When I first got into the investment business, the overwhelming majority of companies followed the rules of Generally Accepted Accounting Principles. Now most companies report earnings based on Pro Forma rules.
Pro Forma earnings are when you adjust for unusual, non-recurring, one-time expenses. Examples:
• Minus one-time costs of layoffs
• Minus one-time costs of an asset write-down
• Minus one-time costs associated with a takeover
• Minus one-time costs of currency losses
It is the creative use of Pro Forma accounting rules that makes companies appear more prosperous than they really are-because the use of "extraordinary items" and "non-cash charges" has turned corporate earnings reports into a bag of lies.
90% of S&P 500 Companies Report Pro Forma Earnings
In 2010, 70% of the companies in the S&P 500 were reporting earnings based on Pro Forma results. That percentage has increased to more than 90% today.
The simple reason is that Pro Forma calculations make it easier for companies to manipulate their earnings and make profits appear higher than they really are.
As a result, there is a huge difference between how corporations are advertising performance and how they actually did.
S&P 500 "real" earnings have fallen for the last three quarters
If corporate America were forced to use GAAP rules, S&P 500 earnings would have been 12.7% less than reported. The last time the gap between "real" and "massaged" profits was that wide was back during the 2009 Financial Crisis.
Let's put those profits in perspective. The P/E ratio of the S&P 500 using Pro Forma accounting is 16.5 times forward earnings estimates. However, the P/E ratio balloons to 21.5 time earnings using GAAP rules.
Despite what you hear on CNBC and Bloomberg, stocks are not reasonably priced.
That's disgraceful, but even with the use of liberal Pro Forma accounting, the profits of the companies in the S&P 500 have declined for the last three quarters in a row.
The last time this happened was Q1, Q2, and Q3 of 2009… oops, that pesky 2009 Financial Crisis again!
What should really worry you is that despite the brutal start to 2016, stocks are much more expensive than they seem and very vulnerable to even more pain.
Don't get ripped off
This accounting razzle-dazzle scam wouldn't work without the cooperation of three parties:
1. Dirt-bag accountants who will do whatever it takes to make profits look bigger than they really are;
2. Dirt-bag Wall Street analysts that give a wink-wink to the phony numbers;
3. Gullible investors who think corporate America and Wall Street are on their side.
Don't worry about corporate America and Wall Street; they are making lots of money. The odd man out could very well be you. So I hope you are using this mini-rally to take some of your stock market chips off the table.
That these shenanigans are going on doesn't mean you're powerless, though. On the contrary, there's an utterly gratifying way to stick it to the scamsters, and it involves making bearish bets on big corporations that aren't doing as well as they claim.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.