Thursday, February 26, 2009

Don't Judge a Book By Its Cover (or a Story By Its Headline)

From the Desk of Joe Rollins

This may be surprising to some of you, but many years ago I had a career outside of public accounting in private industry. One of the accounts I worked on at an accounting practice was a company that erected elevated water tanks throughout the United States, and when they offered me a job, I took them up on it. I was there for several years, working my way up through the ranks to be the president of the company.



At some point, I became interested in buying an ownership interest in the company, but when I realized that wasn’t going to happen I decided to start my own CPA practice. I left that company under great terms, with the company becoming my first client and the owner remaining one of my best friends for thirty years until he passed away in late 2006.

When I worked for the water tank company, I often had to go to the job sites where water tanks were under construction. We would spend anywhere from a few days to two weeks in the field, hanging around the job sites, getting in the way and asking questions that irritated the tank builders.



Back then, tank builders were akin to circus performers; there jobs were extremely dangerous and could be devastating if they made even the most minor mistake. The workers made a lot of money for taking on such risk, and most tank builders never had any problems getting dates. In fact, when a tank crew moved into town for a job, it wasn’t unusual for spectators to come out and watch them construct the tanks, where they would hang upside-down 150-feet off the ground while welding the bottom of a water tank.


In order to save money on a hotel room, a tank worker would sometimes shack up with a local girl. That way, he could use his hotel per diems for more nighttime entertainment. Believe me, these guys were the most skilled and courageous construction workers I’ve ever had the pleasure of knowing.

There’s a particular memory I have of working for the water tank construction company that really stuck in my mind. For the most part, the tank workers consisted of very young men. As the tanks got higher and higher, it became more difficult for older men to climb the tanks. It was relatively rare to actually see a tank builder over the age of 40. But on a particular job I worked on for over a week, there was a crew member that was close to 65-years old. He was a hoist operator and usually did not climb the tanks; he job was to hoist workers and materials up and down the tower. When he wasn’t doing that, he would hang around the bottom of the tank and clean up the debris.

As with most tank builders, this fellow worked hard and played hard. He tended to drink too much and too often, and he looked much older than his 65 years. I got to know him very well, as I was usually hanging around on the ground and watching while the tank builders did all the hard work. At night we would all go out to dinner, and this particular guy was always the first to order. Notwithstanding the restaurant where we went to dinner, he always ordered fried shrimp, never looking at the menu.

Several years later, I heard that he had tragically died in a car accident on a rainy day outside of Bruce, Mississippi, his hometown. When I was reminiscing about him to my friend who was the construction superintendent, he informed me of something I had never heard before. Apparently, this gentleman could not read or write, which explains why he always ordered fried shrimp and never looked at a menu. I suppose we were lucky to always go to restaurants that offered that Southern delicacy.

The reason I am relaying this story actually does have something to do with finance. Basically, I wanted to point out that there are people who just read the headlines without ever reading the actual article. I am blown away by the lack of information I see in the financial press and how it’s misinterpreted. In this particular post, I wanted to provide a few specific examples of how news today has been so misinterpreted by the financial press, and while things are surely grim, they are certainly not as bleak as it’s being reported.

A good example of how reading a headline but not the story can further negatively impact sentiment is as follows. On Friday, February 19th, the Federal Reserve cut its forecast for 2009 GDP growth in the United States. The Fed is now projecting a drop in the economy for 2009 in the range of 0.5% to 1.3%. In January, they had forecasted that the economy might even grow in the range of 0.2 to 1.1% in 2009. Therefore, the Fed basically downgraded the economy by approximately 2% from their previous estimates. But the headlines only indicated that the U.S. Federal Reserve forecasted negative GDP for the U.S. economy in 2009, which really shouldn’t have come as any surprise.

What was confusing to me about this headline was that so many people took this headline at face value without seeing the underlying positive news. As I’m sure you’re aware, the Fed has announced that the GDP declined for the 4th quarter of 2008, and its first revision was at 3.8%. Almost all respected economists are forecasting that the loss in GDP for the first quarter of 2009 will likely be in the range of 3.5% to 5.5%. These are certainly large and frightening percentages. However, if you really think about the Fed’s projection of a drop in GDP growth for 2009, hopefully you’ll see my point regarding the embedded good news.

On Friday of last week, the Federal Reserve was forecasting that the 2009 total year GDP decline would be 1.3%. If you take into consideration that the first quarter loss would be 4%, how could you possibly arrive at only a loss of 1.3% when you start out with a loss in the first quarter of 4%. Doesn’t that imply that there will be some extraordinarily good quarters in our future this year?

Perhaps I have grown so accustomed to sensationalized headlines that I always read entire articles with a fine tooth comb. The article regarding the Fed’s lowering of its forecast for the U.S. economy set out that the projected GDP would have positive growth in the third quarter of 2009 and substantial positive growth in the fourth quarter of 2009. This makes it clear to me that there will be high growth in GDP in the last two quarter of 2009 in order to overcome the two very negative first quarters of 2009.

The article progressed by setting out more of what I deem is also good news. The Federal Reserve is forecasting GDP growth in 2010 at 2.5% to 3.3%, with even higher growth in 2011 at 3.8% to 5%. Accordingly, it should be fairly clear to everyone who read the entire article that the negative headline failed to describe the actual content of the article. A more appropriate headline would’ve pointed out that the Fed is forecasting a significant turnaround in the economy only six months from now, which should progressively increase to extraordinarily high growth by 2011.

Once again, I implore you to read beyond the headlines. These days, you just won’t get the full story without reading the entire article. With all due respect to my tank worker buddy who was a smart guy in spite of his inability to read an write, if you can read the menu, you might find that there are other things to order than just fried shrimp.

On Monday, the stock market took a severe turn downward, and at the end of the day, stock prices were essentially at the same level they were in 1997. It’s hard to believe that a 12-year period has basically been evaporated by the fear and the constant selling that the professionals are doing on Wall Street. Many investors are now losing face in the financial systems because the professionals are manipulating the numbers and making the fundamental analysis of investing meaningless.

Rather than cry in my beer (which I have been known to do these days), I decided to try to objectively evaluate whether there was any validity to stock prices being at the same level today as they were at in 1997. I must admit that some of the so-called experts espousing their theories on the financial news are not only discouraging but most of them are just incorrect. I can’t help but think that the pundits on TV who are saying all the banks are insolvent and need to be nationalized are the same people who are shorting the very stock they’re criticizing. There’s absolutely no indication anywhere that the U.S. government wants to nationalize banks, but this is what we’re hearing ad nauseam on the financial news.

In an attempt to determine whether stock prices are fair right now, I decided to review the most basic information regarding the U.S. economy. As I have often mentioned, profitability is the most important component of investing. Obviously, the U.S. economy and interest rates have a major impact, but by far the most important component of stock values is profits. So I must wonder whether profits and the GDP in the United States are better or worse than they were in 1997. The answer would be whether stock prices are properly valued today based upon economic data.

I reviewed the following charts to try to assess this information. I didn’t have the information going back to 1997, so I began my study at the beginning of 2001. As a point of reference, please remember that this was before September 11, 2001, and before the Federal Reserve started cutting interest rates to stimulate the economy in early 2001. It was also before the major meltdown in the tech bubble. All-in-all, it was actually a pretty good time for the U.S. economy.



As my chart indicates, the GDP in the United States at the beginning of 2001 was essentially at $10 trillion. As of today, the U.S. GDP is at approximately $14.3 trillion. Therefore, the GDP has grown over the intervening eight years by a stunning 43%. Pundits that want to criticize everything probably didn’t notice that our economy grew by almost 50% during the George W. Bush years.

Again, the most important component is corporate profits. So what has the effect of corporate profits been in the same relevant timeframe? As the following chart indicates, corporate profits at the beginning of 2001 were roughly $550 billion. Even with the significant reduction in corporate profits due to the bank implosion, corporate profits were most recently reported at $1.1 trillion, just off the all-time high of $1.23 trillion. So I don’t overstate my case, while corporate profits have essentially doubled over the last eight years, stock prices have remained flat.



I question whether the people reporting all of the negative sentiments in the financial news have ever researched the facts represented in the chart above. It just seems like all we hear is negative news when the news is better than what is being reported by the financial press.

Like most everyone, I cannot forecast when the stock market will turn around. However, basic textbook principles of investing tell you that the stock market turns around approximately six months before the economy. This is because stock prices are driven by improving corporate profits. We’re only a week away from March – almost exactly six months from the anticipated start of the turnaround in the U.S. economy. If the Federal Reserve is correct, 2010 and 2011 are going to be great growth years.

Corporate profits are double what they were in 2001, but have certainly been reduced within the last 12 months. With the economy improving and GDP growing, it would seem that corporate profits would start accelerating. I don’t know for sure, but based upon everything I’ve learned over the years, there certainly is ample fundamental ground for the stock market to start performing better soon.

As always, these are just some of my thoughts. I could be wrong…

1 comment:

Jamie Turner said...

Bravo, Joe! I got so frustrated with the negative news stories that I started a 5-part series on my blog called "Good Economic News." Worth noting -- Walmart, Coca-Cola, Heinz, McDonald's and Pepsi have all reported recent revenue increases. But you wouldn't know it by the way the news media is portraying it.

Times are tough, but we'll get through this.

Thanks for the additional information on the economy. I'll include it (with a link) in tomorrow's posting on "Good Economic News."