Can You Trust Earnings Reports?

Throughout mankind's history, scales have been a symbol of equality. As much as commoners rely on scales to be treated fairly, "ueber commoners" try to escape the scales of justice and equality and want to be measured by different and better standards. In his Gettysburg Address, Abraham Lincoln exhorted his listeners to ensure the survival of a government of the people, by the people, for the people. It seems like survival of the fittest like forces have turned a government of, by and for the people into a government of, for and by special interest groups. Buffett: No More Robin Hood This week we read that even the Robin Hood of investors, creates his own rules. Warren Buffett — the only candidate to even remotely resemble a Robin Hood of Wall Street — had a friendly exchange with the SEC about the treatment of actual losses. Warren Buffett's Berkshire Hathaway (NYSE: BRK.A ) was sitting on $1.86 billion in losses caused by declining Kraft Foods (NYSE: KFT ) and US Bancorp (NYSE: USB ) stock. The losses were more than 12 months old and according to current accounting rules had to be written down. Perhaps Warren had seen how Wall Street is allowed to bend accounting rules to its favor (more about that in a moment) and thought: "What they can do I can do better." In short, Berkshire didn't write down the $1.86 billion in losses because … drum roll … as Berkshire's Chief Financial Officer Marc Hamburg's reasoned: "We believe it is reasonably possible that the market prices of Kraft Foods and U.S. Bancorp will recover to our cast within the next one to two years assuming that there are no material adverse events affecting these companies or the industries in which they operate." In other words, Berkshire didn't want to write down losses, because under the right circumstances there's a fair chance that stock prices will recover. Perfect Conditions — 100% Profitability Of course, under the right conditions any loss could reverse itself. But, because we don't live in a perfect world, we have accounting rules. The final numbers are designed to help investors evaluate a company's current financial health. If the doctor tells you that you have high cholesterol, do you tell him: "Don't worry, under the perfect conditions I'll eat only raw vegetables," when in reality you live on burgers and fries and should be on a double dose of cholesterol meds? Interestingly — and very smartly — Warren Buffett's new knight, Todd Combs, has stolen the headlight and absorbed the attention of what otherwise could turn into a full-fledged accounting scandal. Further Implications Courtesy of the post-2007 credit contraction, Wall Street Banksters (NYSE: XLF ), the administration, and reputable companies have become quite adept at the denial and cover-up approach. Case in point, Fannie and Freddie. In 2008, management for the ailing housing giant denied financial trouble.  On Sunday, Sept. 7, 2008, the government seized control of Fannie and Freddie. Nevertheless, stocks rallied on Monday the morning after. Despite stock's (NYSE: VTI ) party mood, the ETF Profit Strategy Newsletter considered banks (NYSE: KBE ) and financial institutions (NYSE: XLF ) a "downward spiral with no stop-loss provision" and predicted Dow (DJI: DJI) 7,500 previously in September 2008. As stocks quickly tumbled to Dow 7,500, the government became desperate. Real estate-related losses were piling up; investors lost confidence in the financial system and drove Washington Mutual out of business. The problem was too big to fix, so the administration forced the Financial Accounting Standards Board to change Rule 157. Obviously, the fix is only topical. If it wasn't, why would Fannie and Freddie need an additional $215 billion in aid? The "new and improved" Rule 157 allowed Banksters to value assets at what they might be worth in the future. If bank A purchased a portfolio of real estate (NYSE: IYR ) for $10 million in 2006 and lost $6 million because the assets turned toxic, bank A is allowed to value the portfolio just below $10 million. The very real loss is not included in the current earnings numbers. Can You Trust Earnings? The real question is whether you can trust reported earnings? If Berkshire, along with most banks and financial conglomerates, has the legal right to fudge their earnings we may rightly wonder who else is employing this convenient accounting trick? Some would call them stupid if they didn't. Ironically, Citigroup's profits exceeded estimates because they reduced bad loan provisions. JPMorgan (NYSE: JPM), on the other hand, expects mortgage buybacks (related to the foreclosure disaster) to cost lenders $120 billion. To emphasize, to see  Citigroup (NYSE: C ) reducing its bad loan reserves would be like an insurance company reducing its natural disaster fund right before hurricane season. Be that as it may, the S&P (SNP: GSPC ), Dow Jones (NYSE: DIA ), and Nasdaq (Nasdaq: IXIC ) continue to rally. The Nasdaq 100 (NASDAQ: QQQQ ) has already shot past its April 2010 recovery high, while the Dow and S&P (NYSE: IVV ) are within striking distance. Expect the Unexpected Following a horrendous August, investors were expecting a terrible September and/or October. The opposite happened. As we approach November, we hear that this month usually kicks off the most profitable time of the year. Fourth-quarter institutional cash inflows tend to result in the best consecutive three-month period. As we've discussed here in the past, institutions are not the only ones that provide liquidity right now. The Federal Reserve via its POMO purchases is another one (detailed analysis available in the November issue of the ETF Profit Strategy Newsletter ). This extra liquidity is not to be underestimated. An Extra Black Swan As we've experienced many times, the market tends to surprise the investing masses — most of which are bullish right now. A decline from current prices would certainly be a surprise. To the average investor, who's betting on QE2 to lift the economy and personal investments, a decline would indeed represent a "Black Swan." As noted in any chart, this season of the year, sentiment, and the market's behavior indicates that the next couple of weeks are likely to be pivotal for the upcoming months. As of yet, the market has not given away its true intentions, but it's sending subtle clues. Some recent support/resistance points are likely to turn into trigger levels, which once activated should fuel a move into that direction. The semi-weekly Technical Forecast (part of the ETF Profit Strategy Newsletter) includes the latest technical analysis along with trigger, target, safety and stop-loss levels designed to navigate the current environment profitably.  This article is written by Simon Maierhofer of ETFguide.com. ETFguide is the information leader on exchange-traded funds because of its vendor-neutral approach and its progressive reporting style. Unique features include an ETF bookstore, a monthly e-mail newsletter and subscription-based ETF portfolios.
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