How Wall-Street Hocus-Pocus Inflates S&P 500 Revenues

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But even the well-oiled machine couldn’t hide the decline.

Despite what you might think, there’s a difference between our financial markets and casinos in Las Vegas: casinos aren’t rigged.

In a casino, the odds are officially against you. You know what they are, and you subject yourself to them – statistically speaking – to lose money … while having a blast.

Wall Street on the other hand has become an ingenious hocus-pocus machine where even the most taken-for-granted and often-cited data points are systematically inflated. Yet this particular trick – one of many – is perfectly legal. It’s how it is supposed to be done. And that makes it even more insidious.

The S&P 500 companies account for about 75% of the US equity market capitalization. So when aggregate revenues of the S&P 500 companies rise or fall, it’s an important indicator as to what is happening in the US business scene. It’s also a gauge of the global economy since many of these companies derive their revenues from around the world. So we pay close attention to it.

With 87% of the S&P 500 companies having reported first-quarter results so far, according to FactSet, revenues fell 1.6% from the first quarter 2015, when revenues had already fallen from Q1 2014. It’s the fifth quarter in a row of year-over-year revenue declines. The revenue recession continues.

But it’s actually worse than that.

For example, Telecom Services. According to Wall Street data, revenues in the sector soared 11.2% year-over-year. FactSet cautions that the biggest – or rather only – contributor to growth was AT&T, which reported $40.5 billion in revenues, up a dazzling 24%.

Alas, AT&T is a slow-growth or no-growth behemoth. So it acquires companies to grow its revenues. The last big fish it caught was DirecTV, whose revenues now adorn AT&T’s income statement. But DirecTV wasn’t included in the “Telecom Services” sector before the acquisition. The acquisition brought it and its revenues into the sector.

Without that one deal, year-over-year revenue growth in the Telecom Services sector would have been a nearly invisible 0.3%. The dazzling revenues growth of 24%? A mirage caused by M&A.

AT&T’s acquisition of DirecTV combined two S&P 500 companies into one and put both their revenues under one ticker symbol (T). This made room in the S&P 500 index for another company.

So Signet Jewelers was added to the index last July to fill that vacant slot. In the fourth quarter, this addition inflated S&P 500 revenue growth by $2.4 billion year-over-year. But not a single extra thing or service was sold to get that “revenue growth,” and there was zero impact on the economy.

The same thing happened when Broadcom was acquired by Avago. Both were S&P 500 companies. After the acquisition, their revenues were combined, and in February, the slot left vacant by Broadcom was filled by Federal Realty Investment Trust, whose revenues of $2.4 billion for the quarter were added to the aggregate revenues of the S&P 500 companies, thus generating $2.4 billion in year-over-year “revenue growth” for the index, and zero for the economy.

The US has been through a multi-year merger boom with hundreds of acquisitions over the past years that inflated S&P 500 revenue growth, earnings growth, and all kinds of other metrics.

So far this year, 12 companies were added to the index to fill vacant slots, which had opened up for two reasons:

  • 8 slots: other S&P 500 companies acquired 8 companies that had already been in the S&P 500, such as Broadcom’s acquisition by Avago.
  • 4 slots: Tenet, Gameshop, Ensco, and Fossil Group were kicked out of the index.

The 12 companies that were added had combined revenues in their last reported quarter of $16.5 billion. The four companies that got kicked out had combined revenues of $10.4 billion (including Tenet’s $5 billion). The difference: $6.1 billion.

In other words, these transactions had the net effect of adding $6.1 billion to S&P 500 revenue growth without a single extra thing having been sold. The net effect on the economy was zero. The net effect on investors was that they were duped.

In the second half last year, $7.0 billion of this sort of hocus-pocus revenue growth was added to the S&P 500 companies. It has been going on quarter after quarter, year after year, and is starting to add up. But that’s only part of it.

S&P 500 companies also acquire companies that are not in the S&P 500 index. These might be smaller companies, privately held companies of all sizes, or even large foreign companies that had been traded on foreign exchanges. Each acquisition brings these acquired revenues into the S&P 500 index and inflates its “revenue growth” — though they do zero for the overall economy.

This is only one of the many gears in Wall Street’s well-oiled hocus-pocus machine. Among the other gears are share-buybacks funded with debt, “ex-bad-items pro-forma earnings reports, and fanciful accounting. They’re all designed to make investors’ head spin.

“All it takes is a couple of big tech companies folding and the floodgates open, causing the sublease market to blow up, rents to drop, and new construction to grind to a halt.” Read…  “Market is on Edge”: US Commercial Real Estate Bubble Pops, San Francisco Braces for Brutal Dive

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  36 comments for “How Wall-Street Hocus-Pocus Inflates S&P 500 Revenues

  1. OutLookingIn
    May 9, 2016 at 1:04 am

    This “Three Card Monty” financial economy should not surprise.

    Avarice, greed, hubris, fraud, malfeasance, corruption, etc.
    It’s all there in the financial/politico system.

    This is what has become now known as the “new normal”.
    The general populace at large has begun to wake up and stir.
    It does not like what it see’s. Not one bit. And is now angry.
    This anger has manifested itself in the political arena.
    Soon to grow and blossom against those in finance, whom will be held responsible for their egregious past actions, that have ruined so many.

  2. Agnes
    May 9, 2016 at 1:39 am

    “Sell in May, Go Away. ” This is like the 97% average return promised by some casinos….a warning….

  3. Toddy
    May 9, 2016 at 1:46 am

    Wiley E. coyote still walking on air…

  4. Jungle Jim
    May 9, 2016 at 2:19 am

    There is no doubt that finagling earnings it is widespread, but there are ways to check, especially so by cross comparing the Statement of Cash Flows to the Income Statement. The padding is usually evident in the adjustments. What worries me more than padding income is hiding debt off the Balance Sheet. That’s what sank Lehman and Enron. I suspect that there is a lot of it now.

    The corporate debt loads may go a long way toward explaining the Fed’s reluctance to increase interest rates.

  5. Agnes
    May 9, 2016 at 2:39 am

    There is a relatively new U.S. (February) law that creates a watch list for forex markets. (It must surely REALLY mean fear that the forex swaps are out of control). It has no teeth at all…surely it can’t be there merely to punish the “many … companies deriv(ing) their revenues from around the world.” .

    • d
      May 9, 2016 at 5:36 am

      “There is a relatively new U.S. (February) law that creates a watch list for forex markets.”

      can you expand on that a bit or are you talking about. This deal

      Which is a new currency manipulation watch-list.

      • Agnes
        May 9, 2016 at 7:20 pm

        d Yes, that is the “currency manipulation” to which I referred. Supposedly it is to prevent the “race to the bottom”(and to “protect American jobs”) but I think that is the pretty-girl-skantily-dressed…I think the big banks want some control over the spikes in currency trades sure to come. Brexit, for example, might cause some waves in the derivatives market. The derivatives are still highest in number/amount for forex (far larger than credit default or commodities). It is also interesting that the timing happened right before China started quoting gold and sludge in yuan/renminbi…what are they scared of…a “barbarous relic”? :)

        • d
          May 10, 2016 at 3:21 am

          This watch list will not effect Forex in the retail as you see, I believe.

          The O bummer administration has finally realized ( Or is pretending it didnt know) that for the last 20 + years china in particular has been blatantly manipulating its currency, to destroy American and European industry’s.

          The purpose of it it to send a message .

          This time you take your own hit, you made for yourself, instead of exporting your deflation to The US, through unfair competition.

          Combine it with the Anti inversion legislation, and perhaps O bummer is taking a shot at the globalized Vampire Corporates that are allies of china, yet claim to be American.

          O bummer dropped 10 B of taxpayer money in the GM Stock deal.

          Now GM pays 5m to the US IRS and 980 + M to chinese IRS, in the same year.

          O bummers unions arent happy about that, or than GM is importing Buick’s from china, to America.

          GM may be the straw, that finally made the camel, scream in anger, TOO MUCH.

          Chinese gold fixing gives them, the ability to manipulate their currency and say they aren’t, if they manipulate it against gold as well. It is also part of teh game of displacing the $ as a reserve.

          China wants that status so it can print as much as it likes, when it likes. And ram it down the worlds throat.

          The children Of Mao are, Malicious, Vindictive, Arrogant, Propoganda blinded, Racist, with no Morals, Manners, or Ethics. Worse their hearts arefilled with the blood lust for vengance much like the french post 1870. Which caused 2 world wars. Both of which france lost in, badly.

          China is a bit bigger than france, it acts with evil intent, just as france did after 1870, so will fare no better. How much damage will it do the the planet in the process is the question

          The chinese gold fixing, is like the mainland closed shop stock casino, propaganda, there is no, and will be no, CNY gold window.

          Gold is not a relic, at 1300 US an Oz, it is a ponzi for idiots.

          Look at the divergence silver gold since 1945.

          When the divergence unwinds. Maybe buy some physical gold, until then, trade the paper GLD on margin, if you can Sync with the trend.

          I avoid GLD/XAU as it is too manipulated.

          A shooting war is coming involving china, If japan and America are lucky, they will be able to keep it as a proxy war.

          Are you aware china just brought Asean. By intimidating and Buying the vote of Cambodia and Laos, so that the Philippine sea issue, can not be discussed at Asean, unless on chinas term’s. Asean is now a waste of time nothing put a chinese propaganda puppet.

          Anybody who holds CNY, deserves what will happen to them, it would be more intelligent to hold Rubble’s.

  6. Jerry
    May 9, 2016 at 4:40 am

    Thank you Wolf, another quality interesting article.

  7. Vlad T Impailer
    May 9, 2016 at 4:58 am

    The real question that one should ask about any company is what is the Book Value per share. Now of course if there was only one share out standing for the entire company , the book value per share would be the net asset value of the entity. It tends to be quite unwise to pay too much more than then net asset value for any company. Scamstreet knows this as well. But like most Carnival Barkers that engage in shell games they mislead the most uninformed, who also tend to be found giving their money away to the collection bins found in the lairs of religious organizations and then one day the group of suckers is told that their Pastor has had a failing due to his obsession with pornography and also his inability to control himself from having multiple affairs.

    • robt
      May 9, 2016 at 2:08 pm

      Balance sheets can also be inflated with goodwill, so be careful unless you mean net asset value to be net of goodwill. A few years ago Yellow Pages was a good example. 6 billion dollars just vaporized over a couple of quarters, changing the book value per share from multi-dollars to multi-pennies.

    • ML
      May 10, 2016 at 1:38 am

      NAV is usually only a matter of opinion. With property companies, for example, valuers base their opinion on market sentiment at the time. The fundamental value regardless of sentiment is ignored.
      The theory of NAV is that it the price the company would get per share if stipped bare. As another has rightly said, goodwill must also be excluded. Whether there would in fact be anyone in the market willing to pay the bare price is a moot point. When I am presented with NAV I knock off at least 10-20% to get a more likely figure.

  8. d
    May 9, 2016 at 5:51 am

    This is why I trade the S&P as an index (With across the board success) but dont hold any stock in it.

    I have no faith in, Banks, Stocks, Bond/Treasurys, Gold, or retail urban property, to store my excess liquidity. And no faith in useless art or antiquity’s (Apart from <19 Th Century, Samurai Swords)

    It is a very difficult.

    • d
      May 9, 2016 at 6:10 am

      Should read 19Th >

  9. Chuck
    May 9, 2016 at 5:52 am

    It is not a trick or anything unfair. Aggregate SP 500 revenues must be calculated as they are. There is no other option. EPS is adjusted for M&A, buybacks, stock dilution etc. It is accurate.

    • May 9, 2016 at 8:18 am

      That makes it so insidious: as I said in the article, it’s the way it is “supposed” to be done. And yet it ends up giving falsified information on revenue growth that then in its falsified manner is used to justify stock market valuations.

      If no one ever mentioned S&P 500 revenue and earnings growth, it wouldn’t matter. But these metrics are constantly used to support valuations.

    • d
      May 9, 2016 at 9:58 am

      Yes but it is deliberately distorted in Propaganda releases, to say other than what it really does.

      Its growth is touted as evidence of economic growth, when really as wolf points out, the true peoples economy, is going sideways, or down.

  10. Kevin Beck
    May 9, 2016 at 6:59 am

    I am sick of having to do my own accounting adjustments to undo the sloppy “pro-forma” statements that are being released as headline sales and earnings reports and being touted as such by the Wall Street money scheme. Not that I object to management presenting alternate earnings calculations within their reports; just don’t report those numbers as actual.

    I first encountered this scheme back in the Berkshire Hathaway 1988 annual report. There was a separate page that showed Mr. Buffett’s analysis of how he viewed the diversified company’s earnings. It clearly was labeled as such, and was not used as reported earnings in any way. And it may not have been the first instance, but I have encountered too many ever since.

    I believe it is acceptable for management to include in their shareholder reports so-called alternate earnings models. But these should NEVER be promoted by anyone in any other forum. There’s a reason we have Generally Accepted Accounting Principles: To provide a consistent way of measuring earnings and asset values between different companies and different industries. We do not need to destroy the building block that is GAAP just because there are some intrepid fools that think they can dream up better reporting rules, because GAAP actually works.

    If management feels the need to show shareholders the secret sauce for creating their own behind-the-scenes metrics, then keep it limited to the company reports. And outsiders should not be touting these numbers, because there is no evidence of consistency among them.

    • walter map
      May 9, 2016 at 7:32 am

      Now you know why GAAP stands for “Generally-Avoided Accounting Principles”. Now really, if they just came out and told you the answers it just wouldn’t be any fun.

      But as usual, it gets worse. Most, if not all, publicly-traded corporations keep two sets of books, one for investors, and one for tax purposes. Guess which one is the rosy scenario, and the other as bleak as possible.

      One could surmise that the present state of equity pricing and tax revenues would be substantially different if the roles of the two sets could somehow be reversed.

      In all, accounting is a two-edged sword, and both of them cut. And then there’s the pointy end.

      • ML
        May 10, 2016 at 1:50 am

        I appraise private company accounts. Invariably when the company wants to be accepted as a tenant its director will say the accounts are for tax purposes but the reality isn’t like that. But the company cannot have it both ways. It is either making a good profit as the director claims or it is trading while technically insolvent as the accounts suggest.

  11. Bigfoot
    May 9, 2016 at 8:12 am

    There’s been over 320 companies since 1980 that have been dropped from the S&P & over 420 since 1957 when the list first grew to 500 stocks. The DJIA does the same thing but it’s price weighted so large movements in a few of the highest values companies can create outsized movements in the index. Here’s a historical list of DJIA companies. If you look at the deletions over the years, it’s evident they try to keep it looking ‘good’.

    Thanks for showing some of the financial metrics involved with the recent changes, it really shows what the game is. What I would like to know is the mechanics behind the actual S&P selection. What are the member names? Is there a list of the committee members that make these changes. David Blitzer is the chairman but I haven’t been able to find any other data. I’ve often wondered who are the actual people behind their ratings game too.

  12. Justme
    May 9, 2016 at 11:15 am

    Thanks for pointing out earnings misrepresentations related to the re-jiggering of S&P500, either by dropping/adding companies outright, or by adding companies when two S&P500 companies merge. But in addition to the dishonest accounting of the earnings, is there also not a problem with not accounting for the losses that are incurred when a real investor (or index fund of any kind) must sell the dropouts and buy the newcomers after the announcement of the adds/drops have been made? This is something that has been bugging me for a long time, from before it became popular in the press to publicize S$P500-wide earnings measures provided by Wall St.

    Also, what would be a good system for handling these issues? To force index publishers to provide multiple sets of index values and earnings numbers for each , one with old membership, one with new membership, one with merger-related additions excluded? Maybe one where added companies do not get to have their earnings included except for quarters that are wholly after the inclusion? One where excluded companies losses (or earnings, although losses seem more likely) must be included up to and including the quarter during which they are dropped from the index?

    • Bigfoot
      May 9, 2016 at 3:20 pm

      Link to s&p & gives the calculation methodologies involved. As far as the weighting calculations, they use a lot of different divisors based on many factors. The process is proprietary so we don’t really know for sure exactly how they come up with the weighting. They give you an approximation of what they do, that’s it.

      I had read that when a company is added/dropped they will often stick with the old companies weighting but not always. I guess the answer to your question is they are doing all the calculations for you. As far as individual losses to traders or funds on dropped companies, you don’t get that because you are trading the overall index. Those losses would only be incurred for traders/funds invested in the individual stocks. The index itself isn’t actually buying or selling anything (other than information), just tracking the group for the etf’s, etn’s, or futures that do trade it.

  13. May 9, 2016 at 1:22 pm

    One suggestion is to require the companies reporting earnings to use their net taxable income as reported to the IRS, and use this figure to calculate metrics such as earnings per share, executive performance benchmarks, dividends, bonuses, etc. thus eliminating much of the rationale/motivation for keeping multiple sets of books.

  14. Chicken
    May 9, 2016 at 3:25 pm

    When my broker decides to stop covering a stock they take down all previous references, analysis and guidance for said stock. As if the stock was never analyzed.

    • d
      May 9, 2016 at 5:38 pm

      That says you need a new broker.

      As having made money from pushing what has become a dog. they now wish to erase evidence of what they did with it.

      Probably to the detriment of their clients and the benefit of their pockets

  15. walter map
    May 9, 2016 at 4:01 pm

    Market fundamentalists will assure you that any kind of financial regulation is not only unnecessary but extremely undesirable, because legal regulation interferes with the inscrutable automatic regulation conducted by Mr. Market and his Invisible Magic Hand.

    What they don’t tell you is that they’re pirates who keep Mr. Market in manacles in a dark dungeon and that the so-called Invisible Hand is a mailed fist.

    • walter map
      May 9, 2016 at 4:10 pm

      When Adam Smith advocated for ‘free markets’ he wasn’t promoting a financial free-for-all. He was deploring how the mercantilists of his day had markets so rigged they were essentially locked down to guarantee their own profits, to the detriment of anybody else who also wanted to play in the sandbox.

      Even Milton Friedman eventually figure it out, but it took him fifty years.

  16. Bruce
    May 9, 2016 at 4:47 pm

    You wrote:
    “This is only one of the many gears in Wall Street’s well-oiled hocus-pocus machine. Among the other gears are share-buybacks funded with debt, “ex-bad-items pro-forma earnings reports, and fanciful accounting.”

    Question: FASB Rule 157 (mark to market accounting) was suspended. Did it ever get reinstated?

    Related articles:

    Albert Edwards: “Let Me Tell You How This All Ends”

    “In addition to Edwards reality check, Andrew Lapthorne, SG’s quant guru, has been flagging the following chart to clients… Firstly, we all know by now [wink, wink, nudge, nudge] that US companies consistently put the most optimistic spin on earnings to gratify both analysts that follow their companies and investors who want to hear good news. These manipulated earnings are what is reported each quarter and referred to as pro forma earnings. Andrew points out though that even moderately ‘scrubbed’ MSCI trailing operating earnings have been falling away precipitately in the US (this is a moderate scrub as opposed to a heavy scrubbing as defined by the EPS reported on a GAAP basis). This ties up exactly with what the whole economy profits data is also telling us. Most notably the current divergence between trailing operating profits and pro forma measures only normally occurs as a recession begins to unfold. This matters because the stock market eventually stops reacting to the manipulated pro forma earnings and slumps in line with what is really happening under the bonnet (or hood for my US readers).”
    Glenn Reynolds: Don’t let U.S. become next Rome
    Glenn Harlan Reynolds 6:03 a.m. EDT May 3, 2016
    Entrenched political elites will sacrifice anything to retain power, including their own country.

    “Because political leaders’ chief concern is their own power and position, they’re willing to do almost anything to stave off a collapse, except reduce their own power and position. Kicking the can down the road usually just makes the problem worse in the end, but politicians would rather do that than make any sacrifice up front.”

    Hence the deception now rampant in both the public and private sectors. Nothing substantive, only can-kicking.

  17. ralph
    May 9, 2016 at 4:50 pm

    Every time I read an article like this, I stop for a moment and appreciate the fact that I live in a country that protects free speech (mostly). That is the best chance we have for uncovering this kind of crap. Thanks, Wolf, for exercising your free speech!

  18. walter map
    May 9, 2016 at 5:17 pm

    “I live in a country that protects free speech”

    Corporations are allowed to lie to investors because it is considered a promotional activity, and as such is considered protected speech. No, really.

    The price of freedom keeps going up but the quality keeps deteriorating.

  19. Uncle Frank
    May 9, 2016 at 5:18 pm

    Meanwhile, the forecast is for “blue sky” ahead…

    As companies share their expectations for coming months, the proportion of raised forecasts to those that are lowered is the healthiest it has been since 2011, according to Thomson Reuters data.

    Technology and healthcare sectors are leading the way with forecasts that are even rosier than those of most analysts, including from Adobe (ADBE.O) Stryker (SYK.N) and Baxter International (BAX.N). But they are not alone.

  20. Julian the Apostate
    May 9, 2016 at 6:15 pm

    As a former StarTrek fan (I opted out when J.J. Abrams gutted Rodenberry’s creation in 2009) I am reminded of the Kobiyashi Maru no win scenario at Starfleet Academy. Defined as a test of character, there is no correct answer. Kirk was the only student to beat it by changing the computer’s programming to let him win. Since there was no rule against it his success stood. The only other students to beat the scenario was Hikaru Sulu who did not violate the Neutral Zone, and Mackenzie Calhoun who blew up the Kobiyashi Maru and fled back to his side of the border.
    So how does this relate to Wolf’s article? To survive the S&P no-win scenario you must change the rules, or not get sucked into it in the first place, or blow it up. LLAP

  21. walter map
    May 9, 2016 at 6:29 pm

    “I opted out when J.J. Abrams gutted Rodenberry’s creation in 2009”

    Good man. The revisionist history is uninspired.

    Any clue as to when Earth was invaded by Ferengis?

  22. Julian the Apostate
    May 10, 2016 at 3:00 am

    Probably when they fled from socialism back home.😖

  23. Kevin
    May 11, 2016 at 3:20 am

    Terrific analysis. Great work.

Comments are closed.