The "go-go years" all over again

multex investor ^ | Thurs, 08/01/02 | Rick Wayman, CFA

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The current accounting scandals—and the "crisis of confidence" they have inspired—are nothing new. To gain perspective and prepare for the next cyclical bull market, it's important to understand the historic relationship between accounting and the stock market.

In his 1973 book "The Go-Go Years," John Brooks laid out how the two relate, and I'll lean heavily on his account for this article. Brooks wrote his classic book during the last (long) bear market, and it describes how the preceding bull market (the 1960s) contained the seeds of its own destruction, and how it paralleled the previous bear—the Crash of 1929. The book eerily describes the market conditions since the dot.com bubble began.

Accounting, Brooks argues, is an essentially honorable profession, whatever its pretensions to creativity. One of the dreariest corners of economics, a profession Carlyle called the "dismal science," accounting is seldom scrutinized by reformers or populist legislators; like a skunk, its repelling nature usually protects it from attack.

The profession's first fall from grace came during the boom of the 1920s, when many accountants found devious and misleading ways of writing up companies' book value. (At that time, accounts took little interest in earnings; in fact many companies didn't even report earnings because the market ran on book value.)

Then came the Great Crash and a new wave of high-mindedness and reform. The SEC, which was granted almost dictatorial powers over the accounting practices of public companies, sprang from this crisis of confidence. But the agency quickly adopted a policy of allowing Wall Street and corporations to regulate themselves, and never really exercised its formidable powers.

In the 1960s, as the economy boomed and an increasingly wealthy society sought new places to stow away its excess earnings, millions of new investors turned to the stock market. The naiveté of the neophytes led to a search for simplicity, and they found it by focusing attention on the bottom line. And this simplified view of business performance soon led accountants, including some of the best, to descend almost unawares from their pedestals of objectivity and become at times the willing accomplices of ruthless corporate managements and essentially dishonest promoters. In brief, many of them sold their souls.

By following conservative practices and their consciences, accountants could have prevented most of the shenanigans, but they did not. In recent years, given a vastly expanded a securities market swelled by novice investors, disclosure was used to tell lies to the untutored and the unwary. Accountants came to think legalistically rather than conscientiously, and to do more or less what they were told by management.

And the trumped-up earnings reports that blow through bull markets are the gusts that swell bubbles. That's why I think the current bear market will eventually get as bad as, if not worse, than the 1929 peak and crash. If you don't believe me, consider this: the Nasdaq is down more than 70 percent from its peak, and is tracking very closely to the Dow Jones index of 1921-1932 (which was down about 80 percent at a similar point). But crashes are not labeled as such until much later, when time provides a clearer perspective. Today we are too busy coping with reality to make these comparisons.

But haven't we always been too busy? We were too busy day trading and flipping stocks in the late 1990s to recognize the ominous signs of the bubble. And those who did were rarely heard. The lone voices were not head above the din of talking heads pitching stocks on CNBC and articles on market-trouncing ex-cabbies.

But times have changed. Today there is a crisis of confidence, much like the conditions that existed in the aftermath of the 1920 and 1960 bull markets. There are more articles indicating a turn—cabbie stock pickers are abandoning the market, analysts and investment bankers are being fired, banks are closing the brokerage firms they acquired a few years ago, and Dilbert has lampooned both analysts and accountants.

There are several good things that will result from today's tumultuous market. First, investors will be better educated, as each day brings a new lesson in accounting fraud. Second, stronger companies will emerge from the ashes of the tech and telecom corrections, just as happened in the canal, railroad, and auto sectors in decades past.

And perhaps most importantly, companies will respond quickly to changes demanded by the market. For Wall Street to save itself, corporations, accountants, and the Street must provide investors with proof that they are cleaning up their act. This will occur faster than legislators can act, which is a good thing because government mandates have rarely been timely or very successful.

Perhaps the first proof of this is the recent announcement that Coca Cola (KO) will start expensing stock options. While lobbyists hotly debate this topic with lawmakers, Coke has taken a stand, and the lead, in regaining investor confidence. The question now is when will the rest of the market take Coke's lead?

Richard J. Wayman, CFA, is President of researchstock.com, an independent equity research firm that provides reports and earnings forecasts on under-followed small cap stocks.

Copyright 2002 Muiltex.com

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Excellent "hits the nail directly on the head" article.