ARCHIVE:: APRIL 2002 :: THE MARKETS

'90s Boom:
Lingering Clouds...
Market Bubbles Are Often Followed by Accounting Scandals and Bankruptcies

By E.S. Browning
Staff Reporter of The Wall Street Journal

The bad news for the stock market doesn't seem to end.

First there was Enron's collapse, then Kmart's bankruptcy filing, then Global Crossing's. Stock market analysts have even raised questions about the accounting at such corporate giants as Tyco International and Cisco Systems.

Soon, the optimists say, all these nasty surprises will have to stop, and the budding economic recovery will begin to capture investors' attention.

They could be right, but don't bet all your money on it.

History confirms what a lot of stock analysts and investors have been discovering lately -- that burst bubbles and accounting controversies tend to go hand in hand.

Accounting scandals and bankruptcies, in fact, are one important reason that it can take the stock market years to recover fully from a bubble.

"This is not an isolated event," says Ray Dalio, president of Bridgewater Associates, a money-management firm that oversees investments worth $35 billion. "This is something that will spread" as many companies' accounting practices are examined. "Many more stories will come out. The examination will inevitably turn up more cases of aggressive accounting and there will be a penalty for that aggressive accounting."

Bending the Rules

The root of the problem, say Mr. Dalio and others who have studied the phenomenon, is that stock-market bubbles reward aggressive accounting, since it inflates corporate profits and helps push up companies' stock prices. As bubbles develop and the continued inflation of stock prices becomes paramount, conservative accountants and executives become discredited, and bending the rules becomes standard.

Consider past experience. Corporate bankruptcies and unraveling frauds were among the hallmarks of the 1930s, following the stock market crash of 1929. One accounting trick of that era was to create elaborate webs of holding companies, each helping to hide the others' financial weaknesses, an artifice strangely similar to what Enron did with its partnerships. One of the biggest shocks of the 1930s was the collapse of a vast, once-highflying utilities empire called Middle West Utilities, run by an energy magnate named Samuel Insull.

"Our view would be that bubbles create greed on the part of investors but they also create greed on the part of management," says Jeremy Grantham, a co-founder of a Boston money-management firm. "That was very much the case in 1929 when holding companies [accumulated debt] and bought other holding companies' stock."

As the fallout from the 1929 Crash spread, former New York Stock Exchange President Richard Whitney was sucked in and eventually was arrested and jailed for larceny.

A less extensive bubble was inflated in the late 1960s and burst in the early 1970s, when the so called Nifty 50 stocks fell apart. Accounting scandals multiplied again. The Securities and Exchange Commission in 1975 censured Peat, Marwick, Mitchell, one of the largest accounting firms of the day, for failing to perform proper audits of five companies that collapsed soon after getting clean opinions from their accountants.

More trouble followed the crash of 1987, although it was shorter-lived than the problems of the '30s or the '70s. The once-hot junk-bond market unraveled, insider-trading scandals proliferated, the savings-and-loan crisis grabbed the front pages and real-estate investments went bust.

As similar clouds gather now, Shelly Meyers, a mutual-fund manager in Beverly Hills, Calif., says she is spending a lot of time trying to track down rumors about some of the stocks she holds.

"What we are seeing here in the financial markets is the equivalent of the perfect storm," Ms. Meyers says. "At the same time, we have had three major bankruptcies that were household names -- Enron, Kmart and Global Crossing."

Trusted Professionals

On top of that, analysts have repeatedly had to revise earnings estimates downward, and worries have spread about whether the economy can stage a sustained recovery. Accountants, once among the nation's most trusted professionals, are accused of helping hide wrongdoing and of misleading investors.

The result: Ms. Meyers is hearing as many as four rumors a day about the stocks she holds, and is spending hours on the phone with contacts in brokerage firms and elsewhere trying to check them out.

"My biggest concern at this point is that a rumor-based kind of investing is going to gain momentum," she says. "We, as professionals in particular, have a very important job right now, which is to take a step back, take a couple of deep breaths, and ask whether we are doing our job based on rational analysis or on fears and rumors."

She believes that the swirl of rumors will die down. But "the question is when are people going to have faith in those systems again," she adds.

Some market analysts worry that these problems aren't going to go away soon.

"It is absolutely what almost invariably happens after every bubble," says investment strategist Barton Biggs at Morgan Stanley, referring to the scandals, bankruptcies and accounting disclosures. "You should expect them, but that doesn't mean that people who haven't been through it before aren't going to be surprised. The bigger the binge, the longer and more severe the hangover."