With corporate profits at record levels and stocks regaining the
ground lost during the financial crisis, Wall Street anxiously
anticipates the return of the individual investors to equity markets. It
may be a long wait, because the little guy may have concluded stocks
are a sucker’s bet.
Investors, as opposed to traders, buy stocks in companies whose
profits they expect to rise. The conventional wisdom says stock prices
will follow profits up, but over the last two business cycles, that
simply has not happened.
In March 2000, the S&P 500 first closed above 1500. Since
corporate profits are up 135 percent but stocks have made virtually no
gain since over the last thirteen years.
Buying stocks does not seem to pay any more, because most of the
increased value created by higher profits has been captured by hedge
funds, electronic traders, private equity funds, aggressive M&A
shops, and trading desks at investment banks, which have multiplied over
the last two decades.
Their activities, essentially, fall into two categories. Aggressive
trading—e.g., exploiting complex shorting opportunities, quickly
detecting and exploiting movements in trading intentions of large mutual
funds and other tactics often associated with exotic hedged bets and
electronic trading. Direct asset purchases—buying underperforming
companies, all or in part, to force managers to pay out large sums,
rearrange their companies through mergers and divestitures, or exploit
unattended business opportunities incumbent managers have been lazy
about pursuing.
Not all of this is negative to stock prices or unfair.
Shrewdly synthesizing public information to identify value in
companies ahead of other investors is the way stars like Warren Buffet
became legends. Stock prices rise permanently in wake of their actions,
and that’s good for the ordinary investor already in the stocks they
pick.
Shaping up underperforming companies likely started even before the
first Greek shippers bought out rivals to discharge incompetent captains
and reduce seafaring risk, spread overhead and accomplish more leverage
with potters, weavers, farmers and foreign merchants.
Nevertheless, too much of a good thing—electronic trading and
aggressive hedging—can be disruptive and impose unnecessary risks. Look
at the costs imposed by the May 2010 Flash Crash, and consider how often
private equity and M&A shops acquire companies and load up them
with debt, make big payouts to dealmakers, and then later disappoint
investors and creditors.
Through superior information, quick execution and aggressive
marketing, traders and dealmakers capture a great deal of the potential
increase in value created by new and anticipated corporate profits
before that value is recognized in stock prices. This results in lavish
compensation for traders and dealmakers and stock prices that don’t rise
with profits.
Instead of ordinary folks getting a decent return in their IRAs—in line
with the rise in corporate profits—real estate prices in the Hamptons
and luxury goods sales at Manhattan’s finest stores soar.
Hedge funds, electronic traders, private equity and M&A shops do
act on information that is obtained through careful, legitimate research
but the ordinary investor simply does not have the resources to compete
with those efforts. Moreover, as several SEC investigations into
insider trading indicate, critical competitive information is sometimes
obtained through unethical and illegal means—data pried from incautious
corporate officials and through electronic espionage further
disadvantages opportunities for gains by individual investors and
conventional mutual and pension funds.
The ordinary investor is simply out gunned. For him stocks have become a rigged game.
Peter
Morici is an economist and professor at the Smith School of Business,
University of Maryland, and widely published columnist. Follow him on
Twitter @PMorici1
.
