Bad News Not Cause of Bear Market

On Sept. 3, New York state Attorney General Eliot Spitzer (search) revealed his probe of mutual fund trading abuses. Boiled down to a sentence: Mutual funds allowed hedge funds to make no-risk trades after hours, with the profits coming from the pockets of unknowing mutual fund shareholders.

The financial headlines since have delivered a regular flow of related accusations, charges, resignations, settlements, etc.

A parallel market scandal has likewise made headlines. Ripples keep spreading from the New York Stock Exchange fiasco that began Aug. 27 when NYSE Chairman Dick Grasso's (search) $187 million pay package was made public. Page one of last week's Wall Street Journal offered two NYSE stories; one included a call for the NYSE to end its 200-year tradition of floor traders matching buy and sell orders from investors.

As financial scandals go, the Spitzer probe and NYSE tribulations are piercing indeed. They mock the deepest assumptions of fairness in the operation of the U.S. stock market.

Yet, you'd never know it by looking at the market itself. The major indexes have been climbing briskly. The NASDAQ (search) was up more than 10 percent from Aug. 26 to Oct. 16. Media chatter attributes this to "upbeat economic news," which is getting a lot more attention than the scandal stories.

These surroundings struck me as a bit too familiar. Once I thought hard enough about it, I realized why. Here's a hint: "Enron."

Ask the average investor today for his most lasting impression of the Enron (search) story, and he will likely describe Enron as the "cause" of a falling stock market "effect" in 2002. No event produced as much fretting about the "crisis in investor confidence." Remember?

The "pin-the-tail on Enron for the bear market" game even included a 127-page report from the Senate Governmental Affairs Committee:

"Perhaps most significantly, the company’s failure and the months of revelations that followed triggered a crisis in investor confidence in U.S. capital markets. The repercussions of Enron’s collapse continue to be felt today."

The "continue to be felt today" line underscored the report's exquisitely timed release: Oct. 8, 2002. One day later most major stock indexes fell to their new bear market lows. Connecting the dots back to the Enron scandal was simple. And simply wrong.

Investors, economists and most media types not only have it wrong about Enron and the stock market, they have the chronology backwards. The credit rating service Moody's downgraded Enron's credit rating on Oct. 30, 2001; Enron was a top negative story until March 15, 2002. But the bear market began in January 2000 some 22 months before Enron’s troubles first made headlines.

Just visit one of the many Internet sites that show four-year price charts of the Dow Jones Industrial Average (search). The Dow was near 9100 on Oct. 30, 2001, and climbed to about 10,600 by March 15, 2002. So during "the months of revelations that ... triggered a crisis in investor confidence," the stock market climbed -- yes, climbed -- some 16 percent. Standard measures of investor and consumer sentiment also rose strongly during the same period.

Reverse the logic for a moment. If "cause & effect" ran from the news to the stock market, this chronology would allow you to argue that the Enron headlines were driving the Dow higher. Sound ridiculous? Of course it does. But this particular causality argument is always ridiculous, because news does not drive stock market trends.

So the larger issue is not about Enron -- it's about what people see and think and remember.

Most investors believe "news" drives the major turns and trends in the stock market. The media reinforces this misperception nearly every day. They connect dots when the facts allow no connection whatsoever, as was the case with Enron.

Enron's shenanigans were there all along. Somehow, that fact wasn't "bad news" until the market turned down, and the Dow lost nearly 30 percent in the decline from March to October of 2002. The changing mood caused investors to sell stocks, and then become outraged at outrageous behavior.

Fast forward to now. The economy appears to be recovering, the stock market has been climbing for months ... and so today, conventional wisdom says the two things are related. The good news is good, the bad news is background.

Yet later, when the bear market resumes, let's say in one or three or six months, the conventional wisdom will -- presto! -- blame the decline on the very scandals that are all but buried now. Then the bad news will be bad, the good news will be vapor.

The bad news will have been there all along. Investors will just be choosing to pay attention to it as never before.

Robert Folsom is a financial writer and editor for Elliott Wave International, a financial analysis company. He has covered politics, popular culture, economics and the financial markets for 16 years, and today writes EWI's popular Market Watch column. Robert earned his degree in political science from Columbia University in 1985.