NOT AN ANALYST

Introduction The third quarter earnings season just kicked off few days ago and investors are looking for signs of an improving economy. Several companies are expected report good earnings but be aware that better then expected results doesn’t necessary mean good results. Here are some things to look for in the up comings earnings reports.

Guidance.It indicates the outlook for the future. If earnings figures are reported to be better then anticipated but the guidance is lowered, then you will see some heavy selling.

Good sales. Better then expected sales figures means that demand is stronger then originally thought. It’s probably going to be hard to see higher sales number versus a year ago so growing sales since Q1 is good news. Once it’s established that sales are increasing, look for drivers of sales growth.

For credit card companies and banks: revenue attributed to large reduction in doubtful accounts seems unjustified given this economic environment and it represents a warning sign for potential revenue overstatement.

For banks: Due to joint ventures, mergers and acquisitions, some financial companies may indicate higher asset values or one time gains in the income statement. Look for how much asset growth is attributable to goodwill and carefully monitor changes in reported goodwill. Absence of impairments in this tough economic environment or increase in goodwill is a sign of low quality earnings.

Retailers: large portion of revenue accounted to LIFO liquidation is not sustainable and should be removed. The company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. Once it runs out of cheap inventory, it will have to purchase new inventory at a much higher cost base.

Computer software companies: with providers of goods and services sometimes there is discretion on deciding when a service has been provided. Revenue attributable to large decreases in unearned revenue is another warning signs as the unearned revenue account could be built up during periods of strong growth (customers prepay for service) and tapped into when times are tough like now.

EPS. It’s not necessary a good indication of growth in this economic environment because better net income can be the result of heavy cost cutting or one time tax credits.

Conclusion. Earnings have a tendency to revert back to normal levels (mean reversion) and very low or very high earnings are not expected to continue in the future. This has an economic meaning as capital migrates to more profitable businesses, increasing competition and reducing returns. The net effect of these competitive forces is a return to “normal” earnings levels

Introduction Treasury auctions for long dated maturities have been closely watched by investors and market participants in recent months. The frequency of the auction for 30 Year Bond has been changed to monthly from quarterly and the size of each auction (for all maturities) have been significantly increased as an effort to increase liquidity.

Improving conditions in the equity markets and speculations about rising inflation in the near future, have risen concerned about the success of treasury auctions for long maturities like 30 Year Bond and 10 Year Note. However treasury buying has been very strong since the June auction, sending the 10 Year Note yield below 3.20% and 30 Year Bond yield below 4.00% on both 10/01 and 10/07 respectively, which are level not seen since the beginning of the year when the market was in worst conditions then now.

Bear Market A bear market for treasury bonds with maturities of 10 Years and higher can be on the way. The following are compelling reason for this thesis. Auction results are posted on table 1 at the bottom of the page or here

Recent Auctions The result of the last round of auctions was mixed. On 10/06 the 10 Year Note auction was very strong with a bid/cover ratio of 3.01 and high yield of 3.201 but the 30 Year Bond auction was weak for the first time in months with a bid/cover ratio of 2.37 and a high yield of 4.009%.

Trading Patter The week before the auction on September 28, equity market pulled back due to worst then expected manufacturing data and employment data, however treasury securities reaming unchanged, signaling a possible change of trend. Yields from 30 Year Bond closed on Friday October 02 at 4.011%, a small decline in yield from Monday’s close at 4.045%, the same situation happened for 10 Year Note where yields fluctuated from 3.302% on Monday to 3.221% on Friday

Geithner Factor Beginning in June, auctions experienced a sudden increase in demand from indirect bidders, giving the impression that foreign demand for domestic debt was stronger than ever. But in a little noticed switch on June 1, Geithner appears to have used some artifice in redefining ‘indirect’ buyers to include not only foreign entities but also domestic buyers who place orders to purchase Treasuries through a primary dealer. This “little change” of information reached bond desk just few weeks ago and now traders are speculating that foreign demand is not very strong after all and that yields could be too low at the moment to spur demand. If that’s the case, the fed will have no other option then raise rates.  

 Auction size Supply for recent actions reached levels. The auction size for 10 Year Note has been above 19B and above 11B for the 30 Year Bond since February 2009. The fed is probably going to reduce the auction size at the beginning of the 1^stQ 2010 which will cause a rise in yields, as the fear of inflation is rising and the foreign demand is now uncertain (see the Geithner Factor).

Conclusion Treasury yields are definitely on the rise with the 10 Year Note possibly reaching 4.00% and the 30 Year Bond reaching 5.00% in the 4^th Q of 2010.

10 Year Note Auction Results

30 Year Bond Auction Results

Table 1