Enough Blood on the Streets?

Enough Blood on the Streets?

Don’t say you weren’t warned about the problems in our wobbling economy.

Back on September 10, 2007 I issued a warning about the state of our economy, and the effect that the current mortgage crisis would have upon it. So far, my fears have only partially come to fruition. The S&P 500 has fallen 12.9% from when I blogged, and 19.11% from its high a month later. The DOW has fallen 21.42% from its high. And I am afraid that there will be more “blood on the streets.” (More about that later.)

When I entered the investment business (too many years ago) I did a lot of reading about the stock market. I studied the market’s behavior and its underlying fundamentals, and I saw that, oftentimes, the two did not match. Back in the days of J.P. Morgan and Jesse Livermore, Joe Kennedy and Jay Cooke, it was easy to understand how the “market” would behave in an inordinately insane manner. It was manipulated and there was no regulation. “Inside information” was a commodity that was freely traded for profit.

When FDR started the Securities Exchange Commission, he chose one of the most knowledgeable stock manipulators to be its first chairman. Who better to regulate them?

Today, we have a whole new breed of manipulators roaming the planet free from regulation. Now, manipulation is only part of our problem; the issues are far more endemic than this, and part of the blame must go to the Fed, particularly to Greenspan. But manipulation is an area that makes great fodder for a blog.

The manipulation is taking place on several levels. There is a whole new breed of unregulated fat cat on Wall Street—the Hedge Fund. With trillions of dollars under management, these financial behemoths can exert their financial will with little fear of reprisal. How can this be, you ask? Easy. The Securities Exchange Act of 1933, the Investment Company Act of 1940 and the Employee Retirement Income Security Act of 1974 (ERISA) were all put in place to protect the little guy. Exceptions to Investment Company Act were created for larger, “sophisticated” investors, with the expectation that these guys knew what they were doing. Voila! Regulation D. A safe-harbor loophole in protection from regulation big enough to fit a small planet.

To be fair, for many years this loophole was a welcome thing that allowed oil to be found, buildings to be constructed and companies to be started. I have been part of dozens of these arrangements, usually in the form of Limited Partnerships, which funded such things as genetic research, the musical “Les Miserable,” a new magazine, a beer company and buying a glitzy Palm Beach hotel (where they had to give me a tie at dinner when I was checking the place out). People would make and lose money, but few of the unsuspecting were ever hurt. And the economy didn’t suffer, at least too much. There were big repercussions in the early 1980s when Reagan created tax legislation that favored long-term investing over tax avoidance. This helped bring on the Savings and Loan crisis in the 80s, as much of the tax-driven real estate collapsed. But we got through it okay. Only about $500 million out of our pockets.

In the 1990s, we had the tech revolution and a booming stock market that grew wildly out of proportion. Money managers looked like geniuses. A few even did better than a chimp throwing darts. But, even if you did worse than a chimp, you still looked good.

Mutual funds have loose limitations on the compensation that can be paid to managers. Some of these limitations come from shareholder groups who act as fee watchdogs. So, it was hard to earn more than five or ten million a year, even as a star money manager. In the 1990s, institutional managers, who managed private money, were locked in a price war. This was driven by the big RIA firms like Callan, Wilshire, SEI, Russell and Cambridge who carefully analyzed fees and all sorts of voluminous stats that arise from Modern Portfolio Theory. Fees really do affect risk adjusted return, and the pros know this. So the firms kept the money managers honest.

But the 1990s spawned a new form of investor hunger. People left their jobs to become day traders. Old ladies (probably even some Varicose Vigilantes) cashed in their CDs and bought tech funds. I had a 73 year old client who threatened to fire me in late 1999 because I refused to put his portfolio entirely in technology stocks. I had him in a much more conservative portfolio (and rightfully so!).

With their gaudy returns, intrepid money managers discovered a new way to market their wares and earn billions in the process. The HEDGE FUND. Using use loophole like that discussed above, they went to big investors predicting huge returns. And, as an unregulated hedge fund, no longer would they be burdened by those silly limits that mutual funds have on borrowing money. With some capital in place, they planned to borrow large sums of money (at historically low interest rates) so that these gaudy returns would become magnified, even astronomical! 100% returns. 200% returns per year. Guaran-damn-teed. And the hedge fund manager earns just 25% of the profits. A small pittance for creating such riches. It all looked like a slam dunk. So the managers borrowed, and borrowed and borrowed. And they invested in things for high return, because they were still sure that they were brilliant. They invested in mortgages, using them as collateral for their loans, while making money on the interest rate “spread.”

With the mortgage industry manufacturing loans like a Detroit assembly line, the hedge fund managers built computer based algorithms that took supercomputers to analyze, “proving” that this was a golden goose with no downside. Awash in capital, with access to trillions more in borrowed funds, the hedge funds became willing accomplices in our next investment crisis.

Oops. The world doesn’t work this way that they thought it would. There is no golden goose. There is just a goose. And if you have ever been around geese, you know that they leave a lot of goop on the ground behind them. No, the stock market is a reflection of the human condition. And mankind doesn’t change very much over the years. Neither does the basic market. When you really break it down, the bottom line to the stock market is profits. And overall profits increase only as productivity increases. Let me explain:

When you strip away the rhetoric, there are three major components to the market. There are current earnings. There is inflation. There is productivity growth. Everything else is superfluous. If a stock is selling for $100 per share, and it is earning $5 per share, an investor is earning a 5% current return on his/her capital. If a CD is paying me 2%, stocks look like a pretty good deal. Now, with no real business change, “gross profits” will rise over time with inflation. If inflation is 3%, and my company remains just as productive, earnings will increase with inflation over time. I get a return on my stock of 5% ($5 per share) plus 3% growth in value with inflation.* Now, if my company enjoys a 2% long-term productivity growth, this will increase my earnings more than inflation. So, if we earn 5% within the company, get 3% inflation and have 2% long-term productivity growth, we come up with a long-term stock return of 10%. (5+3+2=10). Omigod! This happens to be right about the long-term return of the stock market! It is really that simple.
*I am simplifying things above to illustrate my point. This example assumes that the company keeps its same price to earnings ratio (P/E) and that other short-term factors are ignored. In the long-run, these things really are essentially ignored, so the longer the time frame, the less the short-term factors matter.)
What makes the market churn is all that happens in the short run. We have high and low inflation, wars, recessions, expansions and changes in politics. We have all sorts of things to worry about. Oh, and we have manipulation.

The bottom line is, except for some inflation and productivity growth, investing is a “zero sum game” where there is an equal loser for every winner. And leverage multiplies the gains and losses. It makes big losers, with blood pouring onto the streets.

Why do we have the blood today? And how much will there be?

We have had a stock and mortgage market that has been blown out of proportion by “external” and “unnatural” forces. (Remember, the stock market is a reflection of the human condition. Most of us in the human race still have one nose, two eyes and two ears.) We have had a confluence of forces that joined together to create a bubble that may pop with a very loud, sticky bang.

We had the Federal Reserve lowering interest rates to ease the pain of the tech bubble. We had the real estate bubble and mortgage refinance boom, prompted by the lower Fed rates. We had pension funds (explained in my earlier blog) who were willing buyers of riskier and riskier mortgage CDOs. We had hedge fund managers awash in unregulated investor money, who borrowed up to ten times that amount. We had investment companies (Citi, Countrywide, Bear Stearns, Lehman, etc.) who borrowed at low rates and purchased huge chunks of the “golden goose” to make money on the spread. Much of this money came from the Fed window, like a bartender selling too many drinks to a drunk.

This was a financial orgy, a toga party befitting John Belushi. And it is coming to the same end that he did. Certain collapse. We have seen some of our largest banks on the verge of collapse. Our government has stepped in with hundreds of billions in direct cash. I suspect that there is much more that that going on behind the scenes, were the Fed lends money against worthless securities at full value. Investment companies have already written down more than $300 billion. And there is more to come. This will range into the trillions when all is taken into account.

There is this weird thing known as “reality” setting in. It always seems to happen, like a hangover. And who pays the price? The little guy! The little guy is the one who has to pay more at the gas pump and at the supermarket. The little guy has to watch his/her 401(k) dwindle in value. The little guy will feel the pinch of higher inflation for the next decade.

I thought there were laws put in place to protect the little guy?

Granted, there is pain everywhere. More than a quarter of the hedge fund have closed shop in the past year. (Imagine if this happened to the mutual funds in your 401(k). Ouch.) A few of the thieves will go off to jail. But fewer will be forced to return their ill-gotten gains, much of it in paper gains that never even existed. No fire sale on Nantucket and the Hamptons in sight.

And we all will slip on the blood in the streets. We might even recognize some of it as our own. Get ready for more bloodletting, and don’t be surprised to see the stock market drop further.

Footnote: In 1923, seven of the country’s most powerful men met at the Edgewater Hotel in Chicago. One of these men, Jesse Livermore, was known for shorting stocks (and creating cabals and rumors to drive them down in price) and buying back when there was “blood on the streets.” (his words). The other men at this gathering were Charles Schwab (who controlled U.S. Steel), Albert Fall (a man with strong political ties to Harding and part of the Teapot Dome Scandal), Arthur Cutten (a commodities speculator), Richard Whitney (president of the New York Stock Exchange), Leon Fraser (president of International Bank Settlement), Ivan Kruegger (a big monopolist). At the time, these men controlled more money than the entire U.S. Treasury. They were wealthy beyond belief. And they were all highly engaged in practices that would be illegal today. Eventually, two of these men would die broke, two went to prison and three committed suicide. J.P. Morgan, another huge monopolist, also died penniless and alone. I am not saying that these were bad guys. They pretty much did what was legal, and they prospered. But when you live by the sword…

I wonder how many of today’s preying carnivores will enjoy the same dark end?