The Enron debacle continues to grab headlines, as investigations accelerate, lawsuits fly in every direction, and the Fifth Amendment gets a really good workout. Even Olympic gold can’t outshine the light generated by such a tawdry mixture of money, politics, allegations, and intrigue. For all of the complexity of the web of enterprises and cast of thousands, however, there is at least one simple theme that harkens back to the first chapter of just about any Economics 101 book. It has to do with information.
I have been saying for quite some time that I believe the stock market will come back with a vengeance. With a trillion dollars or more sitting on the sidelines earning low interest rates, the next rally should be one to remember. Having said that, the Enron aftershocks are delaying this surge and changing market dynamics in fundamental ways.
Any company, no matter how blue chip or how old and established, with even a hint of doubt about accounting practices is being hammered. The Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) are exploring new regulations and guidelines, and will no doubt implement some. Long before they can even get a quorum or call a meeting, however, the market is imposing its own brand of much harsher discipline. Irrespective of any new requirements (which may well be needed), firms will promptly respond to the demands of investors; the consequences of failing to do so are much greater than any fine or sanction.
The issue is so intuitive that we often take it for granted. If you read the most basic primer on economics, it will tell you that one of the essential prerequisites for markets to work is access to reliable information. Without it, neither buyers nor sellers can function properly. While this notion is simple, it is also profound. In fact, the most recent Nobel Memorial Prize in Economics was awarded to three scholars who explored what happens in cases of “information asymmetry” (where one party has more reliable information than another). It explains why people buy “lemons” (the cars, not the fruit) and how otherwise efficient market mechanisms can go terribly askew.
Implicitly, our vast global networks of financial markets rely on the validity of the information they receive. It has become automatic for investors to put considerable faith in public filings. Although the extent (if any) to which the normal process was inappropriately distorted will be arduously examined in committee hearings and jury rooms for the next several years, the bottom line is that the confidence of investors has been shaken. Importantly, the magnitude and implications of the situation are such that it is not merely the prospects for a specific firm that are being questioned (as occurs regularly when there is an earnings restatement or similar disclosure), but the very core of the market itself. The basic textbook requirements for a market are at stake; a stone in the foundation is wobbly.
When events of this nature occur, investors react by (1) imposing higher standards and (2) staying away longer. The former is healthy and will be addressed through both formal and (more powerfully) informal means. But investors’ reluctance to get back in the game prevents the market from reaching its full potential as soon as it should, thus limiting capital access, innovation, and long-term growth. Reliable company information is an absolute requirement for proper market performance. This idea may be so basic that we typically ignore it, but it is also so vital that we can ill afford to neglect it.