Investments–Disinformation

June 19, 2008 by  


By Bob Wood, MMNS

When speaking with investors whose investments I do not manage, I glean a lot of valuable feedback, which helps me understand why so many of them manage their savings poorly. Too often, investors fall prey to bad information — the kind that seems to make perfect sense, as long as listeners are not thinking too hard. Unfortunately, what they hear might well be dead wrong, and their investment returns suffer!

You probably know what I am talking about if you indulge in offerings from the financial media. Let’s start with one of the most egregious examples of bad information or, as I call it, disinformation. How many times in recent months have you heard that ‘’stocks are cheap’’ — based on valuation, with the S&P 500 selling at about 14 times “forward earnings”?

Those who offer this data as serious analysis worth considering for your investment decisions are basically correct. The S&P 500 does, indeed, sell for about 14 times “forward earnings”. I verified this information by printing out current data from Standard and Poor’s web site. Yes, here it is, a “forward earnings” estimate of 14.36. But let’s dig a bit deeper, and see where this data might not be as useful as market promoters claim.

First, the “forward earnings” estimate is based on what are called ‘’operating earnings.’’ Operating earnings are what current S&P 500 prices represent, when compared to the earnings of the index, now trading at 1,346, as I write. But operating earnings are not the same type of earnings a private company owner sees at year end. Operating earnings reflect value after taking out the bad stuff, like massive losses and asset write-downs, which are now so prevalent in the auto sector, airlines and, of course, large financial companies.

Operating earnings have been referred to as ‘’earnings higher up on the income statement,’’ or those not including “one time losses.” But for many companies, “one time losses” seem to occur with some regularity. Look no further than the annual losses incurred at GM, where they are called ‘’one time’’ losses when reported, yet they seem to recur every year.

On the same data sheet pulled from the S&P web site, I see the forward P/E for the index listed as 19.89. That number indicates “forward earnings” for the quarter ending in March 2009, the same quarter as the earlier estimate based on ‘’operating earnings’’. That higher number is based on real net earnings, referred to as ‘’reported earnings.’’ These are true earnings reported after all losses are included, whether temporary or recurring. They are bottom-line earnings, such as any independent owner of a private company would see at the end of the fiscal year.

That number is also the more conservative one since it includes the less “wishful-thinking” earnings number that investors should focus on. Of course, that “forward earnings” P/E of nearly 20 means that investors must wait almost a year to see the actual, and that means that today’s valuations are even higher and less appropriate for investing. Listen closely when promoters talk about “forward operating earnings.” Ignore everything they says from that point forward!

Another area of disinformation involves the forthcoming presidential election: which candidate would more positively affect the economy and the stock market? Of course, we hear consistently that Republicans assure us a better economy and, therefore, stock performance. Yet the historic record clearly shows that stocks have done better under Democratic administrations.

We are also hearing much about tax proposals from each of the candidates. John McCain talks about cutting taxes, even in the face of mammoth fiscal deficits, and those lower tax rates will be positive for stocks. Barack Obama’s call for tax hikes on the rich are obviously bad, since that would surely usher in a recession, at best, or a depression, at worst.

These scenarios are comical reprises of what we heard in 1993 when Bill Clinton proposed raising taxes in an effort to balance the budget and restore confidence in our bond markets. Political hit men like Dick Armey, Newt Gingrich and Phil Gramm screeched about the economic damage that was sure to follow. Of course, we know now that, during Clintons’ terms, the economy was strong, and stocks soared. But those facts don’t matter now.

By definition, Republicans are sure that higher taxes are always bad for stocks, and lower taxes are an economic plus. But since the S&P 500 is lower today than when the current occupant took office — and with the economy in recession, of what benefit were George Bush’s record-setting tax cuts? It would almost seem, considering the performance of our economy and stock market and using Republican rationale, that Clinton must have been a big tax cutter and Bush, a big tax hiker!

Another really bad piece of disinformation peddled now by those in the financial media is that the Fed’s hiking interest rates will be a big plus for stocks. Do you know how much my head hurt when I heard that one for the first time?

The apparent rationale behind that absurd idea is that, traditionally, the Fed has hiked interest rates to cool a hot economy. So raising rates now would be the Fed’s response to our “strong” economy? Nothing could be further from the truth!

So the Fed may raise short-term rates, but that would be in response to the after-effects of previously bungled rate moves, which have taken the Fed funds rate to today’s 2%. That low rate has helped create rapidly rising prices for food and energy products. The falling dollar is the culprit, since cutting rates tends to reduce the purchasing power of currency.

So, in response to rising inflation, the Fed may be forced to raise interest rates. In this regard, always remember a very important, common sense point about investing. Typically, stocks will rise when interest rates are high and falling, and that situation is usually coupled with low valuations for stocks. Bear markets tend to begin when stock valuations are high, about as high as they are today, and when rates are rising.

It makes perfect sense, doesn’t it? When rates are high, so are bond yields, as a rule. Who wants to risk their savings in stocks when bonds are paying out fat yields? It is when bond yields are falling that investors look for higher-yielding alternatives, and since low-priced stocks offer that appreciation potential, investors shift out of bonds and into stocks.

Rising rates are bad for the economy, which usually also hurt corporate profits due to higher borrowing costs. And rising bond yields attract more savers in search of better risk-adjusted returns. And that is what we should expect now in our economy.

For most investors, it is not so much a matter of how much information they can absorb and understand but, rather, knowing which information is useful. Learn to recognize the “disinformation,” which is meant to send you in the wrong direction. From my perspective, what we hear in the financial media, for the most part, is suspect, at best.

Revisit the old adage you may have heard about successful investing: “Invest with your eyes, not with your ears.” But when you do hear something that doesn’t seem to make sense, it is unlikely due to your lack of understanding about esoteric financial theories. If it doesn’t sound right, it probably is not right. And today, disinformation appears to be about 95% of what I’m hearing!

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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