Thoughts from the Frontline

Glass Ceiling Investing

October 25, 2002

Earlier this year I wrote that the deduction of option expenses and proper accounting for pension liabilities would become an issue, and that it was highly likely that when new accounting standards are adopted that these would be addressed. If so, then it would be a large drag upon future corporate earnings. These new accounting standards are going to create a glass ceiling, if you will, over the stock market.

S&P recently announced they intended to start reporting earnings using new standard which dealt with options and pension liabilities, in advance of it being adopted by the accounting industry. Yesterday they released their study of earnings for the S&P 500 for the four quarters ending in June, 2002. Instead of the $44.93 that Thomson First Call reported, S&P said actual reported earnings were $26.74 a share. (Thomson First Call estimates come from Wall Street analysts. They are still clueless, and still shameless cheerleaders.)

Earnings are $26.74, that is, until S&P deducts option expenses and pension liabilities from the companies in their own index, and then earnings drop to $18.48 a share. This is a Price to Earnings (P/E) ratio of 48.6 on the S&P 500, as of the close today. This is clearly still stock market bubble territory, and is why a resumption of a bull market is not in our near future. No bull market has ever started from such high valuation levels. It is at the core of why I think the current run-up is a bear market rally. Enjoy it. It won't last.

This is all bad enough, but the underlying implications are worse, unfortunately, than you would think at first glance. If you will agree to not shoot the messenger, let's slice and dice the S&P numbers and see if we can get a sense for what is coming in the future.

First, this is not a debate about whether we should deduct options expenses. It is highly likely that it is going to happen, so as investors we need to deal with reality. It is also likely that the way in which corporations account for their pension fund liability will be changed as well, and this is going to increase the downward pressure on profits for a significant part of the companies on the stock market. For investors which invest in index funds, this is going to be a real problem. Index funds, especially those which invest in large companies, are going to be seen as dog meat at the end of this decade.

First of all, let's quickly revisit a study I did this summer. Let's start with the 15 largest companies on the NASDAQ, which represented at that time about 37% of the NASDAQ market value. For the group of 15 firms, total 2001 pro forma earnings added up to $25 billion. Real earnings were about half, or $13 billion. But total option expenses for the 15 firms were $12.5 billion. That means pro forma income was cut in half, and real, Honest-to-Pete profits were a mere $423 million, give or take a few million.

Earnings Before Interest and Hype

These 15 firms had a total market cap of roughly $750 billion (the total value of their stock). That means the combined P/E ratio based upon 2001 earnings which deduct option expenses, and using their stock price today, is a little north of 1,789!

If you take away Microsoft, the combined earnings of the remaining 14 is a NEGATIVE $3.5 billion. That means 14 of the largest NASDAQ firms could not combine to make a profit, if you deduct the expense of their options. Seven of these firms had negative earnings once options were deducted.

The tech heavy NASDAQ companies will have a Hobson's Choice when new accounting standards are required in the future. They will: Have to keep giving options and see their earnings suffer, or They will have to actually use money to pay employees, or Employees will make less, which means key employees leave for more generous positions.

None of these options are very attractive, and all will serve to make it harder for these companies to bring realistic P/E ratios to the market. In a tech world where competition is an ever downward pressure on profits, it is unrealistic to think these large companies are going to be able to post even "reasonable" P/E ratios as high as 25, especially when they can no longer be thought of as growth companies. Listen to tech analyst Fred Hickey's excellent and devastating thoughts on the supposed earnings rebound as reported by Aaron Task of

"With typical candor, Hickey described the .... rally itself as 'totally and completely ridiculous,' 'a joke,' 'disgusting' and 'lame.'

"...[the reasons given for the current NASDAQ rise] are merely a retread of the same arguments heard throughout the past 30 months, but "this time it's particularly onerous, because fundamentals are so horrific," the newsletter writer said. "There is no hope of improvement [and] so many bombs went off -- every conference call was negative."

It's not that these tech companies are going away (well, maybe Lucent), or even whether they are well-run and excellent companies. It is simply that they are not going to be able to make the profits they did during the 90's in today's Muddle Through Economy. We must remember to differentiate between a company and its stock price. I can love a company and think its stock price is too high at the same time.

For instance, I have been negative on the stock price of for years, and still am. Yet I love the company, and am one of their loyal customers. I appreciate the way they are willing to lose investor money to sell me hard to get books, and will continue to let them do so in the future. I hope when their bondholders take over the company they continue the practice.

This New Era scenario has been played out so many times, you would think investors and analysts would see the pattern. Whether it is railroads, television, airplanes, electricity or cars, when some "new thing" hits the stock market, it is run up in value based upon ever increasing expectations, and then reality hits, and valuations come back to earth.

There is little fundamental difference between Whirlpool and Hewlett-Packard. They are in mature industries and they sell metal (or plastic) boxes that are useful. Why is a computer chip more glamorous than an auto brake? They are both "widgets" which can be made by many firms, and thus there is a limit on the profit margin.

The larger a company gets, the more difficult it is to maintain margin, especially as their core technologies mature and competitive edge slips away. It is these large companies which comprise the bulk of the NASDAQ. There are some exceptions, but not many. (Microsoft might be an example.)

Between having to expense options and increasing competition and lower margins, the future earnings of large technology firms are not going to grow the 15-25-35% year that analysts project. They will grow, and they will do well, but the value investors are willing to place on future earnings will drop as investors realize these are not growth companies, but are taking their place in the pantheon of Old Economy companies which have normal P/E ratios.

The Hidden Pension Fund Problem

So much for the tech side. But what about the old line companies of America? What about GM, Delta and John Deere? They have been beaten down so much, aren't they full of value yet?

Well, not exactly. We now come to unfunded pension liability. I have written about this before, and it has been in the news this week. Is this old news, already discounted by the market, or is there more than meets the eye? I think it is the latter, as new data comes to light. Let's look at the implications behind the numbers.

First, there are 360 companies in the S&P 500 which have defined benefit pension plans. That means they have guaranteed their retired employees a defined income for their retirement years, for as long as they live . (Remember that last little tag; it will become important in a few paragraphs.)

Credit Suisse First Boston (CSFB) estimates unfunded pension liability for this group is $243 BILLION this year. Morgan Stanley estimates $300 billion. In 2001, companies reported a gain of $104 billion from their pension funds, when they actually saw their pension fund assets go down by $90 billion.

The CSFB estimate is that companies may report pension losses of $15 billion in 2003 even though their actual losses this year will again be many times that amount. Corporations are not required to report losses under current GAAP accounting rules.

But forget reporting losses. These companies are reporting gains. How do you turn a loss into a gain? Simply, you go to a pension fund consultant, ask them to make estimates of what the earnings will be in coming years, and if the estimated earnings in the future years are more than enough to cover estimated liabilities in the future, you get to put the positive difference on your company balance sheet. If you need more earnings, you get a higher estimate. It was so easy in the 90's.

Eric Frye of Apogee tells us of a study done on the 100 largest companies with defined benefit plans. Even though 95% of them lost money in 2001, 88 of them still estimate they are going to earn 9% or more on their pension fund investments in the future. Hope springs eternal.

Compound interest is the eighth wonder of the world. If you assume 9% returns, that means your portfolio is doubling every 8 years. If you assume 9% returns, you can also pad your corporate earnings. You also don't have to use cash to fund a pension. It does wonders for your stock options.

Let's look at what this assumption actually does. I am going to simplify things a little for illustration purposes, but you will get the general idea.

Let's assume Company ABC is going to need $2 billion dollars in its pension fund portfolio in 2010 to meet its obligations to its retirees. At the beginning of this year it had $1 billion in its pension fund. In eight years, if the fund grows at 9%, they will have $2 billion. But this has been a tough year, and they lose $100 million, so now they only have $900 million. They are "under-funded" by $100 million. If they contribute $100 million to their fund, PLUS make up the $90 million they didn't make and if from now on, the fund grows at 9%, then things will be fine.

But what if they started with $1.2 billion? They are still down $100 million, but since they assume 9% growth, they can actually report a profit on their books, since they still have more than they need, again as long as they grow by 9%.

They key is that they still assume that 9% return for 2003 and for the future. More realistic estimates are in the 6% range. However, if you assumed 6% returns, the under-funding for ABC would be in the $300 million range if they started with $1 billion. If they started with $1.2 billion, instead of a profit, they now would have a loss of around $100 million. Under current GAAP rules, they would need to take a charge to earnings this year and start putting cash into the funds. Do you think the CEO of Company ABC is going to let his consultants tell him that 6% is more likely? Not on your stock options, he won't.

(I know it is far more complicated. You have to take into account how long you think your retirees are going to live, the liability may last over many decades and not 8 years, and so on. The principle is the same, just far more complex.)

And now we come to the problem. General Motors is under-funded by CSFB estimates to the tune of $29 billion this year. GM admits that if the stock market does not turn around they will be down by $23 billion. They only made $1.2 billion in the entire year ended June 30, 2002. Will they take a hit for $20-30 billion on their earnings over the next year? Not a chance. Are they changing their assumptions for future earnings? Not likely, as that would make the problem look even worse.

GM reported earnings of $601 million in 2001. But their pension fund lost $7 billion. What would have happened to the price of GM if they reported a $6.4 billion loss? And they are losing again this year. There are a half-dozen companies which lost more than $5 billion in their portfolios in 2001, and unless the market rebounds soon, we will see similar numbers for this year.

It is not just GM. "AMR Corp. (American Airlines), for example, will have a pension plan that is underfunded by more than $3.3 billion by the end of 2002, according to CSFB estimates, more than four times the company's market capitalization. AMR has already paid $246 million into its fund this year, said spokeswoman Andrea Rader, who added that it should not be cause for alarm.

"Like everyone, the performance of the market has hurt us, but it's a long-term issue," Rader said. "A lot of this is just temporary market fluctuations that could recover." (Washington Post)

I love American Airlines. I am a Lifetime Platinum (2,000,000 miles), which means I have spent more than a few hours in their planes. I want them to prosper and do well, as I depend upon them.

But I think I might be alarmed if the company owed $3.3 billion, and the stock market thought they were only worth one-quarter of that. I would be even more alarmed if the company continues to bleed red ink. The quote by Rader is typical of quotes I have read from companies all over the country. They are all hoping the market will come back and save their bacon. They still make return assumptions that are unrealistic in a secular bear market environment. They still keep talking about the long run, but GAAP rules say the long run may come in the next few years, and then the weeping will begin.

S&P 500 companies are underfunded by a mere $246 billion, if you agree with their future return assumptions. If you take the return assumptions back to 6%, the problem is magnified dramatically.

And that assumes 6%. To get to a 9% assumption in a (let's be generous) 5% bond environment, and if you 70% in stocks/30% in bonds that 9% overall return assumes you are getting almost 12% returns on your stock portfolio. But what if the Dow drops to 5,000 as many think it might and the NASDAQ goes to 600? What if your returns are negative for the next few years?

How much are you underfunded then, as your portfolio drops another 20%? The number becomes mind-boggling.

If each of the S&P 500 companies lowered its expected rate of return from the current average of 9.2% to 6.5%, the total cost to earnings would be $30 billion, according to CSFB. But if the Dow drops to 5,000 the number goes off the chart.

Under federal law, if a corporate pension plan is at least 90% funded, the extra payments required to bring it up to 100% can be spread over a period of up to 30 years. But if the funding level drops below 90% of what the actuaries say is needed, companies may be required to refill the fund within three to five years, meaning larger annual cash payments.

Now do you see the problem? In the brave new world of increasing scrutiny of accounting firms, you are going to find them less and less willing to go along with 9% earning assumptions. If they use even 7%, companies are going to have to start lowering projections, and this is going to send them over the 10% underfunded threshold. That means they will have to come up with large capital infusions to the pension fund over the next five years, which comes directly out of earnings. If the stock market drops more, the contributions will be larger. Accounting games will not be able to hide the true liability.

Earnings from 82 companies would have been cut in half if they did not use phantom pension fund profits in 2001. They were hoping for a new bull market to come to their rescue. What would happen if instead of phantom profits they have to start reporting real losses? At some point, they are going to have to eat those "earnings." This is going to come out in future earnings reports, as underfunding becomes more of an issue.

Now, does this mean those firms are going to go bankrupt, or go away? No. Most of these companies have the ability to fund their obligations out of cash flow. Many of them can do it quite easily. But it means their earnings are going to be less. In some cases, it will mean much less. The airline industry has unfunded pension liabilities of over $12 billion. They can't even make a profit, let alone fund that type of liability. And that means their stock prices, and those of firms who are in similar situations, are going to go lower. Since thes360 companies with defined benefit pension plans make up such a large part of the stock market, the indexes will suffer. It is a cap on any potential bull market for the next few years.

Oh, I forgot to mention that next year, the Boston Globe tells us, pensions are going to have to re-figure their actuarial tables on life expectancy. Since we are living longer, they are going to need to set aside even more money than they currently plan. And let's not forget medical costs, which many plans cover. These are increasing every year, and as we live longer, are just going to become even bigger drags on income.

The reality is that for some companies the beneficial owners are going to be the retirees. Shareholders will be asked to take a back seat. Most of them will simply get out.

The Glass Ceiling

The large indexes like the NASDAQ, the DOW and the S&P 500 are populated with the largest companies in the investing world. The technology companies are going to have to start expensing their options or paying their employees more, while fighting a tough competitive environment. Many of the largest Old Economy companies have serious pension funding liabilities.

These two "accounting" issues are a glass ceiling to earnings growth. Before we take into account deflation, competition from China and the rest of the world, over-capacity, debt, consumer exhaustion and of host of other issues, companies are going to have to deal with these accounting issues.

I fully recognize that there are some companies in the S&P 500 which do not have any of the above problems. There are lots of smaller companies which don't fall into the category. But enough of them do that it will make large cap index funds severely under-perform the rest of the market. Pension/endowment funds who slavishly follow Modern Portfolio Theory and who think they must have some exposure to every part of the market will create even more problems for themselves.

The accounting changes will set a new bar. The earnings bar that Standard and Poor's suggests is now appropriate is around $20 for the S&P 500. If you can assume even 10% earnings growth, which would be historically very high, it will take seven years to get back to $40. If you take the historical average P/E ratio of 15 you get an S&P of 600 in seven years. Let's say we all forget history and take it to a ratio of 22. That puts us where we are today.

This is the Glass Ceiling I referred to earlier. It is earnings, pure and simple. Investors are not going to come back into the market until they think earnings are going to grow to levels that justify current stock prices. As more and more investors see these new and lower earnings estimates, they are going to exit until things improve. When new accounting standards are actually adopted, it is my bet that investors will take them seriously. And the standards will seriously lower reported earnings. And this is going to cause problems for index funds. Get out of them. Use this rally as an exit ramp.

Optimists will write and say that investors will ignore the new rules. They will continue to look at pro forma earnings. They will continue to listen to Wall Street analysts. Who cares about options? Pension funding will be a non-issue when the market comes roaring back will once again.

My response is that they are about 90% correct. Many investors will grab onto any life preserver that lets them think their portfolios are going to come back. They want to have the retirement they once thought they had. But over time, as earnings do not grow rapidly, and as analysts continue to be wrong, as the new standards become accepted in the marketplace, more and more investors will lose the faith.

That hope of a return to a bull market and a comfortable retirement is why bear markets take years to finally end, and not months. It will take at least two more recessions before investors finally give in and we see the bottom of this one. And for that we should be grateful. If the Dow went to 4,000 next week, we would be in for a severe recession or even depression very quickly. Because things will drag out for years, we will "enjoy" milder recessions and a Muddle Through Decade. Because you understand what is happening, you can adjust your portfolio accordingly, and do quite well in the meantime. But I feel sorry for those other guys.

The problems I described above are those of mostly large companies and a few penny stocks like Lucent. There are small companies which will do very well in this decade. Just because I am sour on large tech companies does not mean I think all technology is suspect. There are some small firms just starting today that will be giants in the next decade.

Instead of hoping Cisco or JDS Uniphase will come back, I would be looking through the 100 latest companies to go public on NASDAQ. Any company that is too big I would throw out. Find a company with a built-in barrier to entry in its market, solid management and a reasonable business plan.

Or conversely, look for Old Economy companies with a solid track record of growing dividends and low value ratios, and be patient.

I don't pick stocks. But if I did, that is where I would be looking.

As an aside, I would expect a serious continuation of this bear market rally if the Republicans can take the senate. The mere thought that we might see the double taxation of dividends go away could send the market much higher. This would be the single most bullish thing I can think of that might happen, as it would take the focus of management away from managing for expectations and into actually making money and paying it as a dividend. Sadly, even with a GOP Senate, I do not think such a measure could get through, but one could hope.

New Orleans and Santa Monica

I will be in Santa Monica speaking at the Endowments and Foundations Symposium Monday, November 4-6. I will have some time on Monday to meet with clients and potential clients, although most slots are filled. To those who are going to the New Orleans Investment conference Nov. 7-10, I hope to see you there. (

Many of you have asked when I am going to post new chapters from my book-in-progress - Absolute Returns- on the web ( I am gamely working on several, and hope to have them on by the end of the month. For those of you who want to understand why we are in for a long bear market, you should go to the book site and read the chapter on secular bear markets. When I get back from my latest road trip, I intend to go into a closet and finish the thing. You can find this book web site, my bio and links to my free accredited investor e-letter and archives for this letter by going to

There was so much I wanted to cover this week, but just did not get to. I hope to write soon about some recent studies I have seen on demographics and retirement which have serious implications for our society and investments.

Have a great week, and remember to take some time to enjoy your family and friends.

Your doing his part to help American Airlines fund their pension plan analyst,

John Mauldin


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