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How Corrupt are US Capital Markets?

Why has the US stock market done so well in recent months--the Dow increased over 30% since its low on March 11, 2003, and closed above 10,000 on December 11--even with the media reporting one financial scandal after another? We have seen Enron-style fraud from corporate management, Arthur Anderson-style smoke and mirrors from accountants, and now Putnam Funds-style market-timing irregularities from mutual funds. After all this dirt, why aren't more investors voting with their feet?

The most important reason is a sharp improvement in corporate earnings, and in economic conditions in general. The scandals may be pushing the boat of market sentiment downwards, but their effect is being overwhelmed by the rising tide of economic prosperity, at least for now.

To be sure, television, radio, newspapers, magazines, and Internet sites have been hyping financial misconduct, awakening and shaping the type of emotional responses that often have a powerful influence on financial markets. But attention-getting emotions (such as anger) are not the only factors that drive investment decisions.

Investors may respond emotionally, but they are unlikely to let their anger cause them to miss what appears to be a substantive increase in value. The excessive optimism of the late 1990's lingers, so investors are more impressed by the recent upsurge in corporate earnings--seen as confirming their optimism--than they are by the financial scandals. Next to the $100 billion annual rise in after-tax corporate profits in the US in 2003, the scandals look puny.