Mistrust and the bear market

There is an adage that recession uncovers what auditors do not. If that is so, then the recent one turned over a rock like nobody has seen in recent memory.

The Enrons, WorldComs, and others have done plenty to undermine public trust in the financial markets. This paper has had its say about that a number of times. Now a general atmosphere of suspicion, a collective sigh of “what’s next?”, has settled over the industrialized world’s capital markets — and a debate is beginning about what governments should do to restore investors’ trust.

But although they go bony hand in furry paw, mistrust and bearishness are two different things. Mistrust only came on the scene when the bears had driven investors screaming from the market. In that spirit, we’d like to set a few ground rules that may be useful in discriminating good ideas about investor confidence from bad ones.

q Rule the first: nobody who claimed, in the fairytale days of the bull market, that conventional measures of valuation didn’t matter gets to whine about misstated earnings or unjustified capitalization of expenses.

If buyers weren’t paying attention to earnings, cash flow, or balance-sheet items, just how much of the misstatement could have been built into prices? We love a good witch hunt as much as anyone else (and be in no doubt about it, there were witches out there), but to blame duplicitous executives and compliant accountants for the market collapse is just a bit rich. It was buyers, not auditors, who bid stocks through the roof.

In classical valuation models, stocks were valued based on their future cash return. In the mythology of the bull market, growth potential was what it was all about. When sourpuss traditionalists pointed out that even the most generous growth measures would not justify the kinds of prices people were paying for stock, the bulls countered that the metrics didn’t matter: market share, brand recognition, and human capital weren’t being captured in the models.

The fact remains that a lot of people didn’t see through this and kept buying, implicitly loading a lot of value on to these intangibles. So were born the new rules of valuation: price is what you pay today, and value is what you get in the unforeseeable future.

That eventually left some people stuck with a lot of worthless paper, but accounted neatly for off-off-balance-sheet factors like edginess and way-cool market share. When a dot-com company gets nailed for rolling its page-hit counter forward the way slimy used car lots roll odometers backward, then people who followed the “new rules” can complain. Not before.

q Rule the second: if stocks were worth what somebody would pay for them in 1999, they are also worth what somebody would pay for them now.

This rule is closely related to the first rule: it was common during the bull market to reject the whole idea of rational value measures and consider only the price you could get for your shares in the open market.

The problem with depending on that theory of value is that a bull market that does not return capital to investors needs a continuing influx of new money in precisely the same way that a pyramid scheme needs new punters. When that dries up, so do prices.

It may be easy to accept that model while prices are going up. It takes a little more character to accept it while prices go down. The model has one distinct virtue, all the same. Its very simplicity makes it easy for anyone with a pocket calculator to figure out how much value has been destroyed.

q Rule the third: nobody that gloried in the fresh air of free markets then gets to call for more stringent regulation now.

While saying so may put at risk this newspaper’s reputation as an apologist for meat-hunting capitalism, we heard too many bland pronouncements that government’s job is simply to get out of the way of people that want to make money. There may be times that getting curtly and obtrusively in their way is the best thing a government can do.

But that is not the same thing as crying “there oughta be a law” every time the market shakes out fools and madmen. There is a law that deals quite well with these situations; it’s called supply and demand. Demand for paper declined and prices fell. Strange to say, the system works.

q Rule the fourth: it wasn’t different that time, any more than it was different in 1987, 1974, 1929, or the Gilded Age. Those who peddled the “new economy” difference in 1999 should get the same treatment as the prophets who warned the end of the world would come last Thursday afternoon at 4:35. Don’t despair: you can always find someone foolish enough to listen to your next story; it just won’t be us.

One can easily become tedious on this subject, but it’s still true: the moment someone makes the assertion that some new wonder of financial engineering transcends human experience, and “it’s different this time,” he has passed from finance into fantasy. The only difference lies in how long the market will take to realize the falsehood, and turn around and bite the believer. Those so bitten, having behaved foolishly, are not entitled to sympathy for their losses, nor to a respectful ear for complaints about unscrupulous dealing.