Crisis of Confidence
SmartMoney.com
Wed Feb 6, 3:56 PM ET
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 (Other: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 already helped 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 (NYSE:TYC - news) 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 (OTC:GBLXQ - news), struggling Irish pharmaceutical company Elan (NYSE:ELN - news), PNC Financial Services Group (NYSE:PNC - news) and Enterasys Networks (NYSE:ETS - news), a maker of networking hardware and software. In addition, many companies are simply suffering from guilt-by-Enron-association (think Calpine (NYSE:CPN - news) and Williams (NYSE:WMB - news)) or overly complex balance sheets (General Electric (NYSE:GE - news) comes to mind). Others, such as J.P. Morgan Chase (NYSE:JPM - news) and Citigroup (NYSE:C - news), 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.'' |
