The Smart Bird

The Smart Bird: What Could Go Wrong

I guess it is a foregone conclusion that we will have another financial crisis.  It appears the blame game has pre-emptively started with statements like Jamie’s from many of the people responsible for the mess in the financial sphere.  We now see in Fed Focuses on Shadow Banking as It Gauges Financial Risk that they are just now becoming concerned about the $25 trillion shadow banking system that faces few restrictions.  But what is Jamie really telling us…

JPMorgan Chase & Co. head Jamie Dimon said last year’s volatility in U.S. Treasuries is a “warning shot” to investors and that the next financial crisis could be exacerbated by a shortage of the securities…The Treasuries move was “an event that is supposed to happen only once in every 3 billion years or so,” Dimon wrote. A future crisis could be worsened because there “is a greatly reduced supply of Treasuries to go around.

Maybe they feel that blaming the weather for bad economic indications will not work much longer and the market will wake up to the divergence of values and fundamentals.  Short-term tricks to prop up reported earnings can only go on for so long.   We have talked before about stock buybacks and how in aggregate they boosted the S&P 500 reported EPS about 2% above actual earnings growth recently.  But the cash-poor companies have to engage in “add-backs” to boost reported EPS as highlighted by Zero Hedge in red on the following chart.  “Add-backs” are “non-reoccurring” expenses that conveniently increase when actual earnings come up short.

Add-backs in Red

Add-backs in Red

Zero Hedge also focused in one company in NON-GAAP Gimmickry 101:  How Alcoa Just Beat Consensus EPS with the following excerpt:

Which brings us to Q1 earnings which beat consensus of $0.26 by 2 cents, even though revenues of $5.84 billion not only missed expectations of $5.94 billion materially, but the company saw an annual decline in its sales across three of its four core operating segments…The problem is that of that $0.28 in “earnings”, precisely 50% was in the form of, you guessed it, non-GAAP and proforma add backs…In other words, one half of Alcoa’s “EPS” in the quarter was due to what management thought was another quarter of recurring “non-recurring”, non-one time “one-time” charges.

Then we learn from David Stockman that the S&P 500 has nothing on the Russell 2000 small cap stocks when it comes to “add-backs”.  Wall Street is currently telling us the Russell 2000 PE ratio is running a tad high around 20 with implied forward earnings of $63.87 per share, but Mr. Stockman points out a small problem with the numbers.  The same companies reported GAAP earnings of only $14.18 per share to the SEC during the last 4 quarters “on penalty of jail time”.  Obviously, they have quite a lot of reoccurring “non-reoccurring” expenses being reported in footnotes to investors.  This bumps the Russell 2000 PE ratio up to around 80 if you are interest in real earnings.

This does not necessarily mean the market is going to roll over tomorrow as it wakes up to fundamentals.  This dynamic has been going on a long time and when we enter bubble land the terminal phase of the stock market can see a melt up.  In Doug Noland’s quote he is referencing the Hang Seng Composite Index that surged 7.6% in two days due to the fact the 20 most-shorted stocks surged 18% on average as the market melt up takes its toll on short sellers.  China is experiencing their own stock market bubble and I am sure they will experience a similar outcome to all bubbles.

Late-stage speculative runs are often fueled by short squeezes. As deteriorating fundamentals and underlying vulnerability begin to manifest, short positions and bearish derivative bets are initiated as both directional speculations and market hedges. At the same time, prolonged bullish cycles ensure upside momentum and general “bullish” inertia. Blow-off tops can be the result of a confluence of policy measures to ward off collapse and an expansive pool of speculative finance that has profited greatly from gaming policy.

Who would game policy?  And what policy measures to ward off collapse?  Don’t worry everything is fine.  Switzerland is selling 10-year bonds with a negative yield, Japan’s Central bank buys into the stock market when it opens down, global debt approaching 300% of global GDP, Chinese stocks are up 25% already this year as the China premier warns the economy faces downward pressure and the US wants to raise interest rates into a stagnating US economy.

What could go wrong?