Great Expectations

September 15, 2003

The market just won’t quit. The S&P500 was up just under 2% in August and the Dow was up about 2.25%. The real excitement remains with the Nasdaq index, which was up around 5% for the month. Small caps stocks stayed hot, also up almost 5%. Bonds rebounded from huge loses in the previous month; the long bond index was up 1.75%. 

Investors these days expect a lot from the companies they are buying stock in over coming years – earnings have to grow to meet current high expectations. Investor’s expectations tend to be wrong, not just about earnings and stock prices, but about Wall Street in general. Look no further then the scandals of recent years.

First it was executives from Enron, WorldCom, HealthSouth, Adelphia, and others misleading investors about company earnings and revenues, and getting rich in the process.

Then it was investment bankers from Morgan Stanley, Merrill Lynch, JP MorganChase, and the rest, misleading investors about a stock’s prospects in tainted research reports and stock recommendations.

Next mutual fund companies Bank of America, Janus, and Strong allowed certain well-heeled customers to literally pinch returns from other investors.

And now the chairman of the world's largest stock market, the New York Stock Exchange, steps down under fire shortly after his $140 million dollar pay package comes to light. Question: when does the act of regulating companies warrant a higher compensation than actually running them? Answer: when the regulated set the pay package of the regulator.

There is a common thread in the above scandals. In each, the individual investor was shocked by the revelations of malfeasance. They didn’t expect such behavior.

The truly great mystery is not why these shams happened, but why investors were shocked when they did. When did the American investor become such a sucker?

For unknown reasons, the many investors consider Wall Street and the elite of corporate America – people they never meet in person - to be more ethical then business people they come in contact with day-to-day. 

Even though most small businesspeople are ethical and care about the customers they serve, consumers are still naturally wary as they go about spending their hard-earned money: Is this car salesman hiding something? Do these clothes really look good on me, or does this clerk just want a commission? I bet this diamond is worth a lot less than I’m paying for it. Does my car really need this new part? Maybe I should get a second opinion before having this operation – the doctor could be a quack.

And consumers should be wary. In clothing stores, garages, and used car lots, very often honesty is not the most profitable policy. Big business is the same way, but on a far grander scale.

If a CEO is paid with mountains of stock options that become worth tens of millions if a stock goes up and stocks go up when earnings rise, is it really surprising some executives exaggerated earnings? If investment banks primarily make their money doing investment banking for corporations, is it shocking the analysis they publish on those companies is a little more complimentary than is warranted? If a mutual fund company makes much more money from a large investor than from a small investor, isn’t it more or less expected that they’d bend the rules for them (even to the harm of smaller investors)? 

Investors seem genuinely surprised that the head of the New York Stock Exchange asks for a gets a huge compensation package. But contrary to popular myths about looking out for the best interests of shareholders, the NYSE has three main goals: get as many companies to list their shares on the exchange as they can (which raises exchange revenues), create a system where member firms can make as much money as humanly possible, and maintain the market dominance of a old-fashioned open outcry stock exchange system despite the obvious advantages of new-fangled computer based systems. Not so coincidentally, these were exactly the things Tricky Dick Grasso was good at. 

The individual investor doesn’t mean much to the New York Stock Exchange. If Joe E*Trade expected Dick Grasso to help with his investment portfolio, they’d have ended up disapointed . If investors don’t expect anything out of the NYSE other than for the exchange to make as much money for itself as possibly, than you would be as surprised to learn of Dick Grasso’s salary as to hear a member of OPEC made a lot of money.

The scandals on Wall Street should be expected. The reason why we have a Securities and Exchange Commission (SEC) and a wealth of state and federal securities laws and regulations is that whenever Wall Street is given a chance to bilk investors, they eventually take it. Every single rule and regulation on the books today was not created out of thin air by over zealous regulators – they are the result of specific scandals that lead to rules to prevent a similar scandal from happening again. It’s a shame we all have to be burdened by these regulations, but then it’s more of a shame investors were taken advantage of in the first place.

The point here is people should not suppress their natural skepticism when investing. In recent years investors started believing the advertisements from financial services companies. We expected too much from Wall Street. Expect less, and you’ll earn more. Or at least you’ll loose less.