What It Means When Accounting Stories Start Making the Rounds

(This originally ran at Empire Financial Research.)

When I'm screening for companies to recommend in my?QUANT-X System?and?Empire Real Wealth?newsletters, I always start the process the same way...

I type the symbol into a screen created for me by my friends at Kailash Concepts and scroll to the bottom.

Up pops a score there that shows the likelihood that the company is manipulating its earnings... But if things are really bad, the screen flashes the dreaded "manipulator flag."

If there's a flag – and there usually isn't – I move on. If the score is high, I tread carefully. The screen also helps me quickly identify high and low earnings and balance sheet quality, and even potentially good and bad capital allocators.

This is a jumping-off point for further research, and the obvious goal is to first weed out those stocks I wouldn't touch. The manipulator score is part of that process.

The reason I bring this up...

Last week, the?Wall Street Journal?wrote about that score – appropriately called the "probability of manipulation" or "PROBM" model... better known as the M-Score, whose claim to fame was spotting Enron (among others) before it became news.

And not just how the score is used to identify fraud, but how that translates to the economy as a whole...

As the article explained (emphasis added)...

Since the 1990s, the metric has been used to identify red flags at individual companies. Now Messod D. Beneish, a professor of accounting at Indiana University who developed the M-Score in the 1990s, and several co-authors have calculated an aggregate score for nearly 2,000 companies. It shows a disturbing pattern in the historical data:?The probability of manipulation usually rises rapidly in the quarters before the economy tips into recession.

"We think this is a measure of misinformation in the economy," said Dr. Beneish. The new aggregate measure was published in a December paper,?and the latest data –compiled in March and shared with the?Wall Street Journal?– shows that the collective probability of fraud across major companies is the highest in over 40 years.

As is often the case, that shouldn't be a surprise... Nobody but short sellers pay attention or care when stock prices are rising.

And when stocks rise, there's a tendency for two things to happen....

1. Executives start believing their own BS, confusing the stock price with what's really going on at their company.
3. There's pressure to make sure numbers don't disappoint. This can lead to a little stretching here... which can then turn into a lot of stretching there.

And it can all lead to the perception that things are better than they really are – not just for individual companies, but for the broader economy.

This last time was a doozy, and it was obvious to anybody who has been around for more than a cycle or two...

Like famed short seller Jim Chanos, who started talking about something he called the "Golden Age of Fraud" long before the bubble became a bona-fide bubble. In a recent interview with the Institute for New Economic Thinking, he explained it like this (emphasis added)...

And so I coined that term a couple years ago as I started to see post pandemic the excesses really begin to build in the financial markets, both public and private, culminating in 2021, which was the most speculative year that I've experienced in the markets in over 40 years.

And one of the things I teach in my class... is that?the fraud cycle follows the business and financial cycle with a lag.

That is the longer you have an expansion, the longer a bull market goes on the more incidents of fraud occurs as it matures. And then of course once things turn down you begin to get fraud exposed, because many frauds are at their basis a Ponzi scheme and need to raise new and new capital.

And so the poster child for that obviously is what we saw happen in crypto last year, which was the red hot culmination of speculative frenzy, lack of oversight, lack of law enforcement, and just pure unadulterated greed that got caught up, and then exposed in all kinds of schemes that at their very nature simply Ponzi schemes.

This gets us to where we are today...

As one friend – a former short seller and an astute observer of the markets – says...

You know the market is at the end of a cycle because the accounting fraud articles are starting to pop up.

The only question, it seems, is how long this cycle will last... And I have a feeling we have more of these accounting stories ahead of us.

As always, feel free to reach out by commenting below or emailing me at [email protected]. I look forward to hearing from you.