The Next Enron, Part II
"The worst part of the bear market in stocks is still before us, and it will essentially involve the wholesale destruction of the pseudo-financial wealth that the bubble economy has created in the past years." Dr. Kurt Richebacher
What have I done, I asked myself.
"You promised to tell readers what company would be the ‘next Enron," explained a colleague.
"What was I thinking?"
I was thinking wildly. If it is a surplus of credit and not a shortage of character that produces Enron situation, wouldn’t it be easy to spot the next one? Wouldn’t it be a matter of checking to see where the credit went and who got most of it?
But this turns out to be no easy matter. For as Martin Weiss tell us, there are hundreds, or even thousands of candidates. It is like trying to figure out who is the dumbest member of Congress… there are simply too many good choices.
Government sponsored enterprises such as Fannie Mae and Freddie Mac, for example, added trillions to their ‘assets’ over the last few years. They borrowed at artificially low rates in order to buy residential mortgages. Had not the credit markets, real estate market, and appraisers been so generous, they would not have been able to grow so much and homeowners would not have been able to borrow so heavily against their homes.
GSEs are not literally ‘backed’ by the federal government, but who believes they would ever be allowed to fail? They will cost investors a lot of money when the credit cycle shifts against them. But at least their liabilities are in plain view… and they are sure to be bailed out somehow.
A company with liabilities out of plain view is, for example, the derivatives king J.P. Morgan. In recent years, J.P. Morgan has managed to get its name in the paper often. The context is almost always the same – a large company or sovereign nation goes bankrupt and there, prominent among the list of major creditors is J.P. Morgan. The company seems to have a nose for sniffing out bad credit risks combined with an irresistible urge to lend them money.
So, we would not be terribly surprised to discover that J.P. Morgan eventually costs investors a lot of money. Not that we know anything you don’t know, dear reader. But if the company wanted to blow itself up, J.P. Morgan has had access to plenty of HAZ MATS, as they call them on the highways – not the least of which are its derivative trades.
According to the Bank of International Settlements, exchange-traded derivatives grew by 31% since Long Term Capital Management blew itself up. The ‘over the counter’ derivatives market, meanwhile, approaches $100 trillion dollars.
Martin Mayer says that derivatives are a way of shifting risk to the dumbest guy in the room. J.P. Morgan, of course, has some of the sharpest traders on Wall Street. But then, so did LTCM.
An analyst, caught by the ear and brought before a committee of politicians to explain why he had recommended Enron, made an arresting argument. His inquisitors had forbidden him from using inside information, he explained. That would have been against the law. But the information available to the public – that is, the pronunciamenti from the PR departments and CEOs – all said Enron was doing just fine. Who was he to argue with them?
Alas, being an analyst is hard work again. For a few years, it was a celebrity sinecure – with nothing more backbreaking than appearances on CNBC and lunches with media hacks. But now, they’re being asked to actually do analysis!
And almost no matter where they look, they are likely to find candidates for the ‘next Enron’ competition.
"This is almost a culture of corruption," said Senator Byron Dorgan. Dorgan heads the group of poseurs and mountebanks that pretends to explore the Enron case. It will come as no shock to Daily Reckoning readers – he was speaking not of Congress itself, but of Enron’s management. But the same might have been said of a great many companies. Investors wanted great numbers, and management found ways to give them what they wanted.
"Companies use every trick to pump earnings and fool investors," said an article in Business Week from May of 2001. "The latest abuse: Pro forma reporting."
"By so called pro forma reckoning," writes Dr. Kurt Richebacher, "the companies in the S&P 500 stocks index earned $45.31 per share in 2001, giving the market a price-to-earnings ratio of 24.7, according to Thomson Financial/First Call. But by using generally accepted accounting principles, earnings were just $28.31 per share in the 12 months through September, equating to a P/E ratio just under 40."
"The particular attraction of this profit formula [pro forma] is that it literally allows a company to omit any expenses it [wants]… and to report any profit it wants," Richebacher concludes.
Companies have typically wished to report earnings of ‘a penny more’ than investors expected. How did they do so, quarter after quarter, year after year? It was not a feature of careful business management, we believe, but of numbers so vigorously massaged that their bones were broken.
GE, IBM, Quest… and hundreds of other companies… throughout the entire private sector the numbers were twisted into appealing new shapes and sizes.
But if massaging the numbers was such a hit in the private sector, mightn’t it have caught on in the public sector too? After all, the same politicians who criticize Skilling and Fastnow for not revealing the full extent of Enron’s liabilities would never dream of producing a GAAP-based report on the federal budget or its pension schemes.
We have discussed, from time to time, the way in which the masseuses at the Department of Labor do their jobs, too. They do not hesitate to deliver a blacksmith’s blow to the productivity numbers – when the occasion seems to call for it. Nor do they mind taking off their shoes and walking all over the GDP figures… or the CPI. What is left is a body of digits so pliable they can bend them into almost any shape they want.
So completely are the CPI numbers squeezed, extruded, and pawed over, says Dr. Richebacher, that "in the end, the calculation of CPI becomes so sophisticated that they can pick any number they like, and they like low numbers." Widely reported in the media and celebrated in the stock market is the ‘fact’ that GDP grew in the 4th quarter at a 1.4% rate. Yet, explains Richebacher, "had it not been for the government spending and the hedonic deflator [by which Labor Dept. statisticians adjust actual dollars for ‘quality enhancements’], US real GDP growth would have been down in the 4th quarter at an annual rate of more than $50 billion, or more than 2% – far worse than expected."
But in the New Economy of the late ’90s and early ’00s investors got the numbers they asked for.
Working on the numbers – earnings, debt, liabilities, productivity, GDP, inflation – the magic fingers on public and private payrolls made them look far more fetching than they really were. P/E’s, lower than they really were, were justified by productivity figures that were higher than they should have been, because the CPI numbers were reported lower than they actually were.
The entire picture looked better than it really was. And it resulted in an immense amount of wishful credit going where it should not have gone. To Enron… and elsewhere.
More to come…
March 07, 2002
Merrill Lynch and Morgan Stanley seem to have come to the same conclusion: US financial assets are overvalued and vulnerable.
The Financial Times elaborates: "Morgan Stanley, the US broker, is starting to shift its asset allocation away from the U.S. and towards Europe after concluding that US leadership in the global economy and world markets is coming to an end…. The firm said it’s particularly concerned that ‘ballooning’ US current account deficit is now being financed largely by portfolio flows."
US assets are expensive. International investors have been willing to pay a "security premium" to own them, notes Morgan Stanley, because American investments seemed safer than those in other parts of the world. But the Enron story has caused the smart money to wonder – what are US assets really worth? How much of a premium should I pay?
Once the questions begin, they are hard to stop. Aren’t the numbers fudged? Isn’t the U.S. running the biggest trade deficit in history? Aren’t US consumers the most heavily indebted in the world? And haven’t US corporations suffered their worst drop in capital investment and earnings since WWII?
Under the circumstances, why give US assets any premium? Shouldn’t they be given a discount instead?
As we said yesterday, we have no problem with the scheme of things – the loop of global cash and credit that hoists up US asset price. But we have no reason to think it will last forever either.
"Buy stock in Microsoft today," says an email message I got from Dick Young recently, "and, frankly, I don’t see how you can miss long term."
"I’M SURE YOU’VE heard of Microsoft’s ‘Xbox’ by now," he continues. "It’s Bill Gate’s first foray on his new crusade. This "game console" is actually a full- fledged computer in disguise – and the cheapest one on the market at that. It has an internal hard drive, a screaming 733-MHz processor, Internet capabilities, 10 gigabytes of storage space, and it even plays DVDs.
"You see, this first-generation Xbox – with increasingly powerful models to quickly follow – is just the beginning of Bill Gate’s plan to MONOPOLIZE home entertainment and personal computing.
"The man who defined how computers would operate – crushing Apple and Steve Job’s dreams in the process – is about to REDEFINE the computer itself. His vision takes it off the desktop — taking up where Michael Dell left off – to integrate PC power into every facet of your everyday life."
Here at the Daily Reckoning, we wouldn’t know an Xbox from a box of Kleenex. But it sounds like just what we’ve been waiting for – PC power in every facet of our daily lives.
We’re not so sure about buying Microsoft, though. The company’s earnings have gone nowhere in the last four years. But its stock is still trading at 58 times earnings.
But wait. Alan Newman of Crosscurrents notes that Microsoft’s earnings aren’t much better than those of other US companies. If they were reported on a GAAP basis, Microsoft would be trading at more than 100 times earnings. If you were buying the whole company, in other words, at today’s price you’d have to wait until the 22nd century to recover your purchase money from earnings – that is, if everything went well.
Speaking of which… it’s time to ask Eric. How are things going on Wall Street?
– "Cash is trash," the CNBC commentators screamed at their viewers yesterday. Those that had not muted their TV sets months ago acted on the shrill advice by piling into the stock market.
– Is cash really trash? Or, on the contrary, is rushing in to buy over-priced stocks a good way to "trash" your cash? We’ll see.
– There was nothing trashy about the stock market yesterday. The Dow reversed Tuesday’s fluky decline to resume its winning ways. The Blue Chips gained 140 points to 10,574, while the Nasdaq tacked on 24 points to 1,890.
– Not even bad news could dampen the stock-buying fever. No matter how many legal rulings JP Morgan Chase loses, folks keep snapping up shares of the troubled banking giant. Yesterday, the stock jumped another 4.7%, bringing its advance over the last two weeks to more than 25%.
– This, despite the fact that a Federal judge on Tuesday rebuffed JP Morgan’s bid to force 11 insurers to pay up immediately on $965 million of surety bonds related to Enron oil and gas contracts. Judge Rakoff said the insurers presented enough evidence showing that the bonds were the product of fraud by JP Morgan for him to deny the bank’s bid for immediate payment.
– "These arrangements now appear to be nothing but a disguised loan – or at least have sufficient indicia thereof that the Court could not possibly grant summary judgment to plaintiff," he said.
– "Judge Rakoff’s ruling is the second time in eight days that Chase has lost a procedural motion in court involving its trading business with Enron," the New York Times reports. On February 26, a different Federal judge in Manhattan denied a motion by Morgan to block discovery by the plaintiff, German bank WestLB. It seems the unwitting German lender issued a letter of credit worth hundreds of millions of dollars for a transaction last fall between Chase and Enron.
– The letter is now worth nothing, of course.
– "After hearing evidence presented by WestLB," says the Times, "Judge Griesa announced from the bench that WestLB had presented ‘a sufficiently particularized allegation of fraud’ to merit further discovery."
– Need any more reasons to buy JPM shares?
– The Ks are coming! The Ks are coming! This might be the last great opportunity to buy blue chip stocks in near-total ignorance of their true operating performance. This is the time of year when most companies issue their annual reports, otherwise known as 10-Ks. Inside these beefy SEC filings, experienced investors can sometimes ferret out helpful information that companies might prefer to keep under wraps.
– While the arrival of the Ks does not elicit quite as much breathless anticipation as the Sports Illustrated swimsuit issue – a different sort of annual disclosure document – this year’s Ks could be more interesting than usual.
– We wonder what these tedious tomes might divulge in this supposedly new era of corporate transparency. Will companies bare all? Or will investors be treated merely to a financial strip tease, in which companies flash only the most alluring features of their financial physique?
– The naked truth, if that’s what we really get, will be none too flattering for many companies. When stripped down to their GAAP-based income statements, many America companies are about as pleasing to the eye as the patrons in a Russian bathhouse.
– In prior years, very few investors had even heard of a 10-K, much less read one. This year, amidst all the hype about accounting, many more investors will CLAIM to have read one. But in truth, the Ks will flow straight from the mailbox to the circular file, just like they have always done.
– At best, a few more hedge fund managers and over-achieving financial journalists than usual will be foraging through these tediously boring filings looking for an edge, or at least for a good story. But that’s about it.
– Those who do so might find a particularly juicy story in the IBM 10-K, due out of the accounting oven sometime next week. Big Blue promises to divulge the ingredients it uses to cook up its tasty earnings growth. At least, it promises to reveal MOST of the ingredients. We’ll soon see just how transparent the new IBM has become.
– Investors who have grown to love IBM’s ‘earnings a la fluff’ might not care so much for the taste of the new IBM… the one without any artificial sweeteners.
– We should not be surprised to see the stock market stumble a bit, once the 10-Ks start rolling off the presses. Sometimes the truth hurts.
*** Steve Suggerud of the Oxford Club investment team notes that P/E ratios are notoriously unreliable. He proposes Price to Sales ratios as a substitute: "The Price-to-Sales (P/S) Ratio simply compares the price of a stock to the company’s sales for that year. But this is why it may be a better guide to determining the ‘true’ value of a company: it’s much harder to fudge the top line (sales) than the bottom line (earnings).
"Wal-Mart’s stock market value is about $280 billion, while sales over the last year were about $200 billion. So Wal-Mart is trading at a P/S Ratio of 1.4. But what’s this mean?
"Well, historically, stocks on average have traded for just under one times sales (0.9). So, at 1.4, Wal-Mart is expensive by historical standards but it’s still cheaper than most stocks today. And, in fact, you may be willing to pay that premium for Wal-Mart because it is a successful company, especially given some of the real dogs out there today.
"Crunching the numbers," Steve continues, "the P/S Ratio turns out to be a very valuable indicator. Not surprisingly, if you buy stocks when they are ‘cheap’ – based on this ratio – you do much better than if you buy when stocks are expensive.
"By this measure, today stocks are expensive. A conservative estimate of the up-to-the-minute Price-to-Sales Ratio would be 1.3 – or about 40% higher than the 0.9 historical average. Stocks aren’t cheap. Unlike Wal-Mart, Cisco for example trades at 5.7 times sales – nearly 500% over-valued by the "one-times sales" rule of thumb. Intel trades at 7.6 times sales. And Microsoft trades at over 11 times sales. GM, on the other side of the coin, trades at a scant 0.17 times sales."
*** "We believe our staff have the right to a safe working environment," begins a sniffy notice pinned to the wall at the immigration turnstiles at Waterloo train station. It sounds as though the authors might be warming up to a Declaration of Independence or a Nicean Creed. But when they finally come to the point, they are merely warning travelers not to give immigration clerks the rough handling they deserve.
*** Yes, I’ve come up to London for a meeting… and find everyone annoyed with America. "Arrogant" is the adjective that comes most easily to the lips of foreigners, when describing the world’s only super power.
*** What bugs them is not the fact that the U.S. is blasting the lost tribes of Afghanistan… but that it pretends to be the champion of free trade, while protecting its own decrepit industries from overseas competition. "America’s trading partners have reacted furiously," says the BBC. "Trade war looms," says a headline story.
*** Whether it is traffic in people or in steel – open borders are a long way off.
*** But today’s the big day. My daughter, Maria, is supposed to appear on the cover of a beauty magazine distributed all over France. More to come…