Wall Street accelerated the consumer credit revolution the same way it did the real estate bubble: It created a secondary market for credit card, auto loan, and retail paper by securitizing it collecting it in pools and then reselling it as securities called by such names as plastic (credit card) bonds, certificates for automobile receivable (CARs), and other variations of the generic asset-backed securities (ABSs).
For an example of how it works, say 1'm a merchant selling furniture. A customer buys a $5,000 furniture set with payments starting on some future date. I sell the paper to Wall Street, maybe to Merrill Lynch or another major firm, receiving $5,500, the difference representing interest and finance charges I would have earned had I held the paper myself instead of converting it to cash I could use to buy more furniture. Wall Street then pools the paper and issues securities that somebody in Japan, say, winds up owning at an effective cost of $6,000, that difference representing Wall Street's profit.
The point here is that the real price of the furniture set was $1,000 more than my customer paid, representing inflation that, having been created by easy credit, does not register as inflation. In effect, a lid has been kept on consumer prices because the merchant makes part of his profit on the interest.
What will ultimately happen, as the economy goes into recession and defaults begin to occur, is that the credit market will dry up. Then the Japanese either will not buy the paper at all or will demand much higher rates of interest for doing so. As a resulk, when the furniture dealer goes to Merrily Lynch with another $5,000 worth of furniture paper, he may find that they are no longer paying $5,500, but are offering only $4,500. That means the furniture dealer will have to raise his prices. That's when the inflation shows up.
So the Federal Reserve with its easy money policy was creating inflation that wasn't showing up as inflation because the cost of the credit was not in the price. As we saw in our discussion of the housing bubble, mortgage-backed securities were creating the same phenomenon.
Contrast the preceding example with a situation where the buyer saves instead of borrows. With interest compounded, the person with an eye on the $5,000 furniture set might have to put away only $4,750 to have the money needed for the $5,000 purchase.
Frequently hear the argument that the methodology used to calculate savings is flawed because it omits the accumulation of home equity or gains in the stock market. This naive attempt by Wall Street to wish away a chronic problem reveals a complete lack of understanding of the concept of savings and the important role that concept plays in a free market economy.
Savings represent consumption deferred to a future date. It amounts to a personal sacrifice, the deliberate postponement of immediate gratification. Savers make their savings available to finance capital investments that ultimately lead to increased productivity and rising standards of living. In fact, savings are the lifeblood of a market economy. Without savings, capital formation is impossible, and true economic growth cannot take place.
While it is true that home
equity may be an asset to an individual homeowner,
its existence in no way adds to society's stock of
savings.
Home
equity
does not
require the homeowner
to forgo anything or to free up any resources for use in capital
formation. In fact, the only way a homeowner
can tap his or her equity
is by accessing someone else's savings.
If the homeowner
does it
by selling the house, the buyer either uses savings
or borrows someone else's. If the homeowner
does it
by refinancing, the money he or she gets from the bank represents money saved by
others.
Therefore, not only does home equity not represent savings, it represents a potential claim on society's legitimate supply of savings. To the extent that it is used to finance consumption, it preempts savings that might otherwise have been used to finance capital formation.
The main reason American homeowners can access their home equity is that foreigners, whose savings ultimately provide the capital invested by their governments in U.S. Treasury and mortgage-backed securities, are willing, in effect, to lend them the money. Once foreigners come to their senses, mortgage credit will evaporate, and home equity will vanish along with it. Unlike legitimate savings that are permanent, provide real security, earn interest, and represent future purchasing power, home equity will prove ephemeral, disappearing as quickly as it appeared.
From an individual perspective, counting home equity or stock market gains as savings is analogous to gamblers Counting their chips while the card game is still in progress. Having a big stack in front of you means nothing if by the end of the game you're busted.
The same analogy applies to stock market gains. Rising stock values are not savings. Stock appreciation is clearly an as day. During the very month Katrina hit, personal income and spending data revealed a 1 percent surge in personal spending supported by a meager 0.3 percent rise in personal incomes. As a result the personal "savings" rate fell to what at the time was a new all-time record low of minus 0.6 percent.
Of course, as is always the case when disaster strikes, many naive economists looked for the silver lining in the hurricane's cloud, pointing to the spending necessary to replace what Katrina destroyed as being an economic benefit. What such simplistic analysis overlooks is that resources devoted to replacing destroyed wealth are no longer available to create new wealth. Americans would have to either reduce spending in other areas or postpone such reductions through borrowing. Of course, in typical fashion, Americans opted for the latter.
Since the country lacked true domestic savings, the funds necessary to rebuild the infrastructure destroyed by Katrina had to be borrowed from abroad. As a result, our external debt grew by that much more, exacerbating our current account deficit and representing a drain on our future consumption for generations to come. However, once foreigners no longer make their savings available to Americans, the real burden of natural disasters will be more apparent. This harsh reality will expose the fallacy of our phony savings substitutes and provide a needed catalyst for the re-accumulation of legitimate savings.
Of course, such a process will require significant under consumption, and therefore could not take place without an accompanying recession. For most that would be the real disaster.
What really roils me is that so many Americans have their necks overexposed to the risks of common stocks to start with. By that I do not mean that stocks are generically too risky, although I do recommend staving out of the overpriced U.S. stock market and dollar-denominated stocks. Stocks that are selected conservatively and pay high cash dividends are, in fact, my favorite investment alternative, especially where there is the prospect of currency profits, as I'm going to discuss later in detail.
But Wall Street has led the American public to think stocks have the safety of bonds. There's a huge difference, of course. Stocks carry all the risks inherent in business ownership Bonds are contractual loan obligations that must be paid before owners get anything. Because stockholders have all that risk, they should naturally expect a higher rate of return than bondholders. But Wall Street has fostered a myth that because shareholders enjoy unlimited upside (capital gain) potential, they Should settle for a dividend return that, if it exists at all, is often far lower than the interest rate on comparable bonds.
I also feel Wall Street puts an unhealthy value on potential Capital gains. Just look at the widely used formula for setting up an individual's investment program. You take 100 and subtract the investor's age. That determines the basic asset allocation. If the customer is 20 years old, you recommend 80 percent stocks and 20 percent bonds, and then adjust the proportions as the investor gets older on the reasoning that youth justifies risk and advancing age requires safety and income.
My
problem with that kind of thinking is that it assumes stocks
rise in value as
a function of time, that they are always a good buy regardless of valuation, and
that there's always going to be a pool of people that you can sell out to so you can
buy bonds
and retire on the interest.
As we'll see, though, the market has a well-earned reputation for perversity and
there have been long periods when prices
remained flat or declined.
Call me old-school, but I've seen enough of self-serving corporate management to make me want cash on the barrelhead. I want stocks that pay cash dividends and provide a higher yield than bonds do.
Wall Street has also muddled the distinction between investing and speculating. The argument that growth stocks of companies that plow all their net earnings back into the bussness reward shareholders with future capital gains assumes that the objectives of corporate managers and shareholders are the same that the two interests are in alignment, to use more elegant language. Now I'll grant that there have been many companies over the years where this has been true, and where investors profited handsomely from capital gains that, until recently, were taxed at a more favorable rate than dividends.
But to overpay for stocks that don't produce income and derive their attractiveness from the promise of future capital gains that may or may not materialize to my mind smacks more of speculation than investment Some stocks will gain, of course, but only at the expense of other companies, whose earnings shrink. If the market is trading at a given multiple, there have to be stocks whose earnings go up and stocks whose earnings go down. They can't all be winners.
Conflicts of interest are rampant on Wall Street and in corporate America, and the victim is the little guy. I started out as a broker with one of the big investment banks, and know from firsthand experience how Wall Street's symbiotic relationship with corporate America has operated to the disadvantage of retail investors. Year in and year out, the risks of common stocks are played down by firms that make their real money from advisory or underwriting services performed for client corporations.
Brokers are paid extra commissions to push certain stocks as favors to corporate clients or to move positions held by their firms acting as dealers. "Suitability rules" designed to protect investors from undue risk are treated perfunctorily as brokers pass spoon-fed recommendations off to trusting customers who think they're getting thoughtful advice.
On the research side, although stricter regulation has resulted from recent
scandals, analysts are under pressure to favor existing , or potential corporate
clients by assigning higher ratings than their shares
warrant or failing to assign negative ratings to inferior stocks
that retail investors
might otherwise avoid.
Lately, the interests of corporate executives and shareholders have diverged to a point bordering on or actually constituting scandal. The most infamous example, of course, was Enron, where shareholders walked away with nothing after criminal activities by top executives that were so complex and extensive they are being analyzed to this day. Here’s the point, though, and it’s a big one: if Enron had been forced to pay cash dividends, it could never have pulled that paper off!
There were so many other examples of corporate skullduggery at the expense of shareholders-WorldCom, Global Crossing, Adelphia, et al.-in the early 2000s that it really serves no purpose to go into them.
More significant than the laundry list of major scandals are practices we read about every day. Executive stock options that are timed and structured in ways that give managers incentives to make corporate planning decisions designed to maximize their personal profits at the expense of shareholder values are now commonplace. Just the salaries of top corporate executives have become so outsized as to penalize shareholder returns. Stock repurchase plans are often timed to create capital gains to benefit managers.
As this is written, a scandal seems to be breaking that involved the back-dating of executive stock options to capitalize on favorable stock price movements.
Wall Street has conditioned the public to think about stocks simply in terms of their prices. According to Wall Street, prices can only go up if one simply holds them for the long term. Most investors regard low-priced stocks as being cheap and high-priced ones as being expensive. The real fundamental value of the business those shares represent seldom comes up. This general misconception concerning stocks is evident even among my own clients. Whenever I call one to recommend a stock, the first question that I am usually asked is "What's its price?" My typical response is "What difference does price make?"
By itself, the share price confers no real information about the underlying value of the stock. Price is meaningful only when related to other factors, such as earnings, sales, book value, and shares outstanding. When such factors are considered, a stock selling for $5 per share can be expensive while another selling for $100 per share can be cheap.
That's why the public is so confused about stock splits, where a stock's perceived value is enhanced simply by reducing its price, with investors ignoring the increased number of shares outstanding. Stock splits originated because under the old system of trading and commissions odd lots (increments under 100 shares) were expensive to trade, so splits made it easier for small investors to trade in round lots.
For similar and equally foolish reasons, investors believe that it is easier for a stock selling at a low share price to double than for one selling at a high price. However, price is meaningless, as a company's earnings would have to double for the real value of its shares to double, which of course has nothing to do with price. If it were really easier for low-priced shares to rise, perpetual stock splits would rule the day.
The only reason low-priced stocks tend to move faster is that most are less liquid and often manipulated. If it were true that low prices meant faster appreciation, all high-priced shares would split, not at $50 or $100, but at $10, $5, or even a dollar. In most Asian markets, share prices below $1 are the norm, even for billion-dollar companies. However, their prices appreciate no faster as a result of prices being lower.
Wall Street's failure of responsibility is glaring even where clear conflict of interest isn't the issue. I strongly believe Wall Street deserves much more opprobrium than it got for its failure to discourage in a proactive way the naive investor behwior that drove the dot-com bubble. Sure, brokers were only giving customers what they wanted, but I strongly feel they had an implicit fiduciary responsibility to make investors aware of the insanity they knew they were witnessing.
At the risk of sounding unctuous, I don't mind saying that I personally sleep at night with a clear conscience. When other brokers were riding the tech-stock wave, 1 spent many hours persuading my clients to avoid the foolish risk of buying stocks without earnings. "But it's a long-term investment," I'd hear. "Sure, in a company that will not even be around in the long term," 1'd tell them, and more often than not I was right. At Euro Pacific Capital, I do no investment banking. I don't make markets or act as a dealer. I am purely a retail broker specializing in stocks that pay cash dividends, and I plan to keep it that way.
But Wall Street, I'll say again, is rigged against the little guy and I see no signs of that changing, either.
Mutual funds are an overrated investment heavily promoted by Wall Street. During the latter 1990s, as I was still cold-calling prospective clients, a typical question I would ask those who professed to be invested in mutual funds was "What is the yield you are earning?" Of course it was a loaded question, as dividend yields at that time were next to nothing, if not zero itself. Even if the stocks that the funds owned paid some minimal dividend, they were not high enough to offset the fees charged by the funds. However, the typical answer to my question was "My funds are yielding about 20 percent per year." What my prospects were doing, of course, was confusing yield with past performance. How much a fund's share price had risen over the years has nothing to do with its dividend yield.
However, shareholders typically confused illusory price appreciation with actual dividend yield.
Another major problem with mutual funds, and one rarely understood or seldom discussed, is the concept of relative versus absolute performance. Investors of course should be concerned with the latter; however, managers are far more concerned about the former. That often overlooked conflict of interest is vitally important and is the principal reason that most mutual funds will underperform the market in the long run.
This
conflict arises from the way fund
managers are paid and the way funds
themselves are marketed. It's all about short-term quarterly performance,
relative to either a benchmark or competitive funds
with similar objectives. Therefore, no manager
wants to underperform and no fund
wants its recent performance
to compare unfavorably to the performances of its competitors. This reinforces
speculative behavior and causes fund
managers to chase performance
by buying overvalued stocks,
the prices
of which keep rising as more funds
buy.
Then those funds buying such overpriced shares post impressive relative performance numbers, which results in increased inflows from performance-chasing investors. Those funds need to be invested in those same overvalued shares that goosed the performance in the first place, and it is a self-reinforcing cycle. When it ends, of course, the share prices collapse, and long-term investors lose big. However, the managers already earned their bonuses, and since all the funds collapse together, no one cares as no one's relative performance suffers.
Assume a diligent fund manager, with the good sense not to buy the overvalued shares, who instead invests in undervalued companies. The prices of such shares could languish for years before finally rising to reflect the true value of the companies they represent. While such a strategy is fine for investors, it Could be disastrous for fund managers, who would likely lose their jobs long before such investments paid off.
In the final analysis it does mutual fund investors
no good to
pay managers
big-time fees for impressive short-term perfor malice when by the time investors
need their money it's all gone. What is important to investors
is absolute, long-term performance,
which is the furthest thing from the minds of most fund
managers.
If you think mutual funds aren't a flagrant enough example of conflict of interest, try hedge funds. Once relatively obscure bastions for the superrich, hedge funds, which are largely unregulated and exempt from disclosure requirements, have become the current rage, now numbering around 9,000 and holding over $1 trillion in assets. Their managers, the latest crop of gazillionaires, conventionally charge a 1 to 2 percent annual management fee plus 20 percent or more of the quarterly profits. You heard right: 20 percent or more of quarterly profits.
Since "hedge" means to protect against risk, it's ironic that the conflict of interest in hedge funds exists because of heightened risk taking, the very thing hedging was supposed to minimize.
Although, to be sure, the hedge fund universe has its share of exceptional managers, too many of the impressive returns boasted by the industry are produced not by outperforming investments, but by investments with ordinary returns that excessive leverage has turned into huge dollar windfalls on which managers base their 20 percent performance fees.
There's actually very little hedging being done. Most hedge funds would be more accurately termed "risk funds" or "ultra leveraged funds." For example, a yield of 8 percent might be achieved by buying junk bonds. But leverage it up 10 times by borrowing
money at 4 percent, and you magnify the return over fivefold.
In other words, simply by assuming additional risk, an 8 percent return is transformed into a 40-plus percent return through the magic of leverage. If a$1_ billion hedge fund specializing in junk bonds merely leverages up 10 times, an 8 percent return becomes a windfall of more than $400 million, That gives the manager a payday of $80 million.
Hedge fund investors, trusting the expertise of hedge fund managers, are accepting risks they would never assume on their own and giving away 20 percent into the bargain. The hedge fund managers are taking a ton of risk, but with other people's money, not their own. When the risks pay off, the manager gets 20 percent. If the risk goes bad, the manager doesn't lose anything; he just doesn't gain anything. The investors take the hit. Heads, the manager wins. Tails, the investor loses.
Sure, when losses occur the fund
managers have to get back to the last high-water mark before they
can start collecting performance
fees again. But the effect of this is a moral hazard even greater
than existed before the loss: Now they have an even stronger incentive to push
the risk
envelope.
So that 20 percent performance fee creates a powerful incentive to use leverage and, since hedge funds tend to pursue similar strategies, they create short-term market momentum in the direction money is flowing. This tends to increase the paper gains for funds already positioned in those strategies, creating a lot of performance fees in the process.
The problems will arise when everyone tries to get out. The big paper profits will quickly evaporate when the momentum reverses, but that's the investor's problem. While the managers were raking in their 20 percent of profits each quarter on the way up, it's not as though they'll have anything to lose on the way down. They will gain as long as there's a profit. Managers can press a trend until it ends. There's no need to get out early, because there's no way they can lose. They can have their cake and eat yours, too.
Take the recent example of Amaranth, the $10 billion hedge fund that blew up in September of 2006. It lost better than 60 percent of its capital in a few short weeks as some highly leveraged natural gas bets went south. As those bets were paying off the managers made millions, but when they finally blew up, it ",as their investors who got creamed.
Did the Amaranth managers really earn their fat incentive fees for strategies that ultimately caused their investors to lose lots of money? Do you think they're going to reach into their personal pockets to help cushion the blow for their shell shocked investors? Don't hold your breath.
Because the risks of common stocks have a way of getting forgotten amid the dazzle of Wall Street's aggressive marketing, I think it's useful to take a minute to revisit the basics. If it sounds like baby talk, forgive me. I meet a lot of intelligent grown-ups who cry like babies when they bring in their stock portfolios.
Common
stock is simply corporate
ownership
broken down into units that can be bought and sold. When companies
become publicly traded, which happens by way of a highly lucrative investment
banking process called underwriting, the shares, which are traded on organized
stock
exchanges (like the New York Stock Exchange) or electronic stock
exchanges (such as NASDAQ), acquire a market
value.
That market
value is
based not just on what the shares are worth as a portion of the company's
equity, but on what investors in general
think they should be worth, anticipating corporate
and economic developments still in the future. The more assured future profits
seem to be, the more investors are willing to pay for the shares. In a nutshell,
that's what the stock market is basically about,
except for one
all-important thing, which is the risk that stock
investors assume.
Why Common Stockholders Bear the Greatest Corporate Risk
The fact that common stock represents ownership, whether it's ownership of General Motors or ownership of a lemonade stand, means that shareholders assume all the risk of business failure. Except for what they may have received from the business in the form of dividends, which are cash distributions made from profits, the owners (including common stockholders) in the event of liquidation rank last in terms of their claim on assets. Only after every bill is paid, all lenders and bondholders are made whole, and preferred stockholders take their share are common shareholders legally allowed in to rake the rubble.
In a going concern, common stockholders likewise stand at the end of the line when profits are paid out. Lenders, including bondholders, get paid their contractual interest before preferred dividends are paid, and whatever is left is either paid out as dividends on common stock or retained in the business as ownership equity.
How Stocks Are Valued
Stocks, of course, come in all shapes, sizes, and degrees of quality, but their prices tend to be a function of what the underlying companies are expected to earn.
If you were to try to buy a corner cigar store from the retiring owner, for example, you might agree to pay a price of, say, 10 times the store's annual earnings. That would be typical for a business that has an established and reliable Customer base and is mature in the sense that it is not likely to see any marked increase in sales (in which case you might pay a higher multiple). In the case of large, publicly traded companies, a stock's value-whether it's overpriced, under priced, or fully valued is usually measured by its price-earnings ratio, called its P/E or its multiple.
By itself, the dollar share price carries no information with respect to value. The P/E, however, which can be expressed as "trailing" (meaning the current market price is divided by the average earnings per share over the prior 12 months, or as "forward," meaning the current market price is divided by estimated average earnings for the next 12 months), provides an indication of whether a stock is cheap or expensive, particularly when compared to its industry peers.
As we will see when we look at the history of market
cycles in the next section, the overall market
P/E, based on an index such as the Standard &
Poor's 500 index (S&P 500), gives an
indication as to whether
stocks
in general are over- or undervalued
by historical standards.
Other Valuation Ratios
The P/E, although the most widely used Valuation tool, is not the only one. Among the others are the price-to-sales ratio, which has the advantage that sales are less subject to short-term variability than earnings, and the price-to-book value ratio, which relates the stock price to value of the company's net assets and is a very rough indication (because assets are depreciated, valued at the lower of cost or market, or otherwise not reflective of liquidation value) of how the stock value relates to the net asset value.
The P/E's main limitation, however, is that by relating price to earnings, it ignores dividends. Thus, for our purposes in comparing individual stocks, we would want to look at the stock's dividend yield. The dividend yield, called simply yield, is the current market price divided by the annual dividend (i.e., the latest quarterly dividend multiplied by four). Like the P/E ratio, yield is most meaningful when a company is compared with industry peers. Public utilities, for example, have higher yields as a group than stocks in other industries, where earnings are less predictable.
Like P/E, the overall market yield, as represented by an index like the S&P 500, is a useful tool for determining whether stocks in general are over- or undervalued by historical standards.
A Caveat Regarding Dividend Yield
One caveat regarding yield: American companies place a high value on the consistency with which they pay out dividends. This is in contrast with companies in the United Kingdom, which routinely raise and lower dividends as earnings vary. An American company would lower or eliminate its quarterly dividend only as a last resort to conserve cash. What this means, ironically, is that a higher than average yield can be a sign of financial problems.
Say, for example, XYZ company sells at $100 a share and pays an annual dividend of $3, giving it a yield of 3 percent.
Then something happens that will affect corporate earnings adversely, and in reaction to publicity the stock drops to $50. The company, confident the problem can be solved and wishing to preserve its history of consistent dividend payments, keeps the dividend at $3, which has the effect of raising the yield to 6 percent. An investor attracted to the higher yield would be well advised to investigate the earnings problem and make sure it's not going to result in a lowering of the dividend if the company is forced to conserve cash.
Obviously, the point here is that no investment decision is made on the basis of one ratio. The fundamentals of every investment should be analyzed and the company's financial strength and earnings prospects confirmed.
