Operating Versus GAAP Earnings
This Time is Not Different
6/02/16 8:15 AM
As we write this month’s comment the S&P 500 stands at 2,099,
1.33% away from its all-time high of 2,134. So we thought this would be a good
time to discuss whether stocks are cheap or expensive relative to historical
norms. When investors consider this question they most frequently analyze stock
prices relative to past and future earnings. We have the privilege of having
written articles on this subject that were published by Barron’s magazine. The
articles are titled “What’s the Real P/E Ratio” and “A Simple Calculation” (see
attachments). In the articles we describe the various and often confusing
ways that Price/Earnings (P/E) ratios are calculated, and which are used
primarily by bulls, and which are used primarily by bears. If you are not
familiar with this topic or need a refresher we urge you to open the
attachments and read these articles. We continue to subscribe to all that we
stated which can be summarized most succinctly as our belief that it is most
correct to use GAAP (Generally Accepted Accounting Principles) earnings on a
trailing twelve month (TTM) basis when calculating the P/E.
We explain in the attached article that “operating earnings”
exclude write offs, while “GAAP reported earnings” include write offs. That is the main difference, but the
difference that is getting much more important as more and more companies
resort to using “operating earnings” in order to increase their earnings while
bringing down the P/E ratio. As recently
as the early 1990’s GAAP earnings were used exclusively when we started the
entrance into the greatest financial mania of all time. There were so many write offs by companies
making unwise investments and then reversing them, that “operating earnings”,
grew much faster than the companies using GAAP earnings. The write offs that had been unusual (using
write offs as temporary) became common for more and more companies.
So here is some information based on data from S&P’s website
that we believe to be particularly pertinent. With about 97% of the S&P 500
companies having reported first quarter earnings it appears to us that the GAAP
number will be $22.43, give or take a little. When added to the previous three
quarters we get $87.15 a share in earnings. We should add that Operating
Earnings (Non GAAP) look to us to be $99.48, about 14% higher. That
differential is slightly higher than when the market peaked in Q3 2007 and also
higher than when the market peaked in Q1 2000. Recall that the main difference
between Operating and GAAP earnings are that inclusion of extra-ordinary,
non-recurring items in GAAP Earnings. Thus to the extent that extra-ordinary
items exist, Operating Earnings will always be higher than GAAP Earnings. We
also suspect that a good part of this differential (Operating vs. GAAP) is due
to the large volume of stock buybacks (many financed by debt and at excessive
valuations) that we believe have been a major support for the market. When
restricted stock and options that were granted to corporate executives become
vested, the “in the money” amount comes directly out of shareholders
equity. GAAP Earnings capture this while Operating Earnings do not.
So given the above numbers of $87.15 in TTM GAAP Earnings versus a
2,099 close the S&P 500 is selling at a 24 multiple. To put that in
perspective, if you had a business that you worked hard to build that made
$100,000 after taxes and someone walked in off the street and offered you $2.4
million for it you might be inclined to respond “sold to you”! That decision,
of course, might be more complicated and largely be a function of expected growth
rate, but as we see the numbers, 24 is a historically very high multiple for
the stock market in general.
So again from numbers we obtained from S&P here are a few data
points that we believe are enlightening. At the end of 1988 the index was 278,
the P/E was 11.69. The index “took off” from 306 at Q3 1990 and the P/E was
14.08. Those type of P/E’s might be the kind one would therefore view as on the
cheap side, where the market has large potential. On the other side of the
coin, for the several quarters preceding the bursting of the “Dot Com Bubble”
in 2000 the P/E was in the high 20’s to middle 30’s, the highest that we can
document at a top. When the “Housing Bubble” burst, the market dropped from
1527 at end of Q3 2007 and the P/E was 22.19. It had dropped all the way to
1166 (-24%) at end of Q3 2008 and the P/E was 25.38… and THEN the bottom fell
out. The point here is that we are in the ballpark of all time rich valuations
and while it’s impossible to predict the day a bear market begins, history
tells us it is more likely that there is much more downside risk than upside potential.
In our opinion, when this period in stock market history is in the record books
it will prove to have been a major selling opportunity.
History has many examples of “this time is different“ and we
suppose that a big part of the “different” this time is that the economy is
finally ready to take off after a “great job” by the Fed in navigating the
economy out of a crisis (that began almost 8 years ago!) In other words we
finally are about to grow our way out of the low growth/high valuation mess
that we’re in. We fully understand what the bulls are saying or more
accurately, hoping. We and others call this “The Central Bank Bubble”. The Fed did its part by stepping on the gas
to get us out of the recession caused by the bursting of “The Housing Bubble”
(which they and the government were complicit in causing in the first place.) By keeping its foot on the gas for almost 8
years all it did was inflate financial assets and increase wealth
disparity. We continue to believe that “this time is NOT
different” and that in due course “The Central Bank Bubble” will burst.
The Ending of QE
4/28/16 9:05 PM
of QE-3 formed a stock market top formation that presents a very strong technical
resistance that will be DIFFICULT to overcome!!
market swings (based on the S&P 500) have been extremely volatile since the
end of QE-3 in December of 2014. In
fact, ever since QE-1 ended in 2010, QE 2 ended in 2011, Operation Twist
ended in 2012, the market rose slightly and then fell sharply soon afterwards. Now that the Fed ended QE-3 and have started raising rates the stock market has been very volatile and we suspect that the swings will wind up breaking down through the lows of 1812 and 1810 that took place early this year.
(First Attachment—Ending QE and the Markets Reaction).
Attachment—S&P 500 – Ten Market Peaks) These are the same type of stock
market swings that remind us of all the other endings of QE phases. This time the S&P 500 rose into 2015 to
make a record high in May of 2015 at 2135 (rounding out for simplicity). The market has not exceeded that level since
then, even though it has come close numerous times over the past year. In fact,
in 2015 the market rose to 2120 in February, 2115 in March, 2126 in April, 2135 in May, 2130 in June, 2133 in July, 2117 in October, 2115 in
November, and 2002 in December. Also there has been a 2020 peak this April--that's 10 peaks over the past 15 months. That's a lot of peaks to break through, especially when the Fed is trying to tighten and you can see from the first attachment that the market breaks down whenever they just stop loose monetary policy.
made last year were 1867 in August and 1872 in September. The second low in September was interrupted
by a strong move back to 2021 also in September. The lows that were made this year (2016) were
1812 in January and 1810 in February.
These two lows were also interrupted by a sharp move up to 1947 also in
February and the low of 1810 was called the Jamie Dimon low on February 11th. That was because of Dimon’s purchase of his
company stock, JP Morgan, that same day.
The move up since the Feb 11th low has been quite impressive
by rising to 2120 in April and is still pretty close to that peak now (2076
have been watching the stock market rise to new highs without many corrections
over the past seven years. In fact, the
market has not had a significant decline since this bull market started in
March of 2009. Clearly, this seven year
bull market in the U.S. was due to the Fed pumping in enormous amounts of money
into the financial system. Such monetary
policy in the U.S. (and also worldwide) distorted the way money is typically
distributed and inflated the price of stocks, bonds and anything else that
trades, including commercial real estate.
ludicrous monetary stimulation policy was not confined to the U.S. The rest of the world copied the U.S. as well
as Japan, who has been doing a similar monetary policy for the past 27 years
without much success. The Japanese stock
market hasn’t come close to the 39,000 reached by the Nikkei in late 1989. It is now trading around 16,700. The Bank of Japan (BOJ) has been even more
outrageous than our Fed since they have been buying everything imaginable to
keep their economy afloat. Their present
ownership of common stock ETF’s is mind boggling! Their Japanese government and the (BOJ) own
over 10% of over 200 stocks of their most widely traded index, the Nikkei 225.
The BOJ has just recently decided to use negative interest rates to stimulate
their economy and weaken the Yen. The
“unintentional consequences” hit them as the stock market fell and the Yen
rose. Negative interest rates are also
being used by the ECB in order to grow the European economy. As is the case with Japan, we believe their
efforts will fail miserably. In China,
though rates are not negative, the Public Bank of China (PBOC) has “doubled
down” and added huge amounts of renminbi debt over the past seven years. In fact the government debt has grown to 243%
of GDP over the last 7 years.
We have been
extremely critical of all the Central Banks that have been guessing on the
policies they use while hoping everything will work out without even
considering the “unintended consequences” that may occur. Just by studying the first attachment chart
you can see what a difficult time the Fed will have in reversing their
extremely loose monetary policy. Every
time they have tried to reverse it, the stock market drops, and now they are
scared to death of trying to raise rates again after the decline the market
took in January, not long after the first rate hike in December.
In the U.S.
alone the Fed’s balance sheet grew from just over $500 bn in 2009 to $4.5 tn
presently. This drove interest rates
much lower and essentially forced investors (who wanted to get an adequate
return on their money) into risky stock investments, risky bond investments and
even commercial real estate. The Fed
claimed they were saving the U.S. from going through another “Great
Depression”. They could be correct in
that assessment since this crisis is still called the “Great Recession”. What the Fed didn’t tell anyone about is the
fact that they all have been complicit in this crisis.
one of the first institutions that came out being very, very critical of the
Fed since it was so clear to us that what took place to provoke the "Great Recession" was caused by Alan Greenspan. He got it right at first during the dot com era when he stated in 1996 that the worldwide markets reflected "irrational exuberance" but then changed his mind when the stock market continued up and he thought maybe this time it would be different!! When the market finally broke in 2000 he should have realized that the U.S. market was the most overvalued market in its entire history. He didn't and instead in 2003 he lowered interest rates to 1% and kept them there for a year. This started the worst financial crisis and depression since the "Great Depression". As our readers are aware we have comment after comment on our website, Comstockfunds.com , about the Fed and central banks. In fact, we have a “special report” titled “THE CENTRAL BANK BUBBLE”.
believe that if the Fed decides to raise rates at this time, while most other
central banks continue their stimulus plans, the results could be
disastrous. If the Fed does move this
year (which is a high probability), it will drive interest rates higher, the
U.S. dollar higher, and the stock market lower.
If the Fed makes more than one rate hike this year, it will just drive
the rates and U.S. dollar even higher and the stock market much lower. However, if we are correct and the stock
market drops sharply after the first hike, we suspect they will make the first
hike the last hike for the year and maybe forever. In fact, if they really fear the market as
much as we think they do, they could even go back to QE-4. But, in our opinion, if they do the investors
will not continue to be the Fed’s flunkies any longer and the market will still
fall sharply knowing there is no way out of this mess except to tighten.
opinion, once the Fed makes the next rate hike the market will not have a chance
of breaking through the 10 peaks outlined in the second attachment. Those are all peak prices that should hold
with such a weak economic recovery (0.5% GDP for the first quarter), earnings and revenue recessions, and a stock market with very high
valuations (22 times earnings if GAAP earnings are used).
Corporate Buybacks Aren't What They Used To Be
3/31/16 3:30 PM
Engineering” as it applies to a corporate structure usually is defined as the
aggressive use of various techniques to enhance shareholder value by affecting
the balance sheet. Probably none has
received more attention over the last several years as stock buybacks. It seems that not a day goes by that CNBC and
the financial media are reporting that companies have initiated or increased
share buyback authorizations, and there has been a great deal of attention
given over the last many months to whether share repurchases represent a
judicious use of a corporation’s capital.
report we will attempt to shed some light on this topic and also examine what
message the market may be saying about large companies that are doing
buybacks. This is possibly one of the
most important questions facing market participants today since the U.S. has
been in a zero or near zero interest rate environment for 87 months (an
unprecedented amount of time.) During
that time corporations have raised record amounts of long term debt at
historically attractive levels, while at the same time remaining voracious
buyers of their own shares. The major buyback companies as a whole have
outperformed over the last 7 years, since the bottom on 3/9/09. However, this recently has not been the case
as we will illustrate.
Now in this
era where it seems there is an index for any financial asset class that can be
measured there are indexes of companies that are buying back their own
shares. The performance metrics of the
two most popular are reasonably similar so we will focus on just one, the
S&P 500 Buyback Total Return Index (SPBUYUT). This index is calculated by S&P back to
1994 (numbers sourced from Bloomberg), though it appears a more recent creation
since trading volumes and ranges don’t appear until 2013. This index is equal dollar weighted and
rebalanced quarterly. It is a subset of
the S&P 500 consisting of the 100 companies that for the 4 previous
quarters have repurchased the largest percentage of their market capitalizations. We will compare this to the S&P 500 Total
Return Index (SPXT). This index is
capitalization weighted and like SPBUYUT reinvests dividends. It is thus a reasonable “apples to apples’
would argue that returns on financial assets have been inflated by an
experimental and dangerous environment the Fed has created through QE and ZIRP
the numbers tell us that since the market low on 3/9/09, SPXT has returned 252%
while SPBUYUT has returned 374%. A
shorter and more recent time frame, however, tells a somewhat different
story. Since the 3/9/09 market low there
are 29 rolling 4 quarter periods we examined.
Of the 29 periods, there have been five where SPBUYUT
underperformed. There were 2 in 2012 and
the most recent 3 (through this writing on 3/29/16). The largest of the 5 is the last 4 quarter
roll and the underperformance number is 7.02%.
So we believe that the market is starting to punish companies that are the
most voracious buyers of their own stock.
several arguments made by buyback opponents that go as follows:
Buybacks steal from the future by
expending resources that should be used to fund/ensure future growth in
exchange for the short term gratification of a higher stock price that is the
result of the buyback. Worse yet, if
financed with debt, the debt has to be serviced and paid back eventually.
Buybacks do not return money to all
shareholders (as dividends do) but rather only to selling shareholders; (that
are now no longer shareholders)
Corporate managements have an
inherent conflict of interest when, as is typically the case, their
compensation is determined by EPS metrics that are influenced by the buybacks
arguments make sense to many, including us.
It is likely true, however, that when the markets are near the high end
of their all time ranges, most investors either don’t care or overlook these
facts. When the extended bear market
that we see coming arrives in earnest, we believe the finger pointing and
recriminations will arrive with it.
our regular readers know that we believe the U.S. is in a long term
deflationary cycle that is the result of excessive debt (see attached “Cycle of
Deflation”). The debt situation has been
exacerbated for the last 87 months by the “experiment” of QE and ZIRP by the
Fed. Other Central Banks have followed
with their own QE and ZIRP/NIRP. During
this time frame corporations have been large buyers of their own stock with
much of it financed by debt. This most
certainly has been a prop under the market.
But as stated above corporations are doing so to the detriment of long
term investment in the business. While
in the past, indexes of companies doing buybacks have outperformed their market
benchmarks, that has started to change recently. Buybacks done at elevated levels of valuation
will prove to be ill conceived and ill timed (think Devon Energy and Amerada
Hess which recently needed to sell equity at levels far below stock repurchase
levels of the past several years).
Companies doing excessive buybacks will negatively affect future growth
by underinvesting in capital assets; all the worse if financed with debt. Because
of the aforementioned facts and circumstances, yesterday’s stock buyback
winners could prove to be tomorrow’s losers.
We believe that will be the case.
"Stormy Seas" Both in the U.S. and Globally
3/03/16 11:00 AM
warned in the past about the potential for a world-wide deflationary bear
market accompanied by a U.S., and possibly, global recession. We believe this recession and deflationary
bear market have begun and expect it will last through most of 2016 and into
ago Barron’s Magazine ran a cover story titled “Stormy Seas”. The authors were essentially on the other
side of this debate, by claiming “Despite Turbulent Markets”, the U.S. economy
will avoid a recession and grow at a healthy 3% pace this year. However, even if Barron’s is correct and the
U.S. economy grows at 3%, this would still be the slowest recovery since World
nine reasons that we believe there will be a US and possible global recession
The S&P 500 peaked in mid-2015 at
2135 and broke through many areas of support on the way down to the 1800-1812
area. Though it successfully tested that
area in both January and February, we believe that 1800 will prove an important
psychological level that will be breached in short/intermediate term. When this occurs we believe the potential
will be there for a rapid and significant move lower.
The spread between the 10 year US
Treasury and the 2 year US Treasury (flattening yield curve) is now just 83
basis points; the lowest level since late 2007.
This is a deflationary indicator.
According to Bloomberg, high yield
bond issuance was down 72% in February versus 1 year ago. Notable was the complete
absence of issuance by energy and materials firms; a possible indication that
financing is not available. This has
implications for future default rates.
The Bloomberg Commodity Index, which is
calculated back to 1991 and is broadly representative of the commodity complex,
made a new all-time low in January and currently is 68% below its all-time high
set in September of 2008.
Gold has been rallying over the past
few months as investors are worried about currency debasement and negative
interest rates. Negative real interest
rates can occur because interest rates are low relative to some inflation (now)
or interest rates are not high enough to compensate for hyper-inflation (a
possibility in the future as governments further debase currencies).
ISM manufacturing has been below 50
for five months and is now 49.5. 50 is
the break point between expansion and contraction
Downward earnings revisions,
according to data compiled by Bloomberg, are happening at double the average
pace of the last five years with profits seen dropping the most since the
global financial crisis.
The Atlanta Federal Reserve just
lowered its forecast of 1st quarter GDP to 1.9% down from 2.1%. Also significant is that its forecast of real
consumer spending growth was lowered from 3.5% to 3.1%
Fear and Loss of Confidence in
Central Banks. The Fed is looking at
everything they can before raising rates again---weakness in global markets as
well as all financial data. Other
Central Banks are also guessing after the Fed made significant decisions for
the past 7 years –i.e., zero interest rate policies as well as increasing the
balance sheet from $800 bn to $4.5 tn.
They are now scared to death about the “unintended consequences” of
their moves—especially after lowering rates in 2003 causing the housing bubble
and the “great recession”. They are
especially nervous knowing that so many countries have taken on so much debt
over the past few years without generating enough income to pay the debt
down. We believe that debt restricts
economic recovery and will probably cause “Deflation” (see attached “Cycle of
Deflation”). This debt has caused many
countries to fall into recessions (e.g. Brazil, Venezuela and a major slowdown
in China) and its effect has yet to be fully realized.
on a separate note, the people running for the Presidency have us very concerned.
On the Democratic side they are talking
about income inequality and how they can tax and spend more to alleviate it. There has been not a mention of the fact that
ZIRP has been the policy of our Federal Reserve. Zero interest rates are their dictum, not the
outcome of a free market price determined by the true supply and demand of
money. It did not precede income inequality but has
certainly exacerbated it as those with financial assets, real estate and
collectibles have benefitted. On the
Republican side the front runners are in a food fight and demeaning themselves,
our system and the office they seek. No
one, since Rand Paul dropped out, is talking about $19 tn in debt and
potentially $200 tn in unfunded liabilities that are not going away and in fact
growing. We believe this to be the most
important economic factor that will influence the quality of our children’s and
grandchildren’s lives. It is so large an
influence that it has implications for many things including defense,
infrastructure and social spending. They
in turn will factor into our security, quality of life and social order. And that is about as important as it gets!
More Fed Criticism
We Are In Good Company
2/05/16 8:00 AM
commentary (which we also made a “special report”) was essentially a response
to a financial reporter who asked us why we were so negative on the stock
market in 2016 just because the Fed, more than likely, was going to raise
rates. He stated that the stock market
almost always rose during the previous rate increases. We explained the difference between the Fed
tightening now, with enormous headwinds to overcome, relative to the times when
the Fed raised rates in the past. We
went on to also explain why the same headwinds to the Fed tightening would
probably also cause a U.S. recession (and maybe even a global recession).
comment was written in late December just after the Fed had raised the Fed Funds
rate by 25 basis points. Before this
past commentary very few people were warning
about a recession, here or globally.
However, now we are reading a lot about criticism of the Fed, and
virtually everyone that appears on the financial networks seems to have a
strong opinion about the probability of a U.S. or global recession. We have
been critical of the Fed since the Greenspan days but seldom heard of anyone
else criticizing the Fed or complaining about the ineptitude of the Fed. Now, however, after the stock market declined
sharply in January, we seem to hear about these two areas of concern almost every
recent criticism was a Wall Street Journal op-ed article by Martin Feldstein
regarding the Fed on January 14th 2016. The title of the article was, “A Federal
Reserve Oblivious to its Effect on Financial Markets”. We were struck at how closely this article
mirrored everything we have been talking about for years. The synopsis of the article was in the second
paragraph, “The overpriced share values are a direct result of the Federal Reserve’s
quantitative easing (QE) policy. Beginning in November 2008 and running through
October 2014, the Fed combined massive bond purchases with a commitment to keep
short-term interest rates low as a way to hold down long-term interest rates.
Chairman Ben Bernanke explained on several occasions that the Fed’s actions
were intended to drive up asset prices, thereby increasing household wealth and
consumer spending.“ The Federal Open
Market Committee last month didn’t even mention the risk from persistent low
rates. You can well deduce from the
title of the article that Feldstein does not have much confidence in the Fed
and FOMC in extricating the U.S. from the mess the Fed has put us in over the
past 7 years.
Gross asked a sarcastic question of the central banks in his written piece for
his clients yesterday. He asked, “How’s
it Working for Ya?” central bankers. He
then went on to criticize virtually every country that has been under the thumb
of their central bank. We were happy to
see that Bill Gross is on the same page as us.
recently, Rand Paul also criticized the Fed and the entire way our governmental
system works. He stated that the U.S. spends
over $600 bn. on the military in this country which compares to the top 10
countries spending on their military (including Russia, China, and the other
top eight countries spending on the military).
The right wing governmental forces want to spend more than $1 tn. more
on the pentagon while the left wing wants to spend much more on the domestic
side of our economy. Both get their way,
and the taxpayers get stuck with the bill as we borrow $1 million a minute to
support this and other spending. As we
stated in our last comment, the total debt of the county exceeds $100 tn. if
you include unfunded liabilities and promised entitlements. This debt is enormous relative to our $18 tn.
economy. These numbers are the main
reason our economy is growing so anemically.
heard a radio interview with economist Lacy Hunt, whose point of view we very
much agree with. The common theme here keeps
coming back to what the Fed has done to the financial markets by essentially controlling
the price of money rather than have the free market determine it. It has forced savers to chase return, which
cannot be done without increased risk.
And investors are not the only ones farther out on the risk curve than
ever before. We see announcements almost
every day about companies buying back their own stock, often with borrowed
money. As Mr. Hunt pointed out in his
interview, corporations are making financial investments in their own stock at
very inflated levels instead of making capital investments in their businesses. This phenomenon
does not bode well for future economic growth or for future stock market
We have been talking about the Fed and
government deficit spending over the past 15 years. The Fed cannot expect to
control the price of money and not have the economy and markets suffer adverse
consequences. Continuing the rate
increases risks further weakening of an already weak economy recovering at the
slowest rate in history from the last recession. While a cessation or reversal of the rate
rise has, on its own, potential to cause a panic as the markets realize that
the economy is weak and not likely to recover before there is a bursting of
what we and others have termed the “Central Bank Bubble”.
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