Earnings Season

For my long-term investors there is nothing more important than corporate earnings, especially when compared to alternative investments.

Here are some key issues that I follow:

Forward or  Backward?

I read hundreds of analyst reports and earnings call transcripts.  Everyone is focused on future prospects in the analysis of specific stocks.  In the market of stocks, everyone looks to the future.  Somehow, when people try to evaluate the stock market, they prefer to look at the past.  Why?  It is pretty simple:

You can have solid, certain data that is not forward looking, or you can engage in forecasting.  If your perspective is past earnings, ten-year earnings, past peak earnings, or whatever,  you are rooted in what happened last year.  By definition, you will miss what is happening right now.

Earnings Quality

The concept of earnings quality is important, mostly relating to the sustainability of apparent strength.  While there are many challenges to quality, the 2009-era challenges relate to revenue.  The idea is that corporations slashed costs and thereby exceeded earnings forecasts.  From this viewpoint, earnings growth is not sustainable, since costs can only be cut so far.  Without top-line growth, the earnings rebound will falter.

Defining Good News

This widespread challenge has everyone looking for a perfect earnings report:  an earnings beat, revenue growth, and a positive outlook.

Will we see any of these?  How many?

I did not expect much this quarter, since most companies are looking at the same data as the rest of us.  Their corporate economists, if they even have one, are reviewing the modeling of other economists and reading the Wall Street Journal.  Most importantly, in the post Sarbannes-Oxley environment there is a penalty for companies and accounting firms that engage in undue puffery.  In fact, many companies no longer provide guidance.

Actual Data

There is an interesting historical pattern where most companies beat earnings expectations.  Some critics take an interesting position, arguing both of the following:

  • Forward earnings expectations are unduly inflated by optimistic companies and foolish analysts whose job is to sell stocks, and
  • Companies beat expectations which have been driven down to a level that is easy to beat.

For both of these to be true, corporations must spin a positive picture a year out and then violently reduce estimates.  This has not been happening.  Forward earnings estimates have been growing at a solid pace.

The reports from this earnings season have been spectacular.  Take a look at this informative chart from the fine team at Bespoke Investment Group.

Bespoke Net Earnings Guidance 

If this does not grab your attention, you just do not care about data!

The BIG team provides helpful data and charts every day — for free.  If you sign up as a member, you get even more.  For a helpful glimpse, check out this Charles Kirk live chat with the BIG team.

The Right Perspective

Much of today's pundit conversation was focused on the Fed.  Many bearish market observers have taken the following path of analysis:

  1. Expecting an economic collapse since the Fed had no options;
  2. Criticizing the various innovative Fed strategies as unwise and predicting failure (first prediction wrong);
  3. Denying economic progress under the Fed regime (second prediction wrong);
  4. Renewing criticism of Bernanke and team as clueless and repeating mistakes;
  5. Predicting some future failure, stagnation, or stagflation.

Whether these predictions prove to be correct on some multi-year time frame is an open question.  Meanwhile, the immediate impact is hard to deny.

Personally, I look at a one-month time-frame in our TCA-ETF trading, where I update our position each week.  For the average investor, I think a six-month to one-year perspective is more appropriate.  When I look at data, I see continuing, gradual improvement in the economy and, more importantly in corporate earnings — all in the face of a skeptical market.  My initial target is the pre-Lehman levels (both individual names and the market), where we need to take another look.

I outlined today's article during the day, but the Apple Computer, Inc. (AAPL) and Texas Instruments (TXN) reports (after the close) underscore the Bespoke findings.

[Full disclosure:  Regular readers know that my accounts are long AAPL and I have frequently recommended the stock for those needing a growth component.]

The Bias in Reporting Job Losses

Each day’s news brings more stories about layoffs at major companies. The stories get a big play in mainstream media. The leading bloggers also cite the stories and encourage readers to keep a summation of job losses.

This is quite misleading. Job losses occur in highly visible chunks, as we can readily see. New jobs are created a few at a time, both in existing businesses and in new businesses. Even sophisticated observers do not recognize the ongoing job creation from the invisible hand of the market.

Try This Headline

Suppose that the New York Times or the Wall Street Journal had a headline:

100,000 New Jobs Created Today.

Actually, they could run that headline every business day, even during the recession, and it would be accurate.

How do we know? As usual, we start with data. The best illustration available is from the last recession, so let us look back to 2001.

The 2001 Example

The data presented here are drawn from the Business Dynamics series from the BLS. The data are not from surveys. The evidence is from state employment data. Since no one reports employment, and pays taxes, on phantom jobs, these are data that we should believe. Here is the evidence.

2001 Net Jobs

Source: Bureau of Labor Statistics seasonally adjusted data. (Unadjusted data show the same result for the year).

As one can readily see, over 35 million jobs were lost during the year. That is what you would get if you added up all of the layoff announcements and also included job cuts that did not make the newspaper. What most people do not realize is that over 32 million jobs were added. This development is not publicized.

By focusing on gross job losses we get a false impression of the problem. The net losses are bad enough; there is no reason to exaggerate.


There are three important conclusions:

  1. About 90% of announced job losses were offset during the same month by job gains. We should be taking a 90% haircut to those newspaper articles.
  2. There was substantial creation of new jobs in opening establishments, a total of over 7 million for the year. That is something to remember the next time someone scoffs at the idea of business births during a recession.
  3. President Obama dropped the tax credit for new jobs, and that is a good thing. There is no way to separate the new jobs from the credit from those that would have occurred anyway. If the credit were paid for gross new jobs, the money would be gone in a couple of months.

Most importantly, this shows that we should remember that net job change is the key economic concept. That should also be our policy target.

What Went Wrong

There are plenty of “Year in Review” articles in mainstream media and on the Web. Here at “A Dash” we try to add value, so we are not going to tread the same ground. Instead, let us offer a few ideas that seem to have been neglected.

Looking for Causation

Investors looking forward, as they should, need to understand what happened in 2008. The easy explanation, which has plenty of truth, is that there was too much leverage, too much greed, a poor job by rating agencies, and a system that sold homes with teaser rates to many who could not afford adjusted payments.

Having made this bow to the obvious, the story is a bit more complicated. Understanding what happened is important. Why? How else can one know if there is a real solution?

What Went Wrong

Our analysis of problems, as noted, is not intended as comprehensive. It is an addition to what readers have already seen.

There was a real problem in excessive leverage at some Wall Street firms, excessive lending to home buyers, packaging of securities in complex derivatives, and rating agency failures in certifying these securities as AAA. This partly reflected the conflict of public policy – trying to help an aspiring class of homeowners – with the reality of sound lending practices. It was also a manifestation of greed on the part of many participants in the process. Government was slow to address the housing issue. It came at the worst possible time, when we had a President whose strength was limited by an unpopular war. Government agencies did not, and perhaps could not, react with sufficient speed. Few realize that problems must gain widespread perception before they can be addressed. Despite many innovative efforts, government agencies were playing catch up.

There were many who were celebrating this failure. Some hedge funds took advantage of the unregulated credit default swap market to undermine confidence in financial institutions. They “bid up” prices in this thin market, betting on the failure of certain firms. They bought put options, which would pay off if the firms failed. The failures cascaded since mark-to-market accounting rules forced other institutions to write down their holdings, even those that were performing assets. This created an environment that was much worse than the original problem. We were sucking assets out of our lending institutions at WARP speed. There was agreement that leverage was excessive, but no agreement on what level was appropriate, nor how to get from point A to point B. There is an appropriate level of leverage, not zero, and not 40-1.

Because of the general bias against “bailouts” the government chose to allow the failure of Lehman Brothers. This led to an environment where no financial institution believed in the viability of any other. Normal lending – not the leveraged stuff or the national debt – came to a halt. This meant that companies that relied on borrowing to finance inventory through commercial paper could not operate normally. It was a full-fledged credit crisis.

The Bush Administration reacted by going to Congress for a massive plan, hurriedly created and with little detail or oversight. President Bush should be congratulated for action, but there was little time. Congress balked, resulting in a better and more flexible approach. This new TARP plan quickly morphed into a generalized program of preventing the failure of financial institutions through direct investment. Others can and have criticized this action, but there was really little choice. Treasury Secretary Paulson was acting to prevent the dominoes from falling. The Lehman example made the risk obvious to all.

The result is now a holding action, where one administration is fighting to prevent things from getting worse, while we wait for a new one to take power.

What to Watch

As we evaluate the proposals from the Obama Administration, it is important to look for actions that address root causes. Some of these are already in place, including stimulating inter-bank lending and reducing mortgage rates.

The missing pieces are those directed to the dysfunctional reaction of financial markets. It is important to prevent attacks on specific firms via the thinly traded credit default swap market. It is important to break the cycle of forced write-downs of performing assets. It is important to address – quite directly – the housing market, helping new buyers and existing owners alike.

These are all death spirals. Stopping them is the key to limiting the recession effects.