September 1, 2004
After an almost normal 31 percent surge in stock market
values during the first year of this bull market (begun in October 2002),
typical additional double digit gains in stock prices seemed assured for the
second year. Profit grow
remained strong, interest rates rose, but remained low by historical
standards, and world economic activity was booming.
A declining dollar also allowed American producers to
share in the world’s strength early in 2004.
This was not the case in the previous year.
Yet, investors have been troubled by their returns this
year. Chief executive officers
have been downplaying strong performances early in 2004. Almost without exception, earnings guidance has been clipped
in comparison to robust spring earnings performance.
Fears of terrorism, capped by the horrors in Madrid,
and spiking oil prices, account for some of the uneasiness.
Increases in short term interest rate targets also have some
financial officers on edge. But the models comparing earnings as a percentage of stock
market prices to the yield on ten year government bonds continue to suggest
that stocks are substantially undervalued.
To be sure, some investor unease reflects concerns
about how high interest rates might go.
If we are using forward estimates of earnings in our valuation
models, should we not also use forward estimates of interest rates?
I have talked at length about interest rate
determination in the past year. I
certainly believe yields on ten year bonds will be significantly higher a
year from now than they are today. However,
I cannot conceive of a rise in rates that would be significant enough to
make stocks too expensive for expected earnings.
If the problem is not with interest rates, then it must
be with earnings or with unfounded pessimism that will eventually disappear.
Certainly, most forecasters, including myself, have
slashed their estimates of economic growth in the next twelve months.
Higher oil prices and low wage growth are combining to restrain
consumer spending. Both Walmart
and Target have recently lowered their near term forecast of same store
Above trend economic growth will be difficult to
achieve. But even trend growth
should provide sufficient profit gains to push stock prices higher in the
expected rising interest rate environment.
All of which leads to one other prospect:
profits may not be what they seem.
My first clue that something was wrong with reported
profits came from the annual GDP revisions that were reported in July.
Corporate profits were cut more than 8 percent while compensation was
Although standard accounting practices still allow
stock options to be treated as a change in capital, options actually are a
form of compensation. Indeed,
many corporations acknowledge as much by buying back sufficient shares to
cancel the dilution that stock options have upon ownership.
In fact, the resources used for those purchases reflect the
additional compensation that is being transferred to the option receivers.
Apparently, the GDP accounts are ahead of the
accounting profession in trying to adjust reported earnings for that portion
that really is additional compensation to company officers. Thus, some of that reported profits will not enhance the
value of the existing shareholder.
Another problem is unfunded liabilities, especially
medical benefits. Many
corporations are increasing contributions to their under-funded defined
benefit pension programs. However,
liabilities clearly remain. Thus,
some funds will be transferred from future cash flow to the pension
managers. To the extent that
those obligations exist, a portion of current reported earnings again will
not benefit shareholders.
Actually, the unfunded pension balances usually are
reported in the details of corporate releases, even if their headline
profits announcement does not reflect it.
However, the medical obligations to current and retired employees is
not treated similarly. To the
extent that corporations meet these obligations in the future, and some are
reneging on retiree benefits, future shareholder profits will be diminished.
A third problem with profits this year is the cost of
compliance with the Sarbanes- Oxley (SOX) corporate governance provisions.
I am aware of several companies that will suffer 3 to 5 percent
reductions in reported profits because of the additional costs associated
with regulatory compliance. A
lot of the additional accounting costs occur in the second half of this
Stock options, unfunded benefit liabilities, and SOX
all suggest that next year’s corporate earnings may not add to the value
of the enterprise to the extent that analysts currently are reporting.
And that may be what is holding down stock values at this time.