SMARTMONEY.COM: The Economy: Crisis Of Confidence
07 Feb 08:00
By Rebecca Thomas
Of SMARTMONEY.COM
(This report was first published late Wednesday.)
HOW MANY rotten apples does it take to spoil the whole bag? That's the
question investors are asking themselves these days as corporate America
divulges one accounting scandal after another. None has been nearly as
devastating - or as nefarious - as the Enron (ENRNQ) debacle, of course, but
fear continues to ripple through the marketplace nonetheless.
If, in the days ahead, new revelations show that more corporations have
systematically concealed (criminally or otherwise) the true state of corporate
revenues and profits, confidence could be shattered - spelling even more
trouble. As the perception of risk rises, markets would insist on more
compensation for shouldering that added risk. Investors would be willing to pay
less for each dollar of corporate earnings, which would mean broadly lower
stock prices. And lenders would demand more return for parking their money in
corporate bonds, which would mean higher interest rates. This tightening of the
financial markets could constrict the flow of capital, shrink household wealth
and raise borrowing costs. All that in turn could slow spending by both
consumers and businesses, nipping the burgeoning economic recovery in the bud.
OK, that's the worst-case scenario. Still, the potential for an
Enron-inspired domino effect is very much on the mind of behavioral economists,
who study the relationship between psychology and finance. "We have an
accounting crisis at the same time that we have record [price-to-earnings]
multiples, and we're in a recession," says Robert Shiller, the author of
"Irrational Exuberance" and a professor of economics at Yale University. "The
market is vulnerable."
The general investing malaise brought on by daily revelations of dubious
corporate accounting practices - what Wall Street has dubbed "Enronitis" - has
alreadyhelped spark a broad downturn in equities in the New Year. Since stocks
peaked a month ago, the Standard & Poor's 500 is down 7.6%, the Dow Jones
Industrial Average is off 5.9%, and the tech-heavy Nasdaq Composite is 12%
lighter.
To some economists, the pullback reflects a healthy reassessment of
marketplace risk. Companies that used overly aggressive accounting practices to
inflate results will be taken to task, whereas the vast majority of companies
that accurately report earnings will survive the shakeout relatively unscathed.
"It's hard to believe that this is endemic," says Jeremy Siegal, a finance
professor at the University of Pennsylvania's Wharton School of Business. "A
number of companies, particularly in the tech sector, have stretched the
concept of earnings in their favor.... But the vast majority of companies are
clean."
To others, however, the retreat in equities represents an increasingly
pervasive mistrust in the entire corporate-reporting system. Or, as Woody
Dorsey, a behavioral market expert and the founder of research firm Market
Semiotics, explains: "Enron has galvanized the markets to question accounting
and profitability in general.... Every balance sheet now becomes a question
mark, rightly or wrongly." To some extent, this has already started happening.
Although Tyco International (TYC) is perhaps the poster child of the new
guilty-until-proven-innocent mentality (year-to-date, Tyco's stock is down more
than 50% amid concerns over the conglomerate's muddy accounting practices and
rising debt load), charges of suspect accounting have been leveled against a
number of companies, including telecom provider Global Crossing (GBLXQ),
struggling Irish pharmaceutical company Elan (ELN), PNC Financial Services
Group (PNC) and Enterasys Networks (ETS), a maker of networking hardware and
software. In addition, many companies are simply suffering from
guilt-by-Enron-association - think Calpine (CPN) and Williams Cos. (WMB) - or
overly complex balance sheets: General Electric (GE) comes to mind). Others,
such as J.P. Morgan Chase (JPM) and Citigroup (C), are on the hook for billions
of dollars in debt that may never get paid.
"The financial markets are shot through with problems of asymmetric
information," says Lawrence White, a professor of economics at New York
University's Stern School of Business. "What you're going to see is companies
falling all over themselves to be greater revealers."
It's the fear of exactly what these companies might reveal - or keep
concealed - that now threatens market stability.
"Most of us have no way of knowing which company will be next," says John R.
Nofsinger, the author of "Investment Madness: How Psychology Affects Your
Investing...and What to Do About It" and a finance professor at Washington
State University.
This extreme form of uncertainty, is what markets hate most of all. American
capitalism's strength has always been its comprehensive set of rules and
regulations meant to protect shareholders from greedy corporate managers,
explains Terrance Odean, assistant professor at the Haas School of Business at
the University of California at Berkeley. Although U.S. investors are willing
to take on the risk that a business won't live up to its performance
expectations, they've always believed that insider trading and full disclosure
laws would prevent outright fraud. While Odean thinks we're "a long way from
supposing that we can't trust companies not to defraud us," he concedes that
the Enron scandal "is not a step in the right direction."
Barton Biggs, Morgan Stanley's chief U.S. strategist, is blunter: "Investors
know there will always be cheats and frauds, but they rely on the governance
system of the Fed, the SEC, the exchanges and the accounting profession to
protect them," he writes. "If the people begin to believe the stock market is a
manipulated game for insiders, the wealthy and the hedge funds, they won't
entrust their savings and pensions to it. That's a big deal."
For the most part, however, economists remain confident in the continued
smooth functioning of the capital markets, whether or not the stock market
continues to sink. Indeed, the pessimistic assumptions built into the bond
market after Sept. 11 have been easing. To John Puchalla, chief economist at
Moody's Investors Service, that suggests that "things aren't falling apart."
The spread, or difference in yields, between corporate bonds and U.S.
Treasury securities is a sensitive indicator of how worried investors are about
the state of the economy and the health of corporations, since it reflects the
premium they demand for lending money to companies instead of parking it in
risk-free government bonds. At 2.20%, the spread of investment-grade corporate
bonds over Treasurys has remained virtually unchanged this year, and is down
from a peak of 2.50% last fall, according to Standard & Poor's. Spreads on
speculative bonds (bonds that pay a high yield to compensate for greater risk)
over government debt have slightly widened over the past few weeks, to 10.12%
from 9.80% in early January, but that's still down substantially from an
October peak of 12.70%.
"There's a problem, but it's a matter of degree," says David Wyss, chief
economist at Standard & Poor's. "We don't think it's going to get much worse."
And it could be argued that any further Enron-related decline in equities -
so long as it's orderly and moderate - might actually be healthy for individual
investors and the market system in the long term.
For investors, the lesson should be one of diversification.
"To the extent that it alerts workers participating in 401(k) plans to the
risk of holding high fractions of their money in company stocks...it's an eye
opener," says David I. Laibson, assistant professor of economics at Harvard
University.
For the markets, the accounting debacle could have the perverse effect of
restoring investors' confidence in the capital system, assuming government and
corporate reforms lead to greater transparency and fairness.
"The U.S. has led the world in regulation of capital markets," says Yale's
Shiller. "I want to see us move and contain this crisis.... I think that's what
will happen."
For more information and analysis of companies and mutual funds, visit
SmartMoney.com at smartmoney.com.
(END) DOW JONES NEWS 02-07-02
08:00 AM |
