Oh, woe is the stock market! As I write this on July 21, 2002, the Dow stands at 8019, the lowest level since 1997. Nasdaq and the S&P 500 are at similar, pitiful levels.
Thereís more. Richard Grasso, chairman of the New York Stock Exchange said today, "Mondays following Friday declines have always been difficult and I suspect tomorrow will be no different."
Whatís going on?
The first thing to remember is that the precipitous market drop is deeply significant to the country, and not just to investors. The Dow and other U.S. stock markets represent the present and expected future values of all the publicly traded companies that operate in the country. There is no better analyst, person or institution, of where the economy is headed in the future than the market acting as a collective whole.
This does not discount the role of moods, emotional and irrational investors. But the market itself does not work this way. Over the very short-term, the market is not unlike a horse race or football game, where capricious and small events can change outcomes in dramatic ways. But over the long-term, even measured in a couple of months, the market is like a scale. It tells the truth.
The bad news that we see on the stock front is also apparent in the bond market as well. Mike Darda of Polyconomics demonstrated this point last week: "The spread between zero-risk Treasuries and BBB industrial bonds, a forward-looking measure of both credit risk and the cost of capital, has widened by 107 bps (basis points) in the last two months. At 748 bps over Treasuries, risk spreads are at their widest levels for the year."
Let me break this down in laymen terms, starting with the basics and moving up from there. Thousands of different bonds exist, but all of them can be characterized as different types of I.O.U.s. Like any loan, there is a risk that the debtor wonít pay the creditor back. The bigger the risk, the higher the interest rate for the debtor. The difference between a Treasury bondís interest rate, which has almost zero risk, and the BBB industrial bonds interest rate, which measures the level of economic uncertainty, has risen significantly. This is an excellent indication that the market expects tough times ahead, which makes loaning capital (primarily money) more expensive, which in turn means less risk-taking and economic activity occurs.
So things look bad. But what got us into this mess?
The short answer is that it depends who you talk to. However, most people would blame the steep declines to either the loss of trust in the corrupted corporate class, or the response that Washington has taken to the entire corporate class because of a few bad apples.
Even this choice ignores other variables that may be hurting the markets. The deflationary spiral that brought upon the mild recession is ending, but the readjustment process may prove difficult. Also, the threat of future terrorist attacks hurts the markets as well. Having said all this, the collapse in corporate confidence has to be the primary culprit for the marketís current woes.
These corporate scandals are common after boom years, as companies are freer to overplay their hand. Moreover, the deflationary period just ending made the dollar stronger, so debts would become harder to pay back. This is a bad combination. Still, whoís to blame: corporations or Washington?
Clearly, the Enron debacle was the biggest corporate crime ever recorded, but they are in a long list of perpetrators who carried out massive deceit. There have been numerous cases of lying, wishful thinking gone amok, and top executives providing cushy parachutes for themselves while leaving the rest of the staff in the lurch and high and dry. Indeed, the corporate elite hasnít had sufficient checks and balances against them for a long time. Executive pay hasnít been tied to results for a long time, which is a scenario inconceivable for anyone else.
Moreover, an article in the World Socialist Web Site points out that "During this period the wages of the average worker rose by 28 percent, just barely ahead of the inflation rate of 22.5 percent, making the net gain only 5.5 percent. But the compensation of corporate CEOs, combining salaries, bonuses and stock options, rose 481 percent, for a net gain after inflation of 459 percentóa rate of increase 82 times as great as that for workers." Many of you may be wondering why Iím quoting a Marxist website. Well, Iím no fan of the dead ideology and its legacy in the 20th century, and I have faith that freer markets, when working properly, can perform wonders for every part of the world. But Marx was onto something when he observed that if the capitalist class, if left to their own devices, would eat their own seed corn and destroy the system that made them wealthy in the first place. Greed and venality has always been a part of human nature, and we have to protect ourselves from it.
Leaving these issues for another day, there is the counter-argument that corporations, while never perfect, have a vested interest to play it straight with its shareholders, so as to maintain their long-term strength. This does not require much foresight. Why would an investor risk her hard-earned money tomorrow if she was gypped yesterday? Enron and WorldCom are the exceptions that proved the rule.
According to this view, the bills going through Congress right now are so heavy-handed that they will chill legitimate business practices by CEOs just as much as they would prevent the crimes of illegitimate ones. Indeed, the bill that passed the Senate contains civil laws that would apply to CEOs, and civil courts require far less proof of conviction. Jude Wanniski, again from Polyconomics, put it this way: "It is one thing for the feds to be snooping around looking for criminal fraud at Acme Widget, another for the trial lawyers to go on fishing expeditions." Larry Kudlow and Senator Robert Bennett have said similar things in the past few days.
I will be able to surmise which side was in the right on this issue by August, when it will be clear whether corporation mismanagement has hit endemic proportions. If not, then Washingtonís behavior is clearly to blame for the current mess. Either way, I can drop my studied ambivalence.
I am still an optimist. The opportunities that will propel the market for the next 30 years are still staggering. Itís just that things may get darker before dawn.
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