Turkey of the Year

Enron. WorldCom. Adelphia. Tyco. The press was outraged. Investors were outraged. President Bush was outraged. Even John Sidgmore, interim CEO of WorldCom, was outraged. By a 97-0 vote, the Senate voiced its outrage by making unspecified corporate offenses punishable with 20 years in the slammer. Rep. Mike Oxley was so outraged that he ditched his own corporate reform proposal to pile on to the senate bill in conference, thereby renaming it the Sarbanes-Oxley “Corporate Accountability Act.”

The Brookings Institution offered academic justification for the outrage in a study, which claimed that the cost of the “crisis in corporate governance” was about $40 billion, the equivalent of a $10 increase in the cost of a barrel of crude oil. Although the Brookings’ study does have an important disclaimer: “the authors recognize that there is considerable uncertainty surrounding their estimates and predictions,” the press largely ignored it, lest it take away from the sensationalism of the imaginary price tag.

During the stock market slide, Wall Street analysts and investment bankers were happy to bring coal to Newcastle by offering reporters gloomy quotes about a “crisis of investor confidence” that demanded lawmakers’ attention. The problem, Wall Street veterans explained, was that daily revelations of scandal made investors squeamish about diverting savings to financial markets. If investors could be made to “trust the numbers,” the bulls would be back.

But the crisis in investor confidence – to the extent that it exists – is more a product of consecutive years of negative returns in the equity markets than distrust of accounting. Wall Street represents the “sell side” of stock transactions. When vendors of any sort fall on hard times, they blame “market conditions” or impugn the “confidence” of prospective buyers. Otherwise, they’d have to admit to themselves and others that the problem lies not with the buyers, but what they’re trying to sell them.

In many ways the situation resembles a feature from last week’s The Onion, a satirical newspaper that dubs itself ‘America’s finest news source,’ in which a man blames his inability to sell a used 1994 Chevy Astro van on sagging U.S. consumer confidence. Just as the man’s difficulty unloading the van stems more from its high mileage and excessive asking price than any problem with consumers, slackening demand for stocks is a product of poor corporate performance, not unreasonably pessimistic investors.

From January 2000 to November 25, 2002, the Dow Jones Industrial average fell by about 25 percent. The S&P 500 index closed off 37 percent from its 2000 high on Monday, while the technology laden NASDAQ 100 is down almost 72 percent from its March 2000 record close. Total paper wealth lost during this period is between $7 and $8 trillion.

In August of 1999, the capitalization of the U.S. stock market was 160 percent higher than U.S. GDP. This figure was 60 percent higher than the previous record capitalization-to-GDP ratio reached just before the stock market crashed in 1929. Yet even after the bursting of what everyone now concedes was an unsustainable financial bubble, for every $1 generated in GDP, $1.77 is invested in financial markets. Wall Street has successfully blunted charges, rooted in historical analysis, that we are in for a painful correction, either in terms of prices (like 1929), or length (like 1967-1982), or both.

On July 24th of this year, the Dow Jones spiked 6 percent thanks, in part, to two events: 79-year old John Rigas and his two sons were handcuffed and formally charged with defrauding investors of Adelphia, and House and Senate negotiators reached an agreement on the new Sarbanes-Oxley law. Less than three months later, the Dow not only shed the 486 points it gained on that day, but also lost another 400 points to finish over 5 percent lower than its worst July close. As a rudimentary “event study” with a three-month window before and after this supposed monumental day shows (graph below), there is no evidence that the Justice Department’s willingness to prosecute corporate crooks, or the new accountability law has had any effect on blue chip values.

Dow Jones Industrial Average (April 25, 2002 – October 25, 2002)

To be clear: the turkey here is the notion that “corporate wrongdoing” is what precipitated the market’s slide. This is not to suggest that fraud should not be dealt with harshly, or that recent revelations do not suggest that existing corporate governance structures are wholly inadequate in protecting shareholders’ interests. Academics, economists, and policy analysts of all stripes have dealt with these important questions seriously, but politicians can add little value to these discussions. Who better to determine listing requirements, corporate board composition, and executive incentives than the stock exchanges and shareholders themselves?

From a policy perspective, there is much to be learned from the scandals and disclosures of 2002: Incentive-based stock options do not necessarily encourage executives to act in the long run interest of shareholders; the New York Stock Exchange and other markets have not paid sufficient attention to the way the companies listed on their boards govern themselves; the Securities and Exchange Commission’s annual public audit requirement does nothing more than provide investors with false assurance and accounting firms with billions in fees.

But through it all, investors have remained far more confident and optimistic than anyone could have expected. Faith in the markets, and American legal institutions that animate them, has proved more enduring than the media have led us to believe. Instead of passing laws to revive confidence that never disappeared, Congress should work to reform the tax code, ease economic and antitrust regulations, and constrain government spending to allow the private sector to rebound and produce the earnings that will boost equity prices.

It’s time to refurbish the van, not belittle the confidence of those who aren’t interested in buying it.