The Street's Death of a Thousand Cuts

The indexes' flat finish after the WorldCom bomb is no reason to rejoice. Stern reforms that restore trust will be needed to create a sustained rally

By Amey Stone and Eric Wahlgren

When it comes to the stock market, the impact of WorldCom committing what may be the largest accounting fraud in U.S. history was deceptively muted on June 26. The company admitted that it hid $3.8 billion in expenses over five quarters, reporting fictitious profits. But after wobbling most of the day, the Nasdaq ended up 5 points, at 1429, while the Dow Jones industrial average, down more than 180 points in mid-afternoon trading, ended just 7 points lower, at 9120.

Even so, investors shouldn't take the nearly flat market close as a sign the WorldCom news is insignificant. In fact, the apparent accounting fraud is more fuel on a slow-burning fire. Securities & Exchange Commission Chairman Harvey L. Pitt announced late on June 26 that chief executives and chief financial officers of the 1,000 largest U.S. companies will be required to personally attest to the soundness of their financial statements.

This kind of corporate dragnet could either lead to more companies coming under the gun -- or to a quick improvement in public confidence in financial statements. The market has already suffered nearly two months of punishing declines due to a flammable mix of weak corporate profits, accounting scandals, the risk of domestic terrorism, and global political turmoil.


  WorldCom's admission may not have generated the kind of immediate shock to the financial system that creates a selling panic, which would be followed by a buying opportunity. Instead it may prove to be the latest installment in the litany of depressing, incremental bad news that has set increasingly wary investors to wondering if they should be involved in the stock market at all. WorldCom's impact will be felt -- even if it didn't happen the first day after the news broke.

First of all, its revelations charred any remaining shred of confidence the investing public has in the integrity of Corporate America. Unlike Enron, this wasn't a complex case of aggressive managers slicing and dicing the accounting rules too thin. "When you sort it all out, they simply lied," says Gary Gensler, former Treasury Under Secretary who consults on matters of public policy and finance. According to a new Gallup Poll conducted June 21 to 23, confidence in Big Business is at its lowest point since 1981.

Investors who thought they could still pick stocks as long as they did their homework and delved into cash-flow numbers basically have learned they can't. "How many people have looked at [WorldCom's] financial statements over the past year, and nobody found this," says Trip Jones, a senior vice-president at Fulcrum Global Partners.


  WorldCom's potential demise could also create significant ripples throughout the broader economy. On June 26, telecom-equipment stocks were brutalized. Lucent Technologies (LU ) was down 20%, and Nortel Networks (NT ) fell 9%, both to around $1.50. Major corporate lenders like Citigroup (C ) and J.P. Morgan (JPM ) were also punished. Both were down 5%, to $37 and $31, respectively.

The economic ramifications could include financial institutions clamping down on lending activities, sparking a serious credit crunch. Companies, already reluctant to spend, could continue to balk at writing checks, as they worry about financing. A lot of companies are probably looking at cleaning up their balance sheets, getting liquid, and avoiding the SEC, says Gensler. "That's going to divert a lot of attention," he says. Could these factors be enough to derail the economic recover under way? Gensler believes they could.

Throw in global political turbulence, the specter of another domestic terrorist attack, and the plunging U.S. dollar, and investors have plenty of reason to stay on the sidelines. The "ho-hum" response to the latest scandal could be "a sign of deepening near-term investors disinterest, but also a growing disenchantment of a whole generation of investors toward equities," Standard & Poors' investment committee speculated in a depressing June 26 note.


  "It seems startling to me that this market refuses to capitulate," says Jones. "But sometimes capitulation is not a huge down move on large volume. Sometimes it's like Chinese water torture," one dribble at a time. Truth be told, lots of investors would prefer the former.

Many market strategists are still hoping that an improvement in corporate earnings will be enough to pull the market out of its malaise. Second-quarter earnings season, just getting started, should provide the market with some stability. It's expected to be the first quarter in which profits at S&P 500 companies are flat year-over-year, after five straight quarters of earnings declines.

Even if earnings were to exceed expectations, it may take a quarter or two -- or longer -- for investors to regain their lost faith, says Christoph Bianchet, U.S. economist at Credit Suisse Asset Management in New York. One big problem, he adds, is that stocks remain quite pricy when new, tougher earnings standards are applied.


  If stocks are valued using S&P's "core earnings" model, which looks only at the earnings power of an outfit's core business -- and excludes profit-boosting items such as pension gains or asset sales -- corporations are trading at a huge 64 times 2001 earnings, Bianchet says. "By the old measures, stocks are certainly approaching rock-bottom levels," Bianchet says. By the new standards, however, they "aren't very attractive, but are getting increasingly attractive."

In the long run, WorldCom's apparent fraud should lead to the kind of stiff penalties and regulatory action that will ultimately help cleanse the financial system and restore faith in financial markets. In fact, one reason the market rebounded from sharp midday losses on June 26 is that President Bush vowed to get tough on executives who have crossed the line, promising to "fully investigate and hold people accountable" for corporate misdeeds.

"I think the market would be well served, and Wall Street would be well served, if there would be some real reform," says Gensler. "The market isn't going to turn around on that, but it could help set the stage for a turnaround." In the near term, that offers little solace to burned investors. WorldCom may not have sparked a major sell-off, but it goes a long way to ensure that the steady drip, drip, drip of daily declines continues longer than it already has.

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

Wahlgren covers financial markets for BusinessWeek Online in New York.

Edited by Beth Belton

Before it's here, it's on the Bloomberg Terminal.