Tuesday, February 15, 2011

Examing NYT Op-ed "Wall Street's Dead End"

An op-ed by Felix Salmon in the February 13, 2011 New York Times seemed worth examining closely.

THE stock market has been big news in recent days. Last week’s report that Deutsche Börse, a giant German exchange, intends to buy the New York Stock Exchange, creating a company worth some $24 billion, arrived shortly after the Dow broke the 12,000-point barrier for the first time since before the financial crisis.

These developments drew headlines because they seemed to exemplify significant trends in the American economy.

Salmon doesn't explain what "significant trends" these two news items supposedly exemplify. I suppose the trends could be "consolidation of financial exchanges" and "the stock market is going up." But I don't think these news items got attention because they exemplify significant trends.

The NYSE / Deutsche Borse story got attention because it was an obvious and easy story. A potential merger gets announced, a press release goes out, and the story basically writes itself. The story got attention because many Americans, and all of those who read the financial news, have heard of the NYSE.

The Dow breaking the 12,000 barrier gets attention also because it is an obvious and easy story. It is a completely arbitrary milestone, but any reporter, even if he knows nothing of finance, can say, look, we crossed a threshhold.

In truth, the stock market is becoming increasingly irrelevant — a trend that threatens the core principles of American capitalism.

Wow - that sounds bad. Let's read on.

These days a healthy stock market doesn’t mean a healthy economy, as a glance at the high unemployment rate or the low labor-market participation rate will show.

The "these days" that opens the sentence suggests that at some point a healthy stock market did mean a "healthy economy." Is that true? First I'd like to understand a little bit more specifically what Salmon means by both a "healthy stock market" and a "healthy economy."

What I recall from business school is that the stock market is supposed to be a leading indicator of the economy. If you think things are going to improve in a year, you go buy stocks now that you think are relatively low-priced. If a lot of people believe that and follow your example, prices go up. But the economy doesn't pick up until later.

My recall is a bit simplistic, but is Salmon suggesting an even more simplistic interpretation: that stock prices should rise at the same time unemployment falls?

What if businesses are getting more productive - getting more work out of fewer employees? I'd want to invest in businesses that manage to do that. It is unfortunate that people are out of work, but it doesn't necessarily imply that businesses are doing poorly.

But the glory days of publicly traded companies dominating the American business landscape may be over. The number of companies listed on the major domestic exchanges peaked in 1997 at more than 7,000, and it has been falling ever since. It’s now down to about 4,000 companies, and given its steep downward trend will surely continue to shrink.

Simply listing the number of listed companies is playing with statistics. What about the relative size of those 4000 companies vs the 7000 from 1997? Is this necessarily a bad thing? Why is it a bad thing that companies are finding alternate sources of capital outside public markets?

Nor are the remaining stocks an obvious proxy for the health of the American economy. Innovative American companies like Apple and Google may be worth hundreds of billions of dollars, but most of them don’t pay dividends or employ many Americans, and their shares are essentially speculative investments for people making a bet on how we’re going to live in the future.

This is such nonsense it is hard to know where to begin.

Not sure why Salmon believes that not paying dividends makes innovative companies less than fully authentic investments. As an investor, I ought to care about my total return. If I buy a stock at 100, a year later I ought to be indifferent whether the stock price is 110 (I can sell it for a 10% return) or the stock price is 100 and I get a dividend of 10 (10% return). I have a 10% return either way.

Apple employs 38,600 as of September 2009. I'm not sure how many of them are U.S. Citizens, or what Salmon would consider "many Americans."

And I'd love to understand what stocks, according to Salmon, don't constitute a "bet on how we're going to live in the future." If you buy Pfizer, you're betting that we'll be taking pharmaceuticals in the future that are marketed by Pfizer. If you buy GM, you're betting that we'll be driving cars made by GM in the future.

Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money.

"Little more"? The stock market is also a place where many investors make a long-term investments. Speculators may affect prices of individual stocks in the short term, but over the long term the underlying assets will drive the returns.

If there isn't a long-term liquid market for securities after an IPO, then people won't want to invest.

What the market is not doing so well is its core public function: allocating capital efficiently. Apple, for instance, is hugely profitable and sits on an enormous pile of cash; it is thus very unlikely to use its highly rated stock to pay for any acquisitions. It hasn’t used the stock market to raise money since 1981, and there’s a good bet it never will again.

It takes some thought to unbundle the non-sequiturs in this last statement. Investors put money into Apple; Apple made profits; Apple now has cash to invest. How does that serve as evidence that in general the market is not allocating capital efficiently?

At the level of specific allocations, my sense is that managers historically as well as now make the decisions on how to allocate capital. Exceptions would be bonds that fund a very specific investment.

Meanwhile, the companies in which people most want to invest, technology stars like Facebook and Twitter, are managing to avoid the public markets entirely by raising hundreds of millions or even billions of dollars privately. You and I can’t buy into these companies; only very select institutions and well-connected individuals can. And companies prefer it that way.

While it might be true that Facebook and Twitter are the companies in which people "most want to invest," I haven't seen any proof of that. Is that Salmon's personal opinion or the results of some poll?

A private company’s stock isn’t affected by the unpredictable waves of the stock market as a whole. Its chief executive can concentrate on running the company rather than answering endless questions from investors, analysts and the press.

It would be interesting to ask the CEO of a portfolio company owned by one of the big private equity companies if he or she doesn't need to answer endless questions from investors.

Only the biggest and oldest companies are happy being listed on public markets today. As a result, the stock market as a whole increasingly fails to reflect the vibrancy and heterogeneity of the broader economy. To invest in younger, smaller companies, you increasingly need to be a member of the ultra-rich elite.

It may well be true that you need to be well-connected in order to invest in young, small companies, but there is no evidence presented here to support the "increasingly." Is the situation today really different from the situation decades ago? My hypothesis would be that small investors today have fewer opportunities than ultra-wealthy investors, but that the information gap and opportunity gap has gotten smaller over time.

And it is worth mentioning that many of these "ultra wealthy" investors are actually pension funds that pool the money of ordinary folks.

That burden comes largely from the Securities and Exchange Commission, which was created in the wake of the 1929 stock-market crash to protect small investors. But if the move to private markets continues, small investors aren’t going to need much protection any more: they’ll be able to invest in only a relative handful of companies anyway

So what is Salmon suggesting? Reduce the safeguards that protect small investors?

Civilians, rather than plutocrats, controlled corporate America, and that relationship improved standards of living and usually kept the worst of corporate abuses in check.

Really? Where is the evidence? I've seen statistics that show that a greater percentage of Americans own stocks today than decades ago.

And where is the evidence that ownership by small investors kept corporate abuses in check? I think laws like the Clean Air Act and the creation of the FDA had a lot more impact on corporate behavior than activism by small investors.

I'd actually posit the reverse: that large shareholders are much more likely to be in a position to affect corporate behavior.

Today, however, stock markets, once the bedrock of American capitalism, are slowly becoming a noisy sideshow that churns out increasingly meager returns. The show still gets lots of attention, but the real business of the global economy is inexorably leaving the stock market — and the vast majority of us — behind.

Salmon does make a good point that the stock market gets lots of attention - too much. The press report on the stock market because it is easy to do. Any financial news show including NPR feels the need to report how the Dow Jones average closed each day, despite the fact that the daily fluctuations are just noise. And it is also true, and interesting, that the serious trading volume is in bonds and derivatives, not equities.

But the argument that America once basked in a golden age of citizen shareholder capitalism that is now on the decline isn't supported by any evidence in this piece.

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