Effects of the Business Cycle on Perceptions
What we think is important varies with our personal circumstances and the stage of the business cycle. If you talked to people three years ago – when the stock market was booming and everybody was raising money to buy dot-coms that were going to be our saviors and that were going to change everything we do in a spirit of euphoria and optimism and hope – then many would have given very different ideas about the importance of finance. Capital markets were then critical for raising money for junior companies, and transforming the economy.
However, we are now living with the implications of the excesses of the 1990s. As people have seen their personal portfolios dwindle over the last two years, they are more pessimistic about what is actually going on in equity markets. Three years ago, probably most finance people would have said that markets are efficient, period. I think what we can say now is that bond markets are efficient. We have a good handle on pricing bonds. We have a good handle on pricing derivatives. But we don’t have a good handle on pricing equities. Not only do we not have a good handle on pricing equities, but the information we use coming out of the financial statements is unreliable – it is clear that there was a lot more fraudulent activity going on and misrepresentation of data than most people expected.
This is why standard financial analysis is critically important – which is what people have forgotten. They got used to taking financial statements at face value. Enron demonstrated vividly just how far away from reality those financial statements could be, as did WorldCom. Further, they got used to letting financial analysts do their thinking for them and got a rude awakening when they realized, after the fact, that many analysts fudged their reports to generate investment banking fees and, between peers, admitted their reports were junk. In such an environment a return to the basics of due diligence and financial analysis and an understanding of stock prices in terms of the earning power of the company, rather than one-time-only financial gimmickry and stories, are the order of the day.
Many of these remarks simply reflect the impact of the recession. Whenever the economy slows, the stock market crashes, and investors get burned, we see a similar reaction. It happened in the early 1990s and early 1980s and the early 1970s, and it will happen again in about another ten years. Much of the learning, of what we think we know and what we don’t know, depends on the general state of the economy and the capital markets. Before the next crash, we will have a recovery and boom, and most of the hard learned lessons will be forgotten as they invariably are. A new set of investors will again believe financial statements and financial analysts and that the good times will continue forever, but history and common sense indicate this will not happen.
