Commentary

Overstocked Assumptions

This article was published in the Washington Times, July 28, 2002.

When the stock market suddenly showed signs of life on July 24, there was enough news to support everyone’s pet theory. JP Morgan aptly defended itself against efforts to tar the company with the Enron brush and offered to buy its own stock. The House and Senate compromised on an accounting bill that would not let auditing overseers become so independent they could compete with the Securities and Exchange Commission.

The government finally arrested a few corporate execs rather than punish entire companies, which mainly hurts innocent stockholders. And, least noticed but potentially most potent, The Washington Post reported that the White House is considering using the August recess to push for relief from the double taxation of dividends.

The last big accounting scandal was old news by late June, and WorldCom stock was already below a dollar when that story broke. Yet the broad stock market rout began after July 5, when the government offered to help, mainly by criminalizing risk. We were repeatedly promised that stocks would rise if the president preached against avarice and Congress passed any bill described as “tough.” Yet Sen. Joseph Biden, Delaware Democrat, soon noted that the market fell every time President Bush gave another speech against “endless profits.” And Sen. Paul Sarbanes, Maryland Democrat, praised Alan Greenspan’s testimony for calming the markets, but failed to apply that same test to his own bill. On the day the Sarbanes bill passed, the S&P 500 fell 3.4 percent.

Since the government’s crusade to restore confidence had the opposite effect, those who refuse to learn by experience claimed we needed a stronger dose of the same poison — something tougher on corporations and therefore tougher on those who own corporate shares. Markets could not calm down until Congress did.

The government’s fatal assumption was that stocks fell mainly because of accounting problems. That notion could not begin to explain why stocks have fallen even more sharply in Europe, where there was never much of a bubble to begin with. From May until the day before the July 24 rally, our S&P 500 fell by 27 percent, compared with drops of 29 percent in Germany and 31 percent in France.

To explain why stock prices changed, we have to find something that changed. Those who explain the “bubble” in stock prices as the consequence of rising greed can only explain falling stock prices as a consequence of falling greed. But something as constant as greed can never explain something as variable as stock prices. Similarly, it makes no sense to blame the huge swing from rising profits in 1999 to falling profits in 2001 on phony accounting. That only makes sense if you can believe accountants were dishonest only when profits were fabulous and then became extremely honest in 2001, when profits turned to eraser dust.

In reality, stock prices are dependent on just two things: growth of earnings and the P-E ratio (the ratio of prices to earnings). To get stock prices rising, either earnings or the P-E ratio has to rise.

Politicians who promised to “restore investor confidence” were actually claiming the P-E ratio was too low. That is, more confidence would supposedly raise stock prices without any improvement in earnings. Yet journalists who echoed that same confidence game were busily reporting that the P-E ratio is much too high. Those two claims are completely contradictory, and they ignore earnings growth. Stocks fell because earnings growth quickly turned from terrific to frightening. They kept falling partly because too many stockholders had no choice but to sell to raise needed cash.

For S&P 500 companies, the change in earnings per share rose from about 1 percent in the first quarter of 1999 to 27 percent in the second quarter, 33 percent in the third and 49 percent in the fourth. Little wonder that myopic investors became too euphoric. But growth of earnings per share then fell to minus 29 percent by the final quarter of 2000, minus 33 percent in the first quarter of 2001, minus 64 percent in the second, minus 62 percent in the third and minus 40 percent in the fourth. Little wonder that stocks collapsed.

In the first quarter of this year, earnings per share were no higher than the previous year’s depressed level, and the Commerce Department’s broad estimate of corporate profits was 20 percent lower than a year earlier. It is indeed unusual for stocks to do so poorly in the first months of a recovery, but it is equally unusual for profits to do so poorly. Profit margins have been squeezed by high costs of paying interest to creditors. And business-to-business sales of equipment do not benefit from rising house prices or retail sales of Asian goods.

Early second-quarter earnings reports seemed more disappointing than the latest batch. Whenever earnings news is clearly good, such as Nextel, the stock price jumps. As soon as most companies’ earnings are rising, most stocks will be rising, too.

Meanwhile, the best way for Congress to “restore investor confidence” might be to extend the August recess through November.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.