Sunday, May 23, 2010

Unintended Consequences:
Investors Again Lose to the Politicians

Two quotes came to mind last week, the first was by New York Judge Gideon Tucker (sometimes attributed to Mark Twain): "No man’s life, liberty or property are safe while the Legislature is in session. The second was Will Rogers', “This country has come to feel the same when Congress is in session as when the baby gets hold of a hammer.”

We are about to watch the ultimate sausage manufacture of legislation, which continues a long line of unintended painful consequences to American investors, and much more importantly, to our economy. Soon there will be a conference committee named to resolve differences between the US Senate’s “Restoring American Financial Stability Act” and the House’s “Wall Street Reform and Consumer Protection Act.” As the various lobbyists and their dependent members of Congress write the new legislation (in which almost anything can show up), there is one almost guaranteed certainty. The ultimate result will not provide either meaningful stability or reform. This is not to say that there won’t be change. There are likely to be many changes, some large, drafted in the desire to help us avoid future problems similar to what we have suffered from over the last several years. Almost in a Newtonian fashion, the problem is that any legislative action will produce an opposite reaction by those beyond the Washington Beltway. If history is any guide, the unintended consequences will produce additional serious dislocations and risks to the soundness of investors and their retirement capital.


The legislation is an outgrowth of the clamoring by many “to do something” about the losses of capital, income, and most importantly, jobs. Unfortunately, changes in the rules of the game (like moving the goal posts in football), probably do not significantly alter the actions, ambitions, and the talents of the players for the most part. Throughout history, from Biblical times to the volatile trading of May 6, investors’ “animal instincts” drive people in the market place whether it is in the stock markets or the job markets. In a gross oversimplification, these are often summed up as fear and greed. (For those interested in these drivers, you may wish to read my book, MONEY WISE.) No law or regulation can prevent someone from buying something they shouldn’t own because they either do not understand it or can’t afford it. When there is a rush to leave a sports arena it is difficult not to join the exit rush.


There are many trails of unintended negative consequences created by various actions of governments. I could not list all of these, but let me start with one example and trace out some of the implications. Perhaps as a way to control compensation for executives, the IRS limited the tax deductibility of compensation expenses over $1 million dollars, unless the compensation was tied to performance. Within a year after the passage of this diktat, companies found ways to measure performance. Often these were earnings and revenues among other statistical measures. (Note that there were no restrictions on how these success ratios were to be achieved.) In some cases, executives could be richly rewarded but the investors suffered as their stock prices declined. In partial answer to these complains, the movements of stock prices were included in the reward criteria. Most often there was a comparison against a general market index as well as a narrow and hopefully more relevant subset. As CEOs were now less likely to be founder/owners, they looked to their compensations as their payoffs for doing a commendable job. Thus these professional managers now had to worry about relative stock price movements.


This change in motivation set off three impulses. First, managers manage against the time period for their assessment, which in many cases led to more short term decisions. Often these short term decisions postponed longer term benefit to the shareholder. Second, my fellow analysts were quick to sense the change in management’s focus and they also became more short term oriented. Further they understood that relative performance ranking became increasingly important. In turn, this could lead to building mathematical models in order to predict stock prices in the short term. (Later on, these and other mathematical models have led to the development of algorithms which some traders now use exclusively.) The third impulse was to view defined benefit pension plans as profit centers to hopefully produce the equivalent of earnings. At all costs, significant pension losses were to be avoided. (Again the long term investment value could be sacrificed for the benefit of this year’s financial statement.)


As the concern to protect the corpus of the pension fund progressed, many institutions were attracted to “portfolio insurance,” which was an approach that in part, used futures to hedge the market. When the market went down, futures were sold, or in effect, “puts” were put on. The more the market declined, the more “insurance” was placed. Thus in the aftermath of the 500 point drop in October 1987, when the market rallied sharply, the results for some funds were disastrous. To avoid a repeat of this type of automatic trading, once the market started to drop midday on May 6th 2010, many statistical traders cancelled their automatic buy programs. This purported action may well have led to the 997 point intraday loss. (Sometimes it takes awhile for unintended actions to explode.)


Last week the news was full of European debt and related problems as well as some disappointing domestic economic news. Not only was the Senate passing a stability act but there was also legislation attacking the capital gains treatment for “carried interest.”

Perhaps investors showed their fear of the unintended consequences of the week that ended on Thursday, May 13th, when we saw a “normal” year’s net asset value moves in only five trading days. There were twelve fixed income funds up 5% or more for the week and eleven down 5% or more. We saw twenty equity funds up 25% or more and ten that were down a similar amount. What is important to note that is all but one of the equity funds that gained were those with a dedicated short bias. The next best performing group was funds that held general US Treasuries, which was up about 3%. To put this calendar week in perspective, one stock, T Rowe Price (NASDAQ: TROW), perhaps the highest quality publicly traded mutual fund management company (and a personal and fund holding) ended the week at $50.99 after hitting a low of $47.32 and a high of $54.01. Another indicator of the fear in the market place is the VIX which measures the fear level surrounding the S&P 500. VIX is now about 45 compared to close 15 a few months ago.


What this means to investors is that we are likely to see more swinging markets for there will be fewer swingers on the dance floor, another unintended consequence of government intervention.

What do you think?

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