While a long parade of executives has exchanged tailored pinstripes for orange jumpsuits, an even more deserving group of miscreants have thus far eluded their just deserts—those executives’ Wall Street overlords, who wrote the script for the latest and greatest of bull markets, directed the hucksters, and set their standards.
The excesses of the bull market must be put in proper historical perspective. There were substantial reasons for the “New Millennium” market: Lower interest rates and lower rates of inflation warranted higher estimates of prospective income streams and of an accelerated rate of growth of productivity—all of which, unfortunately, were extrapolated into the future.
Furthermore, the boom in U.S. securities was fueled by two sources of demand that will not be repeated: redeployment of pension assets in equities from 50 to 70 percent of total holdings and a balance-of-payments deficit that has ballooned to an unsustainable five percent of GDP, funded by foreign purchases of U.S. securities.
As the bull market aged, by the latter part of the 1990’s, the growth of corporate profits was bound to slow down. In 1997, corporate profits—both before and after taxes—peaked, and they have been in steady decline for five years. Nor was profit growth for the entire decade particularly remarkable. During the 90’s, corporations’ median return on assets remained the same as it had been for the period of 1960-99 and well below that of the 60’s (a comparable period of growth).
If the growth of corporate profits from 1990 to 1997 is valued at the lower prevailing interest rates and adjusted for the typical boom-compared-to-recession rise in multiples, then the year-end stock prices in 1997 are virtually reproduced and justified. That cannot be said for the further 50 percent increase in valuations, in the face of declining profits, between 1997 and 1999, when the stock market finally peaked.
That brings us to the “bull” component of the “New Millennium” stock market. Why did this exaggerated growth of stock prices occur? Both “blue sky” laws governing new issues of securities and regulations for those already listed make it illegal to market financial securities on the basis of fraudulent, misleading, or even insufficient information. Furthermore, the sellers of securities have a duty to disclose conflicts of interest, such as touting issues they are selling or having undisclosed financial interests in the companies whose securities they are marketing. However, such annoyances have not seriously restrained Wall Street brokerage houses in the past nor resulted in serious repercussions for them.
In the final years of the bull market, from 1997 to 1999, the misleading of investors reached a perfection that is historically unparalleled. Investment bankers sold investors, large and small, trillions of dollars of securities on the basis of “momentum,” “projected” earnings, and their analysts’ tongue-in-cheek “buy” recommendations—all without reference to the fundamental information necessary to try to make sound investments: earnings trends, dividends, cash flow, liquidity, and asset values. The perceived values of securities became detached from the hidden realities, and the market valuations of stocks careened to unprecedented levels.
Perhaps the most obvious misinformation that brokers propagated can be found in the covert transition from reported “P/E ratios,” defined as the ratio of share price to actual after-tax earnings for the most recently reported 12 months. First, P/E ratios were replaced with price to forecast earnings after tax (usually double most recent earnings), which resulted in P/E ratios that appeared to be halved. Then came “forecast” price to “EDITA” per share—price to forecast operating earnings before interest, depreciation, and income taxes (as if these charges to earnings are of no consequence). While real P/E ratios had escalated to levels more than double those ever seen before, this reality was obfuscated by these bogus P/E ratios, which were used to claim that bloated share prices remained at normative levels.
In a day and age in which the Golden Rule for corporations is “maximize shareholder value,” the acceptable normative performance standard for stocks (and options) became the “20-20 vision.” That means 20-percent growth and 20-percent return on equity. (The absurdity of such an expectation is obvious: If all American stocks grew at that rate for two decades, corporate profits would equal the total value of the U.S. economy!)
Corporate CEOs got the message: Fore-cast 20-percent growth and 20-percent return—or fake it. So doubled earnings are still being predicted by companies, despite the fact that the U.S. economy is in a serious recession.
Does this provide any clues as to why the fictitious earnings of Enron, WorldCom, and the like have become so widespread? Either CEOs and auditors play ball, or Wall Street has them replaced with more “performance-oriented” players.
The Securities and Exchange Commission and state securities regulators are supposed to be the investors’ cavalry, riding to the rescue—but they arrive long after the investors have been scalped. The New York attorney general fined Merrill Lynch $100 million for conflicts of interest resulting in misleading analyst recommendations, and other states are expected to follow suit. Congress is preparing to investigate whether the Gramm-Leach-Bliley Act has contributed to abuses by allowing the merger of investment banking and commercial banking.
As of mid-October 2002, the stock market had lost eight trillion dollars in value, of which more than four trillion dollars represents unconscionably bloated values that ate up the life savings of many small investors. How are they to secure restitution? (Where are the junkyard-dog class-action attorneys when you really need them?)
The lawsuits against corporations and executives for fraudulent reporting of earnings address only the tip of the iceberg. No one has yet addressed the trillions of dollars investors lost to miscreant investment bankers and brokers. It is time to clean out the Augean stable of Wall Street—taking no prisoners in the process.
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