The magic of Consensual Hallucination.
The simple fact is that corporate earnings data is out there for everyone to see, but no one wants to see it. Instead, everyone wants to see and believe the sweet fairy tale that Wall Street and Corporate America spin with such skill just for us, because if everyone believes that everyone believes in this fairy tale, even knowing that it is a fairy tale, it will somehow lead to ever higher stock prices.
This is part of a phenomenon we’ve come to call “Consensual Hallucination.”
But that fairy tale got spun to new fanciful extremes in 2015.
Revenues of the S&P 500 companies fell 4.0% in the fourth quarter and 3.6% for the year, according to FactSet, with most of the companies having by now reported their earnings. And these earnings declined 3.4% in Q4, dragging earnings “growth” for the entire year into the negative, so a decline in earnings of 1.1%.
While companies can play with revenues to some extent, it’s more complicated and not nearly as rewarding as “adjusting” their profits. That’s the easiest thing to do in the world. A few keystrokes will do. There are no rules or laws against it, so long as it’s called something like “adjusted earnings.” The rewards are huge, in terms of share prices, stock options, bonuses, and for Wall Street, fees. The ultimate target of the magic is earnings per share. EPS is the most crucial term in the canon of the markets.
Turns out, the 2015 “growth” in earnings, and particularly the “growth” in EPS – so a decline – as reported by FactSet and others is a figment of the vivid imagination of Wall Street and Corporate America, called “adjusted earnings,” where everything bad has been “adjusted” out of it.
The reason every developed economy uses standardized accounting rules is to give investors a modicum of insight into what is going on in a company, compare these numbers to those of other companies, and make at least not totally ignorant investment decisions.
In the US, these are the generally accepted accounting principles, or GAAP, the most despised acronym of Wall Street and Corporate America. Yet even these principles offer plenty of flexibility for financial statement beautification. We get that.
Yet they’re way too harsh for Wall Street. So companies file the required financial statements under GAAP for everyone to look at, but then they hype their “adjusted” earnings in their communications with investors. And the gap between the two in 2015 was a doozie.
For example, of the 30 components of the Dow Jones Industrial Average, 20 reported “adjusted” earnings, with 18 of them reporting adjusted earnings that were higher than their earnings under GAAP, according to FactSet. That 18-to-2 relationship alone shows the clear bias of these adjustments: They’re used to inflate earnings, not to lower them to some more realistic level.
These adjusted EPS were on average 31% higher in 2015 than EPS under GAAP. That’s way up from 2014 when 19 of the Dow components reported adjusted earnings that were on average 12% higher than under GAAP.
And yet, despite the soaring portion of fiction, these adjusted EPS of the companies in the DOW still declined 4.8%. That’s bad enough. But under GAAP, beautified as it might have been, EPS plunged 12.3%.
The biggest sinners?
Merck & Co. won hands-down: it reported adjusted fictional EPS of $3.59 for 2015; but under GAAP, its earnings dwindled to $1.56 per share. Its elegant adjustments inflated EPS by 130%! You’d think it would take some balls to somehow get this by keen-eyed Wall Street analysts. But no. Wall Street ate it up. Consensual hallucination.
GE reported EPS of a measly $0.17 for the entire year 2015 under GAAP, but once it got through with excising all the bad stuff, EPS jumped 106% to $0.35. OK, that’s still crummy….
Our tech-darling Microsoft reported EPS of $1.48 under GAAP, and so its financial-statement beauticians set out to do their magic and adjusted them up by 78% to $2.63. Pfizer inflated its EPS under GAAP of $1.24 by 77% to $2.20. And United Technologies, in this elegant manner, raised its EPS by 40% to an adjusted $6.30.
These are among the most established members of Corporate America. Other companies, which were not part of FactSet’s report, were much more extreme.
For example, Twitter lost $0.13 per share under GAAP in 2015, but reported “non-GAAP diluted income per share” of $0.16. Tesla, which is sinking into its own endless sea of red ink, lost $6.93 per share in 2015, but when it got through beautifying the results, its “net loss was $2.30 per share on a non-GAAP basis.”
But there are more layers to this onion. FactSet used earnings from “continuing operations,” when companies provided that number. Companies frequently shed units. GE has gone through a historic binge of that in 2015. And under this “continuing operations” principle, any detrimental earnings numbers that were incurred by a division before it was disposed of would be excluded. So FactSet’s numbers cited here still don’t reveal the true extent of the EPS decline.
And there is another layer to this onion: EPS have been further inflated via adept financial engineering, including heroic share-buybacks with borrowed money at peak prices in 2015. Buybacks reduce the number of shares outstanding, and thus increase earnings per share, even under GAAP. Everyone knows it, and everyone loves it. No one wants to see reality, which is too ugly to behold. Consensual hallucination. And certainly, don’t peel the onion.
So if corporations can’t produce the earnings needed to push this market higher, central banks will have to do that job, at least that’s what Draghi seems to be thinking. But he still doesn’t get it. Read… Bundesbank Fears “Doom Loop”
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