There
are three kinds of lies : lies, damned lies, and statistics. This quote, often
attributed to famed author Mark Twain, succinctly describes how mathematical
facts can easily distort an interpretation of behavioral events through (deliberate)
data selection. While the formulaic calculations (outside of typographical
errors) are 100% accurate, how data is sampled and collected, or the time frame
used within the statistical analysis, can sway results dramatically. This
sleight-of-hand is perhaps most evident in our current economic discourse and
has severe repercussions for millions of Americans who may take a less vigilant
approach to their financial well-being, choosing instead to rely on a fund
manager to guide their nest-egg portfolio. However, even the greatest fund
manager is not immune to the manipulative practices of Wall Street elitists, so
much so that the modern version of Mr. Twain's quote should read, "scams,
more scams, and corporate accounting practices."
Earnings, or income net of all expenses, are the bread and butter of Wall Street. While alternative methodologies, such as technical analysis, have found more common use in forecasting market valuation, the language of corporate accounting dictates that "earnings rules" and will probably reign forever. Spotting a bearish chart pattern simply doesn't resonate as deeply as a company publicly releasing information that their revenue stream has been hit with an unexpected outflow.
In the same spirit, publicly traded corporations live and die by their earnings report. Most of the heavily traded companies have an army of analysts from various investment firms tracking their every move, with each analyst posting their earnings expectation. The aggregate total of this expectation is essentially Wall Street's target for the company : a misfire by management could lead to a negative "earnings surprise" and thus a reduction in market capitalization through the subsequent share price volatility.
The pressure to perform is enormous, which incentivizes a draconian "at any cost" culture within the cubicled walls of corporate America. Since reputation and even jobs are at stake, managers push to find any measure to inflate net income. What the average investor may not realize is that this is rather easy to do despite new federal laws (such as Sarbanes-Oxley) that were put in place to address the accounting scandals of Enron, Worldcom, Tyco and the like.
At the heart of the issue is the "distortability" of earnings. After sales, or revenue, is recorded in the income statement, the cost incurred to achieve that revenue is deducted to produce the gross profit number. The gross profit, therefore, is hard to fake : you're either making sales or not making sales. But in order to produce the net income number, the gross profit has to go through a deduction sequence consisting of operating expenses, tax expenses, and non-recurring events. Within each sequence are several line items that can leverage a significant impact on total earnings. It is in the best interest of the company to whittle down expenses to produce the highest possible net income number.
Several "legal" shenanigans are used to produce favorable earnings, such as shifting expenses from one period to another or fiddling with depreciation costs. Since there are several line items available, it naturally means there are multiple ways to manipulate numbers and with the heavy price publicly traded companies pay for not meeting expectations, investors should read between the lines : manipulation can occur on a frequent basis.
So what's this talk from the mainstream press that against earnings, the stock market is undervalued? This assertion comes from the philosophy that the "price" of a benchmark index, such as the S&P 500, is still "cheap" relative to the net income performance of the companies listed on the index. Mathematically, this is expressed in the form of the Price Earnings ratio, or P/E, where the current market price of a company's stock is divided by its earnings per share. Using a particular methodology advanced by economist Robert Schiller, the S&P 500 index at the end of 2013 had a P/E ratio of 17.2 (with "price" being 1848.36 on the S&P index and its "earnings per share" being 107.45).
A stock with a "low" P/E ratio is (erroneously) assumed to be undervalued due to the implication that the stock price is low relative to how much earnings the company produces. A "high" P/E ratio is (also erroneously) assumed to be overvalued because the stock price does not justify the earnings the company produces. In fact, the P/E ratio is just one of many factors that can be utilized to determine forward guidance ; in and of itself, it is very dangerous to make wholesale assumptions based on one ratio.
A better approach is to use P/E ratio trends : as a company grows in size and revenue, its expectations should follow suit. The price of a stock rises because more people believe it will move higher. Since markets move faster than earnings (stocks are traded every business day, earnings are reported every quarter), a stock's P/E ratio should rise higher overall in a healthy bull market.
Unfortunately, this is not what we are seeing in the domestic stock market (S&P 500) :
Earnings, or income net of all expenses, are the bread and butter of Wall Street. While alternative methodologies, such as technical analysis, have found more common use in forecasting market valuation, the language of corporate accounting dictates that "earnings rules" and will probably reign forever. Spotting a bearish chart pattern simply doesn't resonate as deeply as a company publicly releasing information that their revenue stream has been hit with an unexpected outflow.
In the same spirit, publicly traded corporations live and die by their earnings report. Most of the heavily traded companies have an army of analysts from various investment firms tracking their every move, with each analyst posting their earnings expectation. The aggregate total of this expectation is essentially Wall Street's target for the company : a misfire by management could lead to a negative "earnings surprise" and thus a reduction in market capitalization through the subsequent share price volatility.
The pressure to perform is enormous, which incentivizes a draconian "at any cost" culture within the cubicled walls of corporate America. Since reputation and even jobs are at stake, managers push to find any measure to inflate net income. What the average investor may not realize is that this is rather easy to do despite new federal laws (such as Sarbanes-Oxley) that were put in place to address the accounting scandals of Enron, Worldcom, Tyco and the like.
At the heart of the issue is the "distortability" of earnings. After sales, or revenue, is recorded in the income statement, the cost incurred to achieve that revenue is deducted to produce the gross profit number. The gross profit, therefore, is hard to fake : you're either making sales or not making sales. But in order to produce the net income number, the gross profit has to go through a deduction sequence consisting of operating expenses, tax expenses, and non-recurring events. Within each sequence are several line items that can leverage a significant impact on total earnings. It is in the best interest of the company to whittle down expenses to produce the highest possible net income number.
Several "legal" shenanigans are used to produce favorable earnings, such as shifting expenses from one period to another or fiddling with depreciation costs. Since there are several line items available, it naturally means there are multiple ways to manipulate numbers and with the heavy price publicly traded companies pay for not meeting expectations, investors should read between the lines : manipulation can occur on a frequent basis.
So what's this talk from the mainstream press that against earnings, the stock market is undervalued? This assertion comes from the philosophy that the "price" of a benchmark index, such as the S&P 500, is still "cheap" relative to the net income performance of the companies listed on the index. Mathematically, this is expressed in the form of the Price Earnings ratio, or P/E, where the current market price of a company's stock is divided by its earnings per share. Using a particular methodology advanced by economist Robert Schiller, the S&P 500 index at the end of 2013 had a P/E ratio of 17.2 (with "price" being 1848.36 on the S&P index and its "earnings per share" being 107.45).
A stock with a "low" P/E ratio is (erroneously) assumed to be undervalued due to the implication that the stock price is low relative to how much earnings the company produces. A "high" P/E ratio is (also erroneously) assumed to be overvalued because the stock price does not justify the earnings the company produces. In fact, the P/E ratio is just one of many factors that can be utilized to determine forward guidance ; in and of itself, it is very dangerous to make wholesale assumptions based on one ratio.
A better approach is to use P/E ratio trends : as a company grows in size and revenue, its expectations should follow suit. The price of a stock rises because more people believe it will move higher. Since markets move faster than earnings (stocks are traded every business day, earnings are reported every quarter), a stock's P/E ratio should rise higher overall in a healthy bull market.
Unfortunately, this is not what we are seeing in the domestic stock market (S&P 500) :
While
the P/E ratio in 2013 did jump 32% from its 2011 level of 13.04, since the
collapse of the internet bubble, the P/E trend has been decisively bearish,
with a new low being registered every two or three years. This means that
despite stock market valuations breaking all-time records, the expectation and
the performance of the companies listed on the benchmark indices are lagging.
This divergence between high flying equities and low lying P/E ratios is extremely disconcerting. As mentioned before, markets move faster than earnings. Stated another way, impulse buying (assumption) precedes regret (reality). But if the reality of a purchase were advertised instead of the glitz and glamour, fewer consumers would make impulse buys. What the chronically low P/E ratios are telling us is NOT that markets are undervalued but rather, markets are moving slower than earnings!!!
While providing a full explanation is beyond the scope of this article, what the descent implies is a deflation in both market sentiment and corporate productivity, with sentiment trend heading towards parity with earnings growth rates. This may sound overly gloomy at first glance but look at the P/E trend from the 1970's to the peak of the dot-com era, which moved higher in conjunction with the equities bull market. Today, our equities are moving higher based on artificial liquidity provided by the Federal Reserve but nothing much else.
Do statistics lie? All the time, but the core issue is not the statistical analysis itself, but the application of the data. Wall Street would certainly have you look the other way, focusing on last year's earnings in solidarity without questioning the historical pattern of earnings trend nor its inherent structural vulnerabilities. Stretching the scope of the framework even slightly reveals a far greater truth behind "the truth."
This divergence between high flying equities and low lying P/E ratios is extremely disconcerting. As mentioned before, markets move faster than earnings. Stated another way, impulse buying (assumption) precedes regret (reality). But if the reality of a purchase were advertised instead of the glitz and glamour, fewer consumers would make impulse buys. What the chronically low P/E ratios are telling us is NOT that markets are undervalued but rather, markets are moving slower than earnings!!!
While providing a full explanation is beyond the scope of this article, what the descent implies is a deflation in both market sentiment and corporate productivity, with sentiment trend heading towards parity with earnings growth rates. This may sound overly gloomy at first glance but look at the P/E trend from the 1970's to the peak of the dot-com era, which moved higher in conjunction with the equities bull market. Today, our equities are moving higher based on artificial liquidity provided by the Federal Reserve but nothing much else.
Do statistics lie? All the time, but the core issue is not the statistical analysis itself, but the application of the data. Wall Street would certainly have you look the other way, focusing on last year's earnings in solidarity without questioning the historical pattern of earnings trend nor its inherent structural vulnerabilities. Stretching the scope of the framework even slightly reveals a far greater truth behind "the truth."
