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You'd think the market would be leaping off all this news. But it's not. Clearly, there is a significant disconnect between the economy and the market. Since most people agree that the disconnect cannot go on forever, at some point the economy and stock-market performance must converge. The big questions are: When? Who will do the converging? And will the economy adjust to reflect financial-market performance, or will the financial markets turn around to reflect the economic recovery? The bearish case — that the market woes presage a double dip and some hard times ahead — is easily made these days. But a bullish long-term market outlook can coexist with the recent disconnect between the economy and the market. To do that one must make the case that the recovery is real while the market decline is temporary. And the temporary market weakness can be attributed to the uncertainty related to the determination and valuation of future earnings that came with Enronitis. Enronitis is the catchall phrase for issues relating to corporate governance and disclosures. Outright accounting fraud (i.e. Enron) is just one of the issues at hand. The valuation of defined benefits plans (i.e. IBM) is also part of the problem, and then there are the potential effects of swap arrangements by GE and other large-cap companies. After that, we can lump in the valuation of complicated financial structures that relate to GE; billions of dollars in off-the-books debt as in the case of Adelphia; the practice of so-called round-trip trading as in the case of Dynegy; and recent problems with top management at Tyco. All these examples are leading investors to question the veracity of future earnings estimates. So it is clear that Enronitis is too big to ignore. It is like walking through a minefield — if an investor doesn't know what to look for, their portfolio performance could easily blow up. But the negative impact of Enronitis on stock prices will not be uniform across companies. Those stocks whose values depend more heavily on future profits will tend to decline the most. In other words, Enronitis will affect growth companies much more heavily than value companies. Similarly, the larger companies with pension plans and more complicated financial structures will be much more susceptible to the Enronitis virus. Not surprisingly, the small-caps have been performing better than their larger-cap counterparts. Doubts about future earnings estimates can be devastating to the overall market valuation. In order to get a handle on valuation one needs to come up with reliable estimates of future earnings. Here lies the problem. There are so many "official" earnings estimates available that the information content seems to have declined as the number of estimates has increased. So what we need is a new measure of earnings, and the market will do so in due course. But in the meantime people are in effect giving haircuts to the current earnings estimates in order to get at "more realistic" numbers. These haircuts are producing one-time downward adjustments in valuation. This is de-levering the market and a producing a corresponding decline in value. So we now have an explanation for the current market woes. And all you need do now is believe that earnings — once adjusted — will eventually begin growing at a rate consistent with the economic growth. Today's positive productivity story is for real. As a result, a real GDP growth rate in the 4% range is sustainable, with inflation in the 2% to 3% range. The market will reconnect with our sound economy once the lingering effects of the Enronitis virus are wiped out.
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popular theme among financial analysts is the apparent disconnect between
the economic recovery and the financial markets. Manufacturing is on the
rebound, residential construction is at a record high, inventories are
low, productivity growth is really good, and there is no inflation. What
could be better? 
