As a political conservative, I am constantly measuring the results from corporate America and government policies. Many management gurus recommend that if you want to see how you are doing, measure the results. When you are dealing with outcomes, collecting the numbers on a consistent basis is crucial.
It is distressing when the keepers of the numbers change the basis and way the numbers are collected, recorded and analyzed to measure results. In our culture of headline readers (and little reading of the full story) we often take the numbers at face value then compare them to the history of the numbers to arrive at a conclusion as to how things are going.
Yet we mislead ourselves with this shallow understanding. My 50 years in the investment markets gives me some insight to this problem.
The government recently reported the official unemployment numbers and told us that 4.9 percent of the workforce was not working. Historically, this number (called U-3) looks great at face value. Unfortunately, it is underreporting the unemployment in the United States by huge amounts.
Using the broader unemployment computation (referred to as U-6) we are closer to 10 percent unemployment. In 1994 the Bureau of Labor and Statistics stopped counting people who are underemployed as well as those who are no longer looking for a job. This makes the unemployment numbers look better, while in reality, there is a lot more unemployment in the economy than the politicians are willing to admit.
If the broader, “real” rate U-6 was below 5 percent, then we would have something to celebrate. In the meantime, we need to focus on policies that will get people off of welfare and back into the working economy. Regardless of your political affiliation, the numbers should be telling you that federal government policies are not really effectively reducing unemployment.
Government is not alone in messing with the numbers. Wall Street and corporate America report earnings on a quarterly basis. Historically, corporate profits were reported on a GAAP basis (Generally Accepted Accounting Principles). Corporate America has been shifting to Pro-Forma rules which tend to overstate earnings versus GAAP numbers.
According to Tony Sagami of Mauldin Economics, 90 percent of public companies now report on a Pro-Forma basis, up from just 70 percent five years ago. So while you have been lulled to sleep thinking that corporate earnings are rising, you should be aware that a significant amount of the earnings increase stems from the shift to Pro-Forma accounting rules.
You cannot compare historic earnings trends with the current numbers because of the change in the rules that produce the numbers. In other words, when you can’t get good earnings from your efforts, just change the way you run the numbers so things look good when in fact they are slipping.
How much are the earnings overstated? According to Sagami, if GAAP rules were employed over the last three quarters, S&P 500 earnings would have been 12.7 percent less than reported. Again, you cannot take the headline numbers and compare them to the appropriate history and understand what is happening. Earnings are overstated by rules changes and also by corporate financial engineering which, in turn, is encouraged by the monetary policies of the Federal Government.
There is, unfortunately, more to worry about. Reported sales and earnings have been moved to the present from the future by very low interest rates. That is to say the numbers reported today are estimated to be at the expense of future sales and earnings. Normalizing or raising interest rates in the United States could lead to a recession in the economy and on Wall Street.
Perhaps I am a little too pessimistic. After all, we have had a seven year bull market on the back of monetary policies and few if any fiscal policies that would support a vibrant economy. Wall Street will go where it wants to go regardless of my concerns. So I watch the results of the markets daily, trying to make sense of the results.
Meanwhile, I am aware of the dry rot in the foundation of our economy and I am cautious about the potential for the fallout from manipulating the numbers. I am also aware of what needs to be done to get the economy back on a sustainable basis, where we don’t have to rely on messing with the numbers to make the results look good.
