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Generational Dynamics Web Log for 8-Jan-08
Estimates of fourth quarter earnings continue to plummet

Web Log - January, 2008

Estimates of fourth quarter earnings continue to plummet

Stock prices have continued their downward trends, as price/earnings ratios rise.

Here's the summary from Friday from CNBC Earnings Central:

"As of Friday, January 4th:

25 companies in the S&P 500 have reported earnings for Q4, 68.00% have beaten estimates, 12.00% were in-line, and 20.00% have missed. (Data provided by Reuters Estimates) The blended earnings growth rate for the S&P 500 in fourth-quarter 2007, combining actual numbers for companies that have reported, and estimates for companies yet to report, stands at -9.5%, attributed in part to downward estimate revisions in Financials.

At the start of the quarter, the growth rate for Q4 was 11.5%. (Data provided by Thomson Financial)"

And so, if we put together a table of the changes in fourth-quarter earnings estimates since the beginning of the fourth quarter, we get the following:

  Date    4Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct  1:             +11.4%
  Dec  7:              -1.3%
  Dec 14:              -3.8%
  Dec 31:              -6.1%
  Jan  4:              -9.5%

In other words, earnings estimates become gloomier and gloomier as each day goes by. Over the next 2-3 weeks, companies are going to be reporting their ACTUAL fourth quarter earnings, so we'll soon know which estimates are valid.

In the "bad news is good news" view of the cheerleaders for the stock market bubble, the optimistic view of this situation is as follows:

Most sectors of the stock market are doing fine, except for the financial sector (Citibank, Bear Stearns, and so forth).

When financial firms announce their REAL fourth quarter estimates, within the next couple of weeks, we will see "the mother of all writedowns."
What that's supposed to mean is that all the financial firms will write down huge amounts of worthless CDOs and other mortgage-based assets in their portfolios.

And here's the punch line, according to these optimists: That will be the bottom. Everything that needs to be written down will be written down in the next few weeks. Then things can return to "normal," and the bubble can start expanding again.

Well, that's the kind of thing that we've been hearing for a long time now, and these kinds of optimistic remarks have been wrong every time for a couple of years.

The problem is that there's no way for these financial institutions to know how much of their portfolio is worthless. It's a moving target, a domino effect. As one set of assets is written down, all of the company's assets are put into doubt, the remaining assets might lose their AAA ratings, and that will cause other assets to become worthless.

Just to give one example: CDSs (credit default swaps) are derivative securities that someone purchases from an insurer, who will guarantee that your investment will be repaid if your mortgage-based CDOs become worthless. Under those conditions, your CDOs might have AAA ratings, since they have "double protection" from loss. It's like buying hurricane insurance on your home -- if there's a hurricane, you'll have your home or you'll have money from the insurance policy, so you'll be OK either way.

But what if the insurance company has insured thousands of homes in the same region, and a hurricane strikes and destroys hundreds of those homes? Then the insurance company can go bankrupt, and those hundreds of people are left with neither their homes nor any money.

In the case of CDOs that you've "insured" with CDSs, you're OK as long as the company providing the insurance (known as the "counterparty") is able to repay you. But what if the insurance company has insured billions of dollars in mortgage-backed CDOs, and can't pay if too many of the mortgages end in default.

In fact, this is a story that's been simmering for several weeks. There are a number of companies called "bond insurers." One of these high-flying financial firms, ACA Capital Holdings Inc, lost its investment grade credit rating last month. Now, if your portfolio happens to hold CDOs that are insured by ACA, if ACA loses its rating, then so do your CDOs.

The two largest bond insurers, MBIA Inc and Ambac Financial Group, have been put on notice by Fitch Ratings to find investors or they will soon lose their ratings as well.

These are just a few of the many examples of how the domino effect works. When one set of securities goes down, then it can trigger a fall in another set of securities.

And so, the wishful thinking that the "mother of all writedowns" will occur within the next two weeks, and then it will be over, is literally impossible, since there's no way to know how far it will go. In fact, it won't be fully known for months, if not years.

As earnings estimates fall, price/earnings estimates are rising.

Since most firms use the same models for deciding whether to buy or sell stocks, the stock market as a whole has been trending downward, to match the negative earnings forecasts.

From the point of view of Generational Dynamics, the stock market is overpriced -- by a factor of around 250% -- as I explained in my article "How to compute the 'real value' of the stock market," and we're headed for a generational stock market panic and crash that will lead to a new 1930s style Great Depression.

I recently wrote an article, "Will hyper-inflation make the dollar worthless (like the Weimar republic)?" in which I discussed why, after that crash occurs, the dollar currency will NOT become worthless through inflation, but in fact will become more valuable through deflation.

I've received a number of questions from readers about this article. I apologize for not having answered them all yet (I've been swamped with other work), but soon I will be posting an article answering these questions at length. The short answer -- and the answer that most of the questioners overlooked -- is that once a generational crash occurs, it will have such an overwhelming affect on the American people, that they'll change their attitudes and behaviors in many ways, including turning from spenders into savers. This is the kind of thing that generational theory predicts, and I'll explain why soon. (8-Jan-08) Permanent Link
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Generational Dynamics Web Log for 8-Jan-08 Estimates of fourth quarter earnings continue to plummet

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Generational Dynamics Web Log for 8-Jan-08
Estimates of fourth quarter earnings continue to plummet