June 2, 2002

What If Investors Won't Join the Party?

By GRETCHEN MORGENSON

By many measures, the United States economy is rebounding smartly from its desultory performance in late 2001. But even as economic output surges and corporate profits appear once more to be rising, one closely watched indicator of economic oomph remains depressed: the broad stock market indexes. All of the big-company indexes, the ones that reflect what investors are most likely to own through mutual funds, are still down for the year.

Because stocks normally begin to rise well before evidence of an economic recovery drives up to the door, many investors are baffled by the fact that the market is in reverse. And they are angry, after already enduring two years of losses in the major indexes.

Stocks may bounce back during the summer, of course, as investors gain their footing in unstable times. Indeed, on Friday, stocks rose slightly after the University of Michigan monthly consumer confidence report showed confidence rising in May to its highest level since December 2000.

But if stocks remain stuck in their underlying slump, consumers may rein in their spending, which would damage a fragile economic recovery. Even more ominous, if investors shun stocks for a prolonged period, companies will find it much more difficult and costly to raise the capital they need to expand their operations and increase revenue and profits. That possibility is worrying leaders of corporate America.

"The fundamental issue we're dealing with is uncertainty," said Samuel J. Palmisano, president and chief executive of I.B.M. "It is both geopolitical uncertainty in the aftermath of Sept. 11 and the war on terrorism, and market uncertainty in reaction to the flame-out of the dot-coms and Enron."

That instability is depressing business investment and weighing down the stock market, Mr. Palmisano said. Investors are not only focusing on fundamentals like a company's ability to generate cash, he explained, but they are also demanding sound strategy, skilled management and by-the-book accounting from companies. "It is incumbent on business leadership to demonstrate that," Mr. Palmisano said, "so our credibility will not be questioned."

Terrorist threats and fears about the possibility of nuclear war between Pakistan and India have definitely added to market jitters. A decline in the value of the dollar may be hurting stock prices because it encourages foreign investors to repatriate some funds they have held in dollar-denominated assets like stocks. And what looked like a recovering economy early in the year may falter over the summer or fall, causing what economists call a recessionary double dip.

But another factor weighing on stock prices may not be as evident as tensions in South Asia and the Middle East yet is every bit as menacing to investors. This is investors' growing sense of mistrust in the nation's capital markets and the role they play in helping to generate growth and prosperity.

The steady stream of accounting scandals, corporate chicanery and questionable practices at Wall Street firms is taking a toll on investor confidence — and that has major implications for the stock market as a whole.

Felix G. Rohatyn, the financier and former American ambassador to France, says investors' belief in the integrity of the financial markets has been severely damaged in the last year.

"Our system of market capitalism requires a high level of Protestant ethic," he said. "You need a regulatory system on one hand and a very strong ethic on the other, and within those guideposts you can let the market hopefully promote growth and wealth creation. But if either the regulatory or ethical base begins to erode, then you've got some real problems. And I think that is where we are right now."

Not all stocks are down, by any means. Shares of medium-sized companies have been strengthening, perhaps reflecting a belief among investors that because these companies were more obscure, their managements did not feel the need to resort to aggressive accounting to meet or beat their financial forecasts and prop up their stocks. The Standard & Poor's midcap index of 400 companies is up 4 percent since the beginning of the year.

But larger stocks — and the investors who own them — have definitely felt the pain. The S.& P. 500 has lost 7 percent of its value this year while the Dow Jones industrial average is flat. The Nasdaq composite, where many investors have been hit hardest, has lost 17.2 percent of its value and is trading 68 percent below its 2000 peak.

With returns like these, it is perhaps not surprising that the number of investors who say that now is a good time to invest has dropped to levels not recorded since September 2001, according to the investor optimism poll conducted monthly by UBS and Gallup.

The results of the May poll also indicate where investors think the market is most vulnerable. Their largest concern is dubious accounting practices: 84 percent feel that this issue is punishing stock prices, ranking it ahead of conflict in the Middle East and terrorism. Almost two-thirds of those polled say conflicts of interest between brokerage firms' research departments and investment banking activities are hurting the investment climate.

The poll results also show how much damage the Enron eruption has done to investor confidence. Nearly three-quarters of investors surveyed — 71 percent — said they believe questionable accounting practices are widespread in business, up from 62 percent in February.

As a result, 40 percent of the 1,002 investors responding to the poll say they are less likely to invest in stocks or mutual funds. That figure was 34 percent in February.

It appears unlikely that investor confidence will jump anytime soon. Jason Trennert, managing director and investment strategist at the I.S.I. Group, a brokerage firm in New York, said regulatory investigations into the business practices of brokerage firms were a cloud over the industry that was not going away.

"You're going to continue to see things coming out every day that question how Wall Street does business, and that is not helpful for investor confidence," he said. "Longer term, reforms will be positive to the extent that it will make investors more confident, but the investigations will be a heavy headwind for investor confidence."

Judging from the e-mail messages he has received recently from investors, David M. Blitzer, chief investment strategist at Standard & Poor's, said investors appeared deeply frustrated today.

"In the scandals of the last year, a few people have gotten rich and most investors have gotten poorer," Mr. Blitzer said. "I think they want a sense that it is a fair game and that everybody has an equal chance to win or lose. People seem to feel that for the matter to be settled, somebody is going to have to go to jail."

Mr. Blitzer said he is amazed at the number of investors who have stayed in the market throughout the crashing fall of the Internet and telecommunications stocks and, now, almost daily reports of fresh accounting fiascos at big public companies. He fears that if significant changes are not made to restore investor confidence, many will drift away from stocks.

Volume figures show that this drift has begun, at least among individual investors. While trading volume is still high on the New York Stock Exchange, average daily trades at Charles Schwab in April came in at 192,900, down from 235,000 a year earlier. In March 2000, when the market peaked, Schwab clients conducted 420,100 trades daily.

Mitchell H. Caplan, president of the E*Trade Group, characterized many of his firm's customers — particularly those with more than $100,000 in investable assets — as frozen. "People are trying to figure out what to do and more often than not they are going to cash," he said.

James B. Stack, president of InvesTech Research in Whitefish, Mont., recently returned from the Las Vegas Money Show, a four-day conference where purveyors of investment information make presentations to individual investors. Mr. Stack met hundreds of investors at the show and has concluded that most of them are only now beginning to realize that the $5 trillion they have lost in stocks is not coming back anytime soon, if ever.

"What was lost in paper wealth was real money," Mr. Stack said. "It may not have been booked profits in investor portfolios, but it was perceived as retirement funds. The pain of today is going to evolve into anger; unfortunately, along the way comes mistrust. They're asking: `Who's telling us the truth? Who's giving us the real numbers?' "

One measure of wealth noted by Moody's Investors Service shows how much poorer consumers are today than they were just two years ago. In the first quarter of this year, real liquid financial assets per worker were down an estimated 24 percent from the high of early 2000. Americans are still 36 percent wealthier than they were from 1991 through 1995, but the recent decline is troubling nonetheless.

"Real wealth might seem ample compared to its historical trend," said John Lonski, chief economist at Moody's. "But an extended slide by equity prices could be damaging. Consumer confidence would suffer, and businesses would be less inclined to pursue expansion amid slumping equities. Declining share prices would curb both capital spending and hiring activity."

Perhaps reflecting their fears about investment prospects, consumers are less confident about the possibilities for income growth than they have been in recent years. In a recent confidence report cited by Moody's, tracking the first five months of 2002, only 21 percent of respondents expect higher incomes in six months. That is below the 25.7 percent average from 1996 to 2000 and below the 23.9 percent of a year ago.

The trouble with the current market malaise may come down to this: While nobody wants a frightened investor class, few think that its suspicions or frustrations are irrational. "As the average investor learns more about the shenanigans that went on, he is going to get mad and he has every right to be mad," Mr. Stack said. "You hate to see it because the small investor is paying the steepest price, not because they lost the most but because they lost the greatest amount of what they could not afford to lose."