LOM Weekly Perspectives

People are not automatons. They can innovate and generate surprises by their behaviour. This is what U.S. consumers and producers did in the fourth quarter of last year. Forecasters’ original expectation of negative growth has been roundly contradicted by the hefty upward revision to the GDP growth estimate. Yes, 0% car financing helped a lot to get the rosy results, but it also required optimistic consumers determined to prove that recessions are un-American. Burned by disappointing stock market performance over the past year, they have found some solace in low financing costs and home equity. Never mind that this has resulted in a further increase in an already heavy debt load. Uncle Greenspan has taken care to make its financing as cheap as possible.

Meanwhile, the marvel of financial innovation has meant that all sorts of paper is being shuffled around, transformed, cut up and distributed to a variety of investors. The idea is to make it possible for more borrowers, in different categories, to borrow under diverse and often difficult circumstances – and also for many investors to find palatable investments. We are a long way from earlier days of relatively simple intermediation by financial institutions. Also, we have a whole host of quite complex derivatives to hedge risk or to sauce up returns, according to your taste. Among derivatives, it is not the exchange-traded variety but the over-the-counter type that poses the greatest risk. The excesses of the bubble economy have not disappeared entirely from the system, but their impact has been modulated by a flexible financial system that is nevertheless not immune to systemic risk. Financial flexibility may allow rapid economic recuperation but it is important to remember that risk is not eliminated. It is still present under a different guise.

Upbeat U.S. economic numbers have fired up optimism, as well as causing some short covering, resulting in a substantial upswing in U.S. equity market indices. In the near term the market probably has legs but further down the road its performance is likely to wane unless it gets further adrenaline boosts. No more performance-enhancing interest rate cuts from the Fed is expected, so help has got to come from earnings growth. For now, the economy is picking up nicely, and with firms running a tight ship, operating profits should get a lift. Nice start, but as we have stated previously the main question is not with regard to the first half of the year, for which we already had good indications back in December, but the robustness of second-half growth. Our position has been that economic performance in the latter part of the year is likely to prove weaker than in the first six months, but not bad enough for the economy to slip into a so-called double-dip recession. Essentially, we have to monitor the vigour of capital spending and if it picks up more healthily than expected, then look for the economy to achieve a nice cruising speed by the last quarter of the year.

The cockroach theory of financial reporting held sway for a while – namely, that if you see one or two cases of financial shenanigans there is likely to be a lot more. But, recently, such concerns have receded to the background even though the reality of accounting manipulation is still very much present. One day, the cockroaches may return but, for now, investors are more focused on hopes for a strong recovery. Everybody has an interest in trying to resurrect the good vibes associated with the late nineties. This includes the Wall Street crowd, accountants, corporate managers, the media, as well as investors. Trust may have been shaken among investors but they also harbour hopes and dreams, which are decidedly more powerful forces. Sure, there was management manipulation and accounting illusion in the late nineties. However, managers have been heard to mumble, sotto voce, that they were only delivering what the gallery wanted.

In fact, during that period, competition was very tough and rapid earnings growth difficult to achieve. The distance between illusion and reality was already evident from the discrepancy between the modest performance of aggregate profits from the national accounts estimates and profits, as reported by corporations. Investment professionals know that, in the current environment, restating earnings on a GAAP (Generally Accepted Accounting Practices) rather than a pro forma basis will often lead to significantly lower reported earnings. Looking to the future, the real issue is the extent to which there is going to be pressure on firms to report according to GAAP rather than on a pro forma basis. This is an important question because it will obviously affect current stock valuations. Mind you, GAAP is not perfect either and will still allow manipulation by accountants with good culinary skills. However, it is a whole lot better than the fudgy world of pro forma accounting.