a quick note on mark to market accounting
Mark to market accounting has been at the core of the thesis behind my bullish perspective for some time. Basically, it works like this:
Imagine you had a business that made $100,000 every year. But in addition to that,the business invested $2 million worth of corporate bonds at 7.5%. That would bring in an additional $150,000 each year.
Then imagine that one year - the companies weren't broke, they were still paying interest on the bonds - the bond market crashed. So your $2 mil of bonds were now worth $1.5 mil.
That year you would report a loss of $250k. You actually made $250k, nothing about your situation changed, but you'd report a loss of $250k. Because the market value of your assets fell, so you "mark" them to market and in doing so lose $500k. You make $100k from the business and $150k in interest, you mark down $500k and that adds up to a loss of a quarter mil.
Then imagine that the next year the bond market settled down and your bonds were worth par again... (or $2 mil market value). Then you would theoretically report $750k of income the next year ($100k from running the business + $150k of interest + $500k marked up to market).
Well here on Wall Street, mark to market in all of its sweeping, epic glory, doesn't work that way in all cases.
An insurance company like XL or HIG or GNW or CNO (4 of my 8 biggest holdings, mostly from earlier in the year and largely from near the march lows) has this fascinating and bizzare reality:
1. They DO mark losses to market. If the bond market (insurance companies sell you apolicy, probably make very little off that, then invest the proceeds, and those investments is where they make money) crashes they report a loss as described above.
2. They DON'T mark gains to market. If the bond market recovers, they DO NOT rpeort bizzarely large profits as a result. So, basically, imagine that the bond market crashed one year and recovered the next. GAAP WOULD report the LOSS, but WOULD NOT, report the gain. Book value would show this, but earnings would not.
So, in sum, mark to market accounting in its current form permanently reduces GAAP net earnings, making them unrealistically low. HIGmarked up a couple billion, they did not report earnings of a couple billion. They DID report losses of a couple billion when those investments dropped in value.
This is perverse, its almost unthinkable, its bizzare, but its reality. GAAP is bizzarely and epically flawed. And it will skew earnings DOWN for basically all of time as far as I can tell. Actual earnings will be > GAAP earnings due to these perversions of reality.
Consider that when someone parades a p/e of an indexin front of you to make a bearish argument.
We are in the middle or maybe the tail end or maybe just out of a great recession that was caused in no small part by mark to market accounting and its perverse and peculiar realities. The realities discussed above will be used for a long time as an argument for why stocks are overpriced.