The Angry Market

The blunt message: Investors are repricing stocks to reflect a more honest picture of earnings, options, and the future. Ultimately, that's good.

Markets are fragile things. They depend on a confidence that accumulates gradually but can be shattered suddenly. Our financial markets survived the devastating attacks of September 11 as the nation rallied to the banner of aggressive self-defense. But in recent weeks, an epidemic of corporate scandal seems to have picked up where Osama bin Laden left off, demoralizing investors and threatening the economic recovery. Wall Street and Washington now are embarked on what amounts to nothing less than a restating of the 1990s. The markets will be a long time sorting through the economics of corporate reform. In the meantime, investors should find solace in the hope that the next bull market will rest on a solid foundation of reality.

Some $7 trillion has vanished since the market peaked in March, 2000, but it seems that only in the past week or so has it dawned on most of us that no one--not George W. Bush, not Alan Greenspan, not even Warren E. Buffett--has the power to prevent the further depletion of America's retirement accounts. There was a whiff of panic in the air on July 15, as the Dow Jones industrial average plummeted 440 points, only to abruptly reverse course and rise 400 points in the last hour and a half of trading. Some market strategists argue that this kind of convulsion in market sentiment is a classic sign of the beginning of an end of a bear market. They might be right, but there has never been a bear less classic than the one that afflicts us now.

Start with the cataclysm of September 11 and the cosmic economic and political uncertainties it has engendered, the prospect of a full-bore war with Iraq not least among them. It took only one horrific day to shatter the nation's false assumptions about its security in an increasingly hostile world. The discrediting of the American corporation took much longer.

The notion that every high-tech and telecom castle can reach to the sky collapsed well before September 11, depressing the market. The destruction of the World Trade Center sent share prices into a tailspin, but they quickly rebounded and then some on a wave of patriotic fervor and relief over the U.S. military's resounding early victories in Afghanistan. The national preoccupation with finding bin Laden and the free-floating terrorist menace--What next and when?--delayed Corporate America's day of reckoning. It wasn't until the lid was pried off Enron Corp. late last year that the market began dealing in earnest with the unsavory underpinnings of the speculative mania of the 1990s.

Enron's transgressions were at once so flamboyant and so arcane that at first, the company could plausibly be dismissed as an aberration--a "bad apple," in the President's terminology. But the scandals just kept on coming: Arthur Andersen, Global Crossing, Xerox (XRX ), Adelphia Communications, Tyco International (TYC ), ImClone Systems (IMCL ). With each one, investor confidence took a hit, yet calls for systemic reform continued to be sloughed off by corporate leaders and the White House. The tipping point finally came in June, when WorldCom Inc. admitted that it had magically converted operating expenses into capital costs, artificially boosting income by $3.8 billion. The brazen artlessness of this scheme shook the market to its core and altered the political calculus in Washington virtually overnight.

Accounting issues have periodically bedeviled the stock market, but never so pervasively as they do now and never at a more ticklish time. At this point in the business cycle, the paramount question for investors should be: "By how much will corporate earnings rise?" Instead, it is: "Are anyone's earnings real?" Actually, these two questions are linked in ways that might continue to roil the markets for months. The dilemma is this: Many of the same corporate reforms that are needed to restore investor confidence will depress earnings--and stocks--at least in the short term.

Take the suddenly hot issue of stock-option accounting. It's easy for an accountant to make a case that options are an expense and should be recognized as such on the books. This argument stood little chance when options were making executives filthy rich, but its time appears to have arrived, some 17 years after Buffett began championing it. In the past week, two companies closely associated with Buffett--Coca-Cola Co. (KO ) and Washington Post Co. (WPO )--as well as Bank One Corp. (ONE ) announced that they will start expensing options. If all of the companies in the Standard & Poor's 500-stock index had expensed options in 2001, their earnings would have declined by 24.5%, says S&P.

In many ways, companies have already begun to embrace more conservative accounting methods, often with little fanfare. When CEOs have to personally vouch for their companies' financial statements, as they must start doing on Aug. 14, it's a good bet that they will play it safer than they did in the 1990s, even if it shaves more than a few cents off of earnings per share. Boards are now equally motivated. With investors and politicians alike demanding better governance--and real consequences for directors who don't deliver it--audit committees suddenly are snapping to attention.

Here's an idea: Wouldn't we all be a whole lot happier if we not only admired (and envied) Warren Buffett but truly took the Sage of Omaha as an investing role model? We would buy only the stocks of companies we understood and believed in, and we would hold tight to their shares through thick and thin. We would closely follow the news but never be unnerved by it. We would acknowledge the likelihood that the stock market will not outperform the economy over the coming decade as it did in the 1990s--and we would welcome this as a return to common sense.

By Anthony Bianco

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