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This Earnings Season Ushers in Maximum Uncertainty

To get a feel for this tricky market, check out Jubak's latest survey.

What do you call an investor who says that it's going to be almost impossible to figure out what third-quarter earnings reports mean?

Answer: an optimist. "Almost impossible" may, indeed, be understating the task that lies ahead.


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kicked off earnings season with its report yesterday, and the volume of announcements is set to turn into a flood.

That will give us lots of data, which investors have been anxious for during the past two weeks. We will have our first peek at how individual companies are doing in the post-terrorist-attack economy. And thanks to rules from the Financial Accounting Standards Board, or FASB, that data will be relatively clean.

But what, if anything, will all of it mean? Did a company miss earnings projections because its business is still in a downtrend, or is the understandable post-attack spending slump disguising a long-awaited turnaround? Should investors project a 10% drop in revenue this quarter into the December quarter, or just shrug it off as a one-time problem? And how do you tell whether a company's business has suffered short-term impairment or long-term damage?

Start Digging

Investors don't have the luxury of sitting back for the next year to see how this one turns out. In the next two weeks or so, the amount of uncertainty in the market makes this a risky time to invest. Longer term, however, the odds shift to favor the investor who buys stocks.

Stock market history tells us that it's virtually impossible to call the bottom ahead of time. Markets bottom in periods of extreme uncertainty when virtually nothing is clear. In fact, it's more accurate to say that a peak in uncertainty -- rather than a peak in bad news -- is the defining characteristic of a market bottom.

Stock market history, however, tells us something else about being invested near a market bottom. Being invested near a bottom is extremely profitable. Stocks often make huge initial moves that latecomers miss, and the biggest returns, with what turns out in retrospect to be the lowest risk, take place during these initial stages of a recovery.

So I'm heading into this earnings season determined to wring what certainty I can out of a period of extreme uncertainty. The degree of uncertainty convinces me that this effort is important. It could mark a bottom in the market, or at least a rally inside the current bear market. And I'd like to get as good a feel for the market as possible.

I've come up with four questions about the upcoming earnings season that make up my "survey of uncertainty." None of them can be answered definitively. But the point is to try to measure the current degree of uncertainty. If it is high, and if it looks as if uncertainty will fall in the future and if it looks as if that uncertainty will be resolved in a positive fashion, then buying in the not-too-distant future becomes more attractive.

First, though, some background on the rules that have been used to prepare the earnings numbers this quarter.

New Rules

Last Friday, Sept. 28, the accountants who had been wrestling with the question of how to show the effects of Sept. 11 and its aftermath on company books threw in the towel.

A week earlier, the Emerging Issues Task Force of the Financial Accounting Standards Board had decided it would prepare rules for what kinds of costs and losses a company could treat as "extraordinary." Extraordinary costs go in a separate line on the income statement and don't get counted against income from continuing operations.

But on Sept. 28, the accountants changed course after wrestling with issues like whether an insurance company's losses from the disaster were "extraordinary" or "business-as-usual" since these companies are in the business of insuring against disasters, and how much of a writedown of the value of an airplane that had been taken out of service an airline could take as an "extraordinary" charge. The new rules won't allow companies to call any costs and losses from the terrorist attacks "extraordinary." Those items will instead get lumped in with the results from continuing operations when companies release their income statements.

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The Financial Accounting Standards Board, however, has no say when it comes to the language that companies use in their earnings press releases to explain the results of the quarter. Companies are free to publish a second set of numbers called something like "our results if the attack hadn't happened" and argue that these figures are more relevant to investors than the numbers that meet the accounting rules. Many will, I believe. I'd expect a whole lot of spinning as companies try to put their results in the best possible light.

And that's a pretty good transition to the first of my four questions for earnings season.

The "Uncertainty Survey''

What degree of confidence should investors have in the reported numbers this quarter?

Some companies will do their best to give investors and Wall Street analysts honest numbers and upfront interpretations of those numbers. Some of those companies will even get it right. Others, however, will succumb to the temptation to use the economic effects of the terrorist attacks as a catchall explanation for any and all shortcomings in the company's financial results.

Is there a way to separate the truth from the fiction? I'd look at three factors to judge any company's financial honesty. First, its past track record. Some companies have a history of telling it like it is, as painful as it may be. They're known for their clean books and conservative treatment of everything from when a sale is a sale to customer financing. These companies are likely to tell the truth now, too. At least they deserve the benefit of the doubt. Other companies make it a practice to fudge their numbers by hiding costs and overstating revenue. Want to risk your money now on their honesty?

Second, I'll look at the quantity of the numbers. I'll be more inclined to trust companies that provide me with not just a conclusion, but with enough facts so that I can double-check the logic. For example, I've been impressed in the weeks since the attack with


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. From company reports, investors know that sales spiked at Wal-Mart early on Tuesday, Sept. 11, as consumers stocked up on groceries and bottled water, and then fell off on Tuesday afternoon and on Wednesday as people remained glued to their TV sets. Sales during the weekend, the company reported, returned to near-projected levels. Thanks to its vaunted inventory and sales-tracking system, Wal-Mart has been able to confirm guidance for the quarter on an almost weekly basis to Wall Street analysts. When the company reports, all those numbers will give credibility to what the company says about its performance and prospects.

Third, common sense should play a role. Think about it for a minute. Is anyone likely to be spending more money on things such as cars or computers in the weeks after the attack? On the other hand, is the attack likely to have put a serious crimp in sales at fast-food restaurants? Your own experience will be a good check on the claims that companies make this quarter. Smart companies realize this. Automakers, for example, realize that common sense says that car sales will fall in a period like this, so they've been careful to link better-than-expected post-Sept. 11 sales with new sales incentives such as interest-free loans that were recently put into place. That explanation conserves critical corporate credibility at a point in the stock market cycle when investors are exceedingly skeptical to begin with.

How reliable are any growth trends that investors calculate from even honest numbers?

For companies that provide honest numbers for both top and bottom lines, we'll be able to calculate relatively credible trends.

Let's look at the automakers again. Going into September, the industry was expecting sales to continue to slow -- as they had for months -- from the record pace of 2000. And September's drop in sales to a seasonally adjusted 15.8 million cars, down 9% from September 2000, matches that expectation.

But the top line -- sales volume in units or revenue dollars -- never tells the whole story. We know from the auto companies that only the liberal application of sales incentives kept sales from dropping faster. We know that entire segments of the market for new cars virtually collapsed in September. For example, fleet sales to rental car companies dropped dramatically as rental car companies saw their business fall by 30% to 35% in the weeks after the attacks. And we know that, historically, incentives are at a seasonal low in September because customers motivated by new models don't require rebates and the like to buy.

From all of that we know that profit per car is likely to head downward as we move into the December quarter and into 2002.


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has already moved into the red for the third quarter, with analysts now predicting a loss approaching 20 cents a share. Some analysts also believe that

General Motors

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could see a loss of $100 a vehicle some time in 2002.

I don't believe that will happen. In other auto cycles the automakers have used incentives to support demand by borrowing sales from future quarters, but they haven't been willing to market themselves into bankruptcy to do it. At some point, they bite the bullet, cut back on incentives and let demand fall to its natural level. In this case, that's probably about 14.5 million to 15 million vehicles in sales. The trends say that we'll see that type of sales bottom in 2002.

This same kind of top- and bottom-line analysis applies to many chipmakers that, like the automakers, are facing a margin squeeze as excess supply meets falling demand.

Can we put any trust in guidance for the fourth quarter?

I've got a rule of thumb on this one: The more units at a lower price a company sells and the more customers it sells to, the more reliable its guidance is likely to be. In other words, if a company sells a $10 million software application to just a dozen customers that each have to go through a lengthy approval process, there's a good chance that at least one customer will cancel an order at a time like this. That's enough to make a company miss projections for the next quarter. Projecting demand and sales levels at a time of uncertainty is easier when a company is dealing with the behavior of large numbers of customers.

Can we believe any company that is calling a bottom?

Nobody's using that word, of course, because like the neighbors of the Little Boy Who Cried Wolf, most investors aren't paying attention to CEOs or Wall Street analysts who make that call. They've heard it too many times in the past.

For example, it's hard to believe that



has finally got it right this time. On Oct. 2, the company warned again, announcing that it expected a $3.6 billion loss for the third quarter. Once again, the company would cut jobs -- 10,000 this time -- and sell businesses. All in an effort to bring its cost structure down to the point where Nortel could make money if revenue came to $4 billion a quarter.

Pardon me, but haven't we heard this all before? Last quarter, Nortel announced that it was downsizing in order to reach break-even at $5 billion in revenue. And this round of job cuts comes on top of 30,000 others announced to date.

Of course, Nortel could be right this time -- and that's the problem for investors. One of these days, the companies that have been so wrong in the past when they've said that they see the bottom or that their business has stabilized will turn out to be right.

Clearly, that kind of answer isn't a strong vote for certainty returning to the stock market after this earnings season. And I wouldn't say that we're about to remove the fog, eliminate the vague or send the potentially disastrous packing in any of the four questions I've raised. But it does seem that for some companies, and perhaps the market as a whole, this earnings season will mark the point of maximum uncertainty.

The question now is what to do about it? After 18 months of heavy losses, it may be time to begin rebuilding a portfolio. How do you start? What stocks make sense? What's the best way to deal with the understandable emotions? And what are the best strategies for getting your financial plans on track?

I'll give you my take on those questions in my next few columns.