I simply can't believe my eyes and ears! The latest nonsense circulating in the financial press states that lancing the Enron ( ENRNQ) boil will be good for stock valuations. What a crock! Larry Kudlow first made this contention on CNBC's "America Now" program a few weeks ago. Kudlow is the quintessential financial-media Pollyanna. He finds the stock market's silver lining in every negative market event, every fundamental problem and every scandal. Next, a Jan. 30 article in The Wall Street Journal cited the same rubbish coming from Federal Reserve Chairman Alan Greenspan's mouth. In the same article, Sen. Jon Corzine (D., N.J.) contends that accounting concerns could lower stock valuations and raise the cost of capital for U.S. companies. According to the Journal, Greenspan "dismissed those worries at the same hearing," saying, "there are going to be people out there who are going to say, 'our accounts you can rely on.' And that will probably increase their price-earnings ratios." Since this piece was published, I have seen others make the same case on CNBC.
Give Investors Some Credit
What? The exposure of massive, nefarious accounting fraud in the U.S. financial-reporting system will result in higher valuations?! Give U.S. investors a break. They might be greedy and gullible, but they are not stone-cold stupid. If Greenspan really believes this nonsense, we should pray for him and hire a headhunter. If he just said it to calm the equity markets, shame on him. We do not pay him to do that. The argument Kudlow and Greenspan make sounds like a major case of denial to me. We excoriate the Japanese for their unwillingness to confront the imbalances in their country's financial system, yet we ignore our own! Do not kid yourself. This Enron crisis is huge. Not because of the wealth that Enron destroyed, but rather because of the repercussions it will have on the financial reporting system. Greenspan and Kudlow contend that stock valuations should improve because companies will be forced to report honest income statements. But here's the way I see it: All the "wink-wink" accounting tricks that most companies use to inflate reported profits will be gone: "big-bath" and acquisition charges fed back into income; pension profits; unrecognized option expense; inventory write-offs fed back into profits; special-purpose-entity profits; off balance sheet liabilities; recurring and nonrecurring charge-offs; bogus revenue recognition; and "pro-rata, pro forma, operating profits."
The Future of Valuations
The financial system will purge itself of these accounting tricks, and it won't be pretty. There are probably a few more Enrons, Tycos ( TYC) and Elans ( ELN) out there. More significant for investors, however, will be the stark admission that many companies have played games with the numbers to inflate growth rates and stock prices for many years. Contrary to Greenspan's and Kudlow's assertions, valuations will suffer as companies ratchet down growth rates. Risk premiums for equities will rise in this period of higher uncertainty. Reported profits will be reduced. Stocks will retreat as honest, but lower, profits get capitalized at lower valuations. Shares trade at record valuations today because investors have capitalized the artificially goosed growth rates of many companies. Valuations will not expand because corporate managements suffer a bout of confession and penance. Then again, maybe in a perverse way, Greenspan will be right. He didn't say how stocks' P/E ratios would expand!