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Stocks: 3 Must-Reads for Prudent Investors

By Alex Dumortier, CFA - May 3, 2016 at 12:34PM

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Savvy market observers are highlighting some red flags in this aging bull market.

image source: Jorge Franganillo. Republished under CC BY 2.0.

U.S. stocks are lower in early afternoon trading on Tuesday, with the S&P 500 (^GSPC 1.05%) and the Dow Jones Industrial Average (^DJI 1.05%) (DJINDICES: $INDU) down 1.06% and 0.96%, respectively, at 12:30 p.m. ET.

U.S. companies' engineering extravaganza
Writing in The Wall Street Journal today, James MacKintosh observes [subscription required] that while Valeant Pharmaceuticals International Inc and SunEdison Inc may be extreme examples of the risks associated with financial engineering, U.S. companies have been engaging in one form on a grand scale through the issuance of debt and repurchase of their own shares:

The biggest 1,500 nonfinancial companies in the U.S. increased their net debt by $409 billion in the year to the end of March, according to Societe Generale, using almost all -- $388 billion -- to buy their own shares, net of newly issued stock. Companies have become far and away the biggest customer for their own shares.

As corporate profitability slows, the obvious worry is that this debt will lead shareholders to disaster. Total corporate debt is close to the proportion of the economy hit during the debt-fueled bubble that ended in the 2008 collapse of Lehman Brothers.

Note the corporate profits as a proportion of the economy are also at a historically high level, though this is not necessarily a source of great comfort. As Warren Buffett told CNBC last week [my emphasis]:

Corporate earnings have never been better. As a return on tangible equity, American business has never had it so good: Profits as a percentage of GDP, profit margins up and down the line, business has been very, very good ... So it's not surprising that if the economy is not galloping forward and you already have earnings at this level -- I don't see them jumping a lot from this level.

Remember, an outstanding loan amount stays the same in good times and bad; corporate profits, on the other, hand have the nasty habit of shrinking from time to time.

Mind the GAAP
Speaking of earnings, today's Financial Times' Lex column [subscription required] shines a spotlight on the "GAAP gap" between corporate profits calculated using Generally Accepted Accounting Principles (GAAP) and adjusted earnings, which companies like to highlight instead (no wonder -- they're typically higher because they exclude one-time costs):

At the end of 2015, US S&P 500 reported GAAP earnings were just two-thirds of the adjusted profits, according to Citigroup. It has only been worse during the recessions of 2001 and 2008 ... This growing spread between earnings reports is a worrying trend. It suggests that the market is too complacent about the real health of the corporate sector.

The New York Times' Gretchen Morgenson cast a skeptical eye on this phenomenon recently.

Dealing with uncertainty
Readers of this column will know that this Fool is a massive fan of New York University finance professor Aswath Damodaran and his blog, Musings on Markets. Yesterday evening, Damodaran published a post refuting what he calls a myth about discounted cash flow valuations -- namely that they are useless when there's too much uncertainty. Here's the money quote:

As the investing world gets flatter, with information freely accessible and available to almost all investors, and analytical tools that anyone can access, often at low cost, being comfortable with uncertainty may very well be the edge that separates success from failure in [active] investing. There may be some who are born with that comfort level, but I am not one of them. Instead, my learning has come the hard way, by diving into companies when things are most uncertain and by valuing businesses in the midst of market crises, "by going where it is darkest."

Perhaps there is hope for those of us who were not born with ice water in our veins, after all!

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