Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

Month: May 2016

BEARNOBULL’S WEEKENDER

Did you miss MIND THE GAAP?

Jim Grant’s recent piece:

Jim Grant Asks When The World Will Realize “That Central Bankers Have Lost Their Marbles”
Oil Isn’t the Only Commodity Threatened by Tesla’s Rise
So What Are the Odds, Really?

Pic Your Poison NBC/WSJ Poll among Registered Voters, April 10 - 14

The cards are markedly stacked against Trump when it comes to winning in November. Most national polls show Hillary Clinton beating him in the general election, even though she is nearly as unfavorable to registered voters, according to an NBC/Wall Street Journal survey. Renaissance Macro Research calls Trump’s “net negatives prohibitively high.” And as I shared with you way back in August of last year, Moody’s Analytics forecasts a win for the Democratic nominee, whether that’s Clinton or someone else. Since 1980, Moody’s sophisticated election model has accurately predicted the outcome of every single contest, and in 2012 it even nailed the Electoral College vote.

Trump still has quite a lot of support in the financial industry. A Financial Advisor poll found that, as of today, a little over 50 percent of respondents say Trump will win the White House, while nearly 37 percent say Clinton. Doubleline Capital founder Jeff Gundlach also believes Trump will be the victor, arguing that in the short term, this would be positive for the U.S. economy. The New York billionaire, Gundlach points out, has promised to build up the military and initiate an infrastructure program. 

 

By Gillian Tett

(…) First of all, do not buy banks; or not if you hope government will boost their share price. Until recently, Mrs Clinton was perceived as being soft on Wall Street; indeed, some financiers hoped that bank-bashing would end in 2016.

But Bernie Sanders, her Democratic rival, has performed so well that Mrs Clinton will face pressure to steal his “socialist” language to appease his supporters, and may well pick an anti-Wall Street figure as her running mate, such as Sherrod Brown, an Ohio senator.

Mr Trump may not be so different. Many Republicans would love to repeal the post-crisis financial reforms, and he has criticised the Dodd-Frank Act. But he also seems instinctively hostile to Wall Street. As a self-appointed hero of angry main street voters, he is unlikely to embrace banks.

Second, do not expect a rally in Treasury bonds; at least, not one driven by debt cuts. A couple of years ago, it was presumed that by this point in the economic cycle policymakers would be discussing how to cut America’s vast debt burden. But Mrs Clinton is no fiscal hawk. On the contrary, she seems to lean towards fiscal stimulus, and may try to appease supporters of Mr Sanders this way.

And, while the Tea Party wing of the Republican party is eager to slash debt, Mr Trump has built a career on exploiting leverage. He has vaguely promised to get rid of America’s $15tn debt in eight years; but he also wants to create jobs, boost growth and protect entitlements. Little wonder that traditional fiscally hawkish Republicans dislike him.

Third, embrace infrastructure stocks — whoever wins. Mr Trump built his brand with construction, and were he to win in November he would be likely to unleash a national infrastructure campaign to create jobs and growth. He likes the idea of being a second Dwight Eisenhower, the man who built America’s Interstate highway system.

But Mrs Clinton may do this too. After all, as Lawrence Summers, the former US Treasury secretary, recently pointed out, the beauty of infrastructure spending is that it could create middle-class jobs and growth at a time when monetary policy has reached its limits — at least, if you do not mind raising debt.

Fourth, expect currency volatility. The most eye-grabbing element of Mr Trump’s campaign so far has been his threats about trade protectionism. But Mrs Clinton has turned more protectionist, too, toning down her support of the Trans-Pacific Partnership. No one knows if her newfound caution will actually change trade flows or supply chains. But sabre-rattling on the global stage could certainly quickly unleash some currency swings.

Finally — and most importantly — investors need to invest in assets with an eye to capricious government intervention. After all, if there is one thing that will make sense of this peculiar election, it is the idea that voters have lost faith in the free-market political centre.

With populism rife, Mrs Clinton may deploy more consumer protection and regulation in response, while Mr Trump ay plump for endless protectionism.

Either way, if you want to invest in pharma, cars, tech or pretty much anything else, you would be a fool to make your choice based on economics or free-market theories alone. Populism matters, in investing and politics alike now — even, or especially, if it makes your head spin.

Initially,

“I would borrow, knowing that if the economy crashed, you could make a deal,” Trump said in a CNBC interview.

Later, when the inevitable would happen,

(…) Trump, the presumptive Republican nominee for president, said in an interview with CNBC Thursday that if the economy were in a prolonged slump, he might use his business skills to reduce America’s debt burden by pushing creditors to accept write-downs on their government holdings.

Since the founding of the country Treasury secretaries have been unwavering in their commitment to always make good on government obligations, an assurance that’s helped make U.S. debt a haven from risk around the world. A default would put that status in jeopardy, sinking the value of the dollar and sending yields surging, according to David Ader, head of government-bond strategy at CRT Capital Group LLC. Growth could stall as borrowing costs for holders of mortgages and other consumer loans — which are tied to government debt yields, spiked.

“This is stupid and ridiculous and never going to happen,” Ader said from Stamford, Connecticut. “But it’s not impossible that he could be president, and could try all the seemingly ludicrous and impossible things he’s talked about. You can’t just dismiss it when the guys got his finger on the button, so to speak.” (…)

Americans’ Distaste For Both Trump And Clinton Is Record-Breaking

No past candidate comes close to Clinton, and especially Trump, in terms of engendering strong dislike a little more than six months before the election.

enten-generaldislike-1

MIND THE GAAP?

The earnings ayatollahs are back in force and some readers are enquiring whether the Rule of 20 uses GAAP earnings or not.

It does not, and it should not.

GAAP earnings are useful when analysing individual companies. Some companies abuse the system and investors should do their work before investing. Many people will research the whole web before buying a toaster but will invest in a stock without first spending 30 minutes perusing the annual report, the 10-K and the notes to the financial statements looking for clues about management’s conservatism and/or integrity. Looking back over the years, one can quickly check if “non-recurring” or “one-time” charges actually recur more often then not, raising serious doubts on management’s competence and/or integrity. Always avoid investing in companies using very liberal or doubtful accounting practices. Most corporate executives are pretty smart; those who also feature dubious morality can be highly dangerous to your financial health.

When it comes to index earnings, I use “operating earnings” for the following reasons:

  • companies included in the main indices are seasoned, widely followed and generally run by honest people.
  • the main earnings aggregators are also serious companies which understand the game. Most will actually adjust the reported operating earnings to make sure they are representative of the company’s actual operating performance and coherent within the index and with history.
  • The objective is to be objective, that is using numbers that reflect as closely as possible the true earnings power of companies composing the index. For example, a company may have to write-down an asset or restructure its organization, often incurring large one-time costs that reduce profits for that particular year. Blindly using reported earnings will likely distort the earnings potential of the on-going entity.

Asset write-downs or write-offs generally culminate during recessions when companies often need to streamline their operations or even simply bring an asset value down to its true value since, under GAAP, assets must be carried at the lesser of cost or value. Goodwill created in an acquisition must be periodically tested for impairment. Sharp economic downturns usually bring goodwill impairments which can seriously reduce an index GAAP earnings during the recession year but will often improve the continuing earnings potential. Blindly or dogmatically utilizing GAAP earnings will likely result in lost investment opportunities like was the case in 2009.

Here’s what I wrote on March 3, 2009 (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years):

Since the mid-1980’s companies have been showing 2 sets of earnings: “reported” GAAP earnings and “operating” earnings or GAAP earnings excluding non-operating profits and losses and write-offs. Companies which record “non-recurring” gains or losses or which book write-downs or write-offs in asset values in a given year also provide “operating” earnings so that investors get a “more accurate” picture of a corporation’s “true” profits from continuing operations and its realistic earnings power going forward.

The pros and cons of “operating” earnings are that:

  • It makes sense for corporations to segregate from operating earnings those gains or losses which are deemed outside of the normal operations of a company (e.g. asset sales, discontinued operations). This is also useful to investors who can better appreciate the recurring profit generating capabilities of companies.
  • Write-offs and write-downs are more debatable since they reflect a loss in value of certain specific assets which management or auditors deem inflated in a company’s books given present and expected circumstances. On the one hand, such losses in values reflect the inability of management to extract acceptable or appropriate returns from these assets at their current book values, justifying their inclusion in earnings. On the other hand, to the extent these write-offs or write-downs are one-time non-recurring events, excluding them from “operating” earnings provide a more accurate picture of the company’s earnings power under its new adjusted asset base.
  • There is admittedly a degree of discretion for corporations to classify gains or losses as “recurring” or “non-recurring”. Some companies have used this discretion in such a way that they report “non-recurrings” so often that they become recurring non-recurrings.

Reported vs operating earnings has only been a big factor in market valuation in early 2000, when the tech bubble burst, and …now.

And now. The main culprit this time is the sharp drop in oil prices which has compelled producers to revalue their assets to reflect the lesser of cost or value which, for many, meant taking big write-downs. The stocks of oil producers have adjusted down to their new earnings power long before the accounting charges have been recorded. Large asset write-offs by energy companies do not change the earnings power of non-energy companies nor should they affect their valuations.

RBC Capital charts the ratio of write-offs to “pro-forma” (operating) earnings to reveal the magnitude of recent energy write-offs and the fact that, outside of energy, write-off trends remain within their normal range.

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This chart plots operating EPS as a percent of “as reported” since 1988. The so-called conspiracy has not gotten worse:

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Both GAAP and non-GAAP EPS of S&P 500 ex-Energy companies are expanding.

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