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Wall Street weakened by ‘Enronitis’

Now that the anthrax scare has faded to a distant memory, Wall Street is dealing with a new disease called “Enronitis.” But will the fallout from Enron’s bankruptcy afflict the stock market for much longer? — By Roland Jones
A trader on the floor of the New York Stock Exchange keeps his eye on a monitor shortly after the start of trading Wednesday. Investors have been jittery about corporate accounting in the wake of Enron's collapse.
A trader on the floor of the New York Stock Exchange keeps his eye on a monitor shortly after the start of trading Wednesday. Investors have been jittery about corporate accounting in the wake of Enron's collapse.
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Now that the anthrax scare has faded, Wall Street is dealing with a new disease. “Enronitis” — the fallout from the collapse of energy-trading firm Enron — has infected investors with skepticism over the integrity of regulators, auditors, and company directors. Will the contagion, which has chipped away at U.S. stocks in recent weeks, afflict the stock market for much longer? While many market strategists believe stocks should recover in the coming months, some say the side-effects of the Enron malaise may linger.

Ever since news broke of the extraordinary failure of Enron, investors have cast a cautious eye over the way U.S. companies keep their books, worried that accounting shenanigans at other firms might lead to more Enron-style implosions.

Once the nation’s seventh-largest company, Enron crumbled in the largest bankruptcy in U.S. corporate history last December. Now the company’s executives stand accused of a variety of questionable accounting transactions, including concealing the firm’s debts so they didn’t show up in earnings reports and lying about profits. At the same time, thousands of Enron employees saw their retirement savings evaporate as the company’s share price plunged towards the end of last year.

With a raft of congressional committees working to unravel the chain of events that produced Enron’s demise, the key issue for Wall Street is whether Enron’s lax corporate governance and creative accounting methods will continue to gnaw away at investor confidence, weakening the stock market and endangering what appears to be a fledgling economic recovery now underway.

Market strategists agree that the fallout from the Enron scandal will destabilize investor confidence in the short-term, as investors worry that Enron’s accounting problems are systemic and that Corporate America’s bookkeeping standards are shoddy.

But investors’ confidence will likely be restored if the investigation into Enron discovers that corporate governance deficiencies were limited to the energy-trading firm, resulting in improvements to accounting standards that attempt to make sure they are prevented from recurring, analysts say.

Wall Street nervous
Despite somewhat sketchy evidence, investors have punished stocks they think might follow in Enron’s path. On Jan. 29, the Dow Jones Industrial Average fell 248 points, or 2.5 percent — its biggest one-day loss since Oct. 29 — after Wall Street raised questions about accounting practices at a handful of companies, like Tyco International, Williams Companies and PNC Financial Services.

Williams, an energy firm, delayed its earnings report to assess its financial obligations to a struggling spin-off. And PNC was forced to reduce 2001 earnings following a Federal Reserve review of its accounting methods. Both firms’ stock prices fell sharply.

Another strong sell-off came last Monday after an article in The Wall Street Journal raised new questions about financial disclosures at Tyco International.

The Journal story said that Tyco, a diversified firm that has grown through numerous acquisitions, had spent about $8 billion on over 700 company purchases over the past three years that were never publicly announced. A buildup of concerns about Tyco’s accounting methods has cut its stock price in half. The firm announced plans last month to split into four companies by the end of 2002 in an effort to simplify its financial statements.

A handful of high-profile firms have filed for Chapter 11 bankruptcy protection in recent weeks, including telecom firms McLeodUSA and Global Crossing, and discount retailer Kmart, adding to investors’ anxiety. These are the sorts of corporate unravelings often seen towards the end of a recession, said William Barker, an investment strategy consultant at RBC Dain Rauscher.

Barker added that he thinks the market will “flounder a bit” in the near-term, as investors struggle to grasp some of the implications of the accounting mess spreading through Wall Street.

“Investors have really been caught off base by how widespread this Enron accounting issue is, and now we’re seeing them step back from the market,” said Barker. “Enron is the ‘X’ factor, an unexpected event that has spread more than people thought.”

More confessions seen
More companies are expected to revise their financial statements, past and present, during the first half of the year according to Ned Riley, chief investment strategist at State Street Global Advisors. In most cases restated earnings are likely to be lower, pressuring stock prices, he added.

“We’ll have to live with all the restatements and investors’ confidence will be undermined, but I think we’ll see more consistency in reporting during the second half of the year and we should see a sequential improvement in profits,” Riley said, adding that he still has an “upward bias” for 2002 and expects the Dow Jones Industrial Average and the Standard & Poor’s 500-stock index to both post single-digit returns for the year.

Kent Engelke, markets strategist at Anderson & Strudwick, argues that earnings are likely to come in weaker than expected in coming quarters, as accounting firms follow accounting procedures to the letter. “Companies used to push the envelope, but I don’t think there’ll be any more gray areas, and because of that earnings in general will not increase as much as anticipated”.

Given that stocks are trading at historically high valuations, any short-term concern about the quality of earnings will weigh on the stock market according to A.C. Moore, investment strategist at Dunvegan Associates.

“The market is overbought, so you’re not likely to see any sustained moves to the upside for the next few months,” Moore said. “Business spending won’t kick in until we see companies get some good earnings under their belts, so it’s a time for market psychology to get washed back and forth between hope and caution.”

Steve Young, senior market strategist at Banc of America Capital Management, is more upbeat. As long as we continue to see progress on the economic front, he thinks stock prices will hold at current levels.

“It will take some news in the earnings from to move up off these levels, and that may be one or two quarters away,” Young said. “When second-quarter pre-announcement season comes in March, if we hear companies say that earnings are improving, then the market could move up.”

The wild card is the possibility of another Enron or Tyco, said Young. “These problems are being severely discounted in companies’ stock prices and it’s shaking investors’ confidence and spreading market-wide, so I think if there’s another situation arises like this the market will react in a similar fashion.”

In the meantime, investors are likely to pay more for companies that offer clarity in their earnings reports, Young said, and less for companies with complex accounting for write-offs, spin-offs, tracking stocks, or off-balance sheet partnerships.

In recent days, shares of companies in the consumer products and health-care sectors have performed well, Young said.

But it seems even companies in apparently straightforward businesses are not immune from Enronitis. On Tuesday, investors took a bite out of donut maker Krispy Kreme’s share price after an article in Forbes magazine called the company’s accounting of a lease on a new $30 million mixing plant as an “off-balance-sheet trick.”