The aftermath of the Enron scandal will have a lasting impact on how companies carry out their financial reporting and corporate governance
While investors are likely to experience continued market volatility in the coming months, the general trend of the market will lead the economy upwards in 2002.
Meanwhile, the bankruptcy of Enron, the seventh largest company in the Fortune 500, will have lasting implications for investors in terms of financial reporting and corporate governance.
Stock markets bottomed in late September. Share prices began to recover in October and then surged higher in November amid signs that consumers were continuing to spend and companies were seeing a rebound in orders. This reassured investors that the actions of the Fed to boost liquidity in the financial system following the 11 September terrorist attacks had been successful in preventing a steep economic decline. As the post-11 September fears waned and the consensus embraced our view that the US recession would be mild, investor attention focused on earnings growth in 2002.
After slashing earnings forecasts in the closing months of last year, analysts have once again started to raise them. Once this series changes direction the new trend tends to persist for a while and this should provide support for the market in the early months of this year at least.
Investor attention is now focused on the prospects of recovery for the economy and corporate earnings in 2002. While our estimate of S&P 500 operating earnings for 2002 at $52 is little changed from three months ago, share prices have risen and the market now trades at a price earnings ratio of 22, based on our forecast earnings for this year.
This is not that cheap, particularly as the quality of earnings has deteriorated but considering that we are at an early stage of a new growth cycle, it is unlikely to act as a barrier to higher prices. Renewed investor demand for mutual funds highlights the strong support for equities from capital flows. This improved sentiment has also been reflected in a surge in new issues in recent weeks, although this extra supply may be contributing to the recent sideways drift in the market.
Nevertheless, in an environment of low interest rates, investors are likely to regard potential equity returns as attractive versus most alternatives. Renewed investor confidence showed up in increased demand for equity mutual funds and a preference for companies in the more cyclical sectors of the economy. Technology issues led the advance, buoyed by evidence of improving order trends at industry leaders like Cisco and Intel. Consumer cyclicals posted an impressive end to 2001, leaving them as the only S&P 500 group to post a positive return last year.
The energy sector toiled as oil and gas prices declined due to falling demand and Opec struggled to reach an agreement on production cuts.
The problems at Enron and its ripple effect on other energy marketers pushed the utilities sector into a further decline, leaving it as the worst performing sector of the year.
When Enron filed for bankruptcy in December, it ranked as the largest ever in US history ' the collapse in its share price wiped out over $63bn of shareholder value. Enron transformed itself during the 1990s from an energy utility to a company that developed and then dominated energy marketing.
Its ability to generate consistently substantial profits, in a business where others experienced low margins, was attributed to its superior trading expertise and market knowledge.
Recent events however, highlight that these superior profits were largely the result of creative accounting. In particular, Enron used private partnerships to shift liabilities off its balance sheet and inflate its reported profits. It also issued stock to employees' personal pension finds in matching contributions, with a lock-in until age 50 at the earliest.
Enron's collapse raises fundamental questions about corporate governance and the responsibilities of auditors and regulators. We can expect some tightening up in areas such as financial reporting, the responsibility of audit committees and the investment of pension assets in sponsoring company stock. Whether the impact of the regulatory response to the Enron failure is as important as that of UK regulators to the collapse of Barings Bank remains to be seen. However, it is clear that the quality of US financial reporting will improve and issues of corporate governance will feature more prominently with shareholders and regulators in the future.
In light of modest nominal GDP growth in 2002, we favour well-capitalised companies that are positioned to gain market share. We are heavy in consumer and industrial cyclicals as they should be early beneficiaries of an upturn in growth.
In technology, we continue to favour semiconductor manufacturers and software & services suppliers over hardware and telecom equipment companies.
We remain light in consumer staples as they are likely to derive only limited benefit from a stronger US economy. Exposure to energy is likely to be increased from its current neutral rating because energy prices should stabilise as growth spurs demand.
Renewed investor demand for mutual funds highlights strong support for equities from capital flows.
The Enron situation should lead to some tightening in financial reporting and the responsibility of audit committees.
Enron and its ripple effect on other energy markets pushed utilities sector into decline.
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