Earnings Season Now a Priority
(July 6, 2006)
Dear Subscribers and Readers,
I hope most of our subscribers have found the time to read John Mauldin's latest work “Just One Thing.” If not, then please at least read the chapters by Andy Kessler and George Gilder. Love them or hate them, they are definitely two of the more original thinkers that are relevant to the markets today. In particular, Mr. Gilder in his chapter “The Outsider Trading Scandal” asserts (correctly, as this author believes) that far from protecting stock market investors from unscrupulous insiders or management (after all, a mere rule isn't going to be effective at preventing “criminals from manipulating markets) current SEC rules like Sarbanes-Oxley and “Fair D” has instead caused a dearth of information in the market place and in stock prices – leading to “increased volatility and more vulnerability to outside events.” In Mr. Gilder's own words:
What the regulation of material information accomplishes instead is to sharply inhibit the flow of inside news from companies. Inside information – the flow of intimate detail about the progress of technologies and product tests and research and development and diurnal sales data – is in fact the only force that makes any long-term difference in stock performance. Yet it is precisely this information that is denied to public investors. Information about technology cannot filter out day by day from different inside sources to knowledgeable people who might grasp the significance of it. Instead, information is parceled out by departments of public affairs under guidance of lawyers. The resulting press releases are mostly bombast and bafflegab, zero-entropy documents teetering over a bay of safe-harbor statements often larger than the release itself.
… As a result, the pullulating mass of data and news about technology companies is constipated into a few synthetic disclosure events. What should be a steady outpouring of knowledge – some of it hype, some confusing, most of it ambiguous, like business life itself – emerges instead as a series of media events that leave out everything interesting. Pivotal are quarterly financial reports and merger and acquisition announcements.
In essence, Gilder asserts that aside from benefiting the pockets of the accountants and the bean-counters, regulations like Sarbanes-Oxley and the Fair Disclosure Act have only served to remove all relevant information from both the marketplace and in all stock prices. For the technical analyst, this means that trying to profit from price trends or patterns has become a much more dangerous game, as prices could plunge with no warning whatsoever after an earnings report or disappointing earnings guidance. For the fundamental analyst, that means developing future price scenarios for companies other than large caps has become virtually impossible – especially in industries where future prospects are heavily dependent on technology or in development new markets. In the “good old days” – when bad news would slowly leak out or when investors would gradually figure out that business was bad – the stock price would have slowly taken it into account beforehand, thus allowing both sharp-minded technical and fundamental analysts to get out. Today, this is no longer the case – as many investors now tend to get blinded-sided during an earnings report or earnings warning.
What's worse, this lack of “outside information” has now resulted in a huge advantage for corporate insiders – as the likes of venture capitalists, private equity investors, and corporate acquirers have been able to utilize their huge inside information edge to make very shrewd investments in a grossly inefficient environment. Gilder asserts:
With inside information banished from public markets, privateers capture the wealth. The flow of capital gains bifurcates to the residual inside traders who are legally permitted to learn the intimate facts of the companies in which they invest. Huge winners are conglomerateurs such as Warren Buffett of Berkshire Hathaway and Jeffrey Immelt of General Electric and venture capitalists such as Donald Valentine of Sequoia and John Doerr of Kleiner Perkins Caulfield and Byers.
Moreover, with the decimation of the public's favorite individual stocks of the late 1990s era, the public has by and large given up on individual stock investing and has gone on to solely investing in index funds. As a result, the retail investor's pursuit of relevant information of individual stocks has further diminished – resulting in a still-further decline of information in the market place and in current stock prices. In other words, pricing patterns in many individual stocks have also been subjected to the whims of the index fund investors more than anything else – thus rendering technical analysis in individual stocks truly irrelevant (given that index fund investors inherently do not have any interest in conducting due diligence in the individual components that make up the index).
The message of George Gilder and of this author thus becomes clear: The upcoming string of earnings reports starting with ALCOA on Monday will be a wealth of new information for investors and will thus be a very important determinant of stock prices going forward. This is especially true given the wide dichotomy of views many analysts currently hold on the stock market (with some declaring that we are already in a bear market while others are declaring a new bull market after the Fed is done with its rate hike campaign). This author has taken the liberty of compiling an earnings release schedule (source: Barron's) for various notable companies that will be reporting in the next two weeks:
Will the next spate of earnings report be a trigger for a huge bear market, or will folks who were looking for an earnings slowdown be severely disappointed? Even if earnings come in as expected, what would future guidance look like for companies who are still engaging in the practice? Will corporate management continue with its recent scheme of share buybacks? More specifically, this author is looking for the upcoming four weeks to answer some of his following concerns/issues:
- Lowry's has already declared we are in a bear market – citing the lack of demand from investors and the lack of broad-based strength in many industries and individual stocks. What bothers this investor is that Lowry's does not analyze its “buying power” or “selling pressure” indices separated/based on each class of individual investors, such as corporate insiders, hedge funds, or retail investors. Looking at mutual fund inflows over the last 12 months, it is obvious that the retail investor has continued to shun domestic equities – and thus we know that retail investors have been directly responsible for the weakness in many of Lowry's technical indicators. On the other hand, TrimTabs claims that corporate managements have been buying back their own shares at a record pace. Combined with the record amount of cash acquisitions in recent months and the lack of IPOs, and you have a wildly bullish leading indicator – as corporate insiders have historically been much “smarter” than retail investors in predicting future stock price trends. The question remains: What would cause the retail investor to come back to the stock market? And will this upcoming spate of earnings reports and future guidance play a role?
- With the latest market weakness and rally since May 10th, it is clear that a significant amount of leadership has shifted from the small and mid caps to the large caps, as shown by the following 3-month chart comparing the S&P 100 (OEX) to the S&P 400 (MID) and S&P 600 (SML). Interestingly, the S&P 100 was actually up yesterday, even in the midst of a swoon by many of the major market indices. The question is: Will the latest batch of earnings reports only serve to confirm this leadership or will leadership subsequently shift back to the small and mid caps? For now – especially given that most of the insider buying and share buybacks have been focused on the large caps – this author is betting on the former, but the next two weeks of earnings reports will give us a much clearer idea going forward.
- Given that the Dow Transports has been the leading stock market index since this cyclical bull market began in October 2002, one has to wonder if the Dow Transport component will continue to outperform going forward, especially in the midst of a $75 a barrel crude oil price. Until we see otherwise, the airliners will continue to be the “marginal components” in the index – and will therefore represent the components to watch going forward as they announce earnings. If the airlines manage to match or exceed expectations, then chances are that the Dow Transports will go on to make another new record high (which would be an important confirmation of the current general uptrend in stock prices).
And finally, subscribers may remember that the Barnes Index (a relative valuation indicator of stock prices vs. bond prices) has proven invaluable in predicting the most recent May 10th top. In our May 7, 2006 commentary, we noted:
The threat of a continuing rise in interest rates should serve to put a lid on the major market indices going forward – especially given that the Fed is scheduled to raise another 25 basis points in the Fed Funds rate on May 10th (at some point, the option of getting 5% on a savings account far outweighs getting a 1.7% dividend yield in the S&P 500 or even a 3.5% dividend yield on the Dow Utilities and holding these indices for appreciation). As I have mentioned before, this author uses the Barnes Index (see our March 30, 2006 commentary for a discussion on the Barnes Index) to measure the relative valuation of equity prices to bond prices. In our past commentaries, I discussed that we will not enter the “dangerous zone” (the zone when cash/bonds start to become attractive relative to equities) until we hit the 65 to 70 level on the Barnes Index. As of last Friday at the close, the Barnes Index finally entered the “dangerous zone” when it registered a reading of 67.60.
Given the hugely oversold condition in many of our intermediate-term indicators, this author is revising the “danger zone” in the Barnes Index from a range of 65 to 70 to a range of 70 to 75. The most recent reading of the Barnes Index has it sitting at 64.40. Future directions of the Barnes Index will be determined by the following: The Fed Funds rate, the long bond yield, the dividend yield of the S&P 500, as well as the earnings yield of the S&P 500. As the latest batch of earnings reports start rolling in next week, both the dividend and the earnings yield component in the Barnes Index will change – and should thus lead to a lower Barnes Index reading going forward. That is – while the Barnes Index may be close to its “danger zone” of 70 to 75 right now, this may not be the case once we're done with earnings season in about a month.
Henry K. To, CFA