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Corporate Housecleaning
Getting the market back on track.


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Larry Kudlow

The disconnect between the rising economy and the sagging stock market continues. Good economic news appears almost daily. Yet the stock averages are falling daily.

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The Energy Department reports that gas prices at the pump this Fourth of July holiday were the lowest in three years and down 8 cents from a year ago. Initial jobless claims are the lowest in 15 months. Weekly chain-store sales in June look to rise about 5% from year ago compared to 31/2% in May. Car sales in June were about 161/2 million versus 151/2 million in May.

May factory orders came in stronger than expected with upward revisions in March and April. Business-capital spending is on the rise. For the quarter so far, capital-goods shipments are rising at a 7% annual rate, with orders up at a 17% pace. The high-tech cap-spending composite is up 16% annualized over the past three months. Following solid gains in industrial production, these cap goods stats show that a business recovery is strongly in place.

But stock markets are not focused on this. Corporate evildoers and fraudulent accounting are more important than production and investment at the moment. This cannot last forever. But right now corporate corruption is a strong contagious virus that is spreading everywhere.

An angry President Bush will make a speech on Tuesday that toughens his proposals on corporate reform. He is likely to add criminal prosecution to the CEO certification process. He will also favor much of Harvey Pitt’s SEC proposals, including the nine-member independent accountability board. Pitt has had a complete facelift epiphany. He is no longer Hyman Roth’s man on the commission, defending his former big five accounting firm clients. He was quite angered at the WorldCom chicanery, and now he too joins Mr. Bush on the warpath against corporate crooks.

Meanwhile the Justice Department and the SEC are engaged in the most aggressive prosecution of white-collar crime in 70 years. Remember Richard Whitney, the Morgan-connected president of the New York Stock Exchange? He was thrown in jail in 1929 for insider trading. Current day prosecutors are using that example as their northern star compass.

Accounting rules have become even more complex than the tax code, which is saying a lot. They need to be reformed. As for corporate governance, the right operating model goes like this: senior executives should work for the independent board of directors, and that board works for the shareholders. Look for Bush to endorse this model.

In the last 15 years the stock markets have become democratized as roughly 100 million people comprising about one-half of U.S. households own shares. This democratized investor class has been voting with its dollars lately by disinvesting. They are voting against the system. They are voting against corruption.

The president’s job is to convince them that a reformed system will produce honest accounting and reliable shareholder governance. Evil-doing executives will be punished either by disgorging their fraudulently earned compensation, or a jail term, or both. You do something wrong in this country, then you pay the consequences. There should be no discrimination between white collars or blue collars.

If the president convinces us that he means business in making the necessary reforms to a market system that is basically sound, then he can persuade
investors to vote for the system by reinvesting in it.

Now that the nation has gotten safely through the July 4th holiday, a strong presidential statement on corporate reform could get investors to refocus on economic recovery. If they do, they will soon realize that today ‘s overly downsized stock market worth is somewhere between 20% and 30% undervalued. Make that 40% to 50% if the U.S. military can capture Osama bin Laden and his al Qaeda murderers.



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