By John Crudele at New York Post
Today Jack Ciesielski and I will to try to scare some sense into you.
Who is Ciesielski, and why would he want to frighten you? It’ll take some time to answer that. First things first.
The stock market has been more or less flat most of this year. But at times — like for the past month or so — stock prices have climbed as if Wall Street didn’t have a concern in the world.
Terrorism hasn’t fazed the stock market. Nor has the fact that the Federal Reserve is threatening — yet again — to raise interest rates. Weak corporate profits and revenue declines? Nah, Wall Street doesn’t give a damn about them either.
This column will show you why the performance of companies should be of great concern — and not only because they are, on the surface, lousy but also because accounting tricks are hiding the true horror story. That’s where Ciesielski comes in, but he’ll have to wait in the wings for his turn.
Everyone who reads this column should already know what price-to-earnings ratios are. But just in case you don’t, here’s the explanation: Price-to-earnings — or P/E — are the price of a share of stock compared with a company’s earnings on a per-share basis.
That’s a mouthful. To make it simple, let’s say a company — I’ll call it John’s Co. — earned $1 a share in 2015.
Let’s say investors are buying and selling John’s Co. shares on Nasdaq at $14 each. (I picked Nasdaq because it will piss off the New York Stock Exchange that I didn’t list my company on the “Big Board.”) So the price of $14 a share compared with the $1-per-share earnings gives my company a P/E of 14 to 1.
This is a standard measuring tool used by Wall Street both for companies and the broader market.
Put all 500 companies in the Standard & Poor’s index together and their combined P/E ratio right now is 17.4 to 1.
Based on the hope of rising profits in the future (”forward-looking earnings” is how Wall Street puts it), the P/E ratio for those same 500 companies improves to 16.8 to 1, according to my friends at Thomson Reuters.
Wall Street argues that a stock is more of a bargain at a lower P/E. But by either of the above measurements, stock prices are priced high. Since 1968, the normal P/E ratio on already-reported earnings is 15.5 to 1 (compared with today’s 17.4 to 1) and 14.6 to 1 on future earnings (compared with today’s 16.8 to 1).
What that means is: The S&P 500 index would have to decline to around 1,850 points from Monday’s close of 2086.59 just to get back to historical levels. In other words, if stock prices fell 13 percent, things would only be back to normal.
And there’s no reason stocks wouldn’t fall more than 13 percent. Equity prices can, after all, go below average.
Well, that’s not the only trick up companies’ sleeves. Accounting games are also making the profits reported by companies much less trustworthy which, in turn, means P/E ratios are even more out of whack.
Ciesielski, who writes The Analyst’s Accounting Observer, tells me that accounting manipulation has become very widespread and companies are using gimmicks to make profits look better.
Company executives, explains Ciesielski, “all have a huge incentive to puff their numbers.” Why? Because the bosses of the companies whose shares you buy have much of their compensation tied to their stock’s performance.
How are companies messing with their numbers? Back in the old days, companies used to report profits according to Generally Accepted Accounting Principles — called GAAP for short.
That meant all companies had to follow certain rules so that investors were able to compare apples to apples — profits from one period to another.
Ciesielski says companies are now using creative accounting. GAAP has fallen between the cracks. The use of so-called “extraordinary items” and “non-cash charges” has made corporate earnings reports incomprehensible.
“Non-GAAP earnings are more akin to anarchy,” says Ciesielski. “The non-GAAP earnings phenomenon has been rolling for years now, and shows no signs of letting up.”
How many companies are pulling these accounting tricks? Ciesielski says that, in 2009, 232 of the 500 companies in the S&P index were using tricks — thus straying from GAAP. Last year, 334 companies were doing so.
Hundreds of billions in extra corporate profits were being reported simply by razzle-dazzle. It’s not that profits were actually higher — they were just made to look so.
So, what does all this mean? Simple: Stock prices that already looked expensive are very, very expensive when you factor in the accounting tricks.
I promised you good news, so here it is. Governments around the world have been actively rigging stock markets, either directly or through verbal intervention.
Will stocks be able to stay overpriced once this government help comes to an end? Nobody knows. But at least I feel relieved after warning you about all this nonsense.
Source: The Secret Stock Market Accounting Trick – New York Post
