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Crisis in Confidence
Stock Market News
February 2002
Crisis in Confidence
Just when it looked as though we were pulling away from the September 11 pall, our neighbors in Houston tossed a large wrench into the works. âAccounting-gateâ may be the best way to characterize the Enron saga which appears to have taken on a life of its own. That situation has posed some serious implications for the health of our financial markets. One of the bedrock principals of investing in America has been confidence in audited financial statements. Investors have long assumed, with only minor and rare exceptions, that the books and records of public companies are accurate and reflect the true nature of the business. This confidence is the prime reason that our market trades at a much richer multiple of earnings than the markets of other countries. In fact, for years, many emerging-economy businesses worked diligently to bring their accounting standards up to U.S. standards. Due to the Enron collapse and the associated role of embattled auditor Anderson, investors now face a crisis of confidence.
The issue raised here is the suspicion that other corporations may be operating in a similar, exceedingly precarious fashion, similar to Enron, while their auditors silently sign off on the books. A case in point: Just recently a highly favored company, Tyco International, fell victim to the âEnron-effect.â It announced its decision to break-up the company into four separate firms which had the disastrous effect of decimating its stock price in the process. This is analogous to someone asking me to prove that I am not cheating on my wife. Anyone, anytime, can accuse a company of accounting problems without a shred of evidence. In the current environment, those who profit from short selling need only to make an assertion against a particular company like Tyco and the shares plummet. Presto, the short sellers make big profits at the expense of shareholders. Unfortunately, investors are not drawing conclusions based on what is known, rather on what is alleged. The reason investors react by selling, as in the Tyco example, is because Tycoâs books are complex. Somewhere in the whole Enron scandal, the media managed to convince investors that complex equals bad. When you have multi-billion dollar manufacturing and service business units operating in electronics, flow control, home security, finance, medical devices, and fiber optic cable in a multitude of currencies like Tyco; guess what, your books will be complex. How can Tyco refute claims that their accounting is complicated like Enronâs?
The market is in a mode of selling first and asking questions later. And, in some cases, not even asking, just selling. Ultimately, scrutiny of public-company auditors and accounting practices will be a good thing. One likely outcome will be that accounting firms will not be permitted to sell high-margin consulting services to the very same companies that they are entrusted to audit. This, obviously, would be a good thing. We would all benefit from closer controls on officers and directors self-dealing to the detriment of shareholders.
Like all short-term shocks to the system, this too shall pass. Once it does, investors will re-focus attention on the economy and recovery. At that point, we will probably see an increasing demand for stocks. The Index of Leading Economic Indicators has posted three consecutive gains: October, November, and December.
As indicated in prior commentaries, investors must choose either to believe only what they can see in todayâs data here and now, or put faith in the leading indicators that suggest a brighter road ahead. Yes, the rearview mirror reflects an ugly reality of poor GDP results and worsening unemployment, but recovery appears close at hand.
Generally, caution must still rule. We do not know when the hit-and-run crowd will demolish another companyâs stock. Many financial advisors are attempting to balance the benefits of individual stock ownership with the associated increased business-specific risk, while at the same time attempting to position portfolios to exploit the recovery.
It appears that now is the time to move the âoffenseâ onto the playing field. Not a St. Louis Rams run-and-gun style offense, but rather a very conservative ball-control game plan, keeping both industry weightings and company-size weightings well balanced. Our safe havens of cash and bonds, known as our âdefense,â should be used more sparingly due to our location on the interest rate curve.
The issue raised here is the suspicion that other corporations may be operating in a similar, exceedingly precarious fashion, similar to Enron, while their auditors silently sign off on the books. A case in point: Just recently a highly favored company, Tyco International, fell victim to the âEnron-effect.â It announced its decision to break-up the company into four separate firms which had the disastrous effect of decimating its stock price in the process. This is analogous to someone asking me to prove that I am not cheating on my wife. Anyone, anytime, can accuse a company of accounting problems without a shred of evidence. In the current environment, those who profit from short selling need only to make an assertion against a particular company like Tyco and the shares plummet. Presto, the short sellers make big profits at the expense of shareholders. Unfortunately, investors are not drawing conclusions based on what is known, rather on what is alleged. The reason investors react by selling, as in the Tyco example, is because Tycoâs books are complex. Somewhere in the whole Enron scandal, the media managed to convince investors that complex equals bad. When you have multi-billion dollar manufacturing and service business units operating in electronics, flow control, home security, finance, medical devices, and fiber optic cable in a multitude of currencies like Tyco; guess what, your books will be complex. How can Tyco refute claims that their accounting is complicated like Enronâs?
The market is in a mode of selling first and asking questions later. And, in some cases, not even asking, just selling. Ultimately, scrutiny of public-company auditors and accounting practices will be a good thing. One likely outcome will be that accounting firms will not be permitted to sell high-margin consulting services to the very same companies that they are entrusted to audit. This, obviously, would be a good thing. We would all benefit from closer controls on officers and directors self-dealing to the detriment of shareholders.
Like all short-term shocks to the system, this too shall pass. Once it does, investors will re-focus attention on the economy and recovery. At that point, we will probably see an increasing demand for stocks. The Index of Leading Economic Indicators has posted three consecutive gains: October, November, and December.
As indicated in prior commentaries, investors must choose either to believe only what they can see in todayâs data here and now, or put faith in the leading indicators that suggest a brighter road ahead. Yes, the rearview mirror reflects an ugly reality of poor GDP results and worsening unemployment, but recovery appears close at hand.
Generally, caution must still rule. We do not know when the hit-and-run crowd will demolish another companyâs stock. Many financial advisors are attempting to balance the benefits of individual stock ownership with the associated increased business-specific risk, while at the same time attempting to position portfolios to exploit the recovery.
It appears that now is the time to move the âoffenseâ onto the playing field. Not a St. Louis Rams run-and-gun style offense, but rather a very conservative ball-control game plan, keeping both industry weightings and company-size weightings well balanced. Our safe havens of cash and bonds, known as our âdefense,â should be used more sparingly due to our location on the interest rate curve.
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.
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