Good Surprises This Earning Seasons Will Create Very Bad Future Surprises

With FASB demonstrating no backbone this Thursday and voting to change mark-to-market rules with not a single dissenting vote (demonstrating that not a single FASB board member has the guts to stand up for what is right), the Big Deception is now in play for earnings season which starts tomorrow on April 7th. Despite the fact that the consensus is for earnings to be brutal and consequently, for the global stock market rally to end, here’s what I think will happen.

The timing of FASB’s ruling was in no part coincidental. There was a rush to approve the suspension of mark-to-market rules that allows US financial companies to use their “significant judgment” to value illiquid assets such as mortgage securities and mortgage-backed securities. I’m sure investors appreciate that valuation will be left to the significant judgment of financial executives since it was their fine judgment that helped fuel many of the steps of this global economic quagmire we find ourselves in at the present time. Furthermore, a Marketwatch article notes that, “The FASB approval comes after an effective lobbying campaign on Capitol Hill by the American Bankers Association and other interest groups. Roughly 800 bankers gathered in Washington earlier this week, in part, to meet and press lawmakers to send a message to FASB that the accounting rules needed to change.”

Does anyone but me find it immensely hypocritical that these very same bankers took full advantage of the mark-to-market accounting regulations when distorted market values aided the climb of their stocks to gross overvaluations and billions of bonuses were paid out based upon these gross overvaluations? And since I have heard arguments that FASB’s decision to suspend mark-to-market accounting laws was right because the fair value rule created gross misstatements of assets during bull markets, let me quickly illustrate that this argument is a circular one and holds no weight. In October of 2008, a journalist wrote: “The one fact everyone agrees on is that the current financial crisis centers on trillions of dollars worth of mortgage loans that were packaged together into financial instruments known as mortgage-backed securities, or MBS. Those securities were purchased by banks and Wall Street firms.”

Forgive me for adamantly disagreeing, but the one fact this journalist states that “everyone agrees on” is not even a fact. This is the very “fact” that those who support the end of the “fair value” rule falsely use to justify their position. They state that the the MBS market would not have been so greatly distorted and trillions of capital would not have vanished if companies had not been allowed to mark these assets on their book at their highly distorted mark-to-market values. To attribute our current global financial crisis solely to faulty mortgages or to their faulty valuations demonstrates little understanding of this current crisis. An unsound, fraudulent monetary system based upon fiat currency is what has enabled and created every significant distortion in housing markets and stock markets for nearly the entire past century.

With a sound monetary system, the creation of a $700 trillion derivatives gorilla would have been impossible, huge distortions in real estate markets would have been impossible, huge distortions in stock markets would have been impossible, and the subprime mortgage problem that the author attributes to creating the current global financial crisis would never have grown to its peak inflated state. Consequently, to state that mark-to-market accounting laws created huge distortions in the mortgage market that created this crisis is an invalid, disingenuous, circular argument at best and a flat out lie at worst. But such is the state of financial reporting today — investigative journalism has flatlined and instead almost always rallies to the official party line fed to the media by bankers and government officials.

Though the FASB changes may have come too late for US financial institutions to restate their earnings for the first quarter 2009, and if I’m wrong about the “good surprises” occurring during first quarter earnings announcements, the only possible future outcome of this accounting change will be surprises to the upside with second quarter earnings announcements. In any case, since any continuing rally will be built on the foundation of deception, be wary of a steep decline after this current rally ends. With expectations already so negative for first quarter earnings in US markets, all negative expectations have already likely been factored into the market. Furthermore, since financial executives now have carte blanche to assess asset valuations of their debt securities based upon some Alice-in-Wonderland fantasy land internal valuation model, I would not at all be surprised if some companies, despite the tight deadlines, succeed in convincing external auditors to work overtime to produce revised earnings statements in time for this month’s earnings season. Yes, I do understand that external auditors must approve the bank management’s revised valuation schemes, but given the failure of Moodys, Standard and Poors, the SEC, and most recently FASB, to protect the retail investor as of late, somehow trusting auditors hired by a financial firm to serve as the firm’s gatekeeper in keeping the firm honest provides me with little reassurance.

Additionally, if you have not been aware, financial companies had already been cooking their books to make their earnings appear better than reality before the suspension of the fair value accounting rule. For example, consider this story from Dow Jones Newswires in January of 2009 that reported that Wells Fargo, in reporting its 2008 4th quarter earnings, expanded its definition of bad debt from 120 days delinquent to 180 days delinquent to improve its earnings statement. Even if the corporate revisionists don’t beat the deadline for this earnings season, it merely means that the Big Deception will merely be postponed until 2nd quarter earnings are announced.

In any event, one should remain very vigilant about the modus operandus of financial corporations that they have already implemented and will surely implement again this earnings season: (1) Plant stories in the media about huge losses and worst case scenarios for earnings prior to earnings announcements; (2) With expectations so low, release news that is still negative but not as negative as expected, and thus can be spun into positive news; (3) Sucker in the suckers on more spun stories that the “bottom is in”; and (4) Sit back and watch the short-term rally. If this scenario happens this earnings season, it is near guaranteed to also cause a continuing temporary setback in gold prices and the prices of gold mining stocks as the masses fall victim to this ploy. However, this in no way detracts from the long-term strength of gold.

In the past, many readers have criticized the negative tone of my articles but I would firmly disagree with anyone that claims my articles are “negative”. One of my primary goals is to merely report the stories that the mainstream media fails to cover. If my search for the truth reveals a negative economic environment, then that’s what I report. I will gladly report optimism when I uncover reason to be optimistic. Secondly, in a global market so fraught with risk, and still fraught with grave risks, this doesn’t mean one can’t be profitable. One only needs to take advantage of investment strategies that are different than the masses and one can be strongly profitable. Being profitable in such an environment only takes the courage to zig when everyone else is zagging.

If you wonder why you should be so concerned about the FASB rule change, consider who was instrumental in getting the law changed and the parade of cheerleaders this decision has consequently inspired. Before the passage of the rule change, William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985, called fair value “a major cause of the credit crisis”. Robert Rubin, the former Citigroup senior counselor and US Treasury secretary, concurred and claimed that the fair value rule caused “a great deal of damage”. After the decision to suspend the fair value rule, Citigroup chairman Richard Parsons responded, “Good decision.” Edward Yingling, chief executive officer of the American Bankers Association applauded the decision as well: “Today’s decision should improve information for investors by providing more accurate estimates of market values.”

If you trust the above group of people, then buy into the rallies that will occur when US financial companies start announcing earnings surprises, whether they occur this quarter or next. Otherwise, sell into these “fake” rallies if you’ve entered traditional stock markets in the past couple of months and move your assets accordingly into assets that will continue to climb higher as this monetary crisis deepens.

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