Why Investors Remain Weary and Wary

Fears of war and terrorism, continued mistrust of Corporate America, and a weak economy are forming a vicious cycle that'll be tough to break

By Amey Stone

A year and a half since failed energy giant Enron kicked off an era of financial and corporate fraud-finding, the business world remains locked in an atmosphere of scandal and distrust. That's despite a major reform movement that promised to restore the public's trampled faith and rebuild dysfunctional institutions.

Indeed, investors got smacked again in late February with a huge accounting scandal at Dutch food giant Royal Ahold (AHO ) and the indictments of four executives from Qwest Communications (Q ) and two former Kmart vice-presidents on fraud charges.

"See, it continues," says Frank Gannon, a portfolio manager at AIG SunAmerica, while glancing at a news broadcast of the Qwest indictments on Feb. 25. Does he feel like anything has changed? "Some days I do, some days I don't," he says. "The big question is: Will any of this make investors feel more comfortable coming back into the market? We really haven't seen that yet." Many financial pros think it'll be years before all the emerging and yet-to-unfold scandals work their way through the legal system.

PERSONAL SAFETY.

  Of course, the situation is even more complicated. Iraq and terrorism fears, which have pushed the corporate scandals just off center stage, are also primary reasons why investors and executives aren't able to move past their feelings of uncertainty and loathing. Even as investigations grind on, prosecutions develop, fines are levied, and new regulations take hold, people aren't likely to feel better about much of anything until their concerns about their own personal safety and the future of the country are resolved.

Harkening back to behaviorist Abraham Maslow's hierarchy of needs, management consultant and author Peter Cohan theorizes that people have to feel safe and out of danger before they can worry about higher needs like self-esteem or achievement -- or investing in the future cash flow of a corporation. "I would almost welcome us going back to a point where we could care about the corporate scandals," he says. "If that's your worst problem, that's pretty good."

Overcapacity in many sectors is another reason the economy hasn't been able to push past this period of scandal. Industrial capacity utilization is mired at a low rate of 75.7% (above 80% is considered healthy). Too much capacity in technology and telecommunications is what burst the tech bubble in the first place. Even if a war with Iraq is swift and successful, the economy will still need to use up extra capacity before new investment will kick in.

NOT ENOUGH PLUSSES.

  In many ways, however, this weakness in the economy goes hand-in-hand with the corporate scandals. "It's a twofold effect," says Ken Broad, co-portfolio manager of Transamerica Growth Opportunities Fund (TPSCX ). "We've got the scandals, plus we've learned that what seemed like a buoyant economy was being propped up by numbers being inflated to look better than they were."

Sure, executives have been led off in handcuffs, Wall Street firms have agreed to pay substantial fines, and tough new laws have been written. Boards of directors are more independent, stock research is less burdened by conflicts of interest, and corporate finance departments are a heck of a lot more careful about the accuracy of the information they put out.

Yet few signs show that any of this is making investors feel more confident or the economy stronger. The stock market is dipping perilously close to its lows of October, 2002, and trading volume on the exchanges remains weak. Economic gauges have been taking a turn for the worse: Consumer confidence is falling, the job market remains stalled, and CEOs seem even less inclined to increase spending and investment than they did a year ago. Analysts are ratcheting back their earnings estimates for the rest of 2003 and are already starting to point to 2004 as the year of the recovery.

WISER, SADDER.

  Penalties on errant companies and executives have been too light to convince the general public that times are changing, but they have been heavy enough to scare the wits out of corporate executives. Worried about losing their jobs, they remain unwilling to invest in the future or take any extra risks (see BW Online, 2/27/03, "The Economic Drag of CEO Funk").

The scandals still coming to light indicate that rather than go public with accounting problems last year, some companies instead decided to risk waiting for prosecutors to knock on their door. Regulators are working through a long pipeline of cases, says Scott Wendelin, chief executive of Prospect Financial Advisors, a Los Angeles firm that advises corporations on financing issues.

No wonder once-ebullient individual investors have grown wiser but sadder. Transamerica's Broad still believes firmly that "structural reforms should make things better on a go-forward basis." But until the benefits of reform start to kick in and the negatives of scandal begin to recede, investors will likely remain disengaged. Those who are worried about risk -- be it of war, fraud, or the ongoing weak business climate -- still have good reason to fret.

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

Edited by Beth Belton

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