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Scandal markets { June 26 2002 } Original Source Link: (May no longer be active)
http://www.washingtonpost.com/wp-dyn/articles/A44973-2002Jun25.htmlhttp://www.washingtonpost.com/wp-dyn/articles/A44973-2002Jun25.html
Corporate Scandals Taking Toll On Markets
By Steven Pearlstein
Washington Post Staff Writer
Wednesday, June 26, 2002; Page A01
A major accounting firm convicted of obstructing justice. A leading brokerage caught misleading its clients. Imperious chief executives falling like flies. Huge corporations tumbling into bankruptcy. Business pages that read like the crime blotter.
Now, according to economists and market analysts, these still-unfolding corporate and accounting scandals have begun to weigh heavily on the stock market, the dollar and the U.S. economy. And the effects are likely to linger at least through the end of the year.
Just last night, WorldCom Inc. fired two executives and announced that it had mischaracterized expenses for more than a year, wiping out at least $1.6 billion in reported profits. Its shares, already below $1, plunged as low as 26 cents in after-hours trading.
"The economy and markets right now are in the midst of a full-blown corporate governance shock," said Stephen Roach, chief economist and resident pessimist at Morgan Stanley. "To presume somehow that it's over or the worst is behind us is naive."
Yesterday, the tech-laden Nasdaq composite and the much broader Standard & Poor's 500-stock indexes closed the day just a whisker above their low points after the Sept. 11 terrorist attacks, effectively wiping out the gains from last winter's rally. Analysts said the reversal reflects a growing skepticism among investors about the accuracy of corporate financial reports.
"There is clearly a liquidation going on here as people lose confidence in what companies and proponents of stocks have been telling them," said Robert J. Barbera, chief economist at Hoenig & Co.
Many of those investors are foreigners, who had shifted several trillion dollars into U.S. financial markets in recent years on the assumption that the currency-adjusted rates of return here were significantly better than anywhere else. Now, as they sell stocks and exchange the dollars for other currencies, they have driven down the value of the once highflying greenback by 8 percent against the yen and 12 percent against the euro.
"Foreign investors are coming to the realization that U.S. markets are riskier than they thought," said Richard Bernstein, chief equity strategist at Merrill Lynch & Co.
The effects of this setback on financial markets are already being felt in the real economy.
Desperate to reassure nervous investors about their balance sheets, corporate executives are slashing costs, selling divisions and using free cash to pay down debt. Although such strategies are helping to restore corporate profits, they tend to come at the expense of rebuilding inventories, hiring new workers and investing in new equipment -- activities that contribute directly to economic growth.
"When your stock is going down and you're trying to meet earnings targets by cutting costs, it reinforces the trend toward low investment levels," said John H. Makin, an economist at the American Enterprise Institute. "There's no question that this is helping to delay the recovery."
Consumers, meanwhile, have begun to hunker down again. The government reported last week that retail sales dropped 0.9 percent in May and that consumer confidence fell as much last month as it did after the terrorist attacks last year.
Governments, too, are feeling the effects of the stock market decline as revenue from capital gains taxes falls precipitously. Facing big budget deficits, state and local governments are warning they may soon begin slashing payrolls and purchases. That's another significant drag on the economy.
Economists at Goldman Sachs Group Inc. now estimate that when the books are closed on the three-month period ending in June, the demand for goods and services in the U.S. economy is likely to have increased at an annual rate of 1 percent after adjustment for inflation. That's half of what it was during the first quarter and less than a third of the rate of the final months of last year.
"It is this downward tilt that should be of concern to . . . [those] who have been anticipating a steady strengthening of economic growth through this year," Goldman advised clients Monday.
Certainly not all of this can be attributed to the corporate fraud and accounting scandals.
Forecaster Allen Sinai of Decision Economics, for example, puts the greater blame on anxieties over war and terrorism caused by conflict in Asia and the Middle East and increased talk of an invasion of Iraq.
And James Paulson, an economist and chief investment officer at Wells Capital Management in Minneapolis, cautions that other factors -- falling prices for many goods, anemic wage growth and the waning effectiveness of the Federal Reserve's low interest rate policy -- weigh more heavily on the economy than the corporate scandals.
But while its exact impact is hard to measure, analysts including Sinai and Paulson acknowledge that the ever-widening scandals have now become a significant factor in the recovery's lost momentum.
This is not the way economic cycles usually work. Normally, stock prices rebound three to six months before a recession ends and recovery begins. That's the way things were shaping up last fall, in the rally after Sept. 11, foreshadowing the return to economic growth in the final weeks of 2001. But beginning in March, when it became clear that the accounting and corporate governance problems weren't limited to Enron Corp. and Arthur Andersen LLP, the stock market abruptly reversed course.
"I think it is very serious," said Charles Pradilla, chief investment strategist at S.G. Cowen Securities Corp., speaking of the impact of the scandals on investor psychology.
Pradilla said the revulsion is particularly intense among individual investors in stocks and stock mutual funds -- investors who until recently bought stocks when prices fell in the hope of getting in early on the next bull market. Now, these investors are confronted with the fact that large, well-known companies are suddenly disappearing almost overnight. And it wasn't just the small investors who lost money, but supposedly smart, sophisticated investors have been fooled as well.
"The market now looks like "a crooked house, a sophisticated game of three card monte," Pradilla said. "People have decided that they're better off investing in things they know and understand, like their houses, as opposed to things they don't, like stocks."
A number of other analysts are also looking for continued declines in stock prices as the market reprices the increasing risk of owning stocks.
At Wells Capital Management, Paulson noted that corporations are only now beginning to make the transition from aggressive to conservative accounting. While that will be good for the market in the long run, he said, it will almost surely force a one-time reduction in the level of reported corporate profits. Stock prices, he said, have not been fully discounted for that cultural shift.
At Merrill Lynch, meanwhile, Bernstein has warned clients of a "considerable near term risk" that could see a further 10 to 15 percent decline in the major stock indexes. With the stocks of the S&P 500 still selling at 24 times their expected earnings next year, he said, "our view is that the market, even at this level, is still quite speculative." The historic average is around 15.
The implications of further declines in stock prices are anything but positive for the broader economy. Although this doesn't suggest the economy will slip back into recession again, forecaster Sinai sees little hope that the economy can grow at the 5 and 6 percent annual rates normally associated with economic recoveries. His forecasts calls for growth rates at half that.
"In the 20th century, we have never had a strong, sustained economic recovery when the stock market is meaningfully down," said economist Barbera of Hoenig & Co. "Unfortunately, I don't think it's going to happen this time, either."
© 2002 The Washington Post Company
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