In the Twilight Zone (page 1 of 4)

I have argued before that the lack of any fundamental knowledge of the future prospects and earnings of listed companies didn't just apply to the Internet and the entire TMT (technology, media, and telecommunications) sector, but to most companies.

It was clear to me that the Internet was going to bring about a world of 'frictionless capitalism', which would in turn depress corporate profits, since most companies owed a good portion of their profits to friction. Friction does inflate prices, reduces competitive rivalry, and protects margins.

Profit-friendly friction does come in many guises. Customer ignorance is probably the most important factor, while local monopolies and lack of bargaining power for small businesses are others. The point was simply that the Internet would bring far more transparency to markets and largely eliminate these frictions, while B2B hubs would make it far easier for smaller businesses to band together in order to squeeze concessions from their suppliers - something that only large corporations had previously been in a position to do.

And although I wrote at the time that I believed a period of very disappointing corporate profits was coming, I overlooked one guise of the friction, which relates to the social mood of the investment community - or, to put it more bluntly, its ignorance and boundless credulity.

In the late 1990s, companies were able to book huge profits gains simply because few people cared how companies achieved these profits. In other words, the investment community - caught in a whirlwind of speculation and blinded by the bullish comments of business leaders, analysts, and Mr. Greenspan - was prepared to ignore all kinds of accounting gimmicks, stock buybacks financed with debt, dangerously speculative investment positions, and even blatant fraud in order to boost profits.

The situation in the late 1990s typified what the French sociologist Gustave Le Bon had observed more than 100 years ago in his classic work The Crowd, when he wrote that the crowd is 'not prepared to admit that anything can come between its desire and the realization of its desire', while 'the notion of impossibility disappears for the individual in the crowd'. For as long as stocks were rising, nobody really cared.

The social mood as a source of friction that can boost stocks and corporate profits has been extremely well analysed by Robert Prechter in a very insightful report entitled 'The Socionomic Insight versus the Assumption of Event Causality' in The Elliott Wave Theorist of June 1, 2002 (www.elliottwave.com). According to Prechter, the recent revelations of corporate fraud, including the Enron scandal, were 'not causal to any aspect of social mood whatsoever; it was a result of a change in social mood'.

He rightly points out that the stock market fell for months prior to the Enron scandal as 'this meter of social mood [the stock market] showed increasing negativity - involving conservatism, suspicion, fear, anger and defensiveness - all of which went into precipitating the Enron scandal'. In fact, Prechter argues that the Enron scandal did not discourage investors at all, since after the revelation of the scandal, in October of last year, the stock market rose and investors' bullish sentiment almost soared to a record level while at the same time consumer sentiment improved significantly.

Prechter also makes the following point: Corporate misdeeds are not even to blame for the bear market that preceded the eruption of the Enron scandal.