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Posted 8/12/2002
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Contrarian Chronicles
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Swapping lies around the campfire
It's hard to sing 'Kum Ba Ya' when the tall-tale tellers are hogging the talking stick -- as if we all hadn't heard 'Dow 36,000' a zillion times before.
By Bill Fleckenstein
In the spirit of summer, the Contrarian Chronicles is proud to host its inaugural virtual campfire. Just gather round your flame-retardant PCs and prepare for a round of storytelling.
Like a ghost tale? How about the case of phantom demand in tech land? A fish tale? That would be the GDP number that got away, down the black hole of revisions. And for you science-fiction aficionados, steel yourselves for . . . Dow 36,000. So, by all means, help yourself to a pro forma marshmallow and let's begin.
Tech line dancing features familiar sidestep
For those readers unfamiliar with the dance known as tech guidance, this week's Contrarian Chronicles begins with a look at the widespread sidestep. Exhibit A: National Semiconductor (NSM, news, msgs), which recently announced that it was lowering guidance for the quarter, ascribing most of the trouble to June. But what emerged pretty clearly from the call is that the PC business is weak. Of course, they tried to say, as executives often do, that things have improved in the last couple of weeks. Mind you, that is always the standard line when announcing bad news: just 15 minutes or two weeks before the call, things have suddenly turned around.
Not surprisingly, a few dead fish were trying to find the pony in the room as they inquired about back-to-school. At least the executives at National Semiconductor were kind enough to point out that if you're a components supplier to people who are going to sell things to OEMs for back-to-school, that build is over. National Semiconductor acknowledged the basic hope that its OEM customers could sell enough stuff to necessitate reordering for Christmas, and that perhaps it could expect next quarter to be better. Well, given how I expect the economy to play out, and given my expectations for technology spending in general, I would not be willing to make that leap of faith.
Presoaked in saltwater skepticism
Faith in the economic data du jour, on the other hand, remains alive and well. A few days back, the market was smacked by the release of rather disappointing economic data, and that had people worked up somewhat needlessly, in my opinion. One only has to look at the sizable GDP revisions announced recently to see why a lot of the economic data should be treated with a grain of salt -- witness the downshift in two of last year's quarters from positive to negative GDP growth. That should be a warning for anyone not to read too much into the economic data reports. And now it should be clear that numbers situated to the right side of the decimal point achieve legitimacy solely by demonstrating the sense of humor in those who construct the data.
At some point, I think people will realize that the only thing more squirrelly than corporate data is government data, especially when it comes to how the deficit is calculated. In any case, before this bear market is over, maybe even government numbers will be more accurately calculated. A guy can hope, can't he?
Monthly 'statements' prompt questions
As long as I am compiling a wish list, I might also put in a request for the end to end-of-the-month ramp jobs. That's what seemed to flavor the closing action recently when, with approximately an hour to go, the S&P and the Dow staged about a 2% rally after the market had been under pressure all day. As to the cause of the rally, I could see no apparent reason, other than that this was the end of the month -- the fundamentally correct time to buy stocks. Someday, when we are done with all the investigations, it would be nice to know whether these end-of-month and end-of-quarter ramp jobs were a figment of people's imagination, or actual occurrences. I'll leave it to the reader to decide.
In any case, mundane as it might sound, I only bring up tape-painting because it's just part of what all goes toward undermining the integrity of the market, and, if we're going to try to clean things up, in my opinion, we ought to clean up everything. It's worth noting that the big scandals now unfolding did not spring out of a vacuum -- they were market-related ethical issues, degraded an inch at a time. Or, in the words of the SEC's chief accountant for enforcement, Charles Niemeier, "Most of the problems we see begin in the subtleties."
Scrutiny on the bounty
This quote comes from a very good article that ran in The Wall Street Journal recently called "Meeting Expectations Used to Draw Favor, Now It Invites Scrutiny." The writer offers some worthwhile data about the percentage of companies that made the number by a penny, etc: "In the first quarter of 2001, at the market's peak, 21.4% of S&P 500 companies reported earnings as expected, 16.6% beat those expectations by a penny, and 11.8% beat by two pennies, according to Multex.com. By contrast, only 5.9% missed by a penny, and 3.7% missed by two." So, one can easily see that about 50% of the companies made or beat the number by a penny or two. Isn't it interesting to learn how pervasive the practice of earnings massage has been?
But the breadth of these statistics is nothing compared to the shocking part about this story-within-a-story. In the course of describing the earnings game, the writer quotes one Walter P. Schuetze, former chief accountant for the SEC's enforcement division from 1997 to early 2000: "I saw companies regularly making their earnings estimates by all kinds of earnings management." You heard that correctly, ladies and gentlemen -- the fellow in charge of enforcement acknowledged that he and the SEC knew about the ruse. So, why didn't the SEC bring any action against these companies? What were they doing, playing solitaire? I'm happy they knew, but I'm pretty distressed that the end result of awareness was inaction.
Shattering optical delusions
One CEO who has steered his company clear of the shenanigans in corporate America is Dr. Robert Shillman of Cognex (CGNX, news, msgs), and I just love him for his candor. (For those who don't know, Cognex is a manufacturer of optical inspection equipment.) In the company's recent announcement, he described the difficulty of laying off employees, reserving some rather strong comments about the economy and what he expects going forward. Shillman was most vocal about other CEOs who continue to whistle past the graveyard and/or tout their businesses when perhaps they shouldn't. I would just point out that since about 60% to 70% of Cognex's business is semiconductor/electronics, semiconductor-equipment bulls ought to pay particular attention to the observations from this man.
Shillman said, "This has been an especially difficult decision for us because these are hardworking, experienced and dedicated employees. At the start of this downturn, we chose to absorb losses in order to preserve the jobs of these highly valued employees. However, after three quarters of such losses, we have concluded that this slowdown is likely to continue for an indeterminate [the italics are mine] period of time and, therefore, that it is prudent to reduce our expenses to be in line with the current level of business, in order to return the company to profitability as soon as possible."
He continued: "Many CEOs would follow bad news such as this with comments similar to the following: 'In spite of this downturn, we remain confident about the long-term future of our business, and I am confident that we will emerge even stronger, and better and leaner, than we have been in the past.' But in my view, that is simply wishful thinking; there is little reason for optimism today.
He concluded: "My colleagues and I have spent the better part of our lives building this business, and it is very painful for us to dismantle parts of it today. However, our customers, employees, and shareholders should be comforted by our perseverance and by our very strong balance sheet, both of which ensure that we will make it through these very challenging times . . . irrespective of their duration." To this, I would only add my hope that such candor becomes a staple of guidance in corporate America.
Tied knots 'n tea leaves
Segueing from sources of corporate candor to corporate creativity, I'd like to share an observation about IBM's recent decision to buy PricewaterhouseCoopers Consulting. What's significant here is the purchase price, about 71% of PWC's sales, and what that means for IBM's valuation going forward. When you add the company's market cap of $140 billion (including its debt of $20 billion), and then compare this with its revenues of about $80 billion, you can see that IBM trades at about 175% of sales. So, the price that it paid for PWC, I would argue, is probably a good indication of where IBM will ultimately be valued, which would put it in the $40s.
While in the valuation arena, let's tarry a moment to discuss the Dow 36,000 theory, which James Glassman recently celebrated again on the Op-Ed page of The Wall Street Journal. In this piece, for which "They Have No Shame" would have worked as a subtitle, he basically tried to say that his crystal ball was accurate and that somewhere down a rather unspecified road, the Dow would be fully valued at 36,000. Well, you know, someday the market will be at 36,000. It might be 100 years from now. But to try to fall back on the spurious notion that 36,000 is what it would take to make it fully valued is unremittingly clueless, because anything above 6,000 makes the Dow more than fully valued, in my opinion, and anything over its September 1999 level of 10,318 (when Glassman made his calculation) certainly does.
In any event, he went on to reprise how well stocks had done in the long term, without ever bothering to mention that about half of the long-term rate of return from stocks came via dividends. That was something noticeably absent when the Dow stood at 10,318 three years ago. So the chance of him being right was always about zero, from an intellectual standpoint. Obviously, as enough time goes by, the Dow will be far past 36,000, but that doesn't help anyone.
Pom-pomposity
Further into the piece, and showing an extraordinary ignorance of the process under way, he says, "What's remarkable is that, in spite of this, price/earnings ratios have remained higher than historic averages -- exactly what we expected." (Well, I would argue this is proof positive that we're not done correcting the excesses yet.) And from there, his argument devolves into pure nonsense: "Unfortunately, many politicians and journalists have a vested interest in spreading fear and chasing people out of stocks even though stock investing is the most reliable route to accumulating wealth."
That is the most childish, inane argument I have ever heard, and it's not easy to remain calm when reading it. Basically, what he is trying to say is, you know, were it not for all these "bad"-intentioned people, perhaps stocks would be doing better. It seems to me that most of the media and the politicians had the pom-poms out when stocks were going up. In any case, this is a good example of someone starting out with a losing premise and defending it all the way down.
Insufferable sufferin' succotash
Another orator who has the technique down pat is Al Gore, who recently penned an Op-Ed piece for The New York Times called "Broken Promises and Political Deception." He said, "Uncommon power has combined with uncommon greed to create immense deceptions and losses. Millions of average Americans have been victimized. So have thousands of honest American corporations and the people who manage them, own stock in them, and depend upon them for a livelihood, for sending their children to college and for their retirement."
Mr. Gore is attempting to blame Mr. Bush for the troubles associated with the stock market. Now, that is the irony of all ironies, since these problems took root and festered while Mr. Gore was vice president. I am not suggesting they are directly related to Mr. Gore, because I feel that many of them are related to the Fed and human nature. But for him to blame Bush is the height of lunacy, and outright brazenness. I guess that's just politics as usual. These days, it seems, the brazen bird gets the worm, to mix my metaphors.
Maintenance agreement
Well, that's it for the soapbox, and now I'd like to conclude this week's Contrarian Chronicles with a trading update. Though my positions are scaled back, I have maintained my shorts in a handful of different tech stocks because I am afraid to have these names get away from me on the downside. For any short-seller since the fall of 1998, the only way to stay alive has been to be very trading-oriented and to operate in guerrilla-warfare-like fashion. But I believe that at least with respect to technology, the short side will be more "investible" between here and the end of the year, rather than being so completely trading-oriented.
So, to repeat, I'm inclined to keep some shorts, even though I think the market could rally. I also attempt to hedge away some of the market risk by being long S&P futures from time to time, though I do not hold them now. That said, I pass along these tactics and ideas as food for thought, not as a recommendation for anyone to go out and get short. That's my take on how the environment is shaping up.
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At time of publication, William Fleckenstein owned none of the equities mentioned in this column. Positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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