Curses! Swindled Again!
How Bad Is It?
The latest (September, 2002) issue of Money magazine has a 33-page special report discussing the stock market, with sub-titles: "How Bad Is It?", "How Should I Invest Now?", and "How Should I Manage My Portfolio?" I think it's important to note that this article didn't appear in 1996, when the stock market began to go out of bounds. I was aware in 1996 that the stock market was going around the bend. I called a broker-friend to see if he had any ideas about why the stock market was rising beyond the danger point. He said he didn't. The P/E ratio on the S&P 500 was about 21 at that time, which meant that it was not quite yet out of the pasture. I decided to go with the crowd. After all, there was no telling how high the market would go before it began to sink. Besides, maybe the experts knew something that I didn't know that justified these ever-loftier evaluations. (This was before I had gotten on the Internet. I had no ready sources of information, including such hard data as P/E ratios, book values, and dividend yields.) They knew something I didn't know, all right. They knew that the stock market was going into a "bubble" or mania. Most of them didn't mention this, however. It's bad for business. At least some of them must have known about the 1994 change in Federal Accounting Board rules, engineered by big business, that allowed companies to process stock options "off the books". (Actually, stock options must be included as a footnote in corporate earnings reports.) This allowed companies to pay their employees in stock options rather than in cold, hard cash. These stock options can be exercised up to 10 years from the date of issue, so it amounts to deferred compensation, but it has the effect of diluting the shareholders' stock valuations. By printing up more stock certificates and issuing them to employees in lieu of additional pay, current costs can be minimized, but future liabilities are incurred. (30% of these stock options went to employees; 70% was awarded to executives by themselves.). In other words, the shareholders pay the bill when the reality of many more shares of stock catches up with share prices. (As long as the "tulip mania" is influencing everyone, share prices can continue to rise, but once the binge is over and everyone sobers up, the true cost of this bender becomes apparent, and stock prices seek a rational level.)
How Bad Has This Been?
Today, the S&P 500 trades at about 19 times trailing 12-month earnings. However, if the S&P 500 companies had included their stock options as a business expense, as they were required to do in the past, then their earnings would have been 23% lower, giving them a trailing P/E ratio of 25:1. Next year's earnings (as of July 17th) are estimated to be 15:1, but if stock options are expensed, one analyst concludes that next year's P/E ratio becomes 31:1!.
The earnings of the technology stocks in the S&P 500 would be reduced by 70% if stock options were to be included on the companies' balance sheets. On the other hand, Walmart's earnings would be reduced only 1% and Pfizer's only 7% if stock options were to be expensed like other compensation.
No wonder the NASDAQ has fallen so far!
Some Previous Wall Street Scandals
"Our current plague of of scandals has rich precedents in the history of investing (see 'What Are Some of the More Notorious Wall Street Scandals?' on page 82. In fact, in some respects, we merely witnessing the playing out of a familiar script. Major stock market bubbles have a tendency to end this way. After the crash of 1929, for example, it turned out that Albert Wiggins, the head of Chase National Bank, had made a tidy profit by shorting the stock of his own company. ...
"At the end of the postwar bull market, However, investors were jolted when investigations into the collapse of the railroad giant Penn Central revealed that executives had covered up the extent of problems at the company, and had been dumping stock even while pledging to turn things around. After the bull market of the mid-1980's wound down, federal agents charged Drexel Burnham Lambert's junk bond dealer Michael Milken and accomplice Ivan Boesky with making a fortune from insider trading and market manipulation."
Do Investment Scams Pay Off?
It's instructive to consider what has become of Michael Milken and Ivan Boesky. Michael Milken spent less than two years behind bars, paying back a billion dollars of his ill-gotten gains, but today, he has $800,000,000. He's started a think-tank, a charity, and an education-investment company. Ivan Boesky spent two years behind bars, and paid $100,000,000. He won $20 million, a $2 million home, and $200,000 a year for life in a divorce settlement. So.... does white-collar crime pay? Of course, they probably didn't so anything illegal. Immoral, yes, but illegal: no.
Were the Latter Nineties Any Different from Previous Swindles?
"Indeed, financial historians say this is a textbook case of what happens when a bubble bursts. Economist John Kenneth Galbraith came up with the term 'bezzle' to describe the inventory of undiscovered embezzlement. It increases rapidly in good times and is discovered in bad times---as is happening now.
"So why are we surprised at the recent revelations? Despite the similarities to past eras, there are some telling differences this time around. For one, today's problems have not been confined to the world of Wall Street and high finance but reach across the country to such places as New Hampshire (home base of Tyco, whose former CEO, Dennis Kozlowski, was indicted for evading sales tax on artworks he purchased), (Mr. Kozlowski has recently been hanging around Nantucket, sunning himself aboard his 130-foot yacht.) Mississippi (where Worldcom admitted to inflating earnings), and Texas (where Enron hid losses in off-balance-sheet arrangements). For another, the scandals did immediate harm to local communities in the form of layoffs and lost retirement savings. Moreover, the stocks were market darlings, widely held by mutual funds and individual investors. And even investors who didn't own those stocks got slammed, because the scandals have helped drag the entire market down."
Eventually Be Done?
Don't bet on it. The Enron investigations were begun last October, but, so far, no charges have been filed. The average jail sentence for corporate criminals in the S&L scandal of the eighties was three years. (Federal prosecutors have scoffed at the spectacle of executives being led away in handcuffs, observing that it's strictly a media event designed to make the administration look good.)
The CEOs of nine corporations targeted by government investigations earned a combined $2 billion from 1997 to 2001... an average of $220,000,000 apiece. And this doesn't include the CEO's of publicly held brokerage firms, who made $1.5 billion during this period.
Knock over a convenience store and you're in big trouble, but defraud investors out of a billion dollars and you can probably buy your way out (or so it might appear)..
Where Do We Go From Here?
The S&P 500 has fallen 45% from its March, 2000, peak of 1,527.
The NASDAQ Composite has dropped 75% (!) from its peak slightly above 5,000.
The Dow has declined 32% from its zenith at 11,800.
Perhaps the most significant thing about where we are now is that John Q. Investor is being told that he has been the victim of a swindle. Talk about the New Wave, and about future earnings being the only parameter of importance in pricing a stock is evaporating for the eyewash it was. This happens at the tops of bull markets. There is talk that the old rules no longer apply. Then once a bear market sets in, investors are rudely awakened to the hocus-pocus that such talk always is.
This means that we need to prepare for a return to reality and to business-as-usual. However, it is true that inflation and interest rates are low, and that, at the moment, conditions are very favorable for the stock market.
How Long Will It Take for the S&P 500 to Stand At 1,527 Again?
We know that in 1997, the upper trend line for the S&P 500, in 1997 dollars, stood at 725. Correcting for inflation and real earnings boosts, the upper bound for the S&P 500 should presently stand at or around 900. So irrespective of inflated earnings, a valuation of 864 (Friday's close) is only a little below the upper bound for the expected value of the S&P 500 in mid-2002. Given 2.5% annual real earnings growth, and 3% annual inflation, a value of 1,000 for the S&P 500 would be a reasonable upper trend line value for the S&P 500 in 2004. I could see it rising a little above that, given the current favorable circumstances. However, Money Magazine's forecast for 1,527 on the S&P 500 is 2010. (Inflation alone would account for 384 points of that rise, giving a real value of 1,143 for the S&P 500.... and I'm not confident that even that will come to pass. Don't hold your breath.)
I had opined that the S&P 500 might attain to 1,300 in 2004, and given year-ahead earnings of $72 a share in early 2005, might make it above 1,500. But that was before reading about the restatements, and deflations of earnings that are occurring. That also assumed that earnings alone would be considered in evaluating stocks... that investors would continue to play the earnings game through 2004-2005. But we now know that those earnings are being overstated by a sizable margin because of un-expensed stock options awarded by the companies (and, no doubt, other earnings deceptions) In the meantime, dividend yields are again becoming important. So I'm afraid that an implosive deflation of the stock market is taking place now rather than after 2004, as I had hoped.
The only saving grace is that the markets are finally back within the upper limits of their ranges, and given today's favorable economic circumstances, should stay near or slightly above their trend lines.
When Will the NASDAQ Reach 5,000 Again?
Money Magazine's guess Is 2017.
Updating My 2004-2005 Forecast
Given these inputs and updates, I'm cutting my target for the S&P 500 for 2004 to 1,100. That's close to its level in April of this year. Correcting for inflation, that would be about 1,025 to 1,050 in today's dollars (depending upon when in 2004 or early 2005 it reaches 1,100). If true, that's a real disappointment. On the other hand, it's better than the stock market falling out of bed because of deflation of earnings through massive earnings restatements.
This is a case in which the historic trend channels for stock evaluations give us some kinds of yardsticks regarding what stocks should be worth, independently of other measures.