Irrational Assumptions

John Mauldin | Thoughts from the Frontline
July 5, 2002

This morning I saw economist Larry Kudlow on CNBC once again telling us the markets would turn back up at some point because the economy is getting better. Kudlow is a smart man, and I pay attention to his thoughtful style.

But in this matter he is dead wrong. Over the past few weeks, I think I have made the point that the connection between a growing economy and the stock market is tenuous at best, and sometimes non-existent. A growing economy and a rising stock market co-exist in a secular bull market cycle. It is a virtuous circle. But in secular bear markets, growing economies are not reflected in the stock market.

Quick repeat history lesson: the economy grew twice as fast from 1966 to 1982 as it did from 1982 to 1999. Stock went nowhere in the first period and rose ten times in the latter. You simply cannot make the case that a growing economy will result in a growing stock market.

Over the long term, value drives the stock market, even as emotions such as fear and greed move it on the short run. Today, we are going to look at several reasons why the stock market will have problems over the next few years even as the economy recovers.

Each of these reasons are ways in which the main measure of stock market value, the price to earnings ratio (P/E), will be affected in a negative way. Each of them, in and of themselves, might not mean that much, but the sum of them will weigh heavily on the way we value our stocks.

Irrational Assumptions

I have written about the fact that many major corporations assume they will make 9-10% in their pension portfolios. This has created a serious distortion in corporate earnings.

First, let me set the stage, telling you why this is important. Many public corporations operate "Defined Benefit" pension plans. That means they promise an employee you will get X number of dollars per year when you retire. This is different from "Defined Contribution" plans, where employees make the contribution, sometimes matched by the employer, and the amount they get upon retirement is dependent upon the results they get in their investment portfolio.

Let's say a corporation has put a lot of money into its defined benefit plan. The actuaries tell them they will need to pay out a specific amount of dollars in future years. Each year, they have to determine how much they have to put into the pension fund so that they will be able to meet future obligations.

If management assumes the fund will grow by 10% a year, the actuaries may tell them they are over-funded and do not need to make a contribution this year. If they assume the fund only grows at 6%, the actuaries may tell them they will need to make a contribution this year.

So they can control the amount of money they contribute in any one year by changing the assumptions on the growth of the investments in the pension fund. As you might expect, if you make a contribution to the pension fund that is an expense, and is deducted from your bottom line profits.

Now, here's the cute part. If you assume you are over-funded, you get to declare the amount you are over-funded as part of your corporate profits. There is nothing wrong with this, in a strict accounting sense. There is nothing wrong with the concept. If you can deftly manage your pension obligations so as to make the fund grow, that should accrue to the bottom line.

But the devil is in the assumptions. By manipulating your assumptions, you can manipulate your corporate earnings. In more easy going times, this was called earnings management, and those firms who used such techniques to make sure they met analysts' assumptions were admired. But times have changed, and what was once called management will now be called manipulation.

The difference is that management gets good press and bonus options and manipulation gets jail time.

Now Rob Arnott of First Quadrant comes along and tells us what this means to the corporate bottom line. Arnott is one of my favorite thinkers. His firm manages $15 billion on corporate pension money in a variety of styles and programs, as well as hedge funds and other investments. Arnott's research is first rank.

$50 billion in Phantom Earnings

The average defined benefit plan assumes that its investments will return more than 9% per year in the future. If they actually get 6%, then the S&P 1500 (not 500) will have over-stated earnings by $50 billion per year for the last two years.

"How does a $50 billion earnings impact compare with corporate earnings? Well, in 2000 and 2001, earnings for the S&P 1500 (the S&P "Supercomposite") totaled $524 billion and $252 billion, respectively, with P/E ratios of 25 and 46 times earnings. If return assumptions had been dropped by 3%, then reported earnings would have been $474 billion and $202 billion, respectively, and the yearend P/E ratios would have been 28 and 58 times earnings. Today's P/E ratio would rise from 60 to 80 times current depressed earnings. Yes, $50 billion per year is significant." (Arnott)

According to benefits consultants Milliman USA, the 50 largest U.S. companies last year reported $54.4 billion in profits from their pension-fund investments, which was interesting because the same 50 actually saw portfolios decline by $35.8 billion.(Staton Digest)

Warren Buffett stated clearly in a Fortune article (in the December 10, 2001 issue) "that anyone choosing not to lower assumptions - CEOs, auditors and actuaries all - is risking litigation for misleading investors. And directors who don't question the optimism thus displayed simply won't be doing their job." Buffett thinks assumptions over 6.5% are unreasonable.

Again, let's go back to Arnott:

"But, we've earned double digit returns over the last five, ten, fifteen, twenty and twenty-five years. It's preposterous to expect 7% or less, no? Not really. Assuming an asset allocation mix of 70% equities and 30% bonds (yielding 6%), stocks would have to earn 10.7% to attain a 9% composite return. Stock returns have only four constituent parts:

1.5%dividend yield +2.5%consensus for future inflation +0.0%P/E expansion(dare we assume more??) + ??real growth in dividends and earnings

"This arithmetic suggests that, to get to a 7% return estimate, we need a mere 3% real growth in dividends and earnings. We can do far better than that, no? No. Historical real growth in dividends and earnings has been 1% to 2%. To get to the 3% real growth in the economy, we have turned to entrepreneurial capitalism, the creation of new companies. Shareholders in today's companies don't participate in this part of GDP growth. So, even a 7% return for equities may be too aggressive. To get 10.7% from stocks, we need nearly 7% real growth in earnings, far faster than any economist would dare project for the economy at large, let alone for the economy net of entrepreneurial capitalism."

What Arnott and others, including myself, have pointed out is that the double digit returns of the past have come from ever expanding P/E ratios. Investors have been increasingly willing to overlook value and assume growth. That is typical of the environment of secular bull markets.

The exact opposite happens in secular bears. Arnott, in his calculation above, says we cannot assume that P/E ratios are going to rise, since they are already at their highest levels in history. What he does not say is what would happen if investors started to demand more value? What if the P/E expansion became (dare we say it?) negative?

If investors simply lowered their P/E expectations by 1 or 2 points a year, that could wipe out much of any growth potential for the broad market.

The Chickens Will Come Home to Roost

Many corporations are in a bind. They have over-stated earnings because they assume that the stock market will grow faster than is realistic in the current environment. That means instead of earnings from their pension funds, they have pension liabilities for which they have not yet accounted.

It was as much as 20% in 2001. I should point out that this was just for defined benefit plans, which are about one-third of the total, so that means many companies are far more than 20% off in their earnings.

If you re-state earnings of this magnitude today, you will get hammered in the stock market. You will get sued. Of course, management will trot out the "independent" earnings estimates which they use to support their assumptions. These "rent-an-assumption" estimates are going to be seen as a very flimsy excuse in the Enron Era.

But these assumptions are going to be changed, even if management is forced to do it kicking and screaming.

And that brings us to the second reason P/E ratios are going to get worse even as the economy improves. It's what I sadly call the Wendy Gramm Factor.

Wendy Gramm had the unfortunate position of being head of the auditing committee for Enron. She was head of the Commodities and Futures Trading Commission and Senator Phil Gramm's wife. Those of us who know her know she is smart, honest and as genuinely committed to integrity as anyone with whom you could hope to be associated. There are many in Texas who think the wrong Gramm was running for President a few years ago.

How could she have let Enron get away with such outrageous accounting practices? Shouldn't she be held responsible for the problems at Enron? It happened on her watch, after all.

And that illustrates the problem. When a Wendy Gramm can be misled and fooled by management, accountants and lawyers, what hope does the average audit committee head have? I can tell you that corporate audit committees all over America, especially if Arthur Andersen was the auditor, are doing some serious soul searching.

Corporate boards of directors are like mushrooms: they are kept in the dark and fed horse manure. (My less-than-sainted-Dad had more colorful terms, but you get the picture.)

The purpose of most corporate boards is not so much to oversee management, but to provide access assistance to management. Do you need to talk with the head of another corporation? You call your director who sits on another board with someone who sits on the board of the firm with which you need to talk. That is why so many corporate directors are on multiple boards. It is not their wisdom so much as their rolodexes which they bring to the table. The boards become a sounding board for management, but only rarely become a true check in a major way. Management usually gets its way, unless they screw up, and then they get replaced.

But now that will change. The men and women who sit on these boards are not dummies. Many are and were serious business people in their own right. Being on a major corporate board will no longer be seen as a perk. It now can easily become a liability. Why risk your reputation and fortune to lawsuits for relatively poor pay (when compared to your net worth)? I can guarantee you there is no amount of money worth being on the board auditing committee of Enron, WorldCom, or Global Crossing. The Wendy Gramm Factor is now a reality, and every board member in America wants to make sure he/she avoids it.

In the future, you are going to see board of directors start to require true independence from their accountants. Many will require the accountants to actually report to the board prior to reporting to management. I think many will start to seek second opinions from outside legal counsel on what could be a controversial position. You will see boards hire outside accountants to ferret out potential problems in accounting. They will start to err on the side of caution and conservatism.

Each new shareholder lawsuit is going to reinforce the drive to be conservative.

Having a board of directors breathing down your neck is going to make earnings management much more difficult. Boards will instruct management to paint earnings in the most realistic manner possible.

But it is not just board of directors. It is also going to be the accounting and legal profession. There is an SEC rule called 102.e. Basically, if you give an opinion or audit which is found to be misleading or wrong, you can be barred from practicing before the SEC or auditing public companies.

I will make you a bet that the Arthur Andersen accountants who worked on Waste Management and Sunbeam are still plying their trade somewhere. Ditto for the attorneys. This is wrong. There are standards, and they broke them.

I work in a regulated industry, the financial services industry. In essence, the SEC or the CFTC serve as lifeguards. If I don't behave, they can blow the whistle and order me out of the pool. I will have to find another field to work in. I sign financial statements every month that if they are not accurate, my career is on the line. If it is serious enough, I can go to jail.

I take this damn seriously. I know that every few years, I am going to be audited by 2-3 government regulators, in my office, going over everything foe at least 2-3 days. Not just for my accounting, by the way. Any advertising I do is also subject to scrutiny, as well as company policies, record keeping and hundreds of compliance issues which are all subject to review. Staying "in compliance" is a big part of my world.

My world is full of accountant and lawyers who work to make sure everything I do is correct. I depend upon them to help guide me through a maze of regulations. In the past, if they made a mistake, however, it was only my derriere on the line. I am the one who gets thrown out of the pool. They can go back to their practice.

You can already see this climate changing. We will see laws enforced which will make lawyers and accountants more responsible for their opinions. Frankly, I will enjoy the company.

This is a good thing, and not just because it will make the numbers we see more believable. I use conservative attorneys and lawyers. (I should point out, that everyone else says the same thing. I bet Jeff Skilling of Enron says the same thing in his defense.) They have explicit instructions to keep me three feet from the edge. I don't want to get close enough to look over.

But I see other competitive firms doing things my attorneys wouldn't let me get close to. In a more conservative world, this will level the playing field for the vast majority of firms which do their best to be honest and fair.

While this will be a good development, it will be negative for earnings. Conservative accounting will mean less room to cook the books

(This is the end of Part One. I will do the conclusion in Part Two next week.)

A Few Quick Comments

I am relieved to see the dollar showing some strength. It is not that I think the dollar won't go lower, but I want it to happen slowly so that the markets can adjust. Rapid devaluations cause all sorts of problems.

The Bank Credit Analyst thinks that the dollar is headed to $1.10 to the euro. BCA forecasts are usually on target. Those of you who want to get into euro denominated assets still have some time with this recent pull back.

The stock market jumped 3-5% today, depending upon which index you looked at. I think much of the latest sell-off was traders not wanting to be long going into July 4, and scared of terrorist attacks. These did not materialize (thank God), and so the extremely "over-sold" condition served as a springboard for a major rally. This could be the beginning of the usual summer rally.

If it is, we will see one cheerleader after another telling us that we have seen the bottom and the bull is underway. They will be wrong. This will prove to be another bear market rally. But I have nothing against those who want to enjoy it.

While still growing, the economy is slowing down, as consumer spending is slowing down, unemployment is not falling and confidence is not rising. The key is to watch consumer spending. I think it gradually slows over the next 12 months, which will gradually slow the economy and eventually precipitate the next recession. But it doesn't appear to be slowing dramatically, and so the economy is still on track to Muddle Through this year and for as long as consumer spending remains in even a slight growth mode.

Guy's Night Out

My wife has taken the twins on a girl's night out to a Bed and Breakfast in the country, so the guys are Home Alone. I predict an overdose of beef (my wife is vegetarian so we take these moments when we get them) and action movies. You can just about put that one in the bank.

Contrary to corporate profits, you can never over-estimate the value of family time, not to mention the calories. Have a great week.

Your getting ready to enjoy the testosterone analyst,

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