Of course, I’m not an accountant and so it’s possible I’m overlooking something that makes this much more benign than I think.  But my intuition is that now, perhaps more than ever, it pays to be a skeptical investor, to assume the left side of the ledger is exaggerated.  In this context, I feel it’s reasonable to assume that, until proven otherwise, intangible assets are worth much less than their stated value.  In the extreme case, this implies stocks will ultimately trade down to levels approximating their tangible book value. 

One could object that most of the value in a service economy derives from its intangible assets.  And there is quite a bit of truth to this.

Still, it’s alarming that the ratio of intangible assets to total assets is higher in the US than anywhere else.  And it’s not simply the service sector either.  Large cap industrials- e.g., Honeywell, Comcast, HP, Kraft Foods etc.- are where one finds the greatest abuses.  Kraft claims $43 billion in intangible assets and has a market cap of roughly $36 billion; Comcast claims $77.5 billion in intangible assets and has a market cap of $39 billion. The list goes on and on.  These bloated figures are often the result of acquisitions in which they paid a substantial premium to book value.  If the acquisitions were made during the height of the bull market, then it’s quite likely the premium can no longer be justified, which will eventually lead to impairment charges- Time Warner’s impairment charge last month was largely the result of overpaying for AOL.  A more extreme example in a different sector is Wachovia, paying $25 billion for Golden West Mortgage during the height of the housing bubble.  Less than two years after the acquisition Wachovia’s market cap was less than half the price they paid for Golden West.  Once Wells Fargo took over Wachovia, they immediately recorded a $25 billion impairment charge relating to Golden West. 
 
I agree service companies or companies with great brand recognition have valuable intangible assets.  But even here there is, in my view, cause for concern.  Sony is unquestionably a brand everyone recognizes, and yet intangibles make up less than 10% of their total assets.  39% of Hewlett-Packard’s assets are intangible.  What justifies the difference? 
 
Also, during the depression companies like GE, Coke, Procter and Gamble, IBM, claimed goodwill of $1 dollar.  Again, I don’t dispute the claim that intangible assets have value- I just fear they are not what most companies claim.

“The U.S. government may find buyout firms, hedge funds and other private investors reluctant to help it cleanse banks of toxic assets, hampering efforts to jumpstart the economy… they worry about how the assets would be priced and what guarantees they would get against potential losses.A further concern for investors is likely to be the government’s track record on how it handled the first round of the $700 billion rescue for the industry, when it imposed restrictions on such things as dividends and compensation on banks that received taxpayer money.” (By Paritosh Bansal and Jennifer Ablan )

The second, written at 5:39 PM EST,  says:

“The Obama administration on Monday was nailing down details of a bank rescue plan expected to offer incentives to lure private investors into buying bad debts undermining the financial system and the economy.” (By Kevin Drawbaugh)

CNBC joins the fun,  saying at 6:12 PM EST:

“According to Steve Liesman, here’s what you can expect.

The Bank Plan

-Aggregator Bank for Toxic Assets
-Expanded TALF
-Foreclosure Mitigation
-Expanded Asset Insurance

Liesman tells the traders there will be some form of a bad bank in the plan to soak up toxic assets.”

CNBC reports at 6:19 PM EST that:

“The Obama administration’s wide-ranging plan to stabilize the financial system no longer includes creating a “bad bank” but will still contain measures to buy up toxic assets from financial institutions, according to a source familiar with the plan.”

Is this a deliberate attempt to keep us misinformed?

In case you missed it, last week’s broad rally in the face of bad news was proof enough that the “stock market is telling us that the economy’s future is a lot brighter than its past”…that “the stock market looks ahead”…and that ”mustard seeds planted a while back are now pointing to economic recovery.”    So says CNBC’s Larry Kudlow, an economist whose uniformly dismal predictions are outdone only by the most infamous one of all- Irving Fisher’s claim a few days before the crash of 1929 that “Stock prices have reached what looks like a permanently high plateau.” 

According to Kudlow and his erstwhile partner Jim Cramer, the economy is recovering and the market isn’t as bad as you think since:

-commodities have bottomed and basic material stocks are moving higher

-the Baltic Dry Index doubled in roughly two months

-a financial rescue plan is imminent (again)

-the Fed will do whatever it takes to reflate asset prices

-foreign markets, e.g. China, are firm

Remarkably similar reasons were put forward to explain a powerful stock market rally in the WSJ on June 4 1931, June 23, 1931, and June 27, 1931.  After making a relative high in February 1931, the DJIA fell -39% almost without interuption until early June 1931.  The DJIA then rallied 11% in the first week of June.  After a week of consolidation the Dow resumed its advance, exploding higher for the rest of the month.  From a low of 119 on June 2, the Dow rallied 31% to a high of 156 on June 29.   The WSJ said the following:

On June 4, 1931:

-Recent developments were “taken as evidence of the government’s willingness to do everything in its power to aid constructive business enterprises.”

-…”Trade news was of a more cheerful character, particularly the freight traffic figures for the week ending May 23…scoring an increase of 7339 cars over the previous week.”

On June 23, 1931:

-”Worldwide enthusiasm was aroused over Sunday by President Hoover’s proposal of a year’s moratorium in war debts.”

-The moratorium “was counted upon to exercise a tremendous influence in stabilizing international conditions.”

-”Foreign commodity markets were buoyant…”

-”Vigorous bullish demonstrations took place in the copper stocks on the outlook for better foreign demand for the metal.”

-Many believe “the sudden turn for the better in the international situation has sounded the death knell of the bear market.”

On June 27, 1931:

-”Sharp advances on the Paris Bourse were interpreted to mean that favorable action would be taken regarding the Hoover debt proposals.”

-…”News of the greatest significance appears to have been generally overlooked, namely the purchase of government securities by the Federal Reserve…”

-Fed purchases of government securities indicates “a real change in sentiment, that businessmen will borrow and banks will be willing to lend…Monetary theory indicates that an improvement in commodity and other prices can be looked for.”

Of course, June 1931 turned out to be one of the many impressive, though ultimately fleeting bear market rallies that occurred during the first leg of the Great Depression.  From it’s relative high of 156 on June 29, 1931, the Dow fell -74% before reaching its final low of 40 on July 8, 1932. 

This raises an interesting question about Kudlow’s- and many others- belief that “the stock market looks ahead.”  The stock market is composed of individuals reasoning about the future; individuals have very little ability to predict future events.  If market behavior is the sum of its participant’s decisions, why should we believe the former has predictive capabilities when the latter does not?

June 1931- like October 2007, March-June 2008 and countless other occasions- was undoubtedly an example of the market looking ahead, but it was the market looking ahead incorrectly.  Many of the same reasons we hear today to support the case for a market bottom are eerily similar to those offered in 1931, begging the question if the outcomes will be as well?  Contrary to what the cheerleaders and salespeople say at CNBC,  it’s far too early to know.