NOLTE NOTES
Skeptical of the Euphoria Over "Less Bad"
by Paul J. Nolte, CFA
August 3, 2009

Earnings season is nearly over and just in time for the employment report, which follows closely behind the GDP report of last week that indicating the economic contraction is not as rapid as the fourth of 2008 and first of 2009. Based upon the weekly initial claims data, we may expect payrolls to contract by another 350-400,000 – enough to be of a concern, however may also be hailed as further evidence of an economy that is on the mend. While it is true that the economic is not unraveling at the pace of the turn of the year, it is also not yet close to actual growth. One thing that is a necessity for determining valuations on stocks is earnings growth, which has not yet been evident in the numbers that have been reported (more later), however hope is definitely growing that the trillions of dollars flung into the economic abyss will somehow get the engines started and behemoth moving. While we are skeptical that the euphoria over “less bad” will result in lasting market gains, we are amazed that the gains continue at the pace they have, even since the end of the last quarter!

No need to go into great details over the technical picture of the markets. Suffice it to say that stocks are overdue for a rest, although the “overbought” condition can remain for quite some time before the markets finally take a breather. Excitement is high over the percentage of stocks beating estimates. However, when looking at the hard data a very different picture emerges. Taking out fourth quarter data (as companies tend to write off heavily during that quarter), the difference between “as reported” and “operating” earnings has been quite large in recent quarters. Operating earnings focus on earnings from operations excluding various charges, interest and taxes. There was a time when as reported earnings were actually higher than operating, but not even close today. There have been 15 instances where the difference between the two exceeded 14%; only 3 were prior to 2000. Of the 16 instances where the difference was less than 2% (and more than half had as reported higher than operating) only two occurred after 1996. The point? Earnings quality is very poor (and has been) for the past 10+ years, making valuing the markets that much more difficult. If we look solely at as reported earnings (we believe a better figure), the market is selling for over 200 times earnings – cheap it is not!
 
The decline in bond prices (and rally in yields) stopped abruptly mid-week last week and yields came tumbling down, falling nearly a quarter point as bond investors are feeling the volatility usually reserved for equity investors. As a result of the huge decline, the bond model is once again flipped to the “buy” side, and pointing to lower rates ahead. The auction of treasury securities has gone very well and was one of the reasons for the rally in bonds. Commodity prices continue to rise; however the economic data, while better than it has been, remains weak. The difference in yields between short and long-term rates remains well above 3 percentage points. During the ’00-’03 collapse, yields stayed above 300 basis points for just over three years; so far, we are only on week 28.

© 2009 Paul J. Nolte, CFA
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The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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Paul J. Nolte, CFA | Director Investments, Hinsdale Associates | 630-325-7100 | Email