further driving up the price. I suspect central banks and their counterparts the bullion banks are going to want to drive the price down. If gold continues to rise, it may catch the eventual attention of John Q. Investor and John Q. Public, and that would not be good news for the markets or for confidence in government.
As today’s trading gold and silver shares headed towards new record levels, shares of oil service, biotech, airline and networking stocks came along for the ride. On the downside was heavy selling in retail, financial, and the tech sectors. Investors are steadily losing confidence in the stock market. According to a recent investor poll, investor expectations have dropped. Investors now expect stocks to rise by only 9.2%, down from 10.6% in April. Even worse for Wall Street is that 62% are questioning the integrity of Wall Street research.
Volume came in below normal with only 954 million shares trading on the NYSE and 1.28 billion on the Nasdaq. Market breadth was negative by 18 to 14 on the big board and by 19 to 16 on the Nasdaq.
Overseas Market European stocks fell after a report showed consumer confidence in the U.S. economy, the world's biggest, rose less than expected. BP and HSBC Holdings led the Dow Jones Stoxx 50 Index to its lowest level in 7 1/2 months. All eight major European markets were down during today’s trading.
Japanese stocks fell, led by Nippon Telegraph & Telephone Corp., on concern an expected loss by Europe's Vodafone Group signals slowing demand for telecommunications services around the world. The Nikkei 225 stock average dropped 0.3% to 11,936.08.
Treasury Market Government bonds closed higher in a lackluster session. This week's massive $27 billion 2-year note auction is expected to put a ceiling on bond performance this week. The 10-year Treasury note added 2/32 to yield 5.13% while the 30-year government bond edged up 1/32 to yield 5.665%.
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