Downside® old news

The stock market has now had three down years in a row. Only twice in the last century has that happened, most recently in the early 1940s, and, of course in the first Great Depression. Yet price/earnings ratios remain high by historical standards. The bottom is still a long way down from here.

Retail was slow this season, which shouldn't surprise anybody.

Much has been made of increased productivity in recent months. That's not an indicator of economic growth. Productivity rises in a recession, simply because the least efficient producers and plants shut down first.

We have a war with Iraq coming up, al-Queda is still active, and the Administration is putting in comprehensive Big Brother systems.

Happy holidays.

The San Jose Mercury News, as their top story today, today provided a list of 40 companies whose top management made hundreds of millions of dollars selling their stock before the company tanked. The top five:

This is marginally legal under current US law, but stockholder lawsuits are definitely indicated. The presence of any officer or director of any of those companies in management of another company should be regarded as a sell signal. In some European countries, those people would be barred by law from a management role in a public company for life.

As we've been saying for some time, the current system of compensation by short-term stock options rewards management for volatility, not long-term profitability. We need longer holding periods, much longer ones. Management must be at risk of loss if the company tanks.

President Bush has fired Lawrence Lindsey, his chief economic adviser and former Enron director. Better late than never.

Meanwhile, United Airlines is expected to go bankrupt tomorrow. Most major analysts issued "sell" recommendations a month or two ago, a contrast to the dot-com era, when we'd see "buy' recommendations right up to the bankruptcy. Happy-talk analysis seems to be out of fashion.

Enron's Fastow was arrested a few weeks ago, but pled not guilty. It may take a while longer to get to Ken Lay.

It's now come out that Williams Energy shut down power plants during California's energy crisis to drive up prices.

Pitt and Webster are gone from the SEC, but haven't yet been replaced. It matters who replaces them. If it's somebody with a history of putting crooks in jail, the mess may get cleaned up. If not, the problems will continue.

The Enron investigation continues to move up the food chain. The prosecutors are working this like an organized crime case, which it is. First, Enron exec Michael Kopper was arrested in September. He provided information about Andrew Fastow, Kopper's boss and the architect of Enron's offshore entities for creating fake earnings. Fastow was arrested a few weeks ago. In turn, Fastow can probably give up Ken Lay and some of Enron's board members. They had to know what was going on; that's clear from the board minutes that have been published.

But will it stop there? Many Bush Administration people had strong ties to Enron. Vice President Cheney's connection, of course, is well known. Some less-prominent officials are now trying to hide their Enron ties. The U.S. Trade Representative, Robert B. Zoellick, has removed his connection with Enron from his official biography. (Compare this archived version from 2001. Note the disappearance of the sentence "Mr. Zoellick was a board member of Alliance Capital, Said Holdings, and Jones Intercable, and served on the Advisory Council of Enron Corporation.") Lawrence Lindsey, Assistant to the President for Economic Policy, also doesn't mention in his official biography that he was a director of Enron. Mr. Lindsey is the Administrations's leading advocate of tax cuts as a solution to most economic problems.

Tyco's former CEO, L. Dennis Kozlowski, goes to jail tomorrow. He can't make the $10 million bail; his assets have been frozen as ill-gotten gains of criminal activity. Kozlowski is the first CEO of a Fortune 500 company to be jailed for business crimes in recent years. More will follow.

Some General Electric top executives were jailed for price-fixing in the 1960s, which had a salutary effect on the rest of the CEO community that lasted a decade. A few CEO convictions with long jail sentences will go a long way to turn things around.

In other news, documents obtained from Enron litigation now indicate that Enron had a larger role in California's power crisis than previously believed. That scandal may be moving to the front burner.

• Tyco: execs indicted.
• Enron: this time it's the bankers.
• Chase: a guilty plea.
• ChevronTexaco: tax evasion
• Worldcom again.
• Adelphia: the mess continues

That's just a sampling of recent news stories. There's more to this mess.

Recommended reading:
How Companies Lie, a bitter little book that's not wrong. Valuable insights into the extent of the problem.
Anatomy of Greed, a fun read from an Enron insider.
DownTime, a Guide to Federal Incarceration - suggested as a gift for your least favorite CEO.

Today, Michael Kopper, a former Enron financial executive, pled guilty to conspiracy to commit wire fraud and conspiracy to commit money laundering. Kopper agreed, as part of his plea bargain, to cooperate with investigators. Kopper knew where the bodies were buried; he helped Andrew Fastow, Enron's former CFO, construct all those deceptive off-balance entities Enron used to fake revenue. Note Kopper's position: he's pled guilty, but the sentence will be determined by how well he cooperates. This is standard procedure in organized crime cases, but it's not common in fraud cases. But then, this was organized crime.

Now the rest of Enron's crooks will go down. Fastow, at least, Ken Lay, probably. Maybe some Andersen people, too; Andersen was in on the planning of those off-balance entities.

The Justice Department has opened a criminal investigation of AOL Time Warner. It appears likely that there were phony earnings reports and fake deals designed to exaggerate revenue.

AOL was already in trouble for bad financial reporting. The company was fined $3.5 million back in 2000 for capitalizing the cost of those ubiquitous AOL disks. AOL is under a cease-and-desist order from the Securities and Exchange Commission. That apparently wasn't a strong enough sanction to make management stop.

Who's next? Probably the brokerage firms and banks that made the Enron debacle possible.

WorldCom executives will be charged next week, reports the Wall Street Journal. The former CFO, controller, and probably the former CEO are to be charged with fraud. Now we're getting somewhere. Arrests in all the major cases are needed to restore confidence in the markets.

In many of these big financial fraud cases, it's clear that there was illegal activity in top management, but it's been hard to tell from the outside who knew what when. The Justice Department has been hesitant to indict executives without a "smoking gun" clearly establishing individual guilt before the indictment. But that's not required. Big financial frauds are a form of organized crime, and should be treated as such.

We've been harping on this for a while now, but it's worth saying again: The market is still overvalued. The history of P/E ratios shows just how overvalued the market remains. Even with the dot-coms gone and all the big bankruptcies, stock prices remain far too high. P/E ratios remain higher, far higher, than they have ever been in the entire history of the U.S. stock markets. The black line has to come down to the neighborhood of the blue line.

Chart courtesy of Decisionpoint.com.

WorldCom to declare bankruptcy Sunday. This is the largest bankruptcy ever. There's not much more to say.

Markets are still far too high based on fundamentals. See "Stop this Dream", in the Economist for July 20, 2002. We've been saying that here for some time, but now it's a mainstream position. "The postwar average P/E for the S&P 500 is 15; now it is 40", writes the Economist. So the S&P 500 needs to drop to around 340 (from 848 today) just to get back to the postwar average. That's an average; at times P/E ratios are lower. There are periods when prices are so low that some companies sell below book value. When bubbles collapse, they usually collapse all the way. So the market bottom may be below that average. Again, the bottom is a long way down.

"This is way beyond aggressive accounting. This is Fraud 101, you know, basic illegal conduct." - Congressman Tauzin on WorldCom. Still no arrests, an indication that the Administration's "get-tough" policy remains cosmetic.

"All investment is an act of faith, and faith is earned by integrity." - from a recent Bush speech. When the integrity goes away, so does the investment. But speeches won't help. Tough audits and long jail sentences will. There haven't been any CEO arrests yet. The "crackdown" is, thus far, not seriously hurting the people who perpetrated these frauds.

We're not seeing companies selling below book value yet. P/E ratios are still too high. We're nowhere near the bottom.

Remember, the true value of a stock is the present value of its future dividends. Anything above that is based on the assumption that there's a "greater fool" willing to buy the stock. Much of the time, such fools exist. There's thus a sizable "optimism premium" in many markets. When that optimism premium goes away, we're back to the basics - assets and dividends. We are seeing that now.

More phony numbers. Another collapse. Another Andersen audit client, too.

We predicted the dot-com collapse. That was easy. The dot-coms had terrible, but mostly honest, numbers, and ordinary fundamental analysis worked well on them. Now we're seeing companies go under that had reported good numbers, but were lying. Reading the financial statements doesn't help if they're bogus.

There is no investment without honest reporting. There is only speculation. In the current reporting environment, one could argue that pension funds and others with fiduciary responsibilities shouldn't be in stocks at all.

Fifty years of the Standard and Poor 500 Index

There's the bubble. For half a century, through boom and recession, the S&P 500 (the broadest of the widely-followed indices) stayed in a trading range around a long term trend. Until the late 1990s. This gives a sense of how broad-based the "irrational exuberance" was. It wasn't all tech stocks.

The market top of 2000 was about fifteen years too early. And we're still well above the historical trend, even after the collapse.

The basic fundamentals also indicate that the market as a whole is still far overvalued. Historical price/earnings ratios over the decades average around 16. The Economist says that U.S. companies are averaging a P/E of around 40 now.

The bottom is a long way down from here.

The Washington Post reports that the former chairman and chief executive of Rite Aid Corp was indicted on Federal charges of inflating the company's earnings, destroying evidence, tampering with a witness and secretly moving millions in company funds to a personal side business. Rite Aid stock, around 50 at its peak two and a half years ago, is now down to 3. Yet again, we see how criminal activity led to the collapse.

Arthur Andersen LLP was convicted of obstruction of justice today. The accounting firm that made the Enron mess possible will soon be history. But the individuals responsible remain at large. None of the principals of Enron or Andersen are in jail. Some of them should be.

Jail is a highly effective deterrent against corporate crime. Executives are good at insulating themselves from losses at their companies. It takes prison sentences to get the message through that society will not tolerate illegal acts by management.

The current adminstration proposes to start wars. "The Bush administration is developing a new strategic doctrine that moves away from the Cold War pillars of containment and deterrence toward a policy that supports preemptive attacks against terrorists and hostile states with chemical, biological or nuclear weapons." This is a great change in American foreign policy. Never before has such an aggressive policy been proposed at the Presidential level.

This was a big month for failed coverups. The big ones:

• The FBI, covering up information they had before September 11th.
• Enron and their lawyers, covering up their manipulation of the California energy market
• The Catholic Church, covering up their child molestation scandals.

Investigations continue in the Wall Street recommendations scam, mentioned last month.Merrill Lynch settled for $100 million.

Reports of inflated earnings by major companies continue to surface. Boeing and Global Crossing are some of the most prominent, but the list is long. The proposed reform measures are probably insufficient to get honest numbers. Accounting firms can still consult for the firms they audit, and brokerage houses can still offer analysis of companies whose stock they sell. Sham transactions that inflate earnings are still permitted. The problem has not been fixed.

The truth is starting to come out. Much of the dot-com boom was a scam, fueled by corrupt investment banks who, in the words of the San Jose Mercury News, took "kickbacks from preferred clients in exchange for big allocations of shares in coveted Internet IPOs." The SEC is investigating Morgan Staley, Goldman Sachs, J.P. Morgan, Robertson Stephens, and others for "laddering", a market manipulation scheme designed to inflate stock prices immediately after the IPO. This may turn out to be the biggest "pump and dump" scheme of all time.

New York State Attorney General Elliot Spitzer is widening his investigation. The Securities and Exchange Commission, the New York Stock Exchange, the National Association of Securities Dealers, the North American Securities Administrators Association, and a number of states are now investigating. This could be bigger than Enron and Andersen.

Some of the companies involved, such as VA Linux, were mentioned on our Deathwatch or Misery Row. Those first-day runups were suspicious at the time. Now it's becoming clear what was going on.

New York State Attorney General investigation of Merrill Lynch
"As part of a quid pro quo between the firm and its investment banking clients, Merrill Lynch analysts skewed stock ratings, giving favorable coverage to preferred clients, even when those stocks were dubious investments. This problem and other conflicts of interest are revealed by internal e-mail communications obtained during the investigation by the Attorney General’s office. These communications show analysts privately disparaging companies while publicly recommending their stocks. For example, one analyst made highly disparaging remarks about the management of an Internet company and called the company's stock "a piece of junk," yet gave the company, which was a major investment banking client, the firm's highest stock rating."

"This was a shocking betrayal of trust by one of Wall Street’s most trusted names." - Elliot Spitzer, New York State Attorney General.

Which stocks received phony ratings? The court affidavit names names. Many of these were on Downside's Deathwatch.

"Thus, as previously covered stocks such as Pets.com, Mypoints.com, Quokka Sports, Webvan, iVillage, Buy.com, 24/7 Media, E-Toys, Internet Capital Group, and InfoSpace plummeted, sometimes all the way to zero, retail customers and the investing public were never advised to sell."

This may be just the beginning. Subpoenas have been issued to other securities firms.

Q1 2002

Q4 2001

Q3 2001

Q2 2001