Let's Get Fictional

We live in the Information Age. News travels at the speed of sound and communication is instantaneous. We are bombarded each day with facts and figures about the economy, the markets, and the world around us. In this world of facts and figures one must learn to distinguish between perception and reality. Part of what we see and hear is fact, part is half truth and the rest is fictional. All is not what it appears to be.

The 1990s were described as a “new era” for the American economy. The economy grew at above-average rates driven by technological change and innovation. American companies restructured and became more efficient and productive. The result was an explosion in earnings. The public was sucked into the market by new economic theories that stood basic economics on its head. On Wall Street stocks were always a buy and according to the experts, the markets always went up. Our stock market delivered double-digit gains for the last five years of the decade, which further supported the “new era” thesis.

The 1990s “new era” turned into a bust. Much of what was heralded as a new economic paradigm turned out to be an illusion. It was created with statistical wizardry by government number crunchers and corporate accountants. Statements about the U.S. economic miracle of the 1990s omit several embarrassing details: the expansion of the nation's money supply, the explosion of consumer and corporate credit, gigantic trade deficits, and our dependence on massive amounts of foreign money.

Consumption Drives This New Era Economy

Today, once again you hear stories about a “new era” for the American economy. Unlike the stagnant economies of Europe and Japan, the American economy is experiencing accelerating growth rates. Productivity is up, inflation is down, and corporate earnings have been nothing short of phenomenal. Like the 1990s boom, today’s boom is being fueled by massive amounts of money and credit. Debt levels in the U.S. have expanded to record levels at both the consumer and corporate level. However, unlike the 1990s, government debt is also accelerating. The savings rate keeps falling and debt service payments are at levels that normally forewarn of an impending crisis. The economy is growing at above-average rates with consumption making up a larger portion of the economy. The American consumer continues to astound the experts with their ability to consume, but that consumption is being supported by larger debt extractions from this era’s new bubble in real estate.

This "New Era" is Really An Illusion

While consumption drives the economy, it is increasingly being financed by foreign capital. There are numerous explanations as to why foreign money continues to pour into the U.S. The best reason given is the superior performance of the American economy and the stellar returns earned on American investments. Our economic growth rates are higher, the return on capital is greater and our inflation rates remain low. Reports about the U.S. economy's performance have become outright euphoric. The Fed continues to expound and praise our economic miracle of above-average economic growth, high productivity and low inflation rates. Once again we hear talk about a new economic paradigm. Like the “new era” of the 1990s, this “new era” is no different. It is an illusion. Like the last era, it is the product of economic and financial engineering. It is more of a statistical illusion than it is factual. Earnings have improved since the last recession, but most of those earnings are financially related. Companies are making more on financing widgets than they do making widgets.

Like the previous era’s boom, government statisticians and corporate accountants are hard fast at work creating fictional miracles. It is the purpose of this WrapUp to examine these miracles and to expose their fallacies. We’ll examine four myths as follows:

1) Stellar corporate earnings
2) Strong GDP growth
3) High productivity
4) Low inflation rates

Myth #1 Stellar Corporate Earnings

The corporate scandals are supposedly behind us after three years of reforms. After Sarbanes Oxley, earnings are suppose to be more transparent. However, the reforms initiated by Congress and the SEC did not remedy the situation. Today earnings are as susceptible to manipulation as ever. The reason is that our present accounting system is based on accruals, which give companies wide discretion in using estimates to calculate their earnings. Accrual accounting is supposed to give shareholders a more accurate picture of what is going on in a business at a particular time. Accrual accounting allows a company to allocate revenues to a specific period to better reflect when the sales were made not when the actual sales dollars were received. In a similar way with expenses they can be allocated to a period when the sale was made and not when the money was actually spent.

This is creating an environment of fuzzy numbers. Analysts and investors have to play detective to determine what estimates and assumptions companies are making in order to arrive at current earnings. Understanding what is displayed in the three major financial statements is more of a mystery than ever. The numbers between the three statements (income statement, balance sheet, and cash flow) are often inconsistent and confusing. Various estimates that are made that impact earnings can often be vague and hidden. In addition to trying to ferret out all of the assumptions and estimates that are made, the statements themselves often don’t correlate. The income and cash flow statements can cover different time lines, making it difficult to reconcile numbers. It has become a nightmare for analysts to constantly sort out fact from fantasy. You never can completely trust the numbers. You don’t know what the real numbers might be until the economy falters and earnings come under pressure.

The earnings game is still being played, but with infinitely more sophistication. The pressure to make estimates is still there and as a result accounting games have spread beyond earnings. Normally when analysts suspect foul play, they turn from looking at earnings to cash flows. Companies are aware of this, so the game has spread to altering cash statement. Cash is just as vulnerable to manipulation as earnings. A few examples in ways in which companies are manipulating cash flow and their effects are listed below:

These are just a few examples of how the game has changed. Companies are not only trying to alter earnings, but they are also trying to pump up cash. What is alarming is that the practice of manipulation has moved from earnings to cash flow. Earnings can always be manipulated in the short run, but manipulating cash can eventually harm a business. Extending credit to customers today has become a major source of business for most companies. Companies from Ford, GM, GE, Caterpillar and Pitney Bowes, to Harley Davidson rely on their financing unit to bolster profits. Recent financial statements from Boeing, Ford, and Harley Davidson counted cash from the sale of planes, automobiles, and bikes that were bought by customers using company cash. In many cases the financing unit has become the major profit generator. This is pushing companies into higher risk businesses. Essentially they are becoming bankers. Many companies borrow short-term and lend long-term to their customers or they borrow long-term and swap their debt for short-term variable rate debt. Assets and liabilities have become mismatched in the process. This exposes companies to a whole new category of risk when the economy falters and interest rates rise. Like hedge fund speculators, companies are heavily involved in the “carry trade.”

You see these kinds of occurrences everywhere and they are being practiced by some of America’s most renowned and prestigious companies. GM improved its cash on its balance sheet by borrowing heavily in the capital markets and then swapping some of that debt for variable rate debt using credit swaps. General Dynamics boosted cash flow substantially by reducing its inventory. Lucent Technologies and Jabil Circuit boosted cash by selling their receivables.

These are just a few examples of what is taking place with cash. Companies are aware that analysts are focusing on cash for looking at earnings consistencies and as an indicator of corporate health. So the company accountants are dressing up the cash flow statement. We still have the same problems with earnings with the same number of tricks. The main ways of manipulating earnings are as follows:

1) Sales Manipulation
2) Unusual Gains and Losses
3) Altering Bad Debts
4) Adjusting Inventories

The various shenanigans regarding earnings can be boiled down to two categories: manipulating sales or revenues and altering expenses. The basic trick is to record revenues before they are actually earned, record bogus revenues that actually don’t exist, or boost revenues with one time gains. On the expense side, companies resort to shifting current expenses to different periods or don’t report a future expense liability. The plain fact is companies have a bag of tricks that they can work with today to alter earnings and cash from estimates of pension fund profits, unpaid receivables, old inventory that is overstated on the balance sheet, understated payroll expense through option grants, and understated bad debts.

Unfortunately the world hasn’t changed much since the scandals of the late 1990s. The scandals at WorldCom, Enron, Global Crossing, and Adelphia Communications are all behind us. Yet, there is not a week that goes by where another earnings scandal doesn't surface. It began with corporate scandals. It then moved to Wall Street. From there it moved to mutual fund companies and government GSEs. Finally it has hit the insurance industry. Just last week the Wall Street Journal reported that Fannie Mae faces up to $2.8 billion in additional derivative losses because of new accounting concerns raised by its federal regulator. Last Friday shares in Saks Inc. tumbled after the department store said it would restate its financial results going back to 1999 and the third quarter of last year to account for improper collection of vendor markdown allowances and accounting operating leases. Today the CFO of Delphi resigns amid accounting woes related to improper accounting for payments from suppliers, and off-balance-sheet financing of indirect materials and inventory, resulting in the overstatement of cash flows from operations.

Scandals such as these are a weekly occurrence. In fact you can say it is no longer front page news. The media seems occupied more with the celebrity aspects of the scandals rather than their root cause or proliferation. Last Friday’s circus over Martha Stewart or the trials of Bernie Ebers are some of the more recent examples. Perhaps in the future corporate scandals may become the genesis of a new business reality show. The audience will be taken into the boardroom of a major company as company execs and potential job applicants vie over ways to pull the wool over analysts and investors and outsmart the government.

For investors it is time once again to become cautious. In the words of one analyst, we won’t know how bad things actually are until the economy begins to falter and corporate earnings come under pressure. What we do know is that the gap between C.R.A.P. and GAAP earnings is widening again. The most recent trailing twelve month earnings for the S&P 500 show a gap of $7.68. That is up from the third quarter when the gap was $6.97. Recent research shows that the abuse of accrual accounting is pervasive across a broad swath of companies. There is even a name for it. It is called the “accrual anomaly.” It was discovered by an accounting professor at the University of Michigan by the name of Richard Sloan. Sloan made the discovery years ago that companies that routinely use high estimates in calculating their earnings were most susceptible to a fall, while those with the lowest estimates were most likely to rise. The inability or ability to detect this anomaly can make all the difference between big losses or big gains for investors.

Unfortunately for investors they must detect more than accrual anomalies. They must also decipher the economy with all of its crosscurrents and its own anomalies. Just as there are three financial statements that an investor must deal with when it comes to earnings, there are three economic numbers an investor must also deal with when it comes to the economy. They are as follows:

1) GDP Growth
2) Productivity
3) Inflation Rates

Myth #2: Strong GDP Growth

A growing economy leads to growing profits. In order to get the micro environment right, an investor must get the macro picture correctly. When an economy expands, profits expand. When an economy contracts, so do profits. The problem is that America’s economic growth like corporate profits is overstated. GDP in the U.S. is actually much weaker than what is reported. That is why job growth has been anemic in this recovery. Our economic growth rates are overstated due to substantially understated inflation rates and hedonic adjustments. Hedonic adjustments add fictional dollars to GDP that nobody actually pays or receives. As a result we add dollars to our economy that actually don’t exist. For example spending on information technology went from $467 billion in 2000 to $484.3 billion in 2004. [1] Computers accounted for $101.4 billion in 2000 and $110.8 billion in 2004. However, actual spending on computers increased by only 9.4%. Through hedonic adjustments that 9.4% increase was turned into a 113.4% gain in spending. Computer investment soared, contributing substantially to GDP growth and the illusion that business investment was expanding. Government statisticians were actually able to make the economy and business investments appear much stronger. Hedonic adjustments and other statistical imputations overstate GDP by as much as 14-15%.

As shown in the table above taken from the Bureau of Economic Analysis Survey of Current Business report, actual GDP has been overstated by as much as 15%. The real GDP numbers are much less than what is actually reported in the financial press. Personal income is also overstated as shown below, which means our savings rate in the U.S. is actually much lower if not negative.

This helps to explain the plight of consumers who are increasingly resorting to debt financing to maintain consumption. The economic growth rates are overstated as is the income of consumers, which are shown in the National Income and Product accounts. The chart at the beginning of this article showing equity extraction explains why it has been necessary to extract equity out of their homes to make ends meet.

Myth #3  High Productivity

As to the final distortion, which is the number of jobs the economy is adding each month, we find more statistical magic. Beginning in June of 2000, the Bureau of Labor Statistics began phasing in a new probability-based model adding hypothetical jobs to the monthly job gains. These numbers are revised once a year. The further away you get from the benchmark year, the further the distortions. The table below lists the hypothetical jobs created by the Bureau in each month’s job numbers. The numbers reported last Friday showed a resilient employment market with the economy adding 262,000 new jobs. Included in this number were 100,000 hypothetical jobs. We don’t know if these jobs actually exist, because they were created with computer models. One a year in March, the Bureau adjusts the models.

The reader will notice that these hypothetical jobs are seasonal. They appear to be stronger in the spring and late summer. Investors will have to monitor the economy more closely this summer after the Fed has raised interest rates a full percentage point. I suspect we will begin to see more weakness, which will surprise the markets. After all, the GDP numbers are made up as are the employment gains. It explains the widening gap between what happens on Main Street and what is reported on Wall Street.

Myth #4  Low Inflation Rates

As to that other piece of fiction known as the inflation rate, well that is another story that would require a master’s thesis in and of itself. I will highlight just a few of the inconsistencies. Several years ago the markets got a scare with a sudden drop in the inflation rate between 2001 and 2003. The markets became overly concerned about deflation even though the cost of just about everything was going up. Energy prices were gradually increasing, the cost of food and raw materials were rising, and service fees began their upward march. Housing prices began to go up double digits, mortgage loans began to swell and the American consumer went on a spending binge. At the same time the Fed was injecting vast amounts of money and credit in the banking system with the securities markets adding hundreds of billions of new dollars through securitization of everything from mortgages, installment loans to credit cards. The money supply as represented by M3 grew from $7.164 trillion to $8.820 trillion during this period.

To worry about deflation at a time the money and credit markets were exploding were absurd. As it turned out the researchers at the Atlanta Fed figured out the distortion. The culprits were rent and used vehicle prices. With the housing market exploding, the national vacancy rate jumped from 7.8 percent in Q4 of 2000 to 10.2 percent in Q4 of 2003. Because of the way the CPI is computed, more weight is given to the price of rents rather than the price of homes, even though only 31% of the population rents versus the 69% of the population that owns a home. The Atlanta Fed researchers showed that the contribution of rent to CPI core inflation fell 0.8 percentage points. At the same time the Fed’s own Flow of Funds showed substantial increases in inflated real estate values as shown in the table below:

The other culprit that lowered CPI was the decline in used car prices as a result of new car demand. Record low financing rates, zero-cost loans, and rebates had increased demand for new cars, causing used car prices to fall. Used vehicle prices in the CPI are derived from wholesale auction prices. The surge in demand for new cars increased the supply of used autos in the wholesale market. The drop in used car prices deducted 0.3 percentage points from CPI. The combination of lower rents (0.8%) and lower used car prices contributed 1.1% of the 1.6% decline in CPI from 2001-2003. Had the government shown the increase in new car prices and new home prices in the CPI, everyone would have been talking about inflation instead of deflation. The rise in housing prices was looked upon as a bull market rather than a manifestation of monetary inflation.

As Kurt Richebächer, Bill Gross, and many others have been shouting recently, the actual inflation numbers are much higher than what is stated in the financial press. Even when the numbers jump, they are reduced to the core rate as the more volatile energy and food numbers are routinely subtracted from the CPI and PPI numbers reported each month. [As if people don’t have to eat or drive to work each day.] By understating the CPI inflation rate, GDP and productivity number are overstated. To arrive at real GDP, the government must first reduce the nominal GDP dollars by the rate of inflation. By grossly understating the inflation rate, the government overstates economic growth and productivity. Through statistical manipulations not only is GDP and productivity overstated, but along with it personal income and personal savings.

Why These Distortions?

Who benefits from these distortions? Obviously, the government does through low inflation rates, impressive GDP and productivity growth. Lower inflation numbers reduce government expenses in the form of cost of living adjustments to social security and government retirement pensions. It also reduces the rate of interest on government inflation adjusted bonds (TIPS). The economy also benefits from lower interest rates, which would not be possible with higher inflation numbers. According to Pimco’s Bill Gross, the BLS has expanded the use of hedonic adjustments and applies these adjustments to everything from computers, DVDs, automobiles, washers/dryers/refrigerators to college textbooks. Hedonics is used to adjust as much as 46% of the weight of CPI. And they are just getting started! More studies are on the way at the Bureau to find other areas of the economy and the inflation indexes that could benefit form hedonic adjustments. According to Pimco, studies the real inflation rate would be as much as 0.5 -1.1% point higher. Even then I believe they are being generous.

We live in a fictional world, a time of half truths and distortions. Life on Main Street is different than life on Wall Street or in Washington. In the real world households have to contend with rising prices in basic goods they need and consume every day. The job market remains weak along with wages and personal income. Savings rates are stretched to the limit as the average family or household finds there is less money in checking at the end of the month. In order to make ends meet they must tap the limits of their credit card each month just to pay for necessities. When the limits run out, they have to tap the equity in their home, if they are fortunate to own one.

It is no less difficult for investors who must speculate with their investments in order to make up for a lack of savings. Investors must contend with all of the vagaries and untruths of the markets and corporate earnings. They hope they have read the markets correctly and their decisions have been made on correct information. If analysts and professionals have a difficult time, what chance does the individual have against the machinations and games that are played with earnings and corporate balance sheets? Perhaps that is why they speculate and invest short-term. In a fictional world that has corrupted its values by cheap money, speculation not investment becomes the real game.

Chart courtesy: http://www.pimco.com/

Jim Puplava

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