It Wouldn’t be a Real Bear Market Rally if it Didn’t Test Your Confidence in Your Position

It is the age of optimism. Or at least the week of optimism. Or the age of denial. Or lack of thinking.

Perhaps it's too early to say. But after the long holiday break and the news that Goldman Sachs somehow eked out US$1.8 billion in earnings in the last quarter, you get the feeling that the Aussie market might enjoy a stroll in the green today.

The futures were pointing north this morning (up 63). So yes, it does look like the rally that began in March may keep rolling on in mid-May. Anecdotally, we're sensing this rally has legs too judging by the number of people calling us an idiot via e-mail. It wouldn't be a real bear market rally if it didn't test your confidence in your position.

That said, it should be a quiet week as traders work off their hangovers from the weekend. This gives us a moment to discuss earnings. The Goldman result is one of those stories that give the impression it is safe to get back in the water. But earnings don't always tell you what's going on with a business, mostly because, as my friend Dan Ferris says below, earnings are "fictional."

Dan says that in his experience, "The bond market is far more efficient than the stock market. Bond investors focus on the likelihood that a company can repay its debts. They analyse the cash-flow statement and the balance sheet. Of the three common financial statements, these two leave the least room for imagination. Cash can be counted. Assets can be priced."

"Stock investors, on the other hand, tend to focus on something called 'earnings,' which are reported on the income statement. Earnings are fictional. They are a product of modern accounting, most of which seems to have been designed to sucker naïve investors. If financial statements were genres of books, you would say the cash-flow statement is an honest memoir, the balance sheet is a well-researched biography, and the income statement is fantasy science fiction."

"Goldman Sachs, for example, claimed to have 'earned' more than $20 billion over the last three years, but actually lost more than $100 billion in cash. Which do you think is likely closer to reality? Or look at MGM. MGM claims to have $3 billion in 'earnings' over the last three years. But looking at its cash flows, it seems like it really lost about $2 billion, which is why it was forced to add yet another $1 billion to its debt load."

"Just make a note and stick it on your computer screen," Dan advises. "Don't buy stocks that have wide and continuing discrepancies between what they report in earnings and what they make in cash. Don't buy stocks that add, continually, to the amount of debt they carry. And don't buy stocks whose bonds are trading at a huge discount from par."

More on cash flow, the income statement, and the balance sheet tomorrow.

Dan Denning
for The Daily Reckoning Australia

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