Looking for the Hobgoblins: Explaining the Chaos in the U.S. Stock Market

By Scott B. MacDonald

According to the Oxford American Dictionary, a hobgoblin is "a mischievous or evil spirit." For anyone watching the events of the New York Stock Exchange and the NASDAQ in April and early May, it would appear that an army of hobgoblins has marched through Wall Street sweeping all before it, leaving only the dead and dying. Indeed, an extended hobgoblin assault on the U.S. financial system could become a risk to the economic recovery if it erodes the weak reeds of investor, consumer and management confidence. Until the hobgoblins leave us alone, we expect to see ongoing volatility in both equity and bond markets.

Where did the hobgoblins come from? They were created during the 1990s economic and stock market booms. They emerged from a loosening of accounting standards, the quest for more complicated financial engineering and correspondent erosion in financial transparency, a collusion in the interests between accountants and the companies they audited, and big egos allowed them to run rampant. In a sense, the business culture was "fast and easy", mirroring the times when the stock market rose to ever-higher levels and created a carnival-like atmosphere on Wall Street that gripped most of North America. Investors big and small threw their money into the stock market boom, which finally began to peter out in 2000 and 2001.

Now that the carnival has ended, the mess must be cleaned up. It is a time for finger pointing, hence the arrival of hobgoblins and market volatility. In a sense, we are undergoing what happens each time a boom goes bust - apportioning the blame. As Michael Lewis, author of Liar's Poker, recently commented: "We have arrived at the beginning of the end of a process that seems to be psychologically necessary after every stock market bust. Huge sums of money can't simply have been lost by greedy little investors. Someone must have taken them." Consequently, there is a witch hunt for anything that smacks of the excesses of the 1990s - bloated CEO bonuses, large debt build-ups by companies, and bad corporate practices.

There are a large number of companies that were kings of the carnival during the 1990s that are now struggling against fierce competition, negative investor sentiment and SEC investigations. Enron has already fallen, leaving in its wake an ongoing scandal, angry employees, and an imploding Authur Andersen. Other former high-flyers - Tyco, Xerox, Lucent, and Qwest - are all grappling with deeply depressed stock prices, an acute loss of investor confidence and downward ratings pressure. Most recently, the energy sector has come under renewed scrutiny after Dynergy, CMS Energy and Reliant Resources revealed that they engaged in "round trip" trades, i.e. the purchase and sale of power and gas with the same counterparty at the same price - much like Enron.

Part of the loss of confidence in these stars of the 1990s comes from the role played by the accounting profession. Although there were a few critical voices about the "flexibility" of accounting firms vis-á-vis their customers during the 1990s boom, these were cries in the wilderness. The Enron scandal, however, brought the role of the accounting profession front and center when it was revealed that Arthur Andersen was involved in destroying evidence and other questionable practices. As Richard Breeden, former chairman of the SEC from 1989 to 1993 stated in an interview to Bloomberg: "Senior officials at Andersen have trouble reconciling their duties to investors with their business interests."

While Andersen gained considerable public attention in the aftermath of the Enron scandal, it is hardly fair to single this company alone in having loosened its standards. According to a Bloomberg Magazine study, accountants have given a clean bill of health to more than half of the largest U.S. public companies that went bankrupt from 1996 to 2001. Moreover, shareholders lost $119.8 billion in the 10 largest bankruptcies following audit opinions that had raised no concerns.

Rounding out the picture, a number of major investment banks are now under investigation by the SEC and New York State Attorney General Eliot Spitzer for collusion between their investment bankers and corporate research analysts, one of the many offshoots from the Enron scandal. Yet for all the hoopla, this problem existed well before Enron. As financial industries consultant David E. McClean accurately notes: "The scandal of Wall Street research predates Enron by many years. It did not take an Enron scandal to know that the relationship between research and corporate finance departments has been a troublesome one, although the analyst cheerleading surrounding Enron drew the world's attention, as never before, to how professional stock recommendations really work."

However, the witch hunt of Wall Street research departments does provide a guilty party for people to point to with indignation. Those investors who lost money based on the advice from Wall Street analysts are being converted by the wave of a lawyer's wand into hapless victims. Yet, by investing in the stock market any investor is partaking in something called speculation. There are no guarantees of profits or money back. An investor puts his money down hoping to make more money. Research is meant to help the odds - not to provide a sure-fire get-rich machine.

At the same time, it is important to draw the line that research should not be fraudulent. Wall Street has a long history of rouges and no doubt the 1990s produced its own generation, some of them apparently wearing the garb of research analysts.

Another element adding to the volatility of the stock market it that expectations over the future direction of the U.S. economy are too high. While the 5.6% real GDP growth in the first quarter of 2002 was a strong rebuttal to anyone still clinging to the idea that the recession was lingering, it also generated false expectations that the rest of the year would be as robust. Simply stated, we do not see real GDP growth of 4-5% in 2002, but closer to the 2-3% range. While consumer demand has helped maintain some momentum through the end of 2001 and into 2002, it does not have too much further to go. What was amazing about Q1 2002 was that consumer spending excluding motor vehicle sales rose from 2.6% in Q4 2001 to 6.2%, a substantial uptick. As John Lonski, Chief Economist for Moody's commented: "The performance of household expenditures amid the most pronounced contraction of payrolls since 1991 has been amazing. "Don't expect it to last, especially as unemployment rose in April to 6 percent.

The U.S. stock market is likely to remain a chaotic place for much of 2002. Witch hunts take time. There are political careers to be pumped up, lawyers' fees to be negotiated, and a public to stir with indignation at the infamy of it all. Yet, beyond the froth caused by the hobgoblins, the U.S. economy is making a rebound, albeit one that is slower than many would like. In addition, corporate America is rapidly overhauling its governance practices, the accounting profession is restructuring and hopefully investors are becoming a little more aware of the many pitfalls and bear-traps that await the unwary. We remain cautiously optimistic about the U.S. economy and see 2003 as a better time for the stock market. Hopefully by that time the hobgoblins will be gone and it will be time to get back to business.