Shaken Markets

RAY SUAREZ:

On Wall Street the bear has been growling. The Dow Jones Industrial Average is down 22 percent from its high in 2000. The tech-heavy NASDAQ index is now down a staggering 70 percent from its April 2000 peak, all this, despite much positive news. Today, for example, there were strong reports on home sales and durable goods.

So is the virtual wave of accounting scandals taking a toll on investor confidence? We put that question to Catherine Gordon, who heads the Investment Counseling and Research Department at the Vanguard Group, the nation's second largest mutual fund firm; Lynn Stout, Professor of Securities Regulation at the UCLA School of Law; and Tom Gallagher, Senior Managing Director at the International Strategy and Investment Group, a Wall Street research firm.

Lynn Stout, let's start with you. What does it mean, to see the indexes finding these new post-Sept. 11 lows?

LYNN STOUT:

Well, there are a number of reasons why the indexes are lower than they were a year and a half ago that have nothing to do with the loss of investor confidence. We've had a certain amount of economic bad news. We've had the bursting of the tech bubble. I think people with concerns about investor confidence are not so much focused on what has already happened but on what might happen.

RAY SUAREZ:

And what do you mean by that, when you say what might happen, more companies joining the list of those we already know?

LYNN STOUT:

Exactly. When investors get a string of bits of bad news, when they start experiencing stock losses, instead of stock gains, there is always the prospect that they might decide that maybe stocks aren't such a great investment after all. They take their money out of markets, prices go down; they decide that stocks are even a worse investment. Prices go down even further. You can get a sort of a self-reinforcing process that can lead to a very long and potentially very painful bear market.

RAY SUAREZ:

Catherine Gordon, are you seeing any signs of that, either this month or down the road?

CATHERINE GORDON:

Actually we're not, either within the mutual fund industry, industry fund cash flows are quite strong into both stock funds and bond funds, our cash flows are quite strong and balanced across the board, and even when we talk to our investors on the phone, certainly they're calling to ask questions, they have concerns, but we're not seeing any wholesale action on the part of investors to make shifts away from their original plans.

RAY SUAREZ:

So everybody's hoping that this week is the week when things turn around. But so far it hasn't happened that way. You're still seeing people choosing stocks not because there's no other place for the money to go?

CATHERINE GORDON:

Well, I think one of the things that investors have learned, painfully perhaps, over the past several years is the benefit of re-visiting diversification and I think that's what a lot of investors are revisiting their financial plans, making sure that they're investing for the right reasons, and that's leading to the balance that we're seeing in the markets. No doubt, we're in a bear market, but for the investors that we're seeing, they seem to be staying the course.

RAY SUAREZ:

Tom Gallagher, do you see something more dangerous at hand than perhaps your two colleagues?

TOM GALLAGHER:

Well, I think it is important to know just how unprecedented a situation the stock market is in. We're now nine months from the low of the stock market during the recession. On average, of all the recessions in the last 30 years, the stock market's up 37 percent; we're up about 1 percent now. You can take the analysis back to the beginning of the 1900's, and you find the same thing. We've never had such a weak stock market during an economic recovery, so there is something unique going on here. I do think the accounting issues probably aren't the most important thing.

I just think stocks were too highly valued, especially tech stocks, but the accounting issues are an important factor. I think the economy is doing well enough to generate profits that were good according to last year's rules, but we don't know what the new rules are. We don't know what re-statements are going to be. Geopolitical issues are a factor, and I think last we have to put some concerns about the strength of the economy.

RAY SUAREZ:

And you mention how a bounce back has historically started. What about the indexes as a leading indicator, sort of giving us a sign for when individual investors are confident that a recovery is underway?

TOM GALLAGHER:

Well, the role of the stock market in the economy is a complicated one. Sometimes it's anticipating what the economy is going to look like, and I think if you look at the data, the economy looks fine, and that's what the Federal Reserve said in their statement today. It's not a robust recovery but it's not I think fears of a double dip in the economy another recession are overblown.

So I don't think that the stock market is predicting what the economy is going to do, but it can also be a cause. It can cause a weaker economy if shareholders decide to cut back on their spending or the weak stock market causes companies to make cutbacks, it can cause a weaker economy. So far, I don't think that's likely to happen. I think the stock market has to go further down before we worry that it's going to lead to a double dip.

RAY SUAREZ:

Well, Professor Stout, you heard Tom Gallagher's analysis. Maybe you could help us out a little bit on understanding how this all happens. There are plenty of companies still making money, plenty of companies that are fundamentally sound and not in the throes of restating past earnings or having their leaders indicted, yet they get pulled down with everybody else. Why?

LYNN STOUT:

I think it's important to recognize that stock prices are determined not just by economic fundamentals, but also to a certain extent by investor sentiment and particularly by whether they have trust in the market. I think there are some interesting lessons to be learned from history here, although many people don't know it, after the crash of '29, the stock market actually recovered almost all of its value within the next year. It was only after 1930 that prices started going down and down and down until eventually they bottomed out at 15 percent of the 1929 values, and then they didn t recover their value, they didn't return to 1929 levels until 1954.

I think one of the lessons we can learn from this is that investors are willing to stay the course for some time, but if you hit them repeatedly with bad news and in this case I think a combination of the bursting of the tech bubble, some relatively modest problem with economic fundamentals and then the accounting bad news, you do run the risk they will essentially just lose faith. When that happens, you can get the self-fulfilling prophecy that I've discussed, and it can take a long time — years or even decades — for confidence to come back. I'm not saying we're anywhere near there yet, but I am saying that it is reasonable to worry about it.

RAY SUAREZ:

Well, what do you make of Tom Gallagher's example of previous bounce-backs from lows happening a lot faster than this one?

LYNN STOUT:

I would I think he's right that it's actually odd that we don't see some more strength in the stock market following a recession, and I think that's actually a sign that investor confidence has been eroded somewhat. I actually think a more instructive example might also be the bear market of 1973. Now that was a situation where the economy was in trouble, but it wasn't in nearly enough trouble to justify stocks that were trading at P/E ratios — ratio of stock price to corporate earnings — of 5 to 1 or 7 to 1. It's more than just investors… it's more than just the economic fundamentals. Investors' level of faith or trust does matter, does affect prices. Again in the 1970s it took almost a decade for stock prices to recover their levels.

RAY SUAREZ:

Catherine Gordon, as a mutual fund representative maybe you can help us understand the role of small individual investors. Since the 1973 bear market that Professor Stout was talking about, one big change that's happened is that a lot more regular people own stock. How do they play a role in what's happening now?

CATHERINE GORDON:

Well, I think you're right. The '73/'74 market was dominated by large institutions running pension plans because we really hadn't — the 401(k) hadn't been born yet, and today we have a large majority of people responsible for their own retirement assets as well as those assets outside of their retirement account. So there's been a much more … a broadening of the market, if you will, in terms of people making decisions about individual stocks.

And we think that people are making decisions based on their own circumstances and are very involved in making investment decisions and taking responsibility for those investment decisions and wanting to get educated and wanting to know more. So we've seen certainly a lot more written about the whole topic of investment, and investment information is much more readily available to individual investors over the past several years.

I would point out that, you know, particularly when we look at the market, we encourage people to think about their total portfolio, rather than an individual holding in a particular stock or a particular fund. Even within the market itself, although we can talk about the market being down, you know, 12 percent looking at the Wilshire 5000, almost 12 percent, there are sectors within the market that have done quite well. So it's not — and individual stocks that have done quite well. So… and then you pair that up or match that up with bonds, when people look at a diversified portfolio, the news may not be as bad as just looking at the individual stocks or the market we've been talking about.

RAY SUAREZ:

Tom Gallagher, how do individual investors, and small investors in particular, fare in a market like this?

TOM GALLAGHER:

I'm not sure…

RAY SUAREZ:

Are they hurt in a different way?

TOM GALLAGHER:

Well, they've obviously lost money but I don't know that I'd go so far as to say they're going through a crisis. There's a lot of evidence, a lot of it anecdotal, that they're shifting their investments into housing and away from the stock market. They feel that the house isn't going to do to them what the NASDAQ did. It is not going to go down in value by 3/4s over a few years. So in some ways they're responding in a natural way. They're calling their realtor more and their stock broker less.

I also think the broadening of the market you're talking about though is reflected in the political response today. You had President Bush commenting on this. You had the Senate Majority Leader, Senator Daschle, scheduling accounting reform for after the July 4 recess. A number of House Committee and Subcommittee chairmen were on the tape today. You had the New York attorney general saying he's going to be looking into this.

I think that the policy response plays a useful role, or can play a useful role, in restoring investor confidence; if they feel that most of the wrongdoing has been uncovered and you've got a new set of rules that everybody agrees on, I think that can speed the time when the average investor feels that it's safe to get back in the market on a long-term basis.

RAY SUAREZ:

Professor Stout, do you think regulation is part of the answer?

LYNN STOUT:

Well, I think that our approach to restoring investor confidence has got to be two pronged. The first part is enforcing the laws that we have on the books already. I give great credit to SEC Chairman Harvey Pitt, who has started a sort of rather massive investigation of the accounting techniques of the largest Fortune 500 companies, really looking very closely. And that's the first time that's happened in many years. For many years the SEC has simply not been given the budget or the priority to do this sort of thing.

I do think we should also look perhaps at reforming the laws themselves, however, in particular. In 1995, Congress passed the Private Securities Litigation Reform Act, which was deliberately intended to make it harder for defrauded investors to sue. Now with the benefit of hindsight. I'm not so sure and many of us are not so sure that that change was a good idea. Perhaps we should toughen the laws themselves, as well as making sure we enforce the ones that we have.

RAY SUAREZ:

Catherine Gordon, what's your industry doing on the regulatory front? Are you making WorldComs, Enrons and Global Crossing, are you urging them to be less likely, less possible to happen?

CATHERINE GORDON:

Well, I think I would agree. I mean, we clearly have a regulatory system in place that can deal and should deal with a number of these issues. I think we also have to and the mutual fund industry clearly supports that I think we also have to recognize that we live in a free market economy and economies in free markets self correct, and this is clearly an extreme in terms of how accounting principles have been applied, but I think if we step back and look at the long-term that we have to have we continue to have confidence that free markets free markets correct and I go back to a point made earlier, that we are talking about a handful of companies that have abused shareholder trust and have issues.

The vast majority of companies in the American economy are well-run, are managed, and, if anything are probably redoubling their efforts in this kind of environment to make sure they are doing the right thing.

RAY SUAREZ:

Guests, I'm going to stop it there. Thank you all for joining us.