Joseph L. Shaefer's  Instablog

Near the end of 2008, Eaton Corp (ETN) guided investors with their expectation of earnings between $3.80 and $4.80 a share for 2009.  A couple months ago they lowered that guidance to $3.60 - $4.20 per share.  If you bought either time based upon a low expected Price/Earnings Ratio (PE ratio) you were out of luck.  The company declared their current earnings for the most recent quarter plunged 92% -- and they now project that they might maybe earn "up to" $1.85 this year.

But since results topped “analysts' estimates” – which had themselves been reduced two, three, four or more times in just the first six months of the year – the stock gap-opened up 4 points (10%) in one day.

With Eaton engaged in the manufacturing of electrical components for power distribution and control, hydraulics systems and services for industrial equipment, fuel and pneumatic systems for commercial and military use, and truck and automotive drivetrain systems, we'd be hard-pressed find a better bellwether for American manufacturing...

Eaton’s customers are primarily airlines, car and truck manufacturers, and basic industry.  Yet somebody out there not only ignored the current condition of these customers, ignored the fact that ETN’s earnings were off 92%, and ignored the fact that Wall Street manipulated a gap opening by crowing how ETN had beaten (the deflated) earnings estimates.  Because someone is buying shares at what is now going to be at least 25 times earnings even if the company is correct this time.

Are you and I the only investors left in America that actually look at revenue and earnings trends?  Cluebird time – if a company cannot sell more of whatever it provides or produces, it cannot increase revenues.  Absent revenues, the only way to jack up earnings is to cut costs.  Since they’ve been slashing costs for up to two years now, I’d say most companies, if they can’t increase revenues, have only one option in order to survive: fire more people.

This is heart-rending.  It’s like watching Charlie Brown line up one more time for a run at the football.  We all know Lucy is going to pull it away at the last second and we want to reach onto the printed page and pluck him out of harm’s way.  “Not this time, Charlie Brown!  Just, once, get smart!”

But many market-players simply don’t.  If the market are going up – no matter the reason – it must be a good thing.  Of course companies beat their “estimates”; even The Limbo King couldn’t get under a bar placed this low.  It invites humor, not respect.

I use Eaton as just one example.  I could as easily have cited Caterpillar (CAT), another industrial bellwether, whose sales went from $13.6 billion to under $8 billion, Lockheed Martin (LMT), BlackRock (BLK), Merck (MRK), Halliburton (HAL), Johnson Controls (JCI), Weatherford (WFT), Dell (DELL), Nokia (NOK), DuPont (DD), or any of scores of others, including that most American of icons, Harley-Davidson (HOG).   (A great ticker symbol – I wonder if they’d be willing to sell it to Goldman Sachs?)

After Wall Street dumps their long positions into the buying frenzy and these stocks return to more reasonable valuations, I think some, like ETN, CAT, JCI and WFT might be peachy buys. 

Until then, I’ll stay on the sidelines and nibble a bit more at bond funds like SHY, TUZ, BND, AGG and TIP; and inverse ETFs like SKF, SRS, SBB, EUM, PSQ, SH, and DOG.

Until then, I’m involved – but not committed – as I see revenues plunge, earnings plunge, bond debt come due, and layoffs rise.  Wall Street, long these stocks, needs to keep them up just long enough to unload at higher prices, so they will reduce estimates, then trumpet this failed performance. 

On the “Constant Noisy Bullish Chatter” station, Wall Street will send their most photogenic and articulate to express shock – shock! – at how good the numbers are.  “Boy, did Caterpillar beat our (deflated) estimates or what?” they chortle, all the way to the bank. 

Only in George Orwell’s Animal Farm, where all animals are equal but some animals are more equal than others, would the doublespeak of “less dreadful news is actually great news!” be considered rational.  In fact it is insane.  And if no one else is willing to tell the emperor he has no clothes, it falls to thee and me.  Bad news is bad news.  Let it be.  We will recover.  Then there will be good news, and it will be real good news, not manufactured at Wall and Broad.  Dear Wall Street: that wasn't so hard, was it?

We need to accept that, like a human heart, markets and economies expand and contract.  If they just kept racing higher and higher, the same thing would happen to markets as does a living heart that doesn’t take a rest between beats.  It will have a heart attack, like it did in 2000-2001 and again in 2007-2008. 

There is no shame in recognizing the essential cyclicality of markets, nor in the inevitability of reduced sales and earnings in times of contraction.  But with Wall Street’s “guidance” many are tempted to don rose-colored glasses as if none of this is going on.  People losing their jobs?  Yes, but fewer than might have!  Home foreclosures rising?  Yes, but less than we expected! Commercial loans rising?  Hey, at least some companies are still current on their loans! 

And still we listen to the same talking heads from Wall Street whose greed and arrogance brought us here.  As I wrote here, admittedly tongue-in-cheek, “Consumer confidence was down briefly on the news, but less than expected by economists. Residential and commercial real estate sales were down, but less than expected by analysts. Employment was down, productivity was down, and real wages after inflation were all down but all were down less than some clueless lunatic expected. All is well in ToonTown.”

Hello Lucy van Pelt, goodbye heart.

 Full Disclosure: We own short-term bond funds like SHY and TUZ and slightly longer-term (5-10 years) BND, AGG and TIP; and inverse ETFs like SKF, SRS, SBB, EUM, PSQ, SH, and DOG.

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The first in this series of  Wall Street’s (Fractured) Fairy Tales -- Buy and Hold is The Best Strategy – can be found here.

 Others to follow include:

#3 – Program Trading Stabilizes the Markets

 #4 – Discount Brokers Can’t Provide What We Provide  

 #5 – Short Selling by Individuals is Bad for the Market

 #6 – Our Analysts Provide Unbiased Coverage

 #7 – Now That We’re a Bank, Your Money is Safe

 #8 – You Don’t Pay a Commission for Bonds, IPOs, Secondaries, etc.

 #9 – Your Broker is a Keen Observer of the Markets,

 and the Big Lie…

 #10 – Investing is Too Difficult to Do On Your Own

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