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Commentary: Brutal Honesty Could Force a Market Correction


By Mara Der Hovanesian

The heat is on for Corporate America. In the wake of the Enron Corp. (ENE) debacle, the quality of earnings is being questioned as never before. Fancy accounting footwork has raised the ire of Congress. Credit-rating agencies are promising to intensify their scrutiny of fuzzy numbers. And it's not just the bad stuff hidden off balance sheet that's raising eyebrows. Now, even the earnings of such blue chips as IBM and General Electric Co. are getting closer examination.

The impact is already discernable. "Any company that has earnings that people are suspicious of has been taken down in the market," says John D. Chadwick, money manager at New York's Bessemer Trust Co., a private bank. Case in point: Tyco International Ltd. (TYC), whose accounting has been questioned by analysts and short-sellers. When it announced on Jan. 22 that it would divide its manufacturing businesses into four companies, investors yawned even as its execs claimed it might be undervalued by as much as 50%. "Tyco did nothing to allay concerns about their accounting," says Chadwick.

The trend may lead to much tougher accounting practices. That's ultimately good news for the stock market. But in the short run, it raises big questions about whether stocks are now badly overvalued. Many on Wall Street are still using so-called pro forma accounts, which allow companies to present their earnings in the best possible light. By that reckoning, the companies in the Standard & Poor's 500-stock index earned $45.31 last year, giving the market a price-earnings ratio of 24.7, according to Thomson Financial/First Call. But by using generally accepted accounting principles, the most conservative measure, earnings were just $28.31 in the 12 months through September. That equates to a p-e ratio just under 40.

Such a huge valuation discrepancy doesn't look sustainable over the long haul. Moreover, by historic standards, the GAAP-based valuations are very high; even in early 1999, the p-e topped out at roughly 36. Those factors could lead to another sharp market correction, especially if pension funds and money managers opt for a much more conservative view of earnings in the future.

For now, Wall Street is behaving as though nothing much has changed. The S&P is up 17% since its September lows, and only a few of the rosy earnings estimates for 2002 have changed. Consensus estimates call for a 16.9% rise over last year. Prompted by the changes to accounting rules, however, Goldman, Sachs & Co. top strategist Abby Joseph Cohen cut her operating earnings forecast for the S&P 500 by about one-third, to $24 for 2001 and $37 for 2002.

To be sure, the big picture is heartening for the market. Manufacturing has picked up steam, and the Federal Reserve Board's 11 rate cuts have built up tremendous liquidity--two scene-setters associated with rising p-e ratios. Productivity is stronger than in previous recessions, and benign inflation of 1.5% has also justified higher multiples historically. "It's not as bad as it seems," says Joseph S. Kalinowski, equity strategist at Thomson Financial Market Strategy. And analysts are tending to err on the side of caution. While only a third of the S&P companies have reported fourth-quarter earnings, those that have are beating consensus estimates by 3.3%, up less than 1% last quarter.

But earnings jitters may yet rock the markets. More shaky accounting practices could come to light. Some companies won't have registered the full impact of the downturn on their books, while others will still massage their numbers. Investors have "every reason to be twitchy," says Guy R. Elliffe, senior vice-president of Jurika & Voyles Inc. in Oakland, Calif.

If companies want to avoid onerous restrictions from Congress and others on how they report earnings, they need to clean up their accounting act. Those with the most transparency will be rewarded with higher stocks. And they'll deserve it. Der Hovanesian covers Wall Street.


Steve Ballmer, Power Forward
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