Politics & Policy

Earnings-Gap Pap

Life after Sarbanes-Oxley.

Last Monday’s USA Today smugly reported that “Corporate America has finally cleaned up its act.” The catalyst? Unsurprisingly, it’s government regulation, and in particular, the Sarbanes-Oxley bill that passed in 2002.

According to USA Today’s Matt Krantz, the “intense scrutiny on accounting following tough Sarbanes-Oxley legislation” has resulted in a much smaller gap between operating earnings and the actual version that accountants require. Apparently the gap has averaged 21 percent since 1988, but has more recently fallen into the single digits (6.7 percent in this quarter) since the passage of Sarbanes-Oxley in 2002.

To Krantz, the “cleaner books” are related to the above-mentioned bill, and in his mind are “a welcome change for investors.” Rather than test his assumptions, Krantz chose to write of the improving investment climate as though it was fact; utterly unaware that market realities make a mockery of his basic assumptions.

If markets in fact preferred the new accounting, it would certainly show up in investor portfolios. The S&P 500 is up 22.6 percent since the passage of Sarbanes-Oxley on July 31, 2002. That’s an impressive two-year gain by most measures, but not much when compared to market returns prior to the bill’s passage.

Unfortunately for those advocating more regulation, the above number does not tell the whole story. Markets function most impressively for their ability to price in the future. While Sarbanes-Oxley passed in late July, it had been in conference for months, and its passage was assured on June 25, 2002, when Worldcom revealed that it had been engaging in fraudulent accounting.

The real story is that as investors became aware of the truth about Sarbanes-Oxley, they did not buy stocks in anticipation of its passage, but instead sold them at such a furious pace that the S&P 500 fell nearly 175 points over the next three weeks. In short, the markets did not wait for passage to price in regulations that would inhibit innovation and criminalize failure. The S&P’s return since June 25, 2002, is 14.6 percent.

What makes the USA Today piece even more irresponsible is its assumption about investor preference for narrower gaps in earnings. First of all, the reader is expected to agree that a less-than-2-year timeframe is somehow comparable to the 16 years when the average earnings gap was 21 percent.

Second of all, what makes the assumption embarrassing is the huge difference in market returns in the above comparison. Amazingly Matt Krantz wants us to believe that even though the S&P 500 is only up 22.6 percent since the passage of Sarbanes-Oxley, investors are somehow better off. This, despite the fact that the S&P 500 has risen 357.7 percent since 1988, the period in which corporate accounting has been supposedly less reliable.

The Yale School of Management’s Matthew Spiegel has said that Sarbanes-Oxley and other new rules have “put the fear of God” into executives. He’s right, and the result is that instead of maximizing time spent on innovation, executives are understandably immersing themselves in the minutiae of new accounting rules.

The ultimate judge of this new regulatory structure will be the investor. Market returns so far suggest that they might prefer the days of big earnings gaps, and big innovations.

John Tamny is a writer in Washington, D.C. He can be contacted at jtamny@yahoo.com.


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