Shattered Confidence Is Market's Big Obstacle
By ERIN SCHULTE
THE WALL STREET JOURNAL ONLINE
WorldCom's revelation last week that it pulled off one of the biggest accounting shams in history underscores a key obstacle to the stock market's recovery: investors' shattered confidence.
Improving corporate profits are the ultimate driver of the stock market, but if there's a shadow of doubt that the numbers are right, who knows if earnings are really getting better?
"Before you can begin to rebuild trust, you have to come clean as to what your problems were. Bear your sins, be accountable," said Joe Borg, president of the North American Securities Administrators Association. "What the market needs now is no bad news."
While there have been signs of improvement earnings and in the economy -- the first quarter grew at the fastest pace since 1999, the steady stream of accounting scandals has investors cowering.
Concerns over the credibility of corporate accounting have led to a series of setbacks for stocks, leaving major indexes in the red for the year. The Nasdaq Composite Index was down 25% as of Friday, while the Standard & Poors 500-stock index was 14% lower and the Dow Jones Industrial Average was off 7.8%.
Accounting worries have greatly contributed to volatility in the market. At one point last week, news of WorldCom's shenanigans sent the Nasdaq plunging to a new five-year low, though markets ended little changed for the week. Even hints of accounting problems wreak havoc -- General Motors' shares were halted Thursday amid rumors of irregularities at one of its units. The company denied there were accounting problems.
While there's no doubt it would take a nice confluence of events -- steadily improving corporate profits and strengthening economic signals among them -- to firmly and enduringly coax stocks higher, regaining investors' trust in corporate accounting is necessary as well.
How long it might take for investors to feel comfortable with corporate accounting is up for debate, but those who watch the market agree that there are steps to take to hasten the process.
Among them, vengeance.
"A couple of high-profile executives need to go to jail. I'm talking about a maximum-security prison," said Pat Dorsey, director of stock analysis for Morningstar. "That rarely happens with white-collar crime, and more rarely with financial fraud. It seems to me that would be a deterrent" to further accounting chicanery.
Last week, Harvey Pitt, chairman of the Securities and Exchange Commission, vowed before the New York Economic Club that he would push the SEC to complete its investigation of WorldCom "as rapidly as is humanly possible." The agency filed fraud charges against WorldCom in federal court Wednesday.
"Serious jail time is called for by serious financial crime," Mr. Pitt said.
Investors also are demanding that the federal government restrain financial fudgers with new accounting laws.
Democratic majority leader Sen. Tom Daschle of South Dakota said last week that he would be taking up legislation proposing sweeping reforms in the accounting industry in days, rather than in September, when it was initially scheduled.
Proposals include protections for worker-retirement accounts, changes in accounting for stock options, new criminal penalties for people who shred documents, and protections for corporate informants.
Investor advocates also want to see the government give the SEC more money.
"The SEC is woefully underfunded," Mr. Borg said. "They're stretched thin and I think they need more resources.
New bills before the House and Senate propose boosting the SEC's budget next year to $776 million -- a whopping 66% increase above its previously proposed budget.
Still, Mr. Borg added, "you can't legislate honesty in the board room."
That's why investors also want to see less cronyism and more shareholder advocacy on companies' boards of directors.
"The ultimate responsibility for corporate governance rests on the board of directors. But boards have been captured by executives who fill them with friends, relatives and untrained persons," said Harlan Platt, a professor of finance and insurance at Northeastern University. "The situation is like having the inmates in a jail selecting who their guards should be. It just doesn't work."
In addition, reporting standards need to be revised.
Currently, companies don't have to file full quarterly reports when they release earnings publicly.
Mr. Dorsey said the SEC should require companies to release their income, balance sheet and cash flow at the same time so investors can better understand the company's health. The New York Stock Exchange recently called on the SEC to require companies to report complete financial information that adhere to generally accepted accounting principles before any reference to pro-forma or adjusted financial information.
"You don't see 10-Q releases for 45 days after the quarter ends. It's absurd," Mr. Dorsey said. "Right now you see plenty of releases with just earnings, and it really encourages pro-forma accounting."
Maybe the WorldCom admission alone wouldn't have made investors feel like they had been royally duped by corporate bigwigs.
Frankly, it wasn't a huge surprise. The troubled company's shares were already trading at under a dollar, down from a high of $64.50 in June 1999, it was under investigation by the SEC, and there was talk of bankruptcy in the air.
But the former telecom highflier was the latest in long line of companies -- including Global Crossing, Adelphia, Enron and Tyco -- with accounting confessions. Most recently, a new audit of Xerox found that the company improperly accelerated more revenue in the last five years than the SEC previously estimated it did.
Investors are fed up. But they're also worried there are more shoes ready to drop.
Seemingly no one on Wall Street will be surprised if WorldCom isn't the last company to step up and confess its sins, considering the pressure corporate America felt to deliver stellar earnings growth during the '90s -- even if it meant bluffing, in a few cases.
"During the go-get-'em '90s, the old Wall Street adage 'Greed is good' became the mantra," Mr. Borg said. "I would not be surprised if we found there were more restatements. But we hope they're not as extensive."
And WorldCom's troubles could do more than just ruin investors' faith in accounting.
It's a big buyer of networking gear, and recently said it would maintain but not expand its network. That'll hit telecom-equipment companies.
Banks with exposure to WorldCom's debt could be at risk. Even sectors like advertising could suffer if other companies don't pick up WorldCom's slack -- telecom companies are the 7th-largest category in U.S. television advertising, according to Merrill Lynch. WorldCom accounted for 8% of telecom advertising.
Companies that measure growth by Ebitda (earnings before interest, taxes, depreciation and amortization, a measure used to determine growth in companies that aren't yet profitable), like WorldCom did, also are facing increased scrutiny.
Winning investors' trust back will be no easy task, but eventually it will happen, strategists say.
Hugh Johnson, chief investment officer at First Albany Corp. and one who always has something to say about Wall Street's history, took a page from "Manias, Panics and Crashes," written by Charles Poor Kindleberger.
"Swindles of the sort we're seeing are ubiquitous in financial market history and are ever present. They're not unique," Mr. Johnson said. "They're also limited. They are not an infinite number."
Eventually, he says, you get down to the last swindler, and it's followed by a recovery in confidence.
Finally, no matter how many scandals there are or how much money gets flushed down the tubes along with executives' careers, investors will probably never be able to resist the siren song of the stock market.
"It's like going on a date. You get burned once and you say, I'm never going to date again," said John Forelli, Senior Vice President of Independence Investment Associates. "But eventually, you go back, and you go on another date."
Write to Erin Schulte at erin.schulte@wsj.com
Updated June 29, 2002 11:58 a.m. EDT |
