The Dollar Is In Trouble
John Mauldin's Outside the Box

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Introduction

This week we have a special double treat for Outside the Box. Peter Bernstein, the venerable editor of Economics and Portfolio Strategy, has sent two pieces our way. The first is a brief treatise on the dollar which appeared in the Financial Times the day before Greenspan's speech last Friday. It clearly points out the issues facing the dollar and the world if there is a lack of cooperation among nations. In fact, even with full cooperation, there could be quite stormy periods.

The second piece comprises research on the quality of earnings. Bluntly, you can't trust them, and the current system is working against shareholders. I know that is hardly a surprise, but the evidence of how the books get cooked is important.

Peter is the dean of economic writers. The first and long time editor (now serving as a consulting editor) of the prestigious Journal of Portfolio Management, Peter has been observing the investment world for almost 60 years, after serving as a captain in the Air Force in WW2. During his career, he has rubbed shoulders and influenced the movers and shakers in our world. He is the author of nine books on economics and finance plus countless articles in professional journals such as The Harvard Business Review and the Financial Analysts Journal, and in the popular press, including The New York Times, The Wall Street Journal, Worth Magazine, and Bloomberg publications.

His book, Against the Gods - the Remarkable Story of Risk is one of my top five, you gotta read it books. (www.amazon.com) His next book, Wedding of the Waters, due out in late January and which I am reading now, is a powerhouse of historical economic story-telling. (OK, it is nice to be able to get early review copies.)

You can find out more about my friend Peter by going to http://www.peterlbernsteininc.com/. His newsletter is a must read for serious investors and institutions. I would say he has forgotten more than most of us know, except at 80 plus years, he has not forgotten anything. I am proud to offer you his work today in Outside the Box.

The Dollar Is In Trouble

The dollar is in trouble, but it has been in trouble before. Perhaps the past holds the solution everyone seeks.

On September 22 1985, the ministers of finance and governors of the central banks of France, Germany, Japan, the UK and the US signed an accord at the Plaza Hotel in New York City. It stated that signatories "were of the view that recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been reflected fully in exchange markets...In view of the present and prospective changes in the fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to co-operate more closely to encourage this when to do so would be helpful."

Over the next two years, the dollar dropped by 30 per cent and America's deficit on current account began shrinking. By 1991, the current account was just about in balance. A neat job, elegantly executed.

Could we replay the Plaza Accord today? The case would be difficult to make. Aside from enormous differences in the magnitude of the economic problem, the political setting bears no resemblance to 1985. At that time, the ministers and governors who gathered at the Plaza were old pals, used to finding solutions to common problems. The western powers and Japan dominated the world, and everybody else genuflected before them. Today, the picture is far more complex.

On the economic side, the scale of the problem is daunting. The rapidly expanding US current account deficit is now more than 5 per cent of gross domestic product, as against only 2 per cent in 1985. Furthermore, the small surplus of 1991 was also the consequence of a recession in the US that curtailed the flow of imports even as exports kept rising - but the US slipped right back into the red as soon as recovery got under way. Helped by a 25 per cent appreciation in the dollar between 1991 and 2001, the current account deficit has been climbing ever since. In 1985, foreign official assets in the US were a fraction of what they are today; since the end of 2002, growth in official holdings has amounted to more than $450bn. In 1986, the price of oil dropped by 50 per cent; today, the concerns are just the opposite.

In many parts of the world, economic growth is excessively dependent on exports, which depend on a strong dollar. On the US side, the authorities welcome the willingness of exporting nations to finance America's appetite for imports, as it helps finance the federal government's bulging deficit.

But, as Herb Stein, the late economist, put it: "If something can't go on forever, it won't." Private capital inflows into the US are already shrinking. There is a point at which one or central bank or other will cry "Enough already!" and the house of cards will fall in. Indeed, China has already begun diversifying its foreign exchange reserves into other currencies and investments. Protectionist pressures are developing within the US, which - to borrow the Plaza Accord's words - "if not resisted, could lead to mutually destructive retaliation with serious damage to the world economy". At the same time, Americans are creating a setup for foreign nations to blackmail them over unpopular US policies by threatening to cease accumulating dollars, thus prompting the dreaded crisis.

There is, however, a vested interest around the world that firmly opposes "some further orderly appreciation of the main non-dollar currencies against the dollar". Many countries are hooked on exports rather than domestic demand as the engine of growth. Accumulating US government securities in such copious amounts is not exactly comfortable, but appreciation of their currencies against the dollar would be even more uncomfortable, as it would deprive them of their main economic stimulant. The important exception is China, which appears to be laying the groundwork for an eventual appreciation of the renminbi against the dollar.

Nevertheless, as Stein reminds us, the current situation cannot go on forever. The worst solution would be to yield to protectionist pressures in the US, which would immediately invite retaliation abroad. The optimal solution is a replay of the Plaza Accord - an orderly appreciation of the main non-dollar currencies against the dollar, which is a more generalised method of curtailing America's appetite for imports while spurring the development of domestic sources of growth in the rest of the world. Without such an accord, the outlook for an orderly dollar devaluation is dim.

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What's Below the Bottom Line?
The big trouble with earnings and the meaning of dividends

The second-quarter earnings announcement season has attracted as much excitement as ever, along with the usual erratic drops and leaps in stock prices. We wonder why investors pay so much attention to these announcements. Quarterly numbers have never been meaningful, and pennies of deviations from consensus or analysts' expectations reveal nothing about the future long-term earning power that ultimately determines equity values. All of that would be true even if the earnings announcements had high credibility - but they do not. Nor will the data ever attain credibility as long as investors require CEOs to perform high-wire pirouettes every three months in an effort to make the earnings numbers come out where investors hope they will be, and to dream up persuasive excuses for shortfalls.

We defend these assertions in the discussion that follows. The defense will not follow precisely in the order of sentences in the paragraph above. We begin with a few observations about investor obsession with quarterly earnings reports, even on the assumption that the reports are above reproach. We then turn to the matter of how investor fascination with quarterly earnings diverts managements into making less than optimal strategic decisions or even yielding to the temptation to manipulate the results. We devote most space to an exploration of how significant conceptual distortions have diluted the credibility of the earnings data investors receive.

How much attention do quarterly earnings figures deserve?

Quarterly earnings data, by their very nature, are fiercely volatile. In recent years, motivated by an insatiable urge to smooth the data, accountants and executives have concocted something with the auspicious title of Operating Earnings, which supposedly exclude non-recurring items and are, as a result, much smoother than reported EPS. But even quarterly Operating Earnings are too volatile to be useful.

The table below shows mean quarterly percentage changes for reported and Operating earnings, standard deviations around those means, and mean absolute changes for the period from 1988:1 to 1994:4 and from 1995:1 to 2004:1. The absolute changes are the more interesting numbers, because negative quarter-to-quarter earnings changes reduce conventionally calculated averages. In every instance, the standard deviations are large relative to the means, and the means of the absolute changes are all significantly larger than the conventional average changes.

All data are quarterly
1988:1 - 1994:4
1995:1 - 2004:1
Mean % change Reported EPS
4.0
15.7
Std devn % change Reported EPS
23.5
76.1
Mean absolute % chge Reported EPS
15.2
36.9



Mean % change Operating EPS
2.2
1.2
Std devn % change Operating EPS
6.5
8.1
Mean absolute % chge Operating EPS
5.6
6.7



Mean % change Price of S&P 500
4.0
-1.0
Std devn % change Price
6.4
9.4
Mean absolute % change Price
5.9
7.7

Compare the quarterly changes in Operating Earnings with the quarterly changes in reported EPS. The differences are huge. Just consider what accounting gymnastics must have been employed to engineer such gaping spreads between what purports to be the actual earnings and the earnings adjusted for nonrecurring events. For the twelve calendar quarters from 2000:1 to 2002:4, quarterly operating earnings summed to a total of $141.02. Reported earnings over the same period summed to $102.28. In four of those quarters, reported earnings were less than 60% of Operating; in one quarter, reported was only 25% of Operating. How can anyone convert such actual turbulence into such adjusted calm with even a suggestion of accuracy? Even if we take a leap of faith and accept these numbers as fair estimates, differences of a few pennies a share here and there between expected results and actual results can in no way justify the volatility in stock prices that such deviations routinely produce.

Furthermore, what we see here is seriously incomplete. The cost data that produced these earnings figures exclude charges for the expense of option issuance. They also omit adjustments for the overestimates of long-run pension fund returns that averaged over 9% during those years, about which we have more to say below. Accurate reporting of these two items could have reduced the earnings numbers in the peak years by as much as 20%. Perhaps most important, the announcements are always strangely silent about whether Operating Earnings are exceeding or falling short of the cost of capital. There is precious little information of value for the forces that shape stock prices over the long run to which so many investors pay such obeisance.

Second, compare the volatility data for Operating Earnings and for the price of the S&P 500. The numbers are astonishingly close. This array is eloquent testimony to the way short-term variations in Operating Earnings drive the stock market.

The losers in the game of meeting expectations

CEOs who regularly report quarterly earnings below expectations, or quarterly earnings showing wide variability over time, are likely at some point to lose their jobs. Too bad, but CEOs usually end up with pretty good severance pay, so we see no need to shed tears over that. The real losers are the shareholders because of the constraints and temptations this crazy system puts in the way of the company's management. We base this case on two National Bureau of Economic Research working papers published in June of this year. Both studies are worth careful reading.

"The Economic Implications of Corporate Financial Reporting", by John Graham and Campbell Harvey of Duke, and Shiva Rajgopal of the University of Washington (Working Paper #10550), reports on a survey of 401 financial executives plus in-depth interviews with an additional twenty executives on key factors influencing disclosures of reported earnings and other matters relating to earnings.

Here is their key finding: "Because of the severe market reaction to missing an earnings target...firms are willing to sacrifice economic value in order to meet a short-run earnings target." The market focuses so intensely on earnings rather than cash flow that a smoothly growing earnings stream appears to be management's prime objective and metric of successful performance. Seventy-eight percent of the surveyed executives would give up economic value in exchange for smooth earnings. Indeed, if the start-up expenses would mean missing a current quarter's consensus, 55% of these executives would even avoid launching a long-term project with high net present value. Delay in maintenance and advertising expenses is common if such activities might put a bump in the earnings numbers.

There is an irony here. These executives claimed they were generally reluctant to engage in accounting devices in order to manage earnings. Cooking the books to smooth earnings or exceed expectations is a no-no. But "burning" long-term earning power to those ends, to use the authors' expression, is an acceptable strategy. Yet there is no smooth route to create earning power and growth over the long run. The process is inherently uneven. Instead of soothing investors, smoothness and precisely-met targets should make them nervous and suspicious about the costs incurred in the name of regular growth rates and regularity in meeting earnings targets.

The second paper, "Earnings Manipulation and Managerial Investment Decisions: Evidence from Sponsored Pension Plans," by Daniel Bergstrasser and Mirir Desai of Harvard Business School, and Joshua Rauh of MIT Economics, has a blunt opening sentence: "Managers appear to manipulate firm earnings when they characterize pension assets to capital markets and alter investment decisions to justify, and capitalize on, these manipulations." The study uses data from Compustat, Securities Data Company, Pensions & Investments, and IRS Form 5500.

Return assumptions for pension plans appear to be systematically related to the degree to which such assumptions have an impact on reported earnings. Managers increase these assumptions when they aim to acquire other companies or when it is time to exercise stock options. In response to the increased return assumptions, shifts in pension fund asset allocations are so large that a 25 basis point increase in the assumed rate of return is associated with a 5% increase in the equity share of the total portfolio.

What, if anything, do investors know about a company's net worth?

In a world with no surprises, the annual increase in a company's book value would be equal to earnings less dividends, or what is frequently called reinvested earnings. In the real world, there are charge-offs and other types of nonrecurring events. We should therefore expect the actual figures for book value to grow more slowly than a calculated figure based on reinvested earnings without any adjustments. Over the thirty years from 1959 to 1989, as the result of the cumulative impact of nonrecurring charges, the actual book value of the S&P 500 declined to 89% of calculated book value, based on Operating Earnings minus dividends. Then the fun began. By 1999, the reported book value figure was only 74% of the calculated figure, for which, please note, we used Operating Earnings rather than reported earnings. By 2002, another seven percentage points had been shaved off the difference.

The haircuts to book value made return on net worth look handsome in those years, confirming the most optimistic views of the wonders of the New Economy. From 1994 to 2000, the ratio of Operating Earnings to book value soared nearly to 18%, compared to previous highs of around 14% and an average of about 12%. But without the accounting disappearance of big hunks of book value in the second half of the 1990s, return on book would not have reached 14% even in the best years. The write-offs that caused this distortion may indeed have taken recognition of the true state of affairs, but the bunching of these charges in such a short time period makes one suspicious of the validity of the book value data in the early years.

How do Operating Earnings compare with a concept of true economic earning power?

We now turn to a concept of earnings that we originally presented in Economics & Portfolio Strategy in our issue of September 1, 2002. We based our analysis on Nobel laureate John Hicks's commonsense definition of profits as the measure of how much value could be withdrawn from a firm over the accounting period without leaving the company poorer than it was at the beginning.

Professor William Nordhaus of Yale translated Hicks's definition into a workable formula of cash distributions to shareholders plus the net change in real book value.1 We have calculated what Nordhaus terms Economic Profits for the S&P 500 for the years from 1960 through 2002.

The Nordhaus formula leads to a data series that will inevitably run lower than Operating Earnings, for two reasons. First, the net change in book values reflects write-offs that Operating Earnings explicitly exclude. Second, the net change in book value is after adjustment for inflation (which we have measured here with the GDP deflator).

But there is another factor that will tend to raise Economic Profits relative to Operating Earnings: the tricky question of how to measure cash distributions to shareholders, which consist of dividends plus share buybacks. But how do we treat share buybacks when a goodly and increasing portion of the buybacks is tied into option issuance to executives and employees? We discussed this matter at length in our analysis two years ago, citing two academic papers and concluding that "some indeterminate share of buybacks - and more in the 1980s than in the 1990s - has indeed been a substitute for dividends and should be included in the historical estimate of Economic Profits." We exclude the buyback data in what follows for the sake of simplicity, but acknowledge that what we show is an underestimate. The basic conclusion stands firm.

We offer two graphs. The first simply compares Economic Profits to Operating Earnings. The most notable feature of this graph is the absence of meaningful growth in Economic Profits during the boom years of the 1990s, only a part of which can be explained by the absence of buybacks in these data. Investors paid too little attention to the toll on earning power taken by the writeoffs we discussed at some length above.

Chart 1

The second graph has a more revealing story to tell. Corporate executives in the 1990s made a great point about the advantages to shareholders from reinvesting earnings back into the company instead paying them out in the form of dividends. As CEOs were the folk heroes of the day, the investing public accepted the notion that CEOs, in their greater wisdom and concern for shareholder interest, could do a better job of allocating capital than the capital markets could do. That CEOs shut up when the cash distributions took the form of buybacks went unnoticed.

But what was the whole thing was really about? Look below and consider the graph. Here we show the dividend payout ratio on Operating Earnings plotted against the dividend payout ratio calculated on Economic Profits. As Economic Profits is always less than Operating Earnings, the Economic Profits payout ratio is higher. No surprise there.

The real story in the graph is the difference between the two lines during the years from 1995 forward, when the conventional payout ratio sank to levels never seen before, while the payout ratio on Economic Profits, although continuing to be volatile, was only a little below the average levels of the ratio over the long time span from 1968 to 1994. To be specific, the mean payout ratio on Economic Profits from 1995 to 2003 was 14% lower than the average prevailing from 1968-1994. The payout ratio on Operating Earnings, on the other hand, fell by one third over the same period of time. After 1994, the payout ratio on Economic Profits, although averaging lower than in the past, nevertheless had most of its observations within the range established during the period from 1968 to 1994. The payout ratio on Operating Earnings, on the other hand, was in low territory never seen before. Allowing for buybacks would not alter the basic picture and would in any case also raise the payout ratio on Economic Profits. Something profound happened here.

Chart 2

The difference in the behavior of the two series leads to an interesting question. Could we hypothesize that managements were aware that the accountants' concoction of "Operating Earnings" was in fact dangerously higher than true earnings trends, which we have defined by the concept of Economic Profits? Under this assumption, the sharp drop in the observed payout ratio was not totally designed to benefit shareholders by reinvesting a higher share of corporate earnings. Rather, it would have been designed, at least in part, to protect the dividend from future cuts when the inevitable days of reckoning arrive. We will never know the truth in this matter, but the possibility is well worth consideration.

What's below the bottom line?

If quarterly earnings are too noisy to be informative while market pressure for smoothly rising earnings is harmful to shareholder value over the long run, and if corporate net worth has become a mighty fuzzy concept while depressed payout ratios raise disturbing questions, management's responsibility for these problems is only partial and by no means primary. The marching orders to CEOs since the early 1980s have been to heed the needs of shareholders. Isolated managements have royally abused that concept, but the troubles created during the 1990s run deeper.

As long as shareholders define their interests in a self-defeating fashion, the consequences are their fault, not the fault of managements. Just as investment advisory clients often drive portfolio managers to cling excessively to some benchmark and then complain about the absence of alpha, so investors in general are creating an environment in which their best interests are submerged by short-term thinking and a profound failure to understand what long-term success is all about.


1 William Nordhaus, "The mildest recession: Output, profits, and stock prices as the U.S. emerges from the 2001 recession," National Bureau of Economic Research Working Paper #8938, May 2002.

Conclusion

I trust you enjoyed today's Outside the Box. Let us say a special prayer this week that the powers that be, who hold a lot of our future in their collective hands, can figure out how to cooperate for the sake of all concerned. But let us also be grateful that we live in a country where we can take responsibility for ourselves no matter what the turkeys do. Have a great Thanksgiving!

Your already smelling the smoked turkey analyst,


John F. Mauldin
johnmauldin@investorsinsight.com



Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 11-22-2004 4:04 AM by John Mauldin