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of all guest columns written by Dennis C. Butler, CFA
One of the greatest economists of the early part of the twentieth century is now remembered (when he is thought of at all outside the limited confines of the community of dismal scientists) for an ignominious remark made at the height of the great stock market speculation of 1929. Yes, Irving Fisher, despite pioneering work in the quantity theory of money and interest rate determination, is best known for the ill-advised and ill-timed statement that stock prices had reached "a permanently high plateau." Perhaps Fisher can be forgiven for not having had the benefit of a recent study indicating that forecasting really isn't worth the effort after all (as many of us have long suspected). Latter-day economists and Wall Street prognosticators, even if they choose to ignore such hard evidence, would be well-advised to take heed of Fisher's fate and think twice before making predictions about the stock market!
The pattern of action in the financial markets over the past several months brought Fisher to mind and points to another reason why we can at least sympathize with his having jumped to such a hasty conclusion. After their leap in 2003, today's markets have apparently also reached a plateau, and at an uncomfortably high level. We are now witnessing the psychological tendency to believe that current circumstances, if they have persisted long enough, will continue for some indefinite period into the future. On Wall Street, complacency has set in, and attention is focused not on the risks inherent in markets where all assets are richly valued, but instead on whether this year's gains will be larger or smaller than average. Intrusive external factors involving international politics and economic policies, in addition to the extended valuations, have indeed brought a pervasive nervousness to the marketplace, but this does not seem to be translating into much serious concern about market levels or the risks that certain players, such as hedge funds and banks, have been incurring. Despite some griping about high prices, the money keeps pouring in.
Consistent with a market plateau, gains have been slim so far this year following 2003's sizable runup in stocks. Most of the major stock averages spent the past six months a little above or below the unchanged mark, but a little spurt of buying toward the end of the second quarter produced some positive numbers for the half-year. The popular Dow Jones Industrial Average still showed a small loss of -0.2% at quarter's end, but the S&P 500 gained 2.6%. In addition to the general unease noted above, upward price movement has been inhibited by anticipation that the Federal Reserve would begin to raise short-term interest rates to curb rising inflationary pressures in an expanding economy. Longer-term fixed income instruments � those most sensitive to monetary debasement � haven't waited for the Fed to move to decline in price, thereby pushing up yields. The ten-year treasury note, which only a year ago yielded just over 3%, returned about 4.6% on June 30, representing a significant price drop over the period. Small wonder that plus signs were hard to find in the fixed-income markets as well. The shortest-term paper � treasury bills � returned a meager, but positive, 0.4%.
Meanwhile, those of us responsible for allocating investor capital have faced some unpalatable and necessarily tough choices. With pockets of "value" few and far between in an environment where all assets worth considering appear overpriced and expected returns are not worth the risk, low-return cash equivalents are the fallback choice; they may not earn much, but they don't lose money either. For owners of capital impatient with such talk and less concerned about taking chances, there are always alternatives. The alternative of choice in recent years � at least for the well-, and, increasingly, the not-so-well-heeled � has been some flavor of hedge fund. The gunslingers of Wall Street, these trading operations now number over 8000, up from about 2100 since 2000. Aided by the downturn after 1999 and the desultory markets of late, hedge funds have attracted enormous amounts of capital (upwards of $1 trillion versus $400 billion three years ago) in a world-wide scramble to embrace risky assets. (Incidentally, in typical Wall Street fashion this big vote of confidence in hedge funds has occurred just as their trading gains have been declining.) Such rapidly emerging fads always lead to trouble somewhere sooner or later. It seems that Brazil has been particularly indulgent of the funds, even permitting middle class individuals to participate in the fun. The usual heavy losses and lawsuits have followed in due course. The moral is, in all things involving finance, avoid doing what everyone else is doing, especially when your pockets are not as deep.
On a somewhat related matter, it is worthwhile noting that recent statistics indicate "program trading," a term encompassing various computer-generated trading strategies used by hedge funds and others (and which, rightly or wrongly, was implicated in the 1987 stock market crash), now accounts for over 50% of trading volume on the New York Stock Exchange. We have long marveled at the credence given volume figures by certain speculators hoping to divine the markets' future moves. True investment activity, always small, now represents but a minuscule fraction of trades, so what is to be gained by speculating on speculation?
The Agency Problem
Much press attention, legislation and regulatory action in the years since Enron and other scandals has taken aim at corporate governance matters. The Sarbanes-Oxley Act, for example, was intended to increase corporate management=s responsibility for accurate reporting to shareholders. New and proposed accounting standards require public companies to more fully and accurately record revenues and expenses (or at least reveal them in footnotes). Under consideration is a move to permit more shareholder democracy by opening up the director nomination process to shareholders under certain circumstances. The movement towards greater openness, independence and accountability has also reached the investment business after numerous scandals involving, fundamentally, conflicts of interest between fund managers and shareholders. A series of fund companies have been forced to pay fines and restitution to those shareholders. In June the Securities and Exchange Commission, in a close decision that was widely opposed in the industry, ordered that the chairmanship of a mutual fund must be held by an individual who is independent of the company that manages the fund (most people probably are not even aware that a fund and the company that manages it are two different entities.).
While most of these changes are welcome, it is instructive (although, as we shall see, not encouraging) to note that the underlying problem is not new. In 1932 Adolf Berle and Gardiner Means, in their The Modern Corporation and Private Property, defined what is known as the agency problem in corporate affairs. The issue involves the potential conflicts of interest that arise when responsibility for the management of an asset is separated from the ownership of that asset. In the case of a public corporation, ownership is widely diffused among many shareholders, few of whom have an intimate knowledge of the inner workings of their company. Management, on the other hand, has extensive knowledge of the enterprise, in addition to having its hands on the reigns of power. The interests of management (greater salaries and bonuses, a larger domain) often have come into conflict with those of the owners (higher profitability, cash flow and dividends). Management usually gets its way simply because it can, but conflict sometimes erupts when management greed gets out of hand, or when times change and the activities of the managerial class come under greater scrutiny. There has as yet been no real solution to the agency problem, and there probably will be no permanent way of coming to grips with it. Institutional and legal controls may help temporarily, but in the end there is just no substitute for having at the helm people of character who take their positions and responsibilities to all interested parties seriously. Unfortunately, there are too few such individuals to fill all of the available slots.
In the investment business the agency problem arises in a similar fashion when owners of capital hire someone else to manage it for them: in this separation of ownership and management, interests sometimes diverge. As with corporate managers, money managers are very interested in high salaries and bonuses. Empire-building is also no stranger to fund management as evidenced by the tremendous growth in fund assets over the last decade. We are all for greater accountability and independence in the investment business. However, we would caution those who invest their funds through mutual funds and the like not to expect to see much in the way of improved investment results (although potentially lower expenses might help). The money management business is beset by other, in our view, equally serious problems caused by competitive factors that the current reforms (or any regulatory scheme for that matter) do not and probably cannot address. Investment is an activity best done with a minimum of bureaucratic interference and maximum room for individual judgement and decision-making (even the size of the fund is less of an issue when competent individuals can make decisions with a minimum of hindrance). To the extent that new rules hamper the ability to make timely, decisive judgements, investment results will likely not be improved in spite of a funds' more honest dealings with its shareholders. As with corporation managements, there is no substitute for working with people of character and ability.
If you want something in the worst way, you'll get it in the worst way
It used to be that in the old days investment bankers worked to protect security buyers from issuers of unsuitable or worthless securities. The banker's livelihood, therefore, depended on a reputation for honesty and integrity. As the scandals involving investment bankers and stock analysts during the late 1990s showed, the old ways of doing things are long gone. Nevertheless, bankers, in their role of setting the prices of new issues of securities, still serve to put the brakes on rampant enthusiasm on the part of buyers. That this is not a scientific process is evidenced by "money being left on the table" when, during speculative market conditions, the prices of highly sought-after new issues of stocks often soar when they open for trading.
Certain technology-oriented companies are seeking to get around this problem (that is, of leaving money on the table) by using an auction process to issue shares directly to the public, thus doing away with the banker middleman. Presumably this arrangement would permit more individuals who wanted shares to buy them, but we are not sure that this increased financial democracy would result in the greatest good for the greatest number. After all, the objective is to maximize the issuer's take by removing the brakes and letting the price adjust to meet the demand. There may be less money left behind, but there would also be less chance of a price "pop" to please buyers. It may take getting burned a few times by this process to prove the worth of the middlemen.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation,
investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in
Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: [email protected]
URL: www.businessforum.com/cscc.html
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