markets yawn at the options rule

[Miklos Vasarhelyi <miklosv@andromeda.rutgers.edu>]

July 24, 2005

So You Think You Can Outsmart the Market. Good Luck.

By
MARK HULBERT

REMEMBER the debate about the accounting treatment of employee stock
options? 

The fight was intense. One side said that companies should be required to
count options as expenses, in order to give a truer picture of profits,
while the other said that such a move would lead to some companies'
financial ruin. Well, the rules did change: the shifts were announced in
December and took effect in June. 

The stock market, however, has had remarkably little reaction to the
enactment of the new rules. 

There is a lesson to be learned in this collective shrug, and it isn't a
pleasant one for investors. Put simply, it is that the odds of
outguessing the stock market are steep.

Until the rule changed, of course, companies were not required to record
an expense when they granted stock options to their employees. Supporters
of the old accounting rule said it gave start-up companies a fighting
chance to succeed, because they typically do not have enough cash to
attract and keep highly qualified employees. Companies in the technology
sector, in particular, lobbied strongly against changing the
rule.

Proponents of the change argued that accounting for options as an expense
was a matter of honesty. Allowing a company to hide the expense of those
options enabled it to report artificially higher profits, they said,
giving it an unfair advantage.

Last December, the Financial Accounting Standards Board voted unanimously
to change the rule, and the Securities and Exchange Commission is
requiring companies to expense options granted during fiscal years
beginning after June 15. That means the new rule has already taken effect
for companies whose fiscal years began on July 1; the remaining companies
will fall under its provisions within the next 12 months. 

So far, the change has had little perceptible impact on stock prices.
Investors do not appear to be behaving any differently toward companies
where the rule has already taken effect. In fact, the technology sector
has outperformed blue-chip stocks since the board's announcement in
mid-December. The Dow Jones U.S. Technology index has risen 0.4 percent
over that time, versus a loss of 0.2 percent for the Dow Jones industrial
average.

There are many possible explanations for the muted reaction. One is that
many investors were already taking option grants into account when
interpreting companies' income statements, according to Clifford S.
Asness, a managing principal at AQR Capital Management in Greenwich,
Conn. Even before the rule change, companies were required to divulge
details of their option grants in footnotes to their accounting
statements. So what they are now being required to report on their bottom
line could have been easily deduced by "anyone willing to spend 10
minutes with a financial statement," Mr. Asness said.

To be sure, not all investors were willing to do that work. Some dug no
further than the headlines on companies' news releases, and no doubt
their naïveté inflated the share prices of companies that relied heavily
on options. After all, according to Owen A. Lamont, a professor of
finance at the Yale School of Management, it was in the hope of
influencing this "dumb money" that many companies fought the
new accounting rule so vehemently.

We should not exaggerate the market impact of these naïve investors,
however. With thousands of hedge funds looking for overvalued stocks to
sell short, there is plenty of "smart money," in Professor
Lamont's parlance, to take the opposite side of the dumb money's bets.
Before the rule change last December, this smart money could have sold
short the shares of companies that tended to grant the most options. To
the extent that it did so, Professor Lamont said, these companies' shares
would have been beaten down in advance of the accounting change. That, in
turn, would have reduced the reaction the market would have had after
that change was announced.

Yet another reason for the barely perceptible impact is provided by
Jennifer N. Carpenter, an associate professor of finance at New York
University's Stern School of Business. In the long run, the change could
very well help the companies that grant the most options to their
employees, Professor Carpenter said, because the "discipline of
having to expense options may lead firms to grant them more thoughtfully
and efficiently." 

WHAT should we make of all this? Mainly that stocks' movements are very
hard to predict. Even if investors had known in advance that the
accounting standards board was going to change the rule, and when it
would take effect, it is still not clear that anyone could have made much
money.

This conclusion dovetails with the results of past research into what
makes the equity markets go up or down. One widely cited study was
conducted in the late 1980's by three economists - David M. Cutler and
Lawrence H. Summers of Harvard (Mr. Summers is now Harvard's president)
and James M. Poterba of the Massachusetts Institute of Technology. The
professors found that news events accounted for a surprisingly small
amount of the stock market's movements.

None of this relieves investors of the need to view companies' financial
data skeptically. At the same time, it's important to remain skeptical
about our own analysis whenever we interpret the data differently than
the market as a whole. More often than not, we're wrong. 

Mark Hulbert is editor of The Hulbert Financial Digest, a service of
MarketWatch. E-mail:
strategy@nytimes.com.

Miklos A. Vasarhelyi
KPMG Professor of AIS
Rutgers University
Director Rutgers Accounting Research Center
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