Last Updated November 1998

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HAT DO YOU USE TO GAUGE the direction of the market? Some folks look at fundamentals such as corporate earnings while others look at the trading history of similar markets. Either way, you need to be careful if this is how you're making your investment decisions.

If you're looking at earnings, you might want to consider their quality not just their quantity. To see why, check out Creative Accounting. On the other hand, if you're more into voodoo, take a look at How Can I Tell When the Bear is Gone? It's one of our periodic looks at the wonderful world of technical analysis. Hey, it's better than tea leaves.

What do you think? Let us know. We can take it.

Creative Accounting

"Figures don't lie, but lies figure."

 

S THE MARKETS GROW DICIER investors look for something to hold onto, something to provide confidence that their selections won't melt away into the bear market. Earlier in the year, folks were content with promises of future performance as evidenced by the stampede into profitless internet stocks. Now with most stocks well off their highs for the year, everyone wants something a little more solid to hang their hat on.

As a result, actual earnings have become increasingly more important. Companies that merely offer the prospect of earnings in the next five years no longer command the same respect as those that are currently producing. And those that show increasing earnings are in still greater demand. One way to do this is to actually grow earnings. Another way is to play with the numbers.

This isn't limited to penny stocks or companies influenced by the mob. You probably own some companies that are doing some creative accounting. If all you do is glance at the earnings comparisons in the quarterly or annual reports, you'll never realize it. It's not disclosed in bold red type, but rather in comments usually appearing as footnotes. Equally important, it isn't illegal.

Call it aggressive or call it abusive, it just depends which side of the fence you happen to be on. Let's take a look at a couple of examples.

Just Say "Charge It"

Ever noticed the little notations about "nonrecurring charges" that appear in quarterly earnings reports? Ever wonder what the heck that is? In many instances, it's creative accounting. As the name implies, it's a special writeoff for expenses which are out of the ordinary. Often it's used when a company either acquires another or spins off an existing operation. In these cases, it records a one-time charge against earnings to reflect the expenses involved in the transaction.

OK, that's the way it's supposed to work, but here's how it often works:

1. At the very least, a reported charge makes it difficult (if not impossible) to compare the company's earnings to the comparable period. Did they do better or worse? It's pretty hard to tell.
    
2. If you know your company's going to have a loss this quarter, why not make it a big one? After all, any loss will be viewed negatively, so why not make it work to your future advantage? How? By overcharging, of course! Walt Disney pulled this one when it charged about five years of expenses and attributed them to "programming costs" when it purchased Capital Cities/ABC. In essence, expenses for the following years were taken in one period's charge rather than offsetting revenues in the appropriate periods. The result? Overstated, but quite positive earnings in the following years.
    
3. Nonrecurring charges can become quite recurring. This accounting procedure was designed to handle one-time expenses, but many companies seem to have this experience on a relatively frequent basis. Cendant made acquisitions and quarterly charges a regular, ongoing occurrence. As a result, no one really knows what they've earned.

Your Retirement Plan, Our Earnings

Believe it or not, a second source of creative accounting is the old corporate retirement plan. Now we're not talking about the 401(k) you're probably familiar with here. No, at issues is the traditional pension plan. This is the old type of employee benefit whereby the company guarantees its employees a certain percentage of their annual income each year in retirement.

To fulfill this promise, each year actuaries (folks who didn't have enough personality to be accountants) have to determine the benefits accrued by employees. They then compare them to an estimated earnings rate and inflation rate until retirement. If the funds in the plan aren't sufficient to provide these benefits, the plan is underfunded and the employer has to kick in the difference. If there's more than enough already in the plan, the plan's overfunded and the employer's off the hook for the year.

As before, the accounting maneuvers here aren't illegal (as in the recent Unisys case or even immoral as in the 1960's Studebaker shenanigans). They do, however, hide the true nature of the company's earnings. Most are made possible by the recent bull market. Here's two examples:

1. Overfunded balances in corporate pension plans can be recognized as profits if reported over a fifteen year period. In other words, if the fund's investments exceed the actuaries' assumptions for growth (usually 7% a year), the excess amounts can be treated as profits spread over the next 15 years. Any plan which as anywhere near fully funded in the past five years should qualify for this treatment.
    
2. Your government's contributions to corporate retirement plans often go directly to the bottom line. This can happen with any company that has government contracts and a pension plan. For example, the Defense Department allows contractors to bill it for contributions made on behalf of employees working on government contracts. Payments are based on the employees' current accrued benefits without regard to performance of the exiting pension plans. In years in which the plan's earnings exceed the current year's accrued benefits, the government's contributions are booked as revenues adding to the company's profits. A recent Bear Stearns study estimates that approximately 25% of Northrop Grumman's 1997 profits were derived in this manner, and projects that in 1998 this will jump to almost 40%. Don't think this is unique to Northrop.

To be sure, none of these creative accounting procedures are illegal. But at the very least, they're misleading. Earnings derived in this manner don't come from selling the company's widgets, but rather from accounting conventions that have nothing to do with the real world. Earnings may look good, but looks alone shouldn't be what you want to buy.

How Can I Tell When the Bear is Gone?

"When you want to test the depth of a stream, don't use both feet."

-- Chinese Proverb

 

VERYONE WANTS TO KNOW IF the market has reached the bottom. Timers need to know if it's time to get back in while long-term investors want to know if they should hold on or throw in the towel and sell. Several recent e-mails also asked this question.

This is a question for technical rather than fundamental analysis. Fundamentally speaking, a bear market should never have occurred (see September's True Facts in the Archives). Technical analysis is the study of market patterns as opposed to fundamental analysis which focuses on individual company's finances and economic conditions (see Fundamental Technical Analysis in the Archives).

OK, that said, let's take a look at some traditional technical measures of market bottoms.

Off the Charts

Our first chart shows its daily performance for 1998. It indicates the average has a support level around 7500 that was successfully "tested" in early January, early September, and early October. To a technician, the fact that 7500 held in each of these instances is good because it demonstrates the firmness of this support. This may be the bottom.

By the same token, if the bull market is to resume, the average needs to move through the "resistance level" around 8550. For the near term, this may be the point to watch. Theory has it that if the market fails to break through this level, it could indefinitely trade sideways between the support and resistance level.

Historical Bear Trails

It's a sucker's game because the underlying fundamental problems that led to the initial sell-off reassert themselves, taking the market back down to a new low. At that point, the market can trade sideways for quite some time. Trading usually occurs in a relatively tight range, establishing a new base to begin the next, sustained upward move. The painfulness of a bear market isn't determined by the initial or subsequent drops, but rather how long it remains at the lows. In 1987 the recovery was rapid with new highs in nine months. In the 70's the sideways market existed for the good part of the decade.

So how does the current situation fit into this particular scheme? Our third chart shows the Dow's performance from July 1. As you'll notice, it's pretty much true to form. The initial sell-off occurred in late July. The sucker rally in mid-August was quickly followed by another deeper sell-off carrying the market down to the 7500 support level. Since then, the market traded sideways until mid-October when it showed some signs of life. Is the bull market ready to resume or are we simply at the top of the trading range? Other technical indicators may shed some light (well, as much as any technical indicators do).

Turn Up the Volume

As you'll notice, volume was relatively low as the market topped in the late spring and early summer. It then increased as the market fell in September. This alone, would be a bad sign, but as the market turned up in October, volume continued to rise. To a technician, this is positive.

The Bull's Dying Breadth

Hello Low Highs

The chart at left shows the sharply declining number of new highs vs. the weekly close of the Dow Jones Industrials. If you believe in this stuff, it indicates the market has either reached or is very close to the bottom. Hold onto you tea leaves, only time will tell.