The Betrayed Investor

Americans bought into the idea that stocks could only make them richer. Then the market bubble burst -- and then came Enron

By Marcia Vickers in New York and Mike McNamee in Washington. With Peter Coy, David Henry, Emily Thornton, and Mara Der Hovanesian in New York, and bureau reports
Business Week

February 25, 2002

It's 2 a.m., and Jim Tucci is staring wide-eyed at the ceiling--another sleepless night. Instead of counting sheep, he's anxiously tallying up how much he has lost in the stock market. Half of his $400,000 nest egg, he figures, has evaporated in just two years. Forget the retirement property on the Gulf Coast. Forget the long-planned trip to Italy with his wife. Tucci, a 60-year-old sales manager at a voice-recording company in Boston, admits he blew a wad on speculative tech stocks during the Internet bubble. But a year ago, he dove for safety in blue-chip stocks like IBM (IBM ), Merrill Lynch (MER ), General Motors (GM ), and Delta Air Lines (DAL ). Now, 40% of that is gone. Tucci feels suckered. "I'm paralyzed. I can't sell because I'd take such a big loss. I'm sure as heck not going to buy anything. And even if I were, who would I listen to for advice? No one seems to even give off a whiff of honesty about any of this stuff. These days, I just pray a lot."

Some 100 million investors--about half of all adult Americans--can relate to that. They're the new Investor Class that has emerged over the past decade. Predominantly middle-class, suburban baby boomers, they bought into the idea that stocks could only make them richer. They exulted during the long bull market of the 1990s. But they've lost $5 trillion, or 30%, of their stock wealth since the spring of 2000, when the dot-com implosion launched the second-worst bear market since World War II. It wasn't Monopoly money: It was earmarked for retirement, for college tuition, for medical bills.

The Investor Class boomed in the 1990s as more and more people plunged into the market. At the start of the decade, they had $712 billion in 401(k) and similar plans, 45% of it in stocks. By the end of 2000, that had ballooned to $2.5 trillion, with 72% in equities. Their holdings of stock mutual funds mushroomed, too. Over the decade, the amount invested in them increased sixteenfold, to $4 trillion. By the late '90s, the bull market had spawned the cult of equities. Not only did more people begin pouring cash into stocks, but their holdings increased exponentially as the indexes, especially the tech-laden Nasdaq, kept hitting new highs. CNBC and others covered the stock market like Monday Night Football. Investors of all stripes and sizes bought into the stock culture. Owning stocks--whether those of conservative Procter & Gamble or racier Yahoo!--was being in tune with the zeitgeist, simply a part of living in the '90s. "We were just riding the market, and we all felt like we were brilliant because our stocks were going up," says James J. Houlihan Jr., an accountant from Fort Wayne, Ind.

The market's steep rise in the late '90s had a dramatic effect on business, too. Companies merged and acquired furiously. Investors clamored for initial public offerings. "Ventures were able to raise money much earlier in their life cycle, far before any anticipated profitability. In a different era, some of those would have died before getting funding," says David M. Blitzer, chief investment strategist at Standard & Poor's. Millions of new jobs were created, and economic growth and productivity soared. It was boom time. Then it went bust.

Today, the Investor Class is angry and disillusioned because it feels betrayed. On the heels of Enron Corp.'s Dec. 2 bankruptcy filing--America's biggest ever--they are questioning the very integrity of the financial system. And they won't be ignored. They are a powerful group. Most--76 million, or a third of the adult population--are baby boomers who grew up in the era of protests and social activism. Then, they settled into comfortable middle-class prosperity. Once roused, they could again become a force of nature. And they vote.

Suddenly the deck seems stacked against them, at a time when they expected to reap the fruits of their prime earning years. Instead, they're getting poorer by the day, while corporate insiders seem to make out like bandits: taking out millions in personal loans on cushy terms, rewarding themselves with rich options, bonus packages, and feather-bedded pensions. According to a Feb. 11 BusinessWeek/Ipsos-Reid poll, 81% of investors don't have much confidence in those running Big Business. And 68% have little or no faith that the stock market treats average investors fairly. The result: The new Investor Class is losing its appetite for risk and is parking its cash in unglamorous, low-yielding money-market funds and bank savings accounts. Far fewer are opening brokerage accounts. And last year, investors slapped a record 341 class actions on brokers--lawsuits that could cost the brokers as much as $14 billion to settle--charging them with everything from issuing misleading prospectuses to taking kickbacks for IPO allocations. Individual complaints for bad advice soared as well.

How all this shakes out is vital to the health of the U.S. economy. If the crisis galvanizes companies and government into cleaning things up, investors will regain the confidence they need to put money to work in productive investments. The stock market will rebound, and companies will get the funding they need to grow. But if the malaise lingers, the bear market will drag on and the economy could suffer as capital for entrepreneurial ventures and research and development dries up. For sure, the fear that many big companies may be cooking their books makes for a much riskier market. Some experts paint fairly extreme scenarios: "It could lead to a rise in the cost of capital [and] lead to serious concerns about foreigners wanting to invest in America," Senator Jon S. Corzine (D-N.J.), a former Goldman, Sachs & Co. co-chairman, recently told the Senate Budget Committee.

With investor angst rising, Washington has swung into action. Never before have the politicos faced the wrath of so many disaffected investors. In a highly partisan atmosphere, Republicans and Democrats are both moving to shape post-Enron, confidence-building reforms. Even conservatives who extol the virtues of deregulation, individual choice, and private accounts for Social Security and medical care know they cannot promise the magic of democratized investing, while the impression grows that the game is rigged against the little guy. No fewer than 12 congressional committees are probing the Enron scandal and rushing to hammer out reforms designed to do everything from reining in Wall Street analysts to imposing tougher accounting rules on companies and shoring up safeguards on America's retirement savings.

Rarely has Capitol Hill reacted so fast to a burgeoning market crisis. But it will take more than dozens of rapidly crafted proposals and public posturing to restore confidence. Suddenly, no one knows who to trust. In the BusinessWeek/Ipsos-Reid poll, 54% of investors said they are concerned about the honesty and reliability of the investment information they receive. "It's a strange time. People wonder if the wool is constantly being pulled over their eyes. It makes for a very vulnerable market," says Robert J. Shiller, economics professor at Yale University and the author of the 2000 best-seller Irrational Exuberance.

Indeed, the Enron scandal and the swift bankruptcy of upstart telecom Global Crossing Ltd. have cast a long shadow of suspicion about possible accounting improprieties at company after company. The stock prices of energy outfit Calpine (CPN ), conglomerate Tyco International (TYC ), and megabank J.P. Morgan Chase (JPM ) have been battered because of questions about accounting practices. Even such blue chips as General Electric Co. (GE ) and IBM are under the microscope. Americans who came to see their free-market economy as largely immune to the cronyism that plagues many foreign countries were shocked to see how Enron's cozy ties with its own accounting firm inoculated it from scrutiny. "Enron has been elevated to a symbol," says Woody Dorsey of Market Semiotics, an institutional forecasting service. "There's a whole new level of uncertainty about profits, about the integrity of the accounting profession and of Wall Street."

The usual investor watchdogs--the board, auditors, and regulators--all seem to have been asleep or deeply conflicted about their roles. Even professional investors are consumed with fox-minding-the-henhouse worries. In a Feb. 5 study by Wall Street Reporter magazine, 43% of 322 professionals polled said that they are "extremely concerned" about the potential for widespread financial-reporting fraud, and 61% said regulators could do a better job.

Of course, the heavy hitters in Washington, on Wall Street, and in corporate boardrooms contend that investors are overreacting. Says Treasury Secretary Paul H. O'Neill: "While we may need to do some repair work, I don't believe that our system is broken. We have the lowest capital costs of any place in the world, because we've demonstrated that investors' money is safer here." These Establishment figures argue that the economy seems to be picking up steam and that company earnings will soon start to look better. Despite the flaws, they say, the U.S. still has the most rigorous, reliable accounting system, and most companies follow the rules. "The market has already responded to the potential of overstated profits in the same way it responds to an unexpected negative event: ready, fire, aim," says Jeffrey M. Applegate, chief investment strategist at Lehman Brothers Inc.

Even so, some analysts believe the market as a whole remains overvalued. The market's price-earnings ratio is high by historical standards--despite today's low inflation and interest rates. The S&P 500 stocks now trade, on average, around 21 times estimated 2002 earnings--down from around 25 near the March, 2000, peak but still way above the historical average of about 15.

Worse yet, the e's in the p-e ratios could be substantially overstated. The worry is that thousands of companies have consistently, and legally, overstated earnings for the past few years. Robert Barbera, chief economist at Hoenig & Co., figures most of the 26% operating earnings growth reported by S&P 500 companies from 1997 through 2000 was the result of accounting shenanigans. "I don't believe that the earnings growth in the late 1990s was there," he says. That's because tactics such as inflating earnings by excluding the cost of employee stock options from expenses and relying on massive restructuring charges came into vogue. Even established companies started using accounting voodoo, like turning the rising value of their pension-plan assets into higher earnings and using so-called pro forma numbers.

But post-Enron, the accounting games are coming to a shuddering halt. For years to come, investors may question the figures they accepted in the past. Financial reporting is sure to become more conservative. So even when the market settles down, reported earnings aren't likely to boom again and rekindle the force of the last bull market. "It is not that we can't get back to where we were. We were never there to begin with," adds Barbera.

That's especially worrisome because when a crisis like Enron occurs during a bear market, stocks typically take about 12 months to recover, according to a study by Crandall, Pierce & Co., a Libertyville (Ill.) investment research firm. And recovery times from earlier stock bubbles are sobering. It wasn't until 1958 that the market regained its inflation-adjusted 1929 pre-crash level, according to Yale's Shiller. For two decades after 1929, the average real return for the stock market, including dividends, was 0.4% a year, vs. the 25% investors became used to in the late 1990s. Most economists doubt that history will repeat itself so cruelly. After all, the U.S. economy is in much better shape now, and the stock market--though it may be a riskier place than many new investors imagined--has a more level playing field than it had in the post-Depression era.

Still, that's cold comfort for ordinary investors, who read daily about corporate chieftains profiting from insider sales while their own portfolios shrivel. Says Charles Prestwood, a 63-year-old retired Enron employee who lost practically all of his $1.3 million savings, invested in the company's stock: "Something stinks herethere are people at Enron who made millions selling the stock while we, the rank and file, got burned." Such practices weren't confined to Enron. According to SEC filings, Global Crossing Chairman Gary Winnick sold $734 million in shares before the profitless company collapsed.

Arrogant execs are not the only targets of investors' ire. Morgan Stanley Dean Witter analyst Mary Meeker, the onetime "Queen of the Net," pulled down a $15 million pay package in 1999--the eve of the dot-bomb. There's no telling how much money analysts such as Meeker cost investors with their interminable buy recommendations on Internet stocks that eventually went bust.

Indeed, many Wall Street analysts seem to need their own analysts these days--those of the Freudian persuasion. Eleven out of 16 analysts who follow Enron had buys or strong buys on it as late as Nov. 8, despite a series of red flags ranging from a $1.2 billion reduction in shareholder equity to an SEC probe. Part of the problem is that few truly analyze companies these days. Says Paul Patterson, a utility analyst at ABN Amro Inc. in New York: "Analysts don't want to be on the wrong side of a stock that's going up."

What's worse, since they often get paid according to how much investment banking business they can drum up for their firms, analysts play a dual role that is often deadly for investors. At the height of the bull market, Salomon Smith Barney telecom analyst Jack Grubman had buy recommendations on practically all the companies he covered. During that time, Salomon was loading up on investment banking fees from telecom companies, racking up almost $1 billion since 1997--more than any other Wall Street firm. Now, nine of the companies Grubman cheered during the telecom craze are trading for less than $1 a share. At least four are in bankruptcy.

No surprise, then, that shareholders are clamoring for more accountability. Most want to see some of the high-profile execs and accountants who've misled them join the ranks of the chain gang. In our poll, 89% of investors say they strongly favor the criminal prosecution of corporate officials who are implicated in serious financial fraud.

In an effort to placate an angry public, the New York Stock Exchange and the National Association of Securities Dealers issued a proposal to the Securities & Exchange Commission on Feb. 7 that would limit compensation that analysts can receive from investment-banking activity. Other rules would restrict analysts' trading of stocks they cover, ban them from reporting to their firm's investment bankers, and prohibit them from promising favorable ratings to companies they cover.

Enron's collapse has also rocked the agenda of Washington's conservatives. For a decade, GOP strategists predicted that the steady rise of the Investor Class would create a powerful political force in their favor as shareholders saw that wealth came from capital gains, not wages. The result would be an inexorable tilt toward GOP-enshrined policies, such as across-the-board cuts in marginal tax rates, deregulation, and budgetary restraint. Ultimately, the proselytizers insisted, the embrace of the small-investing ethic would create a receptive climate for conservatives' choice agenda. Empowered by the success of their self-directed 401(k) plans, they hoped, stock owners would vote for policies that put individuals, not government, in charge of retirement and health care.

Many voters still support choice, but the crown jewel of the agenda--replacing part of Social Security with individual accounts invested in stocks and bonds--stalled when federal budget surpluses ended. But officials like Lawrence B. Lindsey, President Bush's chief economic adviser, think that the bear market hasn't shaken the agenda. "The theme of all of the President's policies is to give people more control of their lives--be it their tax money, retirement savings, or Medicare decisions," Lindsey says. "There's a recognition that we're in this for the long term."

Even so, investors' response to Enron--and the fear of more Enrons--has taught conservatives a sobering lesson. The clamor for accountability in the financial system means more rules and regulations in a sector they have spent decades trying to deregulate.

With "we told you so" Democrats also in full cry, there's a predictable result: a regulatory stampede not seen since the savings and loan crisis of the 1980s. Democrats were first out of the blocks, calling for limits on the amount of company stock in 401(k) plans and moves to ease shareholder suits against corporate officers, directors, and auditors. But GOP lawmakers are starting to fill the House and Senate hopper with proposals. On Feb. 13, the Republican leadership of the House Financial Services Committee introduced a sweeping set of reforms. They include the creation of a Public Regulatory Organization to investigate auditing failures and discipline errant CPAs, a ban on accountants consulting for audit clients, and increased funding for the SEC's enforcement and corporation-finance divisions.

Despite bipartisan tears for Enron's victims, the parties are taking different approaches. Democrats see Enron as justification for a strong assertion of government power to outlaw conflicts of interest and even restore the ban on companies operating in both the banking and securities industries. "We cannot legislate against greed, but we can and should do what is possible to prevent greed from prevailing," says Senate Judiciary Committee Chairman Patrick Leahy (D-Vt.).

But in the GOP, proponents of investor empowerment are more likely to prevail. Treasury Secretary O'Neill--charged by President Bush with proposing reforms in corporate governance--and SEC Chairman Harvey L. Pitt don't think that Washington rulemakers can anticipate "all the combinations and permutations of every business activity in the world," as O'Neill puts it. Instead, they would cater to the Investor Class with more transparency.

On Feb. 13, the SEC took a large step in that direction by announcing plans to impose far stiffer disclosure rules on companies. Companies must produce quarterly reports within 30 days, rather than 45, and their annual reports in 60 days, rather than 90. Significant trading in company stock by officers and directors must be revealed immediately. Any important changes in business must be reported within days, including waivers from corporate ethics rules or off-balance- sheet financing. Write-offs large enough to affect a company's earnings must also be reported quickly. And the SEC wants laws to bar serious corporate wrongdoers from serving in key posts again. "We believe that we should not give officers and directors who betray their trust a second bite of the apple," says Pitt.

O'Neill wants to hold both corporate CEOs and auditors responsible for ensuring that investors are fully informed. CEOs would have to sign off on a checklist of corporate health indicators--the 5 to 10 key factors affecting a company's future. Top company officials would be personally liable if the list were incomplete or misleading. Similarly, the Treasury chief is likely to propose that auditors give their client companies performance ratings for the quality and completeness of their financial controls. That would replace today's boilerplate audit opinions--a test that few companies ever flunk.

Washington, is of course, responding to an angry Investor Class. That's not half bad. But investors shouldn't let down their guard too soon. After all, what got us to this sorry state was a willing suspension of disbelief about the laws of the market. Real resources went to waste on dimwit dot-coms and overstocked telecom gear. The irrational exuberance of the '90s was as harmful as the irrational pessimism that could grow out of investors' feelings of betrayal. The best outcome from the present wave of angst would no doubt be a return to commonsense investing. Investors should place their bets on rationality, not the next skyrocketing stock.

The New Investor Class

Portrait of a 100-million-strong power bloc

Most likely to have college, graduate, or professional degree.

The vast majority earns more than $50,000 a year; nearly half top $75,000. A majority of those earning $30,000 to $50,000 also invest.

Caucasians are by far the most likely to invest. African Americans and Latinos are less than half as likely to invest as are non-Hispanic whites.

The most likely investors are between the ages of 35 and 49. People under 25 are extremely unlikely to invest, while only about 40% of seniors are in the market.

Some 60% of suburbanites are investors, while just under half of city and rural folk are. Homeowners are far more likely to invest than renters.

When people get married, they think of the future. Couples are much more likely to invest than singles, particularly young singles.

People on the East and West Coasts are most likely to invest. Southerners are the least likely.

Investors tend to read a daily paper, regularly watch the evening news, subscribe to magazines, and use the Internet.

Investors tend to be party loyalists: Republicans and Democrats are more likely to invest than Independents. No ideology prevails. Active traders are strongly Republican.

Union members are more likely than nonunion members to invest. The most prominent investors, however, are professionals and business execs.

Virtually the same number of men and women are investors. Active traders are mainly men. Women form a majority of stock, bond, mutual-fund, and 401(k) holders.

Data: The Pew Research Center for the People & the Press

Poll: They're Fed Up (extended)

How badly has the Enron fiasco shaken confidence in the markets? An Ipsos-Reid poll of 619 investors* conducted for BusinessWeek on Feb. 11 found that they don't see Enron as an isolated case. They are not pulling out of stocks en masse, but they want business to clean up its act and regulators to beef up policing. Highlights of the poll:

Which of the following comes closest to your opinion about the Enron case?

It's a totally unique situation that applies only to Enron.....10%

It's an indication that some well-known corporations have begun using questionable accounting practices of the kind that got Enron into trouble....................................60%

It's proof that there may be an epidemic of deceptive accounting practices involving many well-known corporations....28%

Not sure........................................................1%

Looking ahead, how will the Enron case affect your actions as an investor in the next six months?

It will not seriously affect my investment decisions...........43%

It will make me much more cautious before I make an invest- ment in a particular company...................................41%

It will make me reluctant to invest any more in stocks until I get a better understanding of the extent of the problem......14%

Not sure........................................................1%

When you think about the Enron case, do you worry more as:

An investor who is not sure that the information is honest and
reliable when you research which companies to invest ..........54%

An employee who is not sure your 401(k) plan will provide you with a comfortable, worry-free retirement......................29%



Not sure........................................................3%

Over the next six months, do you think you will probably invest in stocks or stock mutual funds?

                                   11/30-         11/28-         12/2-
                    2/11/02        12/3/01**      12/4/00**      12/7/99**

A lot more 4% 4% 7% 10% Somewhat more 25% 24% 35% 37% Reduce somewhat 13% 15% 13% 10% Reduce a lot 8% 9% 5% 5% Stay the same 47% 42% 32% 29% Not sure 4% 6% 7% 10% Total Invest More 29% 28% 42% 47% Total Reduce 21% 24% 18% 15%

Do you favor or oppose the following proposals?

            STRONGLY      SOMEWHAT      STRONGLY       SOMEWHAT      NOT
             FAVOR         FAVOR         OPPOSE         OPPOSE       SURE

Making top corporate officials who are found guilty of serious financial fraud liable for criminal prosecution 89% 10% 1% 1% --

Requiring executives to release to employees and investors more timely and accurate information about a company's financial health 87% 9% 2% 1% 2%

Beefing up the Securities & Exchange Commission auditing and enforcement division to increase federal policing of the accounting industry 47% 29% 12% 9% 2%

Reducing the time periods when participants in company 401(k) retirement plans cannot sell their shares 40% 21% 15% 16% 8%

Putting limits on employees' ability to invest in their own company's stock as part of their retirement plans 23% 23% 21% 31% 3%

Creating a new government corporation to handle corporate auditing, a move that would replace private accounting firms as primary auditors 12% 12% 22% 50% 4%

In 2001, how many times did you make changes in your investments -- buying or selling stocks or stock mutual funds either within or outside an employer-sponsored 401(k) plan?

25 or more........................................................3%
15 to 24..........................................................3%
5  to 14.........................................................14%
Less than 5......................................................38%
Not sure..........................................................3% 

* Out of 768 adults interviewed, 619 were investors; margin of error for investors: +/- 4%

** BW/Harris Poll

The Fallout

Since Enron's bankruptcy filing on Dec. 2, the market has punished
companies with any hint of murky accounting.


CALPINE 60.3% Discloses a confusing contract with Enron on debits and credits

MIRANT 57.6 Moody's downgrades debt, warns of off- balance-sheet risks

TYCO 48.2 Spars with short-sellers over earnings- growth figures

AES 38.6 Announces earnings with a long list of adjustments

WILLIAMS 38.4 Delays full financial report to retally COS. off-balance-sheet liability

RELIANT 31.2 Delays 2001 results to restate earnings

QWEST 22.6 Telecom bankruptcies cast new doubt on accounting

CISCO 15.6 Haunted by $2.5 billion inventory write- down in 2001;new concerns over revenue padding

J.P. MORGAN 15.6 Reveals new risks from Enron off-balance- CHASE sheet vehicles

COMPUTER 14.6 Changes revenue accounting; Moody's ques- ASSOCIATES tions outlook

* Through Feb. 12

Data: Bloomberg Financial Markets, BusinessWeek

Post-Enron Reforms: What's Real and What's Not

The prospects for congressional action.

-- Employees can sell stock from company matching programs sooner. Count on it.
-- Employers can hire outside advisers to guide workers on investing their 401(k) cash. A lock.
-- Employees get to elect trustees for 401(k)s and pension plans. Unlikely to pass.

-- Faster reporting of all insider stock trades. Excellent. Could happen in 2003.
-- Suing corporate officers for financial chicanery becomes easier. Dubious. Conservatives oppose.
-- Companies must book stock options as an expense. Good. Has bipartisan backing.

-- Closer SEC scrutiny of financial reports. Certain. Commissioners have gotten the message.
-- Investors get more company data and faster. Likely. Treasury Dept. will embrace the idea, but the scope of the rules remains vague.
-- Crackdown on corporate tax shelters. Dicey. The worst may go, but new mutants will emerge.

-- New private-sector board to probe accounting failures and discipline auditors. Certain.
-- Accountants can't consult for audit clients. Good. Big Five are already splitting the roles.
-- Accounting rulemaker FASB overhauled to cut industry and political clout. Iffy. Republicans prefer market-based reforms.

-- Banning soft-money donations to political parties. Some measure likely. But corporate cash will find new roads to politicians' pockets.

Copyright 2002 , by The McGraw-Hill Companies Inc. All rights reserved.