So, What Happens Now?

One of the enduring threads at the Investor Summit held at the SEC on Friday was the dire need for greater financial education in our schools, as well as for adults. Unfortunately, any such curriculum may be a long time in coming, and would be too late for the millions of adults who could have used the same kind of training. Bill Mann takes a look at this inflection point as well as others facing the stock markets.

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By Bill Mann (TMF Otter)
May 13, 2002

There's a great deal going on right now in the world of investing. It seems like just about everything is in flux. I've been thinking about some of these issues, in between diaper changes (not mine) and Mother's Day gifts and the Washington, D.C. area's sudden quest to claim the title "Tornado Alley." That is to say, I've been thinking about them when life hasn't gotten in the way.

So, what does happen next? Lemme be the first to tell you, no one really knows. But the market is in the doldrums, the economy is or is not recovering from what may or may not have been a recession, telecom companies are dropping like flies, banks are shaky, no one trusts company financial statements, and the SEC doesn't really know what to do. Seems like a good time to make some educated deductions.

The Post-Enron Regulatory World
I was a panelist at the SEC Investor Summit on Friday. It was a great event where people who are in touch with individual investors got to speak about the issues that are undermining the U.S. markets. There were of course the pleas that companies provide plain-English descriptions of their businesses, as well as calls to overhaul certain relationships, such as auditor/company ones. (See The Motley Fool Manifesto for some of our recommendations.)

Clearly, we have an opportunity now to make changes that will add stability to the U.S. markets. One issue that was agreed upon by every single person on my panel was the need for better education for Americans about all things financial. How many people might have lower credit card debt if they had learned about it in a high school course? Why do people graduate from college without any idea how to even balance their checkbooks? The obvious block is at the school board level. I'd expect that finally there might be pressure on these boards to adopt a curriculum for financial education in our schools.

The SEC has made some rules for analysts in order to reduce conflicts of interest. My fear is that these rules will  increase the appearance of analyst independence without actually changing anything. Even if an analyst cannot profit directly from an investment banking deal, he or she knows very well that the overall profitability of the firm, to which that investment banking contributes, will be a net positive for his or her pocketbook.

The Market 
As much as we'd like to believe that the market's going to spring forward any minute now, there are powerful reasons suggesting it will not. First, the market is an economic beast. Second, it is nothing more than a collection of all the listed public companies, so shame on us for referring to it as if it is some monolith. All the people who are calling for an end to the bear market in the next few months are forgetting one key thing: This time it is different. And although (or maybe because) the stock market is now a national obsession, I would expect that the recovery, when it does come, will be slow. Years and years slow, because the bankruptcies that are yet to come are going to tax our banking system.

And just you wait to see how the number of diluted shares rockets upwards as soon as there is a recovery. There is a massive, massive overhang of stock options at prices ranging from slightly above where companies are to way above. Since the "Diluted Shares Outstanding" number on the balance sheet takes into account only those options that are in-the-money at a given moment, every tick upward creates more and more reportable dilution.

Was that a recession?
Yup, it was. And it's not done yet. Not even close. There are a few issues that make this one extra special. First of all, for the first time since 1929, we are in a recession that was not caused by monetary policy that was too tight. We have had a period of economic growth that has run from 1982 until 2000, 19 years. That's an unheard of length of time, and, unfortunately, by the end it had been so long since there had been tough times that people, banks, regulators, everyone had let their guards down.

Ben Graham once said that there was a fraud cycle that matched the business cycle. People become incautious at the sign of easy money, and very cautious when the gravy train jumps the tracks. We agree. Heck, we're busy eating a little of that "exuberance crow" ourselves. But the length and extremity of the rise, the participation of more than half of all American households, and the fact that this recession was caused by monetary policies being too loose for so long mean that we've got a huge overhang of problems left to face.

The last vestiges of the tech bubble have left us with hundreds of billions in non-performing capital expenditures that will have to be worked through. That's money loaned by our banks, borrowed by technology firms, many of which are in danger of default, if they have not already done so. The turn could happen soon, but I'm not holding my breath.

There's big trouble for the banks, in the form of rapidly increasing debt defaults. There is an adage about banks that says loans always look like great deals on the day they are made. Banks backed much of the overhang in debt now facing companies that spent willy-nilly at the end of the 1990s. Just like the fraud cycle, the lending discipline cycle runs parallel to the business cycle. These things are fairly hidden, and can go wrong in a big hurry.

(Nasdaq: WCOM) rapid collapse and debt problems have helped bring about yet another orgy of selling among the telecommunications stocks. I don't know when, but this industry is going to get better. The "fiber glut" that many assign to the collapse of these companies is disappearing: Growth in data usage in the U.S. is still somewhere north of 50% per year, and the weaker companies continue to collapse. What we're going to find at some point for the carriers that have the high-demand routes is that the drop in capital spending that occurred in the last two years will create opportunity for companies to instill some pricing discipline. Will it be enough? Dunno, but there is plenty of good reason to start looking for survivors among the telecom carriers.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

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