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  • It's The Top Of The Ninth Inning

    With the DJIA posting another 100 point loss yesterday, the index is once again down for the year, by 0.5%.

    When we began the year, market analysts were predicting gains of 5% to 10% for the year. At this time, it's all going to need to come in the five months remaining. We are questioning the probability that will happen, having serious doubts.

    There has been a fair number of doom and gloom articles over the past couple years, and most have been written off with the authors being labeled perma-bears. It's now time to revisit these articles and look at them in the context of what is currently taking place in the US and the rest of the world.

    Some of the issues we've been concerned about over the past few months have been escalating (e.g. weak earnings and non-GAAP reporting of earnings). However, we are additionally beginning to have external shocks thrown into the situation...Russia, China's inflated/manipulated stock market, Greece, oil, commodities rout, among others.

    At this time last year, the markets were jittery as the Fed was preparing for QE tapering. Many feared that with the elimination of QE, the markets would have to go lower and that the $85 billion per month infusion was unduly supporting the market. After a mild "shock", markets recovered and moved higher. Today, the Fed is signaling it will raise interest rates in September. What we see is an overwhelming number of articles indicating the Fed will not raise interest rates, that it cannot - they will delay, or possibly never increase rates. We also have the IMF, which has now made two requests to the US Fed not to raise interest rates, because the rest of the world is not prepared for the ripple effects. The last IMF request a couple weeks ago suggested waiting until at least sometime in 2016 for the first rate increase.

    We believe the Fed will move forward and raise interest rates by 1/4% in September because the data which the Fed has been telling us it has been watching is indicating the US economy can handle it. We don't believe it's prudent to be playing a game of poker, with the Fed sitting on the other side of the table, as an investor being the one to call a bluff. We very much believe that corporations can handle a rate increase from an economic perspective. However, the psychology of market participants will drive the indexes lower. Part of this will happen because at this time, valuations are out of line with reality. Part of this comes back to our prior thoughts regarding non-GAAP reporting.

    Some will say this is simply a short-term QE taper tantrum all over, but we'd disagree. For the most part, corporate earnings are weakening and have deteriorated over the past few quarters. Low interest rates are no longer providing sufficient stimulus for business investment to drive increased profitability. Stock buybacks, mergers and acquisitions, and other mechanisms of financial engineering are driving the latest round of corporate earnings.

    Now, the thing is that most folks are basically looking at the September interest rate hike as a binary event, but that is foolish. Interest rates will be going higher, and that is all that matters. Whether it's September, December, or early 2016, it is coming.

    It's a crap shoot how the market will react to the Fed's decision come September - regardless of whether interest rates are increased or not, the story can be twisted to be positive or negative. Our belief is that the headlines will be negative no matter how the Fed acts...valuations are simply too high at this time - pushed to current levels by investors looking for yield however they can get it. Throwing money at high-flying share prices hoping for any type of earnings beat has been a favorite these past two weeks. This is yet another red flag for us that the end is near. We see volatility continuing through August with ever increasing turbulence in the indexes, and then we have the Fed decision in September.

    At this time, we have essentially moved to the sidelines, going to 90% cash. Over the past 8 weeks, we've even been purchasing CDs laddering 50% of our portfolio in 3 month to 4 year maturities. Our belief is that there is a much higher probability of a major market correction during the coming months, than for the beginning of the markets next move higher. At best, the markets will stagnate, merely staying within a "narrow" range with DJIA between 17,000 and 18,500. We don't see DJIA moving to levels such as 19,000 or 20,000 - we believe something in the 16,000s is much more likely.

    We've already begun taking some ridicule for our beliefs and portfolio positioning. However, our view is that it is silly to fight for the last 10% profit while risking over 5 years of tremendous gains. The probability is that the market will make a significant move lower, before a significant one higher. Current fundamentals and valuations simply do not support the argument for moving significantly higher - regardless of the interest rate situation.

    Jul 24 7:51 AM | Link | 7 Comments
  • Non-GAAP Abuser Of The Week - Merck

    In my last Instablog I described how investors are having the wool pulled over their eyes with the proliferation of non-GAAP reporting. I made the case that because it is becoming so ubiquitous, references to market PEs are becoming useless and hide the fact that the market is extremely overvalued at this time.

    This week, we saw Merck ($MRK) go full-tilt on non-GAAP reporting.

    A review of Merck's earnings announcement exemplifies my point.

    Q1 Non-GAAP EPS = 85 cents/share

    Q1 GAAP EPS = 33 cents/share (-42% yoy)

    2015 Non-GAAP EPS guidance = $3.35 to $3.48 (raised)

    2015 GAAP EPS guidance = $1.58 to $1.85/share (reduced)

    All the headlines read how the company did so well in the quarter, how outlook and guidance are so good, etc.

    Stay tuned - it will be interesting to see how far companies go in the next few quarters to hide the deterioration of their earnings.

    Apr 30 8:24 AM | Link | 1 Comment
  • The Emperor Is Naked!

    Not a week goes by that we don't see a few articles on investment sites and stories on CNBC and Nightly Business Report where some well-known financial figure is justifying why the markets are overvalued, undervalued, or just right. Invariably, most of the justifications have some basis in corporate earnings and PE vs. historical levels of earnings and PE.

    The problem with these expert arguments is that they all tie back to EPS - company-reported EPS. This begs the question, what is "EPS"? We see two prevalent definitions of EPS these days:

    1. GAAP EPS - this is EPS based on "Generally Accepted Accounting Principles". If you read any company's income statement, this is what the bottom line EPS is.

    2. non-GAAP/adjusted/pro forma EPS and EBITDA - these are what we call "Whatever the company would really like their reported-EPS to be at this time". The company will start with the bottom line GAAP EPS, then add back common expenses that they prefer not to include - thereby giving the ability to boost their reported earnings. In discussing non-GAAP EPS in his book Financial Shenanigans, Howard Schilit provides the following:

    SEC Not Amused by Pro Forma Chicanery

    The SEC has taken note of these schemes. In a March 2001 speech, the agency's chief accountant, Lynn Turner, attacked company disclosures that appeared to "turn straw into gold." He described how the fixation on corporate profits has led companies to move from reporting EPS (earnings per share) to creating the turbo-charged pro forma EBS - Everything but the Bad Stuff.

    The company and analyst justification for reporting non-GAAP EPS is basically "these are one-time non-recurring expenses and don't give a true picture of the business operationally". Only problem is that these expenses occur every quarter and are in fact on-going/common/expected expenses that are part of the operations.

    Where we run into more problems is that historically, companies did not widely report non-GAAP EPS - EPS meant GAAP EPS. It really was not until Internet Bubble (IB) 1.0 that the use of non-GAAP measures began to infiltrate Wall St. and the financial markets. We all know that valuations donned on most internet stocks of the period were bogus, and the use of non-GAAP measures provided a means to inflate many and have some justification. Though we have gone through the purging of IB 1.0, and the sock puppet has died, non-GAAP EPS has not only lived on, but it's thrived and is now the norm. When discussing EPS these days, it is almost a given that what is being discussed is non-GAAP/adjusted/pro forma EPS - AND THIS IS BAD!

    What is bad is that analysts and financial "experts" are now using this concocted EPS in arriving at the proper PE ratio. If you have a bogus EPS, certainly you therefore have a bogus PE. Our contention is that across all the equity markets, we are looking at phony PE ratios and in actuality they are significantly higher. As a result, most of the US equity market is currently wildly overvalued and indexes deserve to be significantly lower.

    One company we follow, that has consistently abused non-GAAP reporting is Speed Commerce ($SPDC). Take a moment to read through SPDC's recent earnings announcement - notice the liberal use of non-GAAP metrics everywhere with only a single, almost hidden reference to the GAAP EPS numbers. At the end of the earnings announcement, the company includes the boilerplate "Use of Non-GAAP Information" statement and they've washed the blood from their hands.

    To summarize:

    • Use of non-GAAP EPS is now more prevalent than ever
    • Importance of GAAP EPS is being trivialized by the investment community
    • Barometers and historical metrics used for determining company and market valuations are now ineffective because of the ubiquitous use of non-GAAP EPS
    • As the economic recovery is maturing, financial engineering is becoming more widespread to mask weakening corporate performance
    • At some point, we believe there is going to be "The Emperor has no Clothes" revelation and it will be followed by a massive "reset". When this happens, things are going to become very ugly for those companies that rely upon and emphasize the use of non-GAAP/adjusted/pro forma EPS reporting.
    Apr 12 1:42 PM | Link | 1 Comment
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