Troubling Tuesday: Earnings Manipulation Exposed

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Includes: DIA, EWJ, FXI, IVV, IWM, NKY, QQQ, SPY, TZA
by: Philip Davis

Summary

AP/Capital IQ study finds rampant manipulation of earnings reports.

Like the subprime debacle of 2008, inflating earnings leads to bubble that collapse upon themselves.

We're already seeing evidence of this as 155 S&P companies hit 52-week lows.

What have I been saying?

Corporations have been FAKING their earnings numbers through financial engineering on a record scale. Now it's not just a conspiracy theory because the Associated Press and Capital IQ have done a study that proves everything I've been saying about earnings this year.

As I have been saying when we analyzed recent earnings quarters, companies have been presenting misleading versions of their results that ignore a wide variety of normal costs of running a business to make it seem like they're doing better than they really are. What's worse, the financial analysts who are supposed to fight corporate spin are often playing along. Instead of challenging the companies, they're largely passing along the rosy numbers in reports recommending stocks to investors.

"Companies are tilting the results," says fund manager Tom Brown of Second Curve Capital, "and the analysts are buying it."

As noted by Dave Fry: "Adjusted vs. GAAP (generally accepted accounting principles) earnings have become more accepted now than previously. Decision Point's Carl Swenlin has been posting the two results side by side for many years. Unfortunately the financial media and Wall Street analysts have become more willing to accept "adjusted" earnings results which can mislead analysts and investors alike. Finally the AP has featured the manipulated illusion of these results. For corporate CFOs this type of stuff, along with overwhelming cheaply financed stock buybacks, have successfully manipulated stock prices."

This sort of thing is not a "victimless crime" that benefits the market in the same way that giving unqualified people sub-prime loans ended up being a catastrophe. Sub-prime lending inflated housing prices well over their actual value and led to a tremendous crash and inflated profit reports drive up the price of stocks and will eventually lead to a similar correction.

Analyzing the S&P, Capital IQ found that one in five companies had inflated their profits by MORE THAN 50% and that some of the companies that seem profitable on an adjusted basis are actually losing money. The adjustments made companies look better by leaving out things like costs related to laying off workers, a decline in the value of patents or other "intangible" assets, the value of company stock distributed to employees, or losses from a failed venture.

72% of the companies reviewed by AP had adjusted profits that were higher than net income in the first quarter of this year. That's about the same as in the comparable period five years earlier, but the gap between the adjusted and net income figures has widened considerably: adjusted earnings were typically 16% higher than net income in the most recent period versus 9% five years ago.

Quarter after quarter, the differences between the adjusted and bottom-line figures are adding up. From 2010 through 2014, adjusted profits for the S&P 500 came in $583 billion higher than net income. It's as if each company in the S&P 500 got a check in the mail for an extra eight months of earnings.

Investors were paying 13.50 times earnings in 2010 and now, just 3 years later, the average is 18 times earnings but, if those earnings also are faked by an average of 16%, now we're talking 21 times earnings or 50% more than people were paying three years ago. THAT's what a bubble is folks and this is NOTHING compared to the complete scam that is going on in China, where the entire market is valued 150% higher in 18 months on much faker earnings than we have!

As you can see from the 52-week low chart, it has become obvious that many of these Emperors actually have no clothes as one-third of the S&P is now making 52-week lows as one by one the earnings shenanigans are being uncovered. This is nothing new to us, as we cashed out on those phony-baloney gains and went short on the market. If you are a bull and buying the F'ing dip - don't say we didn't warn you.

Friday we warned you that the Nikkei was going to take a dive and I said, right in the morning post, that we were shorting the Nikkei Futures (/NKD) at 20,600 and long on Oil (/CL) at $57.75 and long on Gold (/YG) at $1,175 and long on Gasoline (/RB) at $1.98 and, this morning we have:

  • /NKD at 20,000 - up $3,000 per contact
  • /CL at $59.25 - up $1,500 per contract
  • /YG at $1,182 - up $225 per contract
  • /RB at $2.05 - up $2,940 per contract

See how much fun futures trading can be?

There's still plenty of stocks to buy - not all of them are cheating and, fortunately, we're pretty good at digging into those financials and arriving at the truth. We don't play a lot of momentum stocks - we prefer solid companies with solid earnings profiles and THEN we use options to leverage our positions. It's the only rational way to trade these crazy markets.

Be careful out there, the NYSE has become our first index to blow the Must Hold line (11,000) and that 5,000 line on the Nasdaq would be a terrible thing to lose and the Russell is facing a critical test at 1,250, below which it makes a great short (with tight stops above). We already have TZA as a major hedge, of course:

Disclosure: The author is short SPY, IWM, EWJ, FXI.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Positions as indicated but subject to RAPIDLY change (fairly bearish mix of long and short positions - see previous posts for other trade ideas). Positions mentioned here have been previously discussed at www.Philstockworld.com - a Membership site teaching winning stock, options & futures trading, portfolio management skills and income-producing strategies to investors like you.