Enronitis Hides Market's Real Malady: Pricey Stocks

No company in recent memory failed the way Enron did. But the pall that has since fallen on this market isn't Enron's fault alone.

Market watchers note that rumors of accounting irregularities surface almost daily, pummeling stocks of companies that Wall Street doesn't like or understand. Some days the chatter is loud enough to drown out any talk of an economic recovery and send the market stumbling. Tuesday's mild selloff offered yet another example.

But to blame Enron's collapse for every fall in the stock market is to miss the point, some market observers say. Yes, until recently the book-cooking didn't appear to have reached the near-epidemic proportions it has taken on. But at the end of the day, the market's reaction has less to do with the state of the accounting trade than with investors' changing expectations -- and with the continued priciness of U.S. stocks.

Return to Cendant

Enron's certainly not the first accounting scandal to get the market's attention. Big problems at widely held companies are far from unheard of, even in combination. And yet the market has always weathered the storm -- until now, it seems.

Cendant ( CD), for instance, was one of Wall Street's favorite stocks back in April 1998, having doubled over the past year. But after the close on April 16, the company said it had uncovered accounting problems that would force it to restate 1997 earnings. The next day, the stock dropped 46.5%, losing $14 billion in value.

At roughly the same time, another Wall Street favorite was falling apart in less spectacular fashion. Throughout that spring shares of Sunbeam, the electric blanket manufacturer run by "Chainsaw" Al Dunlap, steadily eroded on chatter of accounting irregularities. In June Dunlap, who had become a Wall Street favorite thanks to the stock performance of companies he headed, stepped down and the Securities and Exchange Commission launched an inquiry. Sunbeam shares collapsed.

Despite the sizable investor losses at Sunbeam and Cendant, there wasn't much of a hue and cry about the state of U.S. companies' accounting practices. Except for the unrelated LTCM meltdown that August, there was no marketwide shock to rival the Enron hand-wringing. As a result, when the SEC met with top companies and the big accounting firms that summer in an attempt to usher in more conservative bookkeeping, nothing much followed.

This Is the Day

Today, of course, is another day. Investors nowadays are older and wiser, some observers remark. "Cendant and Sunbeam, you didn't have the CEO testifying before Congress," says Todd Clark, managing director of listed trading at Wells Fargo Securities. "It's a different market."

And maybe that's the point. Two bad years for the stock market have sapped people's confidence in U.S. companies. Still feeling the burn from the collapse of the Nasdaq in early 2000 and the subsequent marketwide daze, investors are starting to think Corporate America had a big part in fobbing the late-1990s myth of unimpeded growth on them.

"People have been burnt and lost a lot of money and now they're paying a lot more attention," says Fahnestock market strategist Larry Rice. "In the bull market, nobody gave a damn -- you couldn't criticize anyone's accounting. Now if you do you're a celebrity. You're a media hero."

Lately there's been a lot of chatter about how the worries about accounting are "overdone," and how as a result stocks have become cheap. Cheap stocks make for good buying opportunities, and investors are always eager to see signs that the market's ready to turn to the upside.

The problem, says Rice, is that stocks aren't inexpensive at all. The forward price-to-earnings ratio on the S&P 500 may not be at its peak, but at 20 it's still higher than it was at any time before 1998. To take an individual example, Cisco ( CSCO) trades around 42 times its expected earnings over the next year. This time in 1998, it traded at around 26 times what it was expected to earn over the next year.

Such historically high valuations may eventually be proven justifiable, but in the meantime they leave stocks vulnerable. Anything that throws a wrench into the bullish expectations that are still embedded in stock prices can seriously damage the works. If stocks were really cheap, nobody would be tossing around such an unfortunate word as Enronitis.

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