By Amey Stone While the stock market remains in a depressingly narrow trading range so far this year, it's becoming increasingly clear that the problem isn't the economy, which is recovering. The issue is disillusioned investors, who, despite the prospect of an earnings bounce later in the year, aren't ready to get back into the game. Many of them don't trust analysts to forecast earnings or companies to deliver honest profits as accounting and analyst-research scandals continue to mount amid accusations of corporate malfeasance.
Although the market rose on June 10, the prior three weeks had brought a 200-point decline in the Nasdaq and below-10,000 trading in the Dow, wringing out the last vestiges of enthusiasm for stocks in the general public. "People have gotten burned in the stock market over and over again," says Peter Cohan, author and investment strategist. "A lot of people have just thrown up their hands in disgust." Talk of real estate and home improvements has replaced stock-market chatter at cocktail parties. Investors haven't just lost confidence in Wall Street, they've moved on.
"AN OPPORTUNITY." What will bring them back? In an effort to restore public faith in the markets, some on the Street are calling for stronger corporate governance, more transparent accounting, and better regulatory oversight. In a recent speech, Goldman Sachs CEO Henry Paulson called the new scrutiny, "an opportunity -- a chance for all interested parties to reassess our current practices and renew our basic principles." But while his and other proposed changes are all well, good, and necessary, most of what's on the table now seems like too little, too late.
It will probably take change of a larger order to really bring investors back into the market. Good news -- like an exciting new technological breakthrough or a surprisingly robust earnings season -- just might do the trick. But chances are that the kind of shakeup required might mean more near-term pain. Here's a list of some changes that might, in the long run, make investors feel like it's safe to put their money into equities again:
Jail Time. Call it the American Way, but many individual investors won't believe things have really changed on Wall Street and in Corporate America until they see some of the worst offenders hauled off in handcuffs. It isn't just that the public wants to find someone to blame for their own stock market losses. Rather, it's a rational assessment that only the real threat of jail time will be enough to get greedy analysts and corporate execs to change their priorities.
A Dramatic Capitulation. Many analysts believe the markets may need to go through a powerful sell-off before a sustainable rally can be mounted. "Another big leg down and a few more die-hards shaken off the roller-coaster, and we might just be in a place where we can talk about building long positions at decent prices," Donald Luskin, chief investment officer at research boutique Trend Macrolytics, wrote to clients on June 6.
Stock Bargains. Once investors are confident that Wall Street's greed machine has been tamed, they'll still need a reason to buy stocks. Given that concerns about domestic terrorism and global political uncertainty aren't going away anytime soon, stocks may have to get a lot cheaper before investors en masse feel like assuming the risk of owning them anytime soon.
"The market is being tarred over concerns about terrorism, accounting, research conflicts, earnings, and the [weakening] dollar," says Sam Stovall, senior investment strategist at Standard & Poor's. "But the one factor that makes it really difficult for us to break out of this is valuations." The trailing price-earnings (p-e) multiple on the S&P 500 is 30 or 40, depending on who calculates it. That's still too high. For most of the last century, p-e ratios have averaged 16. And historically, coming out of recessions, the average has been just 13, says Stovall.
If earnings jump up, p-e ratios would get back in line. But "we'd have to experience at least a 33% increase in earnings just to bring the p-e down to 20, which is still higher than historical norms," Stovall says. There's some reason for hope, though. Business spending could be a lot stronger in the second half of the year, noted Prudential Securities' Edward Yardeni in a recent report. And given the amount of "operating leverage" at work in the economy, investors could be surprised later in the year (see BW Online, 6/6/02, "A Scent the Bears Are Missing").
Improved Financial Reporting. Most investors agree that earnings statements have gotten too hard for outsiders to understand -- and too easy for insiders to manipulate. Tinkering with accounting rules is already under way. But what the market could really use is a brand-new way for public companies to report results in a way everyone can understand.
Standard & Poor's recently came up with a new way to calculate "core" earnings, taking into account the expense of employee stock options, among other things. This proposal's impact would be quite radical if it were widely adopted by the investment community.
There are other ways to deliver corporate results that are easy to grasp and compare. As a kind of one-time resetting of the financial clock, Cohan suggests that companies be required to provide a detailed analysis of how they came up with their 2001 revenue number and then reconcile that with the amount of cash they received from customers. They could also be ranked by how quickly they could come up the data. "It would help us understand which companies are under control and which ones aren't," says Cohan.
Reform CEO Compensation. Clearly, executive pay has evolved in a way that gives managers far too great an incentive to take risks and manipulate results. One answer is for senior management to be paid in restricted stock -- which is accounted for on the income statement and better aligns their interests with those of shareholders, says Ken Broad, a portfolio manager for Transamerica Investment Management. Better yet, they could be required to hold onto the stock for as long as they're running the company.
Another compensation area overdue for change: parachute clauses that allow failed CEOs to get huge payments on the way out. "It is galling," says Broad. "They failed, value was destroyed, and they get rewarded."
Corporate Peer Pressure. Another force that could lead to real change in business practices is for a new crop of leading companies to emerge -- ones that prospered in tough times by having the best in corporate governance, accounting standards, investor relations, and -- yes -- business ethics.
Companies like to emulate successful peers, says Cohan. He thinks Wal-Mart (WMT) and Southwest Airlines (LUV) are two examples of this kind of leading corporation. Broad points to CH Robinson Worldwide (CHRW), a logistics outfit in Minneapolis that has an exemplary compensation plan for its CEO, which includes paying the chief executive in restricted stock that vests over 15 years. It would help restore market confidence if more blue-chip names could be added to the list of standouts.
Institutional Leadership. Individual investors may not have the power to push these kinds of changes through. When it comes to cleaning up corporate earnings statements and forcing reform at major public companies, the force in the economy with the power to alter current practices the quickest is the big shareholding institutions, says Broad. "The onus is on big institutional investors to say, 'No more,'" he explains. Until that happens, or some real reform occurs, individual investors may well decide to put their money elsewhere. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column