Banks are among the worst offenders. On the downside of the biggest credit cycle in history, many banks are slowing the pace at which they’re provisioning for credit losses. Some are even releasing reserves into the income statement.

These are the reserves that banks had been building up to absorb credit losses. In other words, bank executives are employing the “mark-to-model” accounting framework to justify reporting higher earnings by employing subjective (usually rosy) estimates about the future.

If it turns out that we’re not, in fact, past the peak of credit losses in the banking system, banks will have to once again rebuild loss reserves, and perhaps even write off the earnings they’ve been reporting in recent quarters. Bullish banking analysts are certain we’ve seen the worst of earnings performance in the banking system. This from the analysts who didn’t recognize the risks in 2006-07 posed by the macro environment, which wound up wiping out most of the bubble-era earnings during the 2008 write-off tsunami. Furthermore, bank earnings will keep shrinking as both the size of balance sheets and net interest margins shrink as the Fed-engineered ZIRP flattens the yield curve like a pancake.

Another area to look for lower-quality earnings is any company with plant, equipment, and inventories. Lately, it’s become popular to slow capital expenditures to levels far below depreciation and amortization expense. This temporarily boosts free cash flow, but does so at the expense of future earnings. Companies with shrinking asset bases eventually deliver shrinking earnings power and risk erosion of their competitive position. As asset bases shrink, depreciation and amortization expense will also shrink, which temporarily boosts pretax income. I’ve seen several examples of this phenomenon in recent earnings reports.

Sharp swings in inventory can also push earnings up and down. Overbuilding of inventory sows the seeds of future earnings disappointment. During the late 2008/early 2009 liquidation of excess inventories, many companies suffered a squeeze in gross margins in a fire sale environment.

This phenomenon changed by the middle of 2009. Many companies had taken inventory liquidation too far. After the worst of the financial panic had passed, bottlenecks started clogging up the technology supply chain in particular. Since then, the tech supply chain has rebuilt inventories — in many cases, at a rate that exceeds sales growth.

I think you can see how this could all go wrong quickly. Component suppliers are ramping capacities. Distributors are building inventories. Contract manufacturers are scrambling to increase inventories. The product suppliers themselves are adding to their inventories. Then, as has been intimated several times above, end product demand begins to ease (from Europe, from U.S. consumers, etc.). Then all [heck] breaks loose, up and down the supply chain.

This exercise highlights the folly of government stimulus programs. These programs send phony signals up and down the supply chain for manufactured goods. It’s a fool’s errand to try to restore the economic conditions we saw during the 2004-07 credit bubble. This effort to restart the credit cycle was a complete waste of scarce capital, as more investors will likely realize in the coming months.

We’re not going to restart the credit bubble, so if they’re going to do anything, policymakers should focus on minimizing the social shock of transitioning to a post-bubble environment. Unfortunately, hundreds of billions were wasted on propping up zombie banks that could have easily been recapitalized by cutting away the claims of shareholders and junior creditors in bankruptcy, and setting up a legal framework to tame and wind down over-the-counter derivatives — all without a penny of public funds. Policymakers had the entire spring and summer of 2008 to prepare such a plan in the months after Bear Stearns blew up in March 2008. Instead, U.S. taxpayers got “TARPed” in order to bail out reckless bank shareholders and bondholders.

In today’s market, we’re watching traders on Wall Street prop desks trying to make money by front-running the Federal Reserve into its planned Treasury bond buying program. We have a market dominated by carry trades that would blow up in spectacular fashion if the Fed even hinted at raising short-term interest rates.

Speculators with itchy trigger fingers dominate the stock market. The public is withdrawing from most mutual funds, taking the most stable pool of liquidity with it. Much of today’s stock buying is being done with borrowed money, which adds greatly to volatility.

Even worse, the market is expensive if you adjust for the widespread accounting gimmickry we’ve seen in recent quarters. So the next time you hear that the market is “cheap” — and you’ll hear it frequently in the mainstream financial press — remain skeptical about the quality of earnings in the P/E ratio.

Regards,
Dan Amoss, CFA
The Penny Sleuth

Red Flags for Earnings Season Investors was originally featured in the Penny Sleuth.

This is what happens when a market with no investment merit at current valuations runs out of speculative fuel:

Investors may finally be turning their attention to quaint concepts like valuation and risk.

Computerized trading, which is driven by similarly programmed algorithms, is the main culprit. Here are my thoughts on last Thursday’s crash, and how it might change things going forward:

1. When the governments and central banks manufacture the illusion of an economic recovery driven by deficit spending and money printing, the faith in the sustainability of that recovery is — not surprisingly — weak. Now, after two crashes in the space of a decade, the list of greater fools is shorter. Mom and Pop investors have wisely chosen to remain skeptical throughout this bear market rally, making it very narrow and jittery, rather than broad and sustainable. After last week’s drama, I think we can forget about the widely anticipated surge in mutual fund inflows.

2. Thursday’s market was one of many consequences of watering down accounting standards in the banking system in spring 2009. Poor accounting quality introduces an element of Ponzi psychology in the trading of financial stocks. In other words, if everyone owning these stocks knows that earnings are very fudge-able, and embedded credit losses are being stretched way out into the future, they’ll aggressively dump these stocks on any correction.

3. Someone must hold every share of stock that’s been issued. This is why the notion of central bank money printing holding up the stock market forever is too simple. If primary dealers “repo” Treasuries at the Fed, and use the cash proceeds to buy stocks and corporate bonds, they are by definition not strong hands. They close out these trades quickly on days like yesterday. The strategy probably involves paying ever-higher prices into rising, calm markets, and unwinding violently when volatility picks up. This doesn’t make for a healthy stock market. Perhaps Congressional hearings should target the influence of primary dealers borrowing from the Fed to finance risky carry trades.

4. The market has too many impatient, trend-following traders, who sell when “support” levels get hit. They aren’t buying stocks with the view that stocks are fractional ownerships in businesses on sale. Technical analysis loses its value when every technician uses the same strategies, and has similar stop losses, as yesterday showed us.

5. The market doesn’t have enough patient, skeptical investors. This makes bubbles and crashes more likely. The good news is it creates buying and shorting opportunities for contrarians.

6. After last week’s market gyrations, it’s becoming even more apparent that “quant,” or computerized trading exacerbates market swings. Rather than supply cash to the market during panics — and supply stock to the market during melt-ups — it appears that these funds do the opposite. Quant trading relies on the same garbage-in-garbage-out models that created such wonders as “triple-A” CDOs. The physics and math Ph.D.s who create and modify these models should apply this math where it’s actually appropriate and predictive — in engineering problems — rather than markets heavily influenced by emotion. Quants seem to know the price of everything with each passing nanosecond, and the value of nothing. We should seek to take advantage of mispricing caused by quant trading — primarily by adopting a longer time horizon for trades. The less often you trade or invest, the more time you have to think.

7. Crashing markets cause everyone to have a “deer in the headlights” reaction. But it helps calm your nerves if you’re confident in the value and earnings power of the stocks you own. Only computers without an understanding of valuation and market history could have been selling quality stocks at 20-30% of intrinsic value aggressively at the 2008 market lows — which was clearly the case.

8. This isn’t just in stocks. We’re seeing risk aversion in currencies, commodities, and corporate bonds. If the crash in the Euro keeps spiraling out of control, look for Ben Bernanke to set up a massive swap line with the ECB to provide dollar liquidity to leveraged speculators looking to unwinding carry trades.

9. In today’s investment culture, the vast majority of fund managers don’t stay in business if they think too independently. If money managers decide to not participate in a rally because they judge the fundamentals as weak, they often get fired. A few decades of this investing culture has resulted in scary levels of groupthink. The less that fund managers can think and act independently, according to their best judgment, the less efficient the market becomes. Another way of saying “less efficient” is “more prone to bubbles.” Career risk forces otherwise rational, sober managers to buy into an expensive, rising market.

Regards,
Dan Amoss
Penny Sleuth

May 11, 2010

9 Takeaways from May’s Market Crash was originally featured in the Penny Sleuth.

Take a good look at the chart below… It’s the NASDAQ 100 Index off the 2007 peak. Does anything jump out at you? It should:

In the past I’ve talked about ABC’s. I’ve talked about Fibonacci levels. I’ve talked about trend channels. That’s a big picture chart. Now let’s zoom in and look a little closer at the chart above.

If the charts above don’t give you some pause, I don’t know what will. Those who are long only? You better be prepared!

Those who are wise enough to take control of their own destiny vs. allowing a traditional Wall Streeter to do so? Better start to think about hedging the long side of your account. Those who have 401(k) plans investing heavily into equities, you might want to think about raising some cash. Those who have IRAs and can’t short? Better be looking at inverse ETFs.

Those who see it for what it really is? Get ready to have some fun on the short side.

Right now, the S&P 500 is setting up the same way the NASDAQ 100 did back in 2007 JUST BEFORE The Markets gave back 10+ years worth of gains. You don’t want to potentially have to go through that again do you? After all those who fail to learn from history are doomed to repeat it…

But not so fast — right now there’s one thing missing: the C Wave of the “ABC down” I’ve been talking about for weeks here. By the time that wave is clear the damage will already have been underway and as we’ve always said you’re late to the party

So the big question at this point is: If this breaks are you going to be prepared to take action or be a deer in the headlights?

In the past couple of weeks I’ve filled Penny Sleuth readers in on some short side actions to take in just such a situation. Hopefully you have been paying attention [Ed. Note: If not, you can check out our archives here…]

Week after week, we’ve been laying out the most likely outcome here based upon technical analysis. Now’s the time to pay attention. Not being vigilant in this market could end up being a serious mistake…

Sincerely,
David Grandey for the Penny Sleuth
AllAboutTrends.net

February 25, 2010

Technicals Warn of a Double Dip Recession in 2010 was originally featured in the Penny Sleuth.

But as the markets work their way back into health and investor confidence continues to creep up month after month, we risk throwing away the lessons of the Subprime Crash of 2008:

Lots of very intelligent investors got embroiled in huge losses last year. Bernie Madoff fleeced scores of wealthy, well-informed investors – many of whom lost everything they had built up over a lifetime. The collapse of some of the biggest financial institutions, including Lehman Brothers and Bear Stearns, thinned out the Wall Street crowd by the millions. And underperforming fund managers hit close to home by taking a bite out of out 401Ks.

In fact, over the course of the last year, the average mutual fund lost 20.95% of its value according to Morningstar. That’s a shock for investors who were used to raking in double-digit gains year after year.

If nothing else, there should be some pretty big takeaways from this financial fiasco. Here are three that you should be walking away with:

1. Know What You Own

Knowing what you own is one of the tenets of stock investing. But it means more than being able to name the holdings you have in your portfolio. In late 2007 and early 2008, the general consensus on stocks was that the bullish tone of the market was set to continue.

But in reality, stocks had been expensive for quite some time. Just how valuable were stocks before the bottom fell out of the market? Here’s a look at historical P/Es of the S&P 500 every quarter since 1936:

The consensus is generally that the average P/E of the S&P 500 is around 10; it’s not. Since 1936, the S&P 500 has averaged 15.8.

But in late 2008 the S&P’s price to earnings ratio had risen to the mid 20s. In fact, they hadn’t touched that 15.8 average in 13 years. For the first two quarters of 2008 before stocks went into freefall, the S&P’s P/E ratio averaged just over 23… 45.5% higher than the historic average.

Now, there are a lot of reasons why the market should have a higher P/E than it has in the past – constituent companies have changed pretty dramatically in the last 73 years, for starters – but that still doesn’t explain why companies delivered investors with 39% less earnings bang for their buck between 2005 and 2008.

The information suggesting that the market might be overvalued was easily available, but the investor sentiment told us to buy full steam ahead.

2. “The Market Can Stay Irrational Longer than You Can Stay Solvent”

That famous quote from economist John Maynard Keynes resounds just as true today as it did in the 1930s. Keynes was qualified to make a statement like that – he was one of a few prescient investors who made a fortune by avoiding the great depression, and picking up undervalued stocks dirt cheap in its aftermath.

Markets tend to overreact to important news. They overreacted to the subprime crisis by slashing stock prices by an average of almost 50%, and they’ll likely overreact again as we recover from March 9’s market lows.

Those overreactions are only magnified when it comes to penny stocks. Because the smallest companies have the smallest trading volumes, their true values and share prices are often not reconciled. And while that can provide penny stock investors with a huge buying opportunity, it can also provide us with a huge headache as we wait for our valuations to come to bear.

3. Don’t Believe the Hype

The mainstream financial media deserves a share of the blame too… Traditionally, the tone at the major financial networks has been pretty predictable – their pundits sing the market’s praises when things are good, and solemnly decry the dangers of stock investing when things turn sour.

And as the first signs of the subprime collapse started rearing their ugly head, the pundits were in full perma-bull mode…

It’s time to take what we hear on the financial news with a grain of salt.

Cheers,
Jonas Elmerraji

June 16, 2009

Three Lessons Learned from the Subprime Crash was originally featured in the Penny Sleuth.

If we all had time machines, we would be millionaires. But we have not had the luxury of playing Monday morning quarterback with our investments. Until now, that is…

Thanks to the recent stock market crash, we have the opportunity to pick up seriously cheap shares that were flying high until mid-September. In some cases, this is a chance to hop into a time machine and buy these stocks before they became household names. Until recently, these stocks were the darlings of Wall Street. And when the market stabilizes, these stocks could quickly return to favor…

There are few defensive plays like health care – after all, people don’t stop getting sick, and health benefits aren’t something that cost-conscious employers can cut without enduring the wrath of angry employees. But despite health care’s promise for weary investors, the sector hasn’t been immune from the losses seen across the board in the last year.

As a whole, the health care sector has fallen almost 30% since the beginning of 2008. Health insurers have had it worse – these names dropped 40% in the last quarter alone.

If you’re wondering why one of the most regularly profitable sectors in the market has taken such a beating, you’re not alone. Billionaire Carl Icahn is among the many investment pros that have seen their health care losses mount this year. So are Warren Buffett and George Soros.

Explains BusinessWeek’s Ben Steverman:

“On a basic level, investors are worried that Democrat-led health care reform in Washington is going to shake up the health care sector and hurt profits. But it’s actually more complicated than that. The U.S. health care system is astonishingly complex and few people know exactly what President-elect Barack Obama may propose nor what Congress would approve. And few can predict how that legislation (if it passes at all) would impact particular subsectors, industries and individual companies.”

That doesn’t mean that moves in Washington won’t impact the health care sector – they will, though not necessarily in a bad way. Analysts recognize that whatever plans are put into place will most likely involve the private sector. Government changes could actually be good for scores of health care companies, especially health insurers.

Best,
Greg Guenthner

January 5, 2009

Buying into the Health Care Comeback was originally featured in the Penny Sleuth.

“Yesterday is history. Tomorrow is a mystery. But today is a gift. That is why it is called the present.”— Old saying, recently revived in Kung Fu Panda

I watched Kung Fu Panda last weekend as part of my son’s 10-year birthday party. There were some good quotes in it, including the one above. Another one I liked, also from the wise old turtle Master Oogway: “Your mind is like water. When it’s agitated you can barely see clearly. But once you become quiet and are in peace, then everything becomes clear…”

Certainly, the market’s recent dramatic swings have scrambled the heads of many investors. Mostly, it’s been a nasty slide down — a history-making drop. And that will make a lot of people give up. (From the November 24 issue of Wall Street Journal, “‘I just don’t have the stomach for it anymore,’ says [semiretired computer programmer Eugene] Hibbs, 66 years old… Now, Mr. Hibbs is sitting on Treasury bills.”) But now is the time to really pay attention. It’s been a history-making drop, and it may also seed some equally breathtaking opportunities.

Last week’s rally notwithstanding, this bear market has few precedents. Really, you have to look back to the 1930s. According to Barron’s, at the low on November 20, the S&P 500 has given back a decade worth of gains. Even after surge on Friday, November 21, 2008 would still be the worst year for stocks since 1931, when they dropped 53%. In the whole of the 20th century, no decline has exceeded 50%, save for the 1929-32 bear market. The S&P 500 is off 45% from its October 2007 high — that’s after last week’s rally.

Whether our bear market looks ultimately more like 1929-32 or 1937-38 is an open question, of course. The former went on to post a total loss of 86% top to bottom. The latter, though, rallied and made up 50% of the losses in the next six months. Another hopeful message: The average time to recoup a bear market loss has been 22 months, excluding the 1929-32 collapse. As with the big crash, so with the rebound — it will come when people least expect it.

Resource stocks look like they’ve already had their 1929-32 style crash in just the last few months. Many resource names are already down 80% or worse from top to bottom. It’s incredibly ugly out there. Even companies that looked like they were in decent financial shape only a few months are now scrambling to raise liquidity and stave off a financial crisis.

A strong balance sheet means that financially, you are in control of your own destiny. It means you don’t need to raise money, nor do you have a looming debt coming due soon. It means you’re going to be a survivor.

It’s going to come down to the survivors. The upside could be spectacular on the other side for them.

Regards,
Chris Mayer
December 1, 2008

Bear Market 2008: What the Crashes of the 1930s Reveal about the Present was originally featured in the Penny Sleuth.