Why Bears Focus on GAAP Earnings, & Why I Don't

A very popular argument you hear from the bears these days is the fact that many market strategists are basing their stock forecasts on what are called "operating earnings." Since third quarter earnings season is in full swing this week, I thought I'd take a moment to give you my views on "operating" earnings and the comparison with the bears' preference, "GAAP" earnings.

First of all, let's clarify the difference between the two measures. GAAP stands for Generally Accepted Accounting Principles. These are the rules that accountants use when creating financial statements for corporations. However, just because accountants prefer GAAP, that does not mean that stock investors should necessarily care as much as they do about GAAP earnings.

Investors often create their own measures of value based on what they truly care about when investing in publicly traded businesses, namely cash flow. For example, capital intensive businesses are typically valued on EBITDA, or earnings before interest, taxes, depreciation, and amortization. EBITDA is usually simply called cash flow.

Moving back to the market in general, 2007 estimates call for the S&P 500 companies to earn $93.50 in operating earnings but only $86.00 under GAAP. If you find a 16 P/E appropriate, for instance, you can surmise a fair value on the S&P 500 of either 1,496 or 1,376, depending on which earnings number you use. If you are a bear and are trying to convince people that stock prices are overvalued, which number are you going to use? Obviously, the latter since it is 8% lower.

One of the larger components that accounts for the difference in GAAP and operating earnings is the expensing of stock options. As many of you know, the accounting industry has mandated that companies treat stock option grants as expenses, and reflect that on their GAAP income statements. Since operating earnings focus on actual cash flows from operating activities, they exclude options-related expenses because it doesn't actually cost a company any money to issue stock options to their employees, even though those options may have monetary value to the holder in the future. GAAP rules account for the expenses to differentiate between firms that issue options and those that do not.

Personally, I have to disagree with the accountants on this one. If booking imaginary expenses for option grants was supposed to show investors that two firms with different compensation structures are indeed different, then they have ignored the fact that the effects of issuing options do show up on the income statement already for all publicly traded companies; under "earnings per share."

Issuing options does not in any way change the amount of profit a company is earning. As a result, I think it is silly to pretend that it does by expensing them. What is does do, however, is dilute existing shareholders by increasing the total shares outstanding of a corporation. Two companies that are identical in every way except their use of options (or lack thereof) will report different earnings per share (EPS) numbers. The company that issues no options (and thus has no so-called expense) will report higher EPS than a company that issues options, assuming all other factors are equal and held constant.

In my view, that is where investors can differentiate between options issuing firms and those who shun the practice. The dilutive effect of issuing options does in fact show up on the income statement, you just have to move further down the page to see it.

As long as companies that issue options have lower share prices than those that do not (again, assuming all other factors are equal and held constant) there is no reason to pretend that it is actually costing a company real money to issue options. If you do, then the dilutive effect is counted twice (lowering net income once by calling options an expense, and a second time by reducing earnings per share on that lower net income figure via higher share count).

That hardly seems fair to me and as a result, for companies that issue a lot of options (tech companies, for example), in my view it is perfectly fine to use non-GAAP earnings when valuing stocks.

Thoughts on the Financial Media

Since it came up in discussions regarding my last post, I wanted to touch upon the issue of the financial media a bit more. I think it is important for investors to understand why media outfits like the NY Times (NYT) might not be the best resources to use when making investment decisions. Recent events involving a story the aforementioned paper published about Warren Buffett's interest in buying a 20% stake in Bear Stearns (BSC) bring the issue to light even more.

For those that didn't hear about it, shares of Bear Stearns rose more than 10% on Wednesday after the NY Times reported that Buffett was one of several parties discussing the purchase of a minority stake in the troubled investment bank. Within minutes other reporters were playing down the story after speaking with sources they have within the industry. The next morning, Bear even refuted the story itself on a call with investors. Lots of people have lost money due to what looks to be an erroneous report. Most likely someone leaked the story to a NY Times reporter, assuming they might publish it, causing a temporary jump in the stock price, allowing them to sell some stock at a nice profit right before the end of the quarter.

Now, yes, that explanation as to why it all happened is purely speculation on my part. However, based on what happens all the time on Wall Street, coupled with the fact that the story was immediately rebuffed by numerous sources, including Bear Stearns, leads me to be cynical and suspect that the Times did not check with many reliable sources before reporting Buffett's supposed interest.

I bring this up because media outlets are not the most trustworthy of resources when trying to gauge the merit of a particular investment. The NY Times is often guilty of this because they are based in the financial capital of the world and have access to lots of Wall Street people, but many other media people make the same mistakes.

It shouldn't really be all that surprising though, that is, the fact that newspapers and the media in general is often biased in their reporting. In recent months, the NY Times has published numerous stories, from numerous reporters, regarding many different financial corporations including student lending firms, credit card issuers, and mortgage companies. Some of these firms I am invested in, so although I don't read the NY Times regularly, I have seen some of the "journalism" that has been published to the extent that it has caused stock price movements that interest me.

It is no secret that the Times has a liberal bias in many cases, and some of their attacks on large consumer lending companies makes it clear that some of their reporters are purposely trying to criticize large financial institutions for their lending practices, whether it be to college students, sub-prime home owners, or credit card dependent consumers. I guess it's just the world we live in.

Now don't get me wrong, I am all for throwing the book at companies that break the law or act in extremely unethical ways. By no means am I arguing that unlawful acts should not be punished to the fullest extent, and please don't assume that I am writing strictly to make a political point. Most times I am successful in separating my political beliefs from my job as a stock picker, not only because it serves me and my clients best by doing so, but also because the views are often at opposite ends of the spectrum.

However, since consumer lending activities have become such a big issue lately, the media has started to really cross the line, in my view. It has, in part, I believe contributed to the fact that many Americans feel like they are constant victims of big business, whether it be the oil companies' supposed price gauging (which there is no evidence of), or any type of consumer lending that has been called predatory in nature without any evidence to support the claim.

Stories in recent months from the likes of the NY Times have sharply criticized many financial institutions, and in some cases, have even gone as far as insinuated that they are breaking the law. Some examples of these horrible activities include student loan companies that factor in things like career path and which college you attend when determining your loan eligibility and interest rate, or mortgage companies that are offering wealthier white borrowers loans more often, and at more attractive terms, than minority, less wealthy borrowers. It turns out, in fact, that mortgage companies also offer their sales people higher commissions for more profitable adjustable rate mortgages than they do for fixed rate versions (much like stock brokers usually try to sell clients annuities -- they have high fees and sales commissions of up to 8%!).

Now, if you read these stories without a cynical tilt you are more likely than not going to conclude that companies like Countrywide (CFC), Sallie Mae (SLM), and JP Morgan Chase (JPM) are crooks who are discriminating against anyone and everyone in the name of profitability. Those profits in the end wind up in the hands of wealthy executives and shareholders, which results in an ever-widening gap between the wealthy people making the loans and the less wealthy ones receiving them. This press coverage does result, at least in the short term, to lower stock prices and a general anger toward big business in general. In my view, these attacks are not only often unfair, but in some cases completely one-sided and oftentimes based on assumptions that are simply untrue.

For instance, is it fair to imply that it is at most illegal, and at least unethical, to factor in what degree you are seeking and what school you plan on attending when deciding whether or not to offer you a student loan and at what interest rate? Believe it or not, lenders offer loans to people based on what they think the odds are of being repaid. The better your credit, the more likely you are to not only get a loan, but also a low interest rate. Lenders need to consider this issue more than any other when deciding who to lend money to. The higher the risk, the less often you will qualify for a loan, and even when you do get approved, your increased credit risk results in higher interest rates.

Now, does anyone think that which college you attend and which career path you are pursuing might be relevant factors in determining a borrower's creditworthiness? The fact is, there is a direct correlation between education, career, and annual income. It also stands to reason that the more money you end up making, the higher probability there is that you will be able to pay back your student loan. Therefore, is it unfair to accuse Sallie Mae of illegally discriminating based on school choice or career path? Most economists would say "yes."

The same arguments can be made on any number of fronts. Do a smaller percentage of minority borrowers get low interest rate loans because of their skin color and ethnic background, or is it because of their credit worthiness? Most likely, the latter. That does not mean we should not strive to put in place policies that seek to get minority education levels and incomes on par with everyone else, it just means that accusing the banks of racism is probably crossing the line.

The current mortgage and housing industry downturn we are seeing is partly due to the fact that lenders actually abandoned these basic lending principles. Traditionally, the better your credit history, the better loan you were offered. Not surprisingly, the housing boom led companies to get greedy. The more loans they made, the more money they made (at least in the short term, as we are finding out now).

The result was that the lenders completely turned their lending practices on their head. If you couldn't afford a standard 30 year fixed rate mortgage with 20% down, a new type of loan was created for you allowing little or no down payment and an attractive teaser interest rate. All of the sudden, people who couldn't get loans were able to go out and buy houses they couldn't normally afford. And that's how we got ourselves in this mess.

Amazingly, we lived in a world where the better your credit, the worse your loan terms! High quality borrowers put 20% down on their house and paid 6% interest while sub-prime borrowers put less down and got low single digit introductory rates. How on earth does that make any sense?

It doesn't, but people are paying for it now. Many lenders have either gone out of business or are losing money hand over fist now since they failed to align the credit worthiness of the borrower with the loans they were offered. And yet, some people want to criticize smart lenders for doing their due diligence and aligning credit histories with interest rates.

Consumers are also to blame since those facing possible foreclosure are constantly being quoted as saying they were so intent on getting their house that they didn't read the loan agreement before signing it. Well, if you were about to be loaned hundreds of thousands of dollars and didn't bother to take the time to read the paperwork to find out how much that loan was going to cost, maybe it's your fault for taking the money just as much as it was the lender's fault for offering it to you.

I'm getting a little sidetracked here, but the basic point is this. It is imperative that lenders size up the creditworthiness of borrowers to determine loan terms that are appropriate to compensate them for the repayment risk they are taking. Doing so is not illegal or unethical, although hundreds of biased press stories will try to convince you otherwise. These issues are all coming to a head in 2007 and due to the highly divided political landscape our country is facing, people are becoming more and more inherently biased. It's a shame that this is the case, but it is simply reality. And it's not just the Times, of course. Conservative papers will be coming from the exact opposite end of the spectrum. It's just the world we live in today.

This is important from an investing standpoint because you need to consider these issues if you are going to allow the media to play a role in your investment decisions. I would recommend that you not base your investing on what you read in the media. Due to inherent biases, there is going to be information left out because it doesn't prove a certain desired point, and other information is going to be embellished to make a certain case seem even stronger.

The best thing to do is to base your decision on the facts, not on opinions. In many cases that means taking what public companies say at face value. It is true that there will always be Enrons and WorldComs in this world. However, there are far more biased press reports that ignore facts than there are crooked companies and executives. If you are trying to research a company's mortgage portfolio, for instance, and the company is willing to break out in agonizing detail exactly what loans they have made (what the delinquency rates are, what the credit scores of the borrowers are, etc.), then you are probably better off analyzing that data than the opinions expressed in the media.

If a company is unwilling to disclose the data you feel you need to make an appropriate investment decision, then find another company that will. In the world we live in today there are too many people with an agenda or a bias that colors what they feel, think, and publish. Heck, I'm guilty of it too. If I'm going to write about a stock that I am invested in, won't I tend to be bullish? Of course.

However, the merit of my opinion can be greatly increased if I use facts to back up my assumptions. If someone offers up facts and you agree with their underlying assumptions, it is far more likely they will be right. If you read or hear something with a lot of opinion and speculation, but little in the way of facts (say, for instance, in the case of Warren Buffett's supposed interest in buying Bear Stearns), perhaps it is prudent to be more skeptical.

Take the case of Bear Stearns, for example. On Wednesday the NY Times reported that Warren Buffett was discussing taking a 20% stake in the company. There was no evidence in the story that suggested the rumor had any merit. Within 24 hours numerous reporters were doubting the story after talking with their sources and Bear dismissed the rumors directly. We cannot know for sure if Buffett will wind up buying a 20% stake in Bear Stearns, but based on the factual information we have, I wouldn't be willing to bet any money on it.

Full Disclosure: No positions in the companies mentioned at the time of writing

Examining Dualing Market Outlooks

Does anyone else find it pretty strange that two people can look at the exact same set of data and reach two dramatically different conclusions? I'm speaking of market strategists who try and determine if the overall equity market is overvalued or undervalued. The bulls think we are 20 or 30 percent undervalued and the bears see the exact opposite scenario. How can people differ that much on the outlook for the domestic stock market? It's not like we're are trying to value a single company, where I could understand widely varying outlooks. The stock market as a whole can't be overvalued and undervalued at the same time.

The key to analyze this dichotomy is to look at the S&P 500 P/E ratio, which is the most widely used metric to value the overall market. This isn't as simple as it sounds though. You arrive at different numbers depending on if you use the trailing twelve month (TTM) P/E or the forward P/E. Personally, I use forward P/E ratios when valuing stocks, because equities are claims on future earnings, not profits already earned. However, the most bearish market strategists use trailing numbers because doing so results in higher P/E ratios, which imply higher valuations. For the purpose of this piece, I'll use TTM P/E ratios, mainly because historical data is easier to find.

Another point of contention is which earnings calculation to use. The two most commonly cited are operating earnings and GAAP earnings. Operating earnings are meant to gauge how much cash a firm's operating businesses are generating, whereas GAAP numbers are really more of an accounting standard and don't always reflect true profitability. For instance, one of the biggest contributors in GAAP earnings is stock options expense. Accountants insist that companies issue GAAP income statements that place a value on expenses incurred by issuing stock options, even though no economic cash cost is incurred.

Currently, the P/E on the S&P 500 index is anywhere between 15.4 (forward operating earnings) and 18.0 (trailing GAAP earnings) depending on which of the four measures (forward vs trailing/operating vs GAAP) you use. I don't think we need to agree on which P/E to use to analyze whether or not the market is wildly overpriced or underpriced. For the most part, the bears think P/E ratios should be lower, or will be lower shortly. The bulls think if P/E multiples do anything, they should go up, not down.

Keep in mind, I am referring only to those people who think the market is meaningfully mispriced right now, say by 20 percent or more in either direction. I fully understand that this is only a subset of all market pundits. I'm simply interested in looking at the dichotomy that exists between them.

Let's take a look at an interesting chart that should shed some light on this debate. The graphic below shows the historical trailing P/E of the S&P 500 index (blue) along with a five-year moving average (black).

As you can see from the chart, the stock market typically trades at a P/E of between 10 and 20. Depending on which number you use, we are currently either right smack in the middle of that range, or on the upper end of it. If you are using P/E ratios as your yardstick, you really can't make a compelling argument that stock prices are dramatically too high or too low.

The real question in this analysis, if we assume the historical range is a pretty good guide to stock market valuation, is whether we should be closer to 10 or 20. How much investors are willing to pay for equities can depend on many variables, but the most important ones are interest rates and inflation. Don't take my word for it though, both logic and historical statistics back up this assertion.

Since stock prices reflect future earnings discounted back to present day values, there is a negative correlation between interest rates and stock prices. When rates are low, investors are willing to pay higher multiples of earnings, and vice versa. Inflation measures have the same effect on demand for equities. When inflation is high, the "real" (net of inflation) return on stocks goes down or becomes negative, which crimps investor demand for equities, lowering multiples.

Since the economic backdrop is crucial in determining the appropriate valuation level for stocks, the fact that the United States currently is operating a growing economy in a low interest rate, low inflation environment sheds a great deal of light into where stock prices might trade. The middle or upper end of the historical range is not only not unrealistic, but it makes a lot of sense.

Making the argument that P/E ratios should be dramatically higher is simply not prudent given the historical data. Defending a P/E toward the low end of the range also isn't very compelling given the current economic backdrop. As a result, I think a simple look at history, coupled with a basic overview of current economics, shows that the market is neither wildly overvalued, nor wildly undervalued.

Insider Selling Could Mean Anything, Whereas Buying Can Only Mean One Thing

At Peridot Capital, I tend to ignore insider selling completely. Sure, a lot of sales inside a company can indicate management feels their stock is overpriced, but there are dozens of other reasons top brass sell stock, and they are never required to give the reason for their actions. Investors should be able to tell if a stock is grossly expensive or not on their own, if they indeed manage their own money, so insider selling data really can't be relied upon.

Insider buying, however, I believe is crucially important. While I can make a laundry list of reasons why someone chooses to sell a stock, the reasons to buy are much fewer in number. In fact, there's only one (to make money). It's not surprising that studies have shown much more meaningful correlation to stock performance and insider buying, as opposed to insider selling. And with that, I'll leave you with the following Associated Press story that ran on Friday evening. To those who think there are bargains among the wreckage of the latest correction, you're not the only ones...

AP: Insider Buying Set Records in August

Friday September 7, 6:17 pm ET

NEW YORK (AP) -- Insiders purchased shares of their companies' stock at a record pace in August, analysts said, as credit market deterioration threw stocks into a tailspin during the month. The trend of buying among insiders, who are typically long-term investors, was one of the few bullish signals last month, said InsiderScore.com, a Web site that tracks insider transactions.

According to Thomson Financial, insiders drove buying volumes to their highest monthly levels since 1990, with $465.5 million in purchases.Insiders in the energy, retail and insurance industries led the buying spree, said InsiderScore.com analysts in a research report released Wednesday.

In the energy sector, insider buying was at its strongest since the spring of 2005, boosted by large purchases by RPC Inc. Chairman Randall Rollins, Cheniere Energy Partners LP Chief Executive Charif Souki and insiders at other companies. Schlumberger Ltd. Director Michael Marks and Nustar GP Holdings LLC Director William E. Greehey also bought shares as their companies' stock came down from 52-week highs.

In the retail sector, which was hurt as economic uncertainty slowed shopping this summer, top executives at several companies bought stock as shares fell to 52-week lows in August. American Eagle Outfitters Inc. Chairman Jay Schottenstein and other insiders bought 184,575 shares. Barnes & Noble Inc. Chairman Leonard Riggio bought 100,000 shares, his first purchase in two years. The CEO of Best Buy Co.'s international operations bought 11,300 shares, the largest insider purchase of the electronics retailer's stock in more than two years.

In the insurance sector, more than 10 insiders bought shares at Conseco Inc. after the company's stock plunged in August. Also, Prudential Financial Inc. Chief Financial Officer Richard J. Carbone bought 10,000 shares last month. Unitrin Inc. and American Financial Group Inc. were among other insurance providers that reported large insider purchases in August.

In other sectors, Yahoo Inc. President Susan Decker and Director Arthur Kern bought more than 65,000 shares of the Internet search company, which has slipped against rival Google Inc.

Also, three directors of American Express Co. bought 63,000 shares of the credit card company in August.

Fed Fund Futures Could Be Setting Market Up for a September Sell-Off

You would think that with everything Fed Chairman Ben Bernanke has said publicly thus far regarding the current turmoil in the mortgage and credit markets, the market might be at least somewhat doubting that a Fed Funds rate cut is coming later this month at the next FOMC meeting. After all, Bernanke came out and said the Fed is not responsible for bailing out lenders and consumers who made bad decisions in a loose lending environment. Quotes like that should at least temper people's expectations a little bit that a rate cut this month is essentially guaranteed. Well, that does not appear to be the case.

As of late Wednesday, a 25 basis point cut was fully priced into the market and there was a whopping 72% chance of a 50 basis point cut also priced into futures quotes. Given the actions we have seen from the Fed thus far (namely choosing to inject liquidity rather than lower interest rates for consumers) and the words they have chosen in public speeches in recent weeks, I have to take "the under" on the Fed Funds futures bet.

Now, that is not to say that there won't be a rate cut. That could surely happen, and you could justify it several ways. It just seems to me that the Fed wants to try every other option they have at their disposal before giving in with a rate cut, which many see as bailing out people who made ill-advised decisions and thus contributing to a moral hazard issue.

Because of that, I think saying there is a 100% chance of a cut this month is overly optimistic for interest rate bulls. And a 72% chance of a 50 basis point cut is even more aggressive. Right now, I'd put the odds of a cut of any magnitude between 50% and 75% based on what Bernanke has said and done so far.

I bring this up not because I think people should speculate in the futures markets, but because it's important to understand what is currently priced into the marketplace. If we don't get a cut later this month, which I think is certainly more probable than the markets currently are telling us, then stocks are going to sell-off. That is what we open ourselves up to when the market prices in something as a certainty even though there is still an undeniable fact that nothing is certain about the September FOMC meeting.

And even if we do get a cut of 25 basis points, we could still see the market not react positively because more than half of people right now expect 50 basis points (who knows what that number will be at meeting time). Just be aware that the risk-reward trade off right now in the short term doesn't appear all that favorable as long as you assume two things. One, the fed fund futures market accurately gauges what the market is currently pricing into prices. And two, the market will be reacting to interest rate speculation and action in coming weeks.

Don't Blindly Follow Carl Icahn (or anyone else for that matter)

From the Associated Press:

BONITA SPRINGS, Fla. (AP) -- Shareholders of WCI Communities Inc. elected billionaire Carl Icahn to the board of the struggling homebuilder on Thursday, more than four months after management rejected his $22-per-share takeover bid. Icahn and WCI clashed for weeks over Icahn's proposed takeover and control of the board, each urging shareholders to support their candidates, before settling recently on the compromise approved Thursday. WCI nominated three of its candidates, plus Icahn and two of his candidates. Three additional directors were nominated jointly by WCI and Icahn. Icahn companies control more than 14.5 percent of WCI.

That's right, Icahn wanted to buy WCI for $22 per share. The stock currently trades at $9. That boneheaded bid lands him a board seat because of his 15% stake in the company. But hey, if I was a shareholder and he bid $22, I'd vote him on the board too.

Seriously though, I bring this up because many investors blindly buy stocks that billionaires like Icahn and Buffett get involved with. Although they make a lot of money, they are human too, so they make mistakes just like the rest of us. As a result, do your homework even if you want to follow a great investor into an investment. If your research yields a strong reason to buy (which would likely not have been the case with WCI) then at least you have less of a chance of making a mistake.

Full Disclosure: No position in WCI

Post-Vacation Thoughts

Wow. What a week and a half to take a vacation. Either it was a great time to miss, or it was the opposite. Obviously I'm biased, but I'd have to go with the former. Sometimes the daily volatility of the market sends investors on more of an emotional roller coaster than anything else, and that isn't usually helpful. After all, roller coasters end up right where they started for the most part.

It looks like the S&P 500 traded in a 8.9% intraday range during the 8 trading days I missed, from 1370 all the way up to 1503. Despite that, when all the dust settled, stock prices dropped only 2 percent during my time away, so really my trip (I was in Boston and Cape Cod) saved me some emotional highs and lows.

I haven't had a lot of time to catch up yet, but one thing did get my attention, so I thought I would share. I don't know if it got a lot of airtime or not (likely not given it was pretty eventful with the Fed moves, etc), but the market finally got the long awaited 10 percent correction (at least on an intraday basis -- 11.9% -- it was only 9.6% on a closing basis).

Now, normally this would be unimportant enough that I might not even mention it, but there are a couple reasons why I think it is notable this time around. First, there were tons of people who were refusing to jump in with excess cash until we got that "official" drop. It sounds silly, but when investment strategists think the market is overbought, as many had for several months as the S&P crossed 1400 and then 1500, they need a significant sell-off to be convinced some excesses are removed. I have no doubt that market players who were waiting for a 10% down move are beginning to put some cash to work slowly.

Normally, a 10 percent correction is no big deal. We expect them to happen. I don't have any statistics handy, but I'd guess we see one every year or so on average. They are normal and very healthy. Amazingly though, we had gone four and a half years without a full 10 percent drop in the S&P 500 index. This worried a lot of people because it was the longest streak ever without a sizable market drop. I don't think it signaled the end of the world or anything to anybody, but when you go that long, you are due for a fall, and while nobody knows exactly when it will happen, it still prevents investors from getting overly bullish and firmly committing investment funds. The streak, in the eyes of many, was simply a symbol of the times, an overbought market that was being powered by many things, including the private equity M&A boom, which appears to be normalizing.

As I comb through the individual company news times of interest from the last week and a half, I'll be sure to share anything that catches my eye that would have otherwise been posted had I been in the office. Feel free to let me know if there is anything you would like me to write about in coming days. It's good to be back, and thanks for your patience during my vacation time.

Hedge Funds Can Just Freeze Redemptions... Must Be Nice

Maybe it's just me, but is anyone else amazed that when hedge funds run into trouble (as many have recently by investing in mortgage-backed securities) and investors ask for their money back, the fund can simply say no? This is astonishing to me.

Now, don't get me wrong. Managers can run their funds any way they want. Typically, fund rules stipulate that investors can withdraw money only during certain windows (quarterly and annually are most common). That makes sense, as it can be tough to put on positions if people can just come and go as they please. But how about when you ask for your money back during a pre-approved window and the hedge fund comes back and says "Sorry, but we have frozen redemptions."

Bear Stearns (BSC) did this with their recent funds that ultimately went bust and are being sued right now because of what they allegedly told investors regarding the riskiness of the portfolios when they tried to get their money out.

Why on earth would anyone invest in a hedge fund that gave you no guarantee that you could take your money out if you wanted to? How can hedge funds get away with simply denying one's request? Do any readers out there invest in hedge funds? Are you worried about wanting to get your money out at some point and being told you can't? Seems risky to me...

Full Disclosure: No position in BSC at the time of writing

Just Don't Panic

On days like this the best advice I can give is, don't panic. Panic selling just because the market gets a little scary will, more often than not, prove to be a big mistake. Every once in a while the psychology of the market takes over. Regardless of fundamentals, stock prices simply move in irrational ways. The best thing to do is simply sit tight and wait it out.

This is not to say that every stock's move lately is irrational, but a company can post strong earnings, have a good conference call, get a nice stock price bump, and then a few days later the market tanks and the shares are much lower than they were before. In the short term, psychology always trumps fundamentals.

However, if you've done your homework and are confident in your investment thesis for particular names, just wait it out. You can add to positions if you want, but that can be hard in a tape like this. Selling into the panic most likely will cause you to have called the bottom and not profited from it.

Are there any real contrarian buys out there? I would not try to bottom fish in the mortgage area. There will be a point in time where Countrywide (CFC) is a buy, but I think we have a long way to go. It looks like the housing market won't improve much, if at all, in 2008. I think it's too early to jump in.

That said, the reason why CFC will be a buy at some point in the future is because of the valuation. Unlike the brokerage stocks, which could be facing peak earnings, Countrywide is staring at trough earnings and the stock still trades at a 10 P/E. It could certainly get worse before it gets better, so CFC's recently reduced 2007 guidance of $3.00 per share might be too high. Who knows, maybe they'll earn $2.00 when it's all said and done, which means there is plenty of downside left. Until housing stabilizes for a long period of time and inventories diminish, I would stay away.

All in all though, just don't panic. We've gone through periods like this before (earlier this year in fact), and things always wind up being okay longer term. Unless we see serious and sustainable ripple effects in the economy from the housing market, I am not overly concerned. However, patience is required during times like these more than others.

Full Disclosure: No position in CFC at the time of writing

Why Would a CEO Stick with Quarterly Guidance?

I read an interesting take on this question today and I think it has a lot of merit. While many of us would prefer public companies abandon quarterly guidance, there are reasons why a CEO would keep giving it out. One reason might be to make them look good, and therefore enhance their job security.

If you are an active investment manager (whether for personal assets or professionally) you have likely observed in recent years that a pattern has developed during earnings season on Wall Street. Companies tend to beat estimates for the most recent quarter and guide estimates lower for the current and/or future periods. The end result is that most quarters finish with earnings coming in ahead of estimates on the whole.

While stock prices might dip in the short term because investors care more about future guidance than earnings already booked, this practice sets the bar very low. By keeping expectations meager, it maximizes the odds that the company will beat numbers next quarter, and that makes management look good. Under-promise and over-deliver ("UPOD" as Jim Cramer calls it). It works, and it's what public companies should do in general (although maybe less often than every three months).

I think this is a great explanation for why many companies will keep playing the guidance game. It sets the bar low, makes them look like they're doing a good job running their companies, and boosts their job security. If you don't give guidance at all, the analysts could set the bar too high, forcing you to miss numbers and get an earful from investors.

How can investors play this growing trend? Buy stocks after a post-earnings sell off due to a guide down. After the company sets the bar low, investors adjust their valuations accordingly. Over the next couple months, Wall Street will realize the numbers are too low and the stocks will get a boost as strong performance is priced in again. Use that strength to pare off positions before the next earnings report if you think they might be lackluster or conservative.

That seems like the best way to trade the ever-growing trend of beating earnings and guiding lower for future quarters.