08 Feb 2002 Enron ‘ron ron da do ron ron’
Remember the sensation caused by the all-girl rock bands in the early sixties? Doo-Wop ‘classics’ like He’s a Rebel and Da Doo Ron Ron by the Crystals and The Leader of the Pack by the Shangri Las filled the airways. The early 2000’s might well be remembered for the exploits of Mr. Kenneth Lay, the rebel, and his pack of execs and auditors, who have wrought their own brand of havoc on our culture. It’s hard to go anywhere without hearing people talk about Enron and its massive and complex web of greed and deceit.
The markets have felt the full force of the Enron scandal as investors wonder how many more Enrons may be lurking out there. Blue chips like and GE, Disney, and American Express saw their shares decline this week as analysts and others wondered out loud how many other complicated businesses used questionable accounting tactics to conceal their financial skeletons. The S&P 500 and the NASDAQ declined 4% and 7%, respectively, as the insinuations and charges flew from Washington, or Hollywood East.
Economic news and earnings releases over the past week have been, on the whole, better than expected, but the guidance given by a few major corporate leaders has been more cautious than investors were willing to tolerate. Cisco, for instance, traded up over a dollar on the strength of its earnings numbers released on Wednesday night, but finished down 8% yesterday after Chief Executive John Chambers said that third quarter sales would likely grow only slightly, if at all. The warning, however, did not thwart 21 one of the 45 analysts who follow Cisco from resounding their buy or strong buy recommendations, on the same day as Mr. Chamber’s remarks. Of those 45 analysts, 31 have buys, 11 holds, and 3 sales. The number of buys has increased steadily since June of last year. Cisco is an excellent example of the disconnect in this market between the fundamentals of companies earnings and the economy and the behavior of investors. Stock price movement is often counter-intuitive. Defensive stocks like General Mills further highlight the extent of nervousness in the market, if not their over-valued status. The company saw its shares fall 14% on Wednesday when management lowered their quarterly profit outlook.
Investors all but ignored the good economic news of last week as initial jobless claims fell by 15,000 to 376,000 last week, below the consensus forecast for 390,000. The four-week average declined to 380,000, the lowest since early August. The insured unemployment rate tends to lead the official unemployment rate and remained at 2.7%, still below the local peak of 3.1% in November. “While it is too early to say the recession is over, we are seeing stability in our markets,” said Rajiv Gupta, chief executive officer of Delta. The third-largest airline said this week it will lay off 300 fewer pilots than originally planned and is recalling an unspecified number of reservations agents who took one-year leaves of absence in November. There are other signs hiring may be starting to stabilize. The volume of help-wanted advertising in major U.S. newspapers rose in December for the first time in 12 months, the Conference Board reported last week.
The productivity of U.S. workers surged in the final three months of last year as businesses eliminated jobs and reduced worker hours faster than they cut production. Productivity, or the amount produced for every hour of work, rose at a 3.5% annual rate in the fourth quarter, the Labor Department said. That was the fastest since a 6.7% pace of increase in the second quarter of 2000 and compared with a 1.1% rate in the third quarter. Economists say gains in productivity boost standards of living by allowing companies to pay workers more without raising their unit costs, and allow the economy to grow at a faster rate without causing inflation to accelerate. Not since 1969-1970 has productivity risen during the first three quarters of a recession. For all of 2001, productivity increased 1.8%, the slowest since 1995.
Unit labor costs, or the amount paid for each unit of production, fell at a 1.1% rate in the fourth quarter, the first decrease in two years. The decline followed a 2.6% increase in the third quarter. For all of 2001, unit labor costs rose 3.9%, the biggest increase since 1990. After languishing at a 1.4% annual rate from 1976-1995, productivity rose to a 2.5% rate during 1996-2000 as the economy boomed and investments in computers, the Internet and other technology paid dividends. The productivity increase encouraged Federal Reserve Chairman Alan Greenspan to allow the economy to grow at a 4% pace or faster from 1996 through mid-1999.
On the negative side, the U.S. service economy unexpectedly showed signs of contracting last month. The Institute for Supply Management reported that its index fell to 49.6 in January from 50.1 in December, signifying contraction. The index has fallen below 50 (contraction) for eight of the last 10 months. Services account for 80% of the U.S. economy. The index underscores how fragile this recovery is. Tom Daschel’s announcement on Wednesday of the death of the stimulus bill sent the market into hasty retreat.
Investors generally believe the economy is in recovery, but it is a very anemic one. A stimulus package, even a pork bill would have provided the economy with a much-needed boost. But, it looks as though it will not come now because of election-year politics. The outcome is not at all surprising as we know ‘gridlock’ would result with Jeffords’ infamous switch to the Independent party. The Senate swung to Democratic control, while the House held its thin Republican majority. The result; this economy will have to pull itself up by its own bootstraps. It will take longer than it might have with stimulus, but the economy should be that much stronger as a result. The Nietzsche mantra “that which doesn’t kill you makes you stronger” hopefully applies. My chief concern is that each major market retreat, each Enron scandal, each Kmart bankruptcy has the potential to drive investors out of America’s equities markets indefinitely or permanently. I believe Greenspan’s call last week for improved economic education of America’s youth was, in part, motivated by a similar concern.
There is indeed fear in this marketplace, but remember, a bull market ‘climbs a wall of worry.’ There are indeed many signs of fundamental improvement in this economy and among our nation’s leading corporations. As I write this Brief, it is reported that wholesale inventories fell another .6% to their lowest level in two years. At some point soon, factories will have to increase production to meet future demand. The timing and sustainability of that demand is what we are all asking, but the signs are more positive with each day. Sales at retailers like WalMart showed their largest gains in two years last month. That means empty shelves that will have to be restocked. The inventory rebuild alone will provide significant economic growth in the coming months according to Mr. Greenspan. The sustainability of the inventory build, of course, depends upon the consumer and, to a lesser extent, business. Individual consumption and business investment remain under everyone’s microscope.
It’s still the Bear’s party and they can cry if they want to, but someday soon, we will get back to the business of business; consumers consuming and enterprises innovating, creating, and selling. The market has been rough lately; there is no doubt about that. Reasons abound to wonder when it will get better. But we can take comfort in the knowledge that equities outperform other investment vehicles over long periods of time.
Looking out a year or two, it’s difficult to believe that stocks will not outperform cash or bonds. Our companies are strong financially, both from a balance sheet and a cash flow standpoint. They have withstood the difficulties in their respective industries and stand out as leaders. They have used this time to grow their market share at the expense of their weaker competitors, improve their operating efficiencies, and continued their research and development efforts. We believe that our companies are indeed ready for the coming business cycle, ready to lead their industries into a new era of growth. Keep the faith.