Posts tagged ‘Standard & Poor’s’
Inflation and the Debt Default Paradox
With the federal government anchored down with over $14 trillion in debt and trillion dollar deficits as far as the eye can see, somehow people are shocked that Standard & Poor’s downgraded its outlook on U.S. government debt to “Negative” from “Stable.” This is about as surprising as learning that Fat Albert is overweight or that Charlie Sheen has a substance abuse problem.
Let’s use an example. Suppose I received a pay demotion and then I went on an irresponsible around-the-world spending rampage while racking up over $1,000,000.00 in credit card debt. Should I be surprised if my 850 FICO score would be reviewed for a possible downgrade, or if credit card lenders became slightly concerned about the possibility of collecting my debt? I guess I wouldn’t be flabbergasted by their anxiety.
Debt Default Paradox?
With the recent S&P rating adjustment, pundits over the airwaves (see CNBC video) make the case that the U.S. cannot default on its debt, because the U.S. is a sovereign nation that can indefinitely issue bonds in its own currency (i.e., print money likes it’s going out of style). There is some basis to this argument if you consider the last major developed country to default was the U.S. government in 1933 when it went off the gold standard.
On the other hand, non-sovereign nations issuing foreign currencies do not have the luxury of whipping out the printing presses to save the day. The Latin America debt defaults in the 1980s and Asian Financial crisis in the late 1990s are examples of foreign countries over-extending themselves with U.S. dollar-denominated debt, which subsequently led to collapsing currencies. The irresponsible fiscal policies eventually destroyed the debtors’ ability to issue bonds and ultimately repay their obligations (i.e., default).
Regardless of a country’s strength of currency or central bank, if reckless fiscal policies are instituted, governments will eventually be left to pick their own poison…default or hyperinflation. One can think of these options as a favorite dental procedure – a root canal or wisdom teeth pulled. Whether debtors get paid 50 cents on the dollar in the event of a default, or debtors receive 100 cents in hyper-inflated dollars (worth 50% less), the resulting pain feels the same – purchasing power has been dramatically reduced in either case (default or hyperinflation).
Of course, Ben Bernanke and the Federal Reserve Bank would like investors to believe a Goldilocks scenario is possible, which is the creation of enough liquidity to stimulate the economy while maintaining low interest rates and low inflation. At the end of the day, the inflation picture boils down to simple supply and demand for money. Fervent critics of the Fed and Bernanke would have you believe the money supply is exploding, and hyperinflation is just around the corner. It’s difficult to quarrel with the printing press arguments, given the size and scale of QE1 & QE2 (Quantitative Easing), but the fact of the matter is that money supply growth has not exploded because all the liquidity created and supplied into the banking system has been sitting idle in bank vaults – financial institutions simply are not lending. Eventually this phenomenon will change as the economy continues to recover; banks adequately build their capital ratios; the housing market sustainably recovers; and confidence regarding borrower creditworthiness improves.
Scott Grannis at the California Beach Pundit makes the point that money supply as measured by M2 has shown a steady 6% increase since 1995, with no serious side-effects from QE1/QE2 yet:
- Source: Calafia Beach Pundit
In fact, Grannis states that money supply growth (+6%) has actually grown less than nominal GDP over the period (+6.7%). Money supply growth relative to GDP growth (money demand) in the end is what really matters. Take for instance an economy producing 10 widgets for $10 dollars, would have a CPI (Consumer Price Index) of $1 per widget and a money supply of $10. If the widget GDP increased by 10% to 11 widgets (10 widgets X 1.1) and the Federal Reserve increased money supply by 10% to $11, then the CPI index would remain constant at $1 per widget ($11/11 widgets). This is obviously grossly oversimplified, but it makes my point.
Gold Bugs Banking on Inflation or Collapse
Gold prices have been on a tear over the last 10 years and current fiscal and monetary policies have “gold bugs” frothing at the mouth. These irresponsible policies will no doubt have an impact on gold demand and gold prices, but many gold investors fail to acknowledge a gold supply response. Take for example Freeport-McMoRan Copper & Gold Inc. (FCX), which just reported stellar quarterly sales and earnings growth today (up 31% and 57%, respectively). FCX more than doubled their capital expenditures to more than $500 million in the quarter, and they are planning to double their exploration spending in fiscal 2011. Is Freeport alone in their supply expansion plans? No, and like any commodity with exploding prices, eventually higher prices get greedy capitalists to create enough supply to put a lid on price appreciation. For prior bubbles you can reference the recent housing collapse or older burstings such as the Tulip Mania of the 1600s. One of the richest billionaires on the planet, Warren Buffett, also has a few thoughts on the prospects of gold.
The recent Standard & Poor’s outlook downgrade on U.S. government debt has caught a lot of press headlines. Fears about a technical default may be overblown, but if fiscal constraint cannot be agreed upon in Congress, the alternative path to hyperinflation will feel just as painful.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in FCX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Operating Earnings: Half-Empty or Half-Full?
A continual debate goes on between bulls and bears about which earnings metric is more important: reported earnings based on GAAP (Generally Accepted Accounting Principles) or “operating earnings,” which exclude one-time charges and gains, along with non-cash charges, such as options expenses. Bulls generally prefer operating earnings (glass half-full) because they are typically higher than GAAP earnings (glass half-empty), and therefore operating earnings make valuation metrics more attractive. This disparity between earnings choice is even broader over the last few years due to the massive distortions created by the financial crisis – gigantic write-downs at the vast majority of financial institutions and enormous restructurings at non-financial companies.
Options Smoptions
The options expense issue can also become a religious argument, similar to the paradoxical question that asks if God can create a rock big enough that he himself cannot budge? Logic would dictate that operating earnings should adequately account for option issuance in the denominator of the earnings per share calculation (Net Income / Shares Outstanding). As far as I’m concerned, the GAAP method reducing the numerator of EPS (Earnings Per Share) with an expense, and increasing the denominator by increasing shares from option issuance is merely double counting the expense, thereby distorting reality. Reading through an annual report and/or proxy may not be a joyous experience, but the exercise will help you triangulate share issuance estimates to forecast the drag on future EPS.
On a trailing 12-month basis (Sep’09 – Sep’10), Standard & Poor’s calculated reported earnings with about a -9% differential from operating earnings, equating to approximately a 1.5 Price/Earnings multiple point differential (17.8x’s for reported earnings and 16.2 x’s for operating earnings). For the half-glass full bulls, the picture looks even prettier based on 2011 operating earnings forecasts – the S&P 500 index is priced at roughly 13.6x’s the 2011 index earnings value of $95.45.
Forward More Important Than Backwards
As I make the case in my P/E binoculars article, the market is like a game of chess – a good player doesn’t care nearly as much about an opponent’s last moves as he/she cares about the opponent’s future moves. Financial markets operate in the same fashion, future earnings are much more important than prior earnings. From a practical standpoint, GAAP earnings are relatively useless. Market purists can evangelize about the merits of GAAP earnings until they are blue in the face, but the fact of the matter is that investors are whipping prices all over the place based on Wall Street EPS forecasts – based on operating earnings (not GAAP). In many instances, especially throughout much of the financial crisis, operating earnings will more closely align with the cash flows of a company relative to GAAP earnings, but detailed fundamental analysis is needed.
As far as I’m concerned, much of this GAAP vs Non-GAAP earnings debate is moot because both reported earnings and operating earnings can both be manipulated and distorted. I prefer using cash flows (see Cash Flow Statement article) because cash register accounting – the analysis of money coming in and out of a company – limits the ability of bean counters to use smoke and mirror strategies traditionally saved for the income statement. In other words, you cannot compensate employees, do acquisitions, distribute dividends, or buyback stock with GAAP earnings…all these functions require cold, hard cash. The key metric, rather than EPS, should be free cash flow per share. Growth companies with high return prospects should be given some leeway, but if the projects don’t earn a return, eventually cash resources will dry up. When EPS is materially higher than free cash flow per share, yellow flags fly up and I do additional research to understand the dynamics causing the differential.
These earnings-based arguments will likely never get resolved, but if investors focus on bottom-up analysis on individual security cash flows, determining whether the glass is half-empty or half-full will become much easier.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. The trailing 12 month data was calculated by S&P as of 1/19/2011. Forward 2011 operating earnings were calculated as of 1/18/2011. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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