Jim Puplava says, "Back at the Casino"...(How true.)...
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Monday's Stock Market WrapUp
Disappointing Monday Market — Yet Another Scandal
If investors were looking for a follow-through from Friday’s relief rally, they were greatly disappointed on Monday. Instead of relief, investors got more pain. Monday started out with another accounting scandal at yet another major company. This time it was Merck, a component of the Dow. A Wall Street Journal story this morning indicated the company recorded $14.1 billion in sales from its pharmacy-benefits subsidiary, Medco, that it never collected. Company officials said its revenue recognition policies conform to GAAP and that there were no indications the SEC had any problems with Merck’s accounting policies. The revenue didn’t affect net income.
The fact that the company used its discretion within the limits of generally accepted accounting principles (GAAP) is perfectly acceptable. Companies are allowed a certain degree of discretion under GAAP. Accounting isn’t a perfect science with some gaps and gray areas. In the case of Merck, they offset the revenues with matching expenses, resulting in no effect on earnings. What Merck did was perfectly legitimate. In fact, Medco used this very same method of accounting before Merck acquired them back in 1993. The problem is the degree of trust with investors has fallen dramatically, so even though what Merck did was perfectly legitimate and did not distort the company’s income, it still made front-page news. Add the Merck story along with the top officers of WorldCom invoking their Fifth Amendment rights before Congress and investors headed for the exit gates again.
Don't Blame the New Accountants and CEOs
The issues of trust and confidence in the financial system are waning, so it doesn’t take much for investors to find an excuse to sell. The real problem is there are going to be a lot more financial restatements before the end of the year. One reason for restatements is more than 2,000 companies will be switching or changing their accountants following the conviction of Arthur Andersen. Many more companies have fired their CEOs. The first thing the new CEO or auditor is going to do is distance themselves from the previous management or accountants. A lot of dirty laundry is going to be aired over the next six months. Almost one out of five companies used Arthur Andersen as their auditor. Those companies that have now switched to newer accounting firms will find their new accountants taking a closer and harder look at the numbers. Accounting firms have suddenly become a lot more cautious after what happened with Arthur and will be looking more closely at how companies derive their numbers.
In addition to the new accountants, new CEOs will also want to set the record straight. They don’t want to get blamed for the previous CEO’s errors. With this year’s new accounting laws going into effect regarding the charge off of goodwill, now is a good time to get rid of any accounting problems. The net result of changing auditors and changing CEOs is there are going to be a lot more earnings restatements between now and the end of the year, putting pressure on earnings. This will be one more hurdle that the markets are going to have to overcome on top of declining earnings and a weak pricing environment for most companies.
Depends on the Derivations
Wall Street’s forecast for the 40%-plus profit improvement for the second quarter will turn out to be a pipedream. I suspect that with the release of second quarter numbers, many companies will start to downplay the second half of the year. At some point analysts will have to take off their rose colored glasses and get real with their numbers, no matter what format they choose to forecast them. Remember we have about five different variations of pro forma numbers used in the reporting of earnings. Maybe we will get a new derivation of earnings that match the times, such as EARAICO (Earnings After Relevant Accounting Information Is Currently Omitted), or we might get a variation of EBIDA, such as ETLGETTAB (Earnings That Look Good Even Though They Are Bad), or perhaps EDFPC (Earnings Designed for Public Consumption).
The point here is that there has to be a major downgrade of earnings for the second half of the year. With layoffs on the rise and the economy weakening outside the consumer’s debt and spending spree, there are no earnings catalysts on the horizon. It is going to take more than just a miracle to get these kinds of numbers for the second half of the year.
Except the consumer, who seems to be oblivious of the perilous position of the economy, businesses and wealthy folks -- the main investors in the economy -- seem to be in difficult straights. According to a Reuters story today, the rich on both sides of the Atlantic have lost $2.6 trillion or 6% of their wealth. According to a recent survey, the wealthy are alarmed at the rate of destruction of their wealth. They are now becoming risk adverse in their investments, shifting to cash and money markets. They are withdrawing from the capital markets. This translates into less money for capital investing. When that happens, the economy contracts. Add to this the propensity for the government to do something totally stupid, such as pass new regulations and raise taxes, and you have the same prescription for another depression.
It is alarming to watch the degree of grandstanding, finger pointing, and pompous self-righteousness of Congressmen and Senators calling for new regulations and new taxes to solve the problem. Liberals have always found taxes and new spending to be a cure for any of society’s problems. The real problem is one of integrity and morality, which can’t be legislated, least of all by government. After all, these are the same people that have told us we were running budget surpluses even though government debt increased by $500 billion. These are also the same people that insist on telling workers there is a Social Security Trust Fund. This is also the same government that cooks its own books through creative accounting, such as seasonal adjustments, hedonic indexing and capitalizing expenditures instead of booking them as expenses as WorldCom did. The ruling class may want to ponder their own improprieties before they point at the sins of others. If you want to clean out the barn, it starts at the top.
Economic News
In other news, despite the threats of terrorism, accounting scandals and an accompanying bear market in stocks, consumers are still of good cheer. Even though the unemployment rate is still rising and job growth has been anemic, the American consumer, God bless him, is doing his part for the country. U.S. consumers borrowed more money in the month of May than at any other time since last November. Credit card debt and other kinds of installment-type loans increased by $9.5 billion after rising $8.6 billion in April. The American consumer seems unphased by recent events and is willing to go even deeper into debt to support his lifestyle. Consumer borrowing is being encouraged by companies such as GM and finance companies, offering zero percent loans, low interest rates, or delayed payments. Over the holiday weekend I was alarmed at the number of furniture company ads offering no payment plans that went out 3 to 4 years.
$ in Billions April (r) May (p)
Revolving $709.8 $712.2
Non-Revolving $986.5 $993.6
Commercial Banks $556.1 $557.5
Commercial Banks Revolving $221.3 $218.3
Commercial Banks Non-Revolving $334.8 $339.2
Source: Federal Reserve, July 8, 2002 r = revised, p = preliminary
On top of credit card debt, mortgage debt and home equity loans are also on the rise. Economists see no danger in all of this debt should the economy soften even further or if job layoffs continue. Economists greeted the rise in the amount of credit card debt as a sign of consumer confidence in the economy. In others words, the economic expansion currently forecast by economists is based on deficit spending by government and debt based spending by consumers. It is odd that economists see nothing wrong with this kind of recovery or any of the dangers that may lie ahead as a result. In addition to consumer debt, the financial industry is also taking on debt by increasing the amount of leverage in the system through derivatives. The new economic formula is as follows:
Debt + (Financial Leverage + Speculation) = Economic Recovery + Rising Financial Markets = Prosperity
Somehow I never recall learning that formula in the economic courses I took in graduate school. But that was long ago, and we are in a new era. We also have New Math, so I may have been missed out on something here since my edumacation took place many years ago.
Today’s Markets—Back at the Casino
Today’s major indexes all ended up on the downside as the US dollar continued to weaken overseas, accounting concerns heightened with Merck, and companies continued to warn on the earnings front. The WSJ story on Merck hit the pharmaceutical sector hard. Biotech was dragged down with it. Other sectors hit were brokerage, oil service, and the defense sector. On the plus side were gold, silver, airlines and bank shares.
Volume was weak with 1.16 billion shares exchanging hands on the NYSE and 1.71 billion on the Nasdaq. Losers had the upper hand with declining issues outdistancing advancing issue by 19 to 13 on the New York Stock Exchange and by 21 to 13 on the Nasdaq.
Overseas Markets
European stocks fell after a regulatory filing by Merck & Co. added to concern about the accuracy of accounting for corporate earnings. The Dow Jones Europe Stoxx 50 slid for the first day in three, falling 0.5% to 3072.90, after dropping as much as 1.6% earlier today. Six of the eight major European markets were down during today’s trading.
Japanese stocks fell, led by exporters such as Toyota Motor Corp., after the yen had its biggest gain against the dollar in two weeks, renewing concern a strengthening currency will reduce the value of overseas sales. The Nikkei 225 stock average fell 0.5% to 10,769.20 after rising as much as 2.1%.
Treasury Markets
Government bonds remained considerably higher across the board as investors searched for a safe haven from the stock market. The 10-year Treasury note added 1/2 to yield 4.80% and the 30-year government bond rallied 23/32 to yield 5.48%.
© Copyright Jim Puplava, July 8, 2002
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