Looking Ahead-Greed or Growth?

Many analysts are in agreement that the stock market could gain ten to fifteen percent by year-end. That outlook is probably based on three assumptions.

First, our troops will take control of Iraq in a short and one-sided conflict.

Second, Federal Reserve economic programs will likely show better results followed by an increase in business spending.

Third, oil prices will continue to fall, probably to the low twenty dollar per barrel range. Lower oil prices would add to corporate profits and provide discretionary cash for consumers.

During this period, long-term interest rates will likely begin to increase along with a decline in long term bond prices. The increasing commodity futures index also points to higher long-term interest rates and probably a higher consumer price index.

Some economists expect rates on thirty-year bonds to increase from about 4.7% to possibly 5.4% with rates on ten-year bonds increasing to the 4.2% level. While these increases are not extreme it would be prudent to shorten the average maturity on fixed income portfolios. Long-term bonds should be exchanged for short-term bonds. This will reduce the impact of declining long-term bond prices on future portfolio values.

While the improving situation in Iraq and lower oil prices will have a positive effect on economic growth, I am less optimistic about sustained improvement in stock prices. Our markets are still burdened by management and accounting issues.

No high-level corporate executives have been jailed and/or fined for their illegal actions. Stock option expensing is still not a mandatory accounting rule and congress cannot seem to agree on how to tax or not tax dividends twice.

Stock option expensing is a major negative for market confidence and growth. It is probably the most widespread cause of the market earnings bubble and resulting bear market.

Under the present rules, option costs are deductible for tax purposes but are omitted as expenses on the income statement. The result is excessive, often obscene, executive compensation that is basically hidden from shareholders.

In 2001, options expensing would have caused Intel to report earnings of 254 million instead of 1.3 billion. You have to admire management's nerve. At Yahoo, options expensing would have taken reported loses from 93 million to 983 million. That is a pretty good management bonus from a company that doesn't show a profit.

Not fair you say. We agree. An attempt to change the accounting rules was proposed in 1994. The senate voted against the change 88 to 9. It seems that lobbyists with fistfuls of corporate cash were able sway the voting. That took the lid off of the corporate cookie jar and the rest is history.

The Sarbanes-Oxley bill was a recent attempt at reform. However, the stock option provision was dropped before the bill was placed on the Senate floor. Senator John McCain and Senator Carl Levin also proposed option reform last year with the McCain-Levin Bill. Senator Tom Daschle stopped this attempt at reform in July of 2002. It is not just Senator Daschle; the majority of congress is to blame.

The good news is that in spite of congress, many corporations have already changed their accounting procedures to recognize options as an expense. About 25% of the Standard and Poors 500 corporations are now expensing options. In addition, many corporations have increased the dividend payouts or started dividend payout programs. Creative accounting cannot pay cash dividends. It takes real profits.

The market cannot have sustained growth as long as corporate management is permitted to pursue policies of greed and deception. Shareholders need to regain control of the companies they own or refuse to invest. Management needs to remember that they are only corporate employees, not sole proprietors. Congress must make sure that corporate executives, directors, auditors and investment bankers respect the rights of America's shareholders and act in the shareholder's best interest. Only a minor percentage of companies are guilty, but it is enough to cast a shadow over the entire market.

These issues will be resolved, either by congress or investor action. When confidence and trust return to the markets, growth will follow.

The real problem is, and has been, one of greed, both in the boardroom and in congress. That greed, practiced by a select few, has jeopardized the financial well-being and retirement security of an entire nation. It is indeed a shame that some of our corporate leadership does not execute its responsibility and obligation with just a fraction of the integrity, dignity and selflessness that is displayed by the young people in our armed services.

Your comments are welcome. Please contact us at www.raymondjamesohio.com.

Larry Cavalena
Registered Principal