Bernie Bin Laden

Don’t blame 9/11 for the bear market. Blame the corporate scandals.

One year after Sept. 11, it’s clear that investors have suffered immense losses because of the actions of a wicked, bearded foreigner. This outwardly pious but inwardly corrupt evildoer, who has shattered the hopes and dreams of thousands of Americans, has become a recluse, fearing to venture out in public and targeted by federal authorities.

Of course, Bernard Ebbers, the Canada-born former CEO of WorldCom hasn’t committed mass murder. He hasn’t even been charged with a crime—yet. And like Osama Bin Laden, he certainly wasn’t alone in wreaking havoc. But his actions, and those of his deputies at the company he created and ran, may have been the straw that broke the back of a market whose post-9/11 resilience was both remarkable and unanticipated.

When the Twin Towers fell, pundits worried that the market would collapse with them. But while 9/11 certainly hammered some sectors—airlines and hotels, to name two—it didn’t cause lasting damage to the economy or to investor psychology. By contrast, the series of faith-draining corporate scandals that culminated with the July 21 bankruptcy filing of WorldCom may have finally accomplished what the dot-com bust, the fiber-optic meltdown, Osama Bin Laden, and even Enron couldn’t: It persuaded investors to abandon stocks.

Wall Street and the stock market suffered grievous blows on Sept. 11, 2001. Thousands of financial-services industry employees were murdered; firms like Cantor Fitzgerald and Sandler O’Neill were crippled. The New York Stock Exchange shut for four trading sessions.

But the recovery effort was stupendous—and swift. By Monday, Sept.17, the exchange reopened for business. Investors sold, yes, but they didn’t give up.

One way to measure people’s faith in stocks is the inflows and outflows at U.S. stock mutual funds. According to the Investment Company Institute, $29.51 billion flowed out of stock mutual funds in September 2001, or 0.87 percent of assets. That’s a lot of dough, but in percentage terms it wasn’t catastrophic. And the exodus was far less dramatic than the one in October 1987, when investors yanked 3.1 percent of all their cash out of the market.

Stalwart consumers, calm institutional investors, companies eager to kick-start the economy, and an accommodating federal government helped restore confidence. The Federal Reserve Board slashed rates aggressively to historically low levels. Fiscal policy helped, too, as new spending on defense and recovery efforts provided a needed stimulus.

So while the Dow plunged 14 percent in the weeks after the attack, it recovered quickly. By Oct. 16, the S&P 500 had reached its Sept. 10 level, and the indexes powered higher in early 2002. In every month between October 2001 and May 2002, investors put more cash into the market than they took out. Net inflows into U.S. stock mutual funds were a robust $14.9 billion in November, $19.6 billion in January 2002, and $29.3 billion in March 2002.

But it all came to an end in this summer. In the past two months, investors have witnessed the arrest of Adelphia founder John Rigas, the rehashing of the Bush-Harken and Cheney-Halliburton stories, the arrest of former ImClone CEO Samuel Waksal and the coincident immolation of Martha Stewart, the rise of New York State Attorney General Elliott Spitzer—the Savonarola of Wall Street—and the demise of Citigroup uber-analyst Jack Grubman. WorldCom, which flailed for weeks before declaring bankruptcy on July 21, 2002, was the granddaddy of them all, the Rose Bowl of stock scandals.

WorldCom had more employees than Enron and a greater valuation at its peak than the Houston energy company. Enron CEO Ken Lay borrowed tens of millions of dollars from Enron; Bernard Ebbers borrowed $408 million—and didn’t pay any of it back. Enron fudged the numbers by hundreds of millions, WorldCom by billions. Enron’s misdeeds were shrouded in obfuscation; WorldCom’s misallocated expenses were baldfaced lies. Joined at the hip to his banker/consigliere Grubman, profiting immensely from sweetheart IPOs, Ebbers seemed the nexus of everything wrong with Wall Street.

It may be just a coincidence, but WorldCom’s bankruptcy came a time when investors finally seemed to decide that enough was enough. On July 10, the S&P 500 took out the low it hit on September 21, 2001, and continued to plunge below 800 in the following weeks. In June, investors pulled $18.05 billion out of U.S. stock funds, and in July they withdrew a record $52.63 billion, 1.7 percent of total assets. That’s twice the relative capital flight of September 2001. Unless things turn around quickly, 2002 could be the first year in which stock funds see net outflows since 1988.

Another way of measuring investor faith is the price-to-earning ratios they place on stocks. Here again, the story of the past year is one of a quick comeback in the fall followed by a capitulation in the summer.

I pulled up some Bloomberg charts that track the change of P/E ratios based on estimated earnings for the current fiscal year. This is admittedly a different measure than P/Es based on reported earnings. But it’s compelling because it speaks to whether investors are willing to take what company management and Wall Street analysts say at face value. And plainly, they’re much less willing to do so today than they were last fall.

Back in the halcyon days of 2000, investors were willing to pay more than $30 for each dollar of profit that S&P 500 companies estimated they would report in the current year. By September 2001, this P/E ratio had compressed and stood at about 23 for the S&P 500. In the weeks after Sept. 11, it fell rapidly to 19 but quickly rebounded to its pre-9/11 levels. By January 2002, the P/E ratio for the S&P 500—based on estimated earnings—stood at a healthy 25.57. But in the months after, it drifted downward before plummeting sharply in June and July. The ratio bottomed at 15.34 on July 26, five days after the WorldCom filing. Today, investors are only willing to pay $18.11 for every dollar of earnings that S&P 500 companies estimate they will earn this year.

Is a dollar of earnings really worth 29 percent less than last January? It is if people don’t have any faith that the estimates are valid and accurate. And even after CEOs and CFOs have certified to the Securities and Exchange Commission that the numbers they report are accurate, investors are still demanding a discount.

The capital flows and P/E ratios prove that investors are no longer willing to pay for profits Wall Street analysts and company executives say they’re going to make because so many have been exposed as liars.

Wall Street, we are told time and again, is a futures market, not a past market. Buy a stock, and you get a claim on a company’s future earnings. But at a time when collective attention is focused on the events of a year ago, it’s clear that investors are looking back, too. And the disaster they fear isn’t hijacked planes striking skyscrapers, but high-flying companies crashing to earth.