May 5, 2003	Monday	Rabi-ul-Awwal 2, 1424

The European and the US stock markets continue to remain weak. The mid-March euphoria, reflected in the sharp gains in major stock indices in the days leading up to the start of operation “Iraqi Freedom” seems to have abated considerably. Once again, focus has shifted back to economic fundamentals.

The economic statistics coming out of both the US and Europe remain weak with most economists continuing to downgrade their forecasts for global GDP growth. The recent decline in payroll employment and a high unemployment rate signify that the US economy is still operating with considerable slack. A prolonged winter and higher-than-anticipated oil prices remain a drag on recovery.The SARS problem is not helping matters either.

But is the problem purely lack of encouraging economic data or is there more to it? Or are the investment community and the financial markets over-reacting to the mixed data coming out?

There is no doubt that the bankruptcies of Enron and Global Crossing appear to have done serious damage to financial markets. The collapse of the Houston-based energy giant has rolled markets around the world as jittery investors continue to wonder whether other companies are using the same accounting tricks to keep debt and other bad financial news off their books. Accounting frauds at Ahold and HealthSouth are recent additions to the notorious list.

The triple influence: Investors may have hoped the end to the conflict in Iraq would inspire a detente between stock market bulls and bears but the two camps seem as divided starting off the second quarter as they were in the first. Many remain skeptical about the quality of earnings being reported by Corporate America. Uncertainty continues to overhang stock markets, particularly as US officials issue warnings to Syria’s leaders. Investors remain concerned about what lies ahead, whether it is the credibility of a corporate balance sheet or the volatile geopolitical situation.

Recently, Richard Grasso, chief executive officer of the New York Stock Exchange, said that the US markets were labouring under the triple influence of a war discount, a terrorism discount and a trust discount. He feels that the third influence is the one that is most damaging. Even if the war and terrorism discounts fade over time, the issue of “trust discount” will not. It must be seriously addressed and resolved by the regulators and business community.

According to Mr. Grasso, the best way to restore public faith is with more aggressive prosecution of wrongdoers. In particular, he feels that executives involved in wrongdoing should not be able to walk away with their wealth and have it sheltered by state laws that protect certain personal assets from seizure. “People who inflict this kind of pain should lose everything.”

Although Mr. Grasso believes the tide is turning, and that investors are still willing to put their money in stocks, the state of markets paints a different picture. New York State Comptroller Alan Hevesi, who oversees the second-largest state pension fund in the United States with about $100-billion of assets under management, believes investor confidence has not hit the bottom even yet. “Investors don’t trust yet. The damage that’s been done is extraordinary,” he says.

According to Mr. Hevesi, more regulatory changes — including even tougher guidelines for auditors, and rules allowing shareholders to more easily sue corporate advisers such as lawyers and accountants — are still needed. The damage that has been done cannot be overstated. “Thousands of people were defrauded, and many lost their life savings. There have been billions in lost value. It’s not enough to say there were a few rotten apples,” continues Mr. Hevesi

Where did it go wrong?: To understand the impact of events such as the bankruptcy of Enron on the evolution of capital markets over the longer term as well as enforce the type of regulation that may prevent such disasters, one needs to look back at history. The 1980s and 1990s were years of enormous expansion for global financial markets as well as for structural and technological changes. Capital markets have participated remarkably well in mobilizing capital resources and responding to the challenges and increased competition resulting from these changes. Starting in 1982, the United States witnessed a rapid increase in the pace and volume of company mergers and acquisitions, new issues of debt and equity securities, trading volumes, and market capitalization. At the same time, financial markets were being deregulated in the United States as well as around the world, and new technologies were being introduced. In the early 1990s, Europe was also experiencing a boom in mergers and acquisitions in preparation for the introduction of a single currency and the disappearance of trade barriers within the European Union in 1999.

This environment provided both opportunities and challenges for investment firms. The stock market plunge of October 1987 was followed by another market slump in 1990. Criminal charges against Drexel Burnham caused the junk bond market to collapse, and insider-trading scandals increased regulatory oversight in the early 1990s. Misconduct in financial reporting, pension fund management, and trading in derivatives produced class action litigation and further regulatory scrutiny.

The Glass-Steagall Act was finally repealed, increasing competition by allowing commercial banks to engage in investment banking and investment banks to engage in commercial banking. Bond markets became increasingly volatile in the 1990s. Globalization presented new opportunities and risks, as evidenced by the Russian default in 1998 that forced Long-Term Capital Management into insolvency.

Some analysts feel that the former US president Bill Clinton should have done more to champion legislative reforms that were defeated in the 1990s, including a failed effort by former Securities and Exchange Commission chairman Arthur Levitt to introduce strict rules preventing auditors from also doing extensive consulting work for their clients. Mr. Levitt was forced to retreat after Republican Senator Phil Gramm threatened to cut the SEC’s budget if it didn’t back down from the proposal.

Recently, Eliot Spitzer, New York State’s crusading Attorney General, warned of looming prosecutions against research analysts over bogus stock recommendations, the final stage in his plan to clean up Wall Street. Mr. Spitzer, who oversaw a $1.4-billion settlement in December 2002 with 10 of the largest brokerage firms on Wall Street, acknowledged that many investors remained skeptical that justice has been served when few individuals have faced prosecution, few have had to give up ill-gotten profits, and few have even been required to admit wrongdoing when settling cases.

Potential beneficiary: Mounting concerns among fund managers about the quality of US corporate earnings is spurring new interest in emerging markets. If the quality of earnings is not guaranteed in the US, why not go to the emerging markets where the quality isn’t guaranteed but stocks are cheap? But while emerging markets provide an increasingly important investment opportunity for global institutional investors, many potential investors remain hesitant to participate. But with the war in Iraq being over, the tone of emerging markets has brightened somewhat. The significant improvement in investor sentiment toward emerging markets is particularly notable.

However, institutional funds are still reluctant to flow into these markets in a big way. Their reluctance is often due to a lack of understanding of the markets on the part of fund managers, restricted access to research, minimal corporate information, risks associated with yet under-developed market economies and the need for liquidity. One of the biggest barriers to investing in emerging nations is the variable quality of basic information in many markets.

Now what?: Following the recent debacles of Enron, WorldCom and now Ahold, a crisis of confidence prevails in the financial system, perhaps more so in the US compared to Europe. For many years, earnings numbers and assets were inflated by companies through financial reporting gimmicks.

Earnings management, or rather mismanagement, results when companies exploit the flexibility in accounting principles that allows financial reporting to keep pace with innovations in the economic and business environment. Companies select accounting options that obscure management’s decisions rather than shed light on them. Some analysts feel that the root of the accounting problem is that stock market bubbles tend to reward aggressive accounting as it inflates earnings.

By some measures, the US market could still be considered expensive, despite the sharp drop from its peak three years ago. What lies ahead? It is all a question of placing confidence in the data and information supporting the valuation of stocks. Valuation is a matter of judgment and, among other variables, is based on corporate financial statements. It is hoped that analysts would now be more vigilant and will exercise caution when commenting on “earnings quality”.

At the same time, the investment community must fulfil its part of the deal and is expected to place much emphasis and weight on the fundamentals driving corporate earnings. Once liquidity starts flowing back into stocks to tilt the balance in favour of riskier investments, US and European stock markets will begin to reverse the negative returns seen over the last three years. Till the time such balance is achieved, equity risk premium will remain high and stock markets may well remain in flux.