My last two posts were designed to stimulate discussion. But lets talk the real problem that regulators, public companies, investor/shareholders and traders face. The problem is that Wall Street doesn’t know what business it is in. Regulators don’t know what the business of Wall Street is. Investor/shareholders don’t know what business Wall Street is in.
The only people who know what business Wall Street is in are the traders. They know what business Wall Street is in better than everyone else. To traders, whether day traders or high frequency or somewhere in between, Wall Street has nothing to do with creating capital for businesses, its original goal. Wall Street is a platform. It’s a platform to be exploited by every technological and intellectual means possible.
The best analogy for traders ? They are hackers. Just as hackers search for and exploit operating system and application shortcomings, traders do the same thing. A hacker wants to jump in front of your shopping cart and grab your credit card and then sell it. A high frequency trader wants to jump in front of your trade and then sell that stock to you. A hacker will tell you that they are serving a purpose by identifying the weak links in your system. A trader will tell you they deserve the pennies they are making on the trade because they provide liquidity to the market.
I recognize that one is illegal, the other is not. That isn’t the important issue.
The important issue is recognizing that Wall Street is no longer what it was designed to be. Wall Street was designed to be a market to which companies provide securities (stocks/bonds), from which they received capital that would help them start/grow/sell businesses. Investors made their money by recognizing value where others did not, or by simply committing to a company and growing with it as a shareholder, receiving dividends or appreciation in their holdings. What percentage of the market is driven by investors these days ?
I started actively trading stocks in 1992. I traded a lot. Over the years I’ve written quite a bit about the market. I have always thought I had a good handle on the market. Until recently.
Over just the past 3 years, the market has changed. It is getting increasingly difficult to just invest in companies you believe in. Discussion in the market place is not about the performance of specific companies and their returns. Discussion is about macro issues that impact all stocks. And those macro issues impact automated trading decisions, which impact any and every stock that is part of any and every index or ETF. Combine that with the leverage of derivatives tracking companies, indexes and other packages or the leveraged ETFs, and individual stocks become pawns in a much bigger game than I feel increasingly less comfortable playing. It is a game fraught with ever increasing risk.
The Pimco (who I think are the smartest guys on the Street) guys talk about a new normal as it applies to today’s state of the world economy. I think just as important is the new normal as it applies to Wall Street. Wall Street is now a huge mathematical game of chess where individual companies are just pawns. This is money in the bank for the big players like Goldman, Morgan, etc. Why ? Because the game of chess is far too complicated for 99pct of the institutions out there investing money. So to keep up, they turn to Goldman, Morgan and the like to invent products for them. “You don’t know how to play the housing boom, let us show you”. “You think the housing boom is about to crash, let us show you how to play that”. “You think that PIIGS are in trouble because they can’t print money to pay debt holders, let us create a product to allow you to play that game” The big houses have the best hackers in the business and they put together the games and sell them to the many, many institutions managing Billions and Billions of dollars. They are the ultimate Hackers selling their attacks to the highest bidder, regardless of which side they are on. That is a new normal.
Again, I’m not passing judgement one or the other. I’m just recognizing what is going on in the financial world today.
It’s rare for companies to go public these days. Just as rare for secondary offerings. The only thing that keeps me in the market is that most of the stocks (not all) pay dividends or some other sort of cash payout. For the first time in my life, I bought outside the United States. I bought Australia in a big way because it is becoming increasingly hard to find new domestic investments that are not influenced by the “hackers” and the games being played on a macro level. It’s hard to believe, but evaluating countries as an investment is now easier than evaluating companies . Even with all the unrest in Europe. Or maybe because of it.
So back to the original question. What business is Wall Street in ?
Its primary business is no longer creating capital for business. Creating capital for business has to be less than 1pct of the volume on Wall Street in any given period. (I would be curious if anyone out there knows what percentage of transactions actually return money to a company for any reason). It wouldn’t shock me that even in this environment that more money flows from companies to the market in the form of buybacks (which i think are always a mistake), then flows into companies in the form of equity.
My 2 cents is that it is important for this country to push Wall Street back to the business of creating capital for business. Whether its through a use of taxes on trades, or changing the capital gains tax structure so that there is no capital gains tax on any shares of stock (private or public company) held for 5 years or more, and no tax on dividends paid to shareholders who have held stock in the company for more than 5 years. However we need to do it, we need to get the smart money on Wall Street back to thinking about ways to use their capital to help start and grow companies. That is what will create jobs. That is where we will find the next big thing that will accelerate the world economy. It won’t come from traders trying to hack the financial system for a few pennies per trade.
And solutions won’t come from bureaucrats trying to prevent the traders from hacking the system. The only certainty when bureaucrats step in is that the law of unintended consequences will smack us all in the head and the trader/hackers will find new ways to exploit the system that makes them big money and even more money for the big institutions that develop products for the other institutions that are desperate to play the game.
Regulators have got to start to recognize that traders are not investors and vice versa and treat them differently. Different regulations. Different tax structure. Different oversight. Individual investors and the funds that just invest in stocks and bonds are not going to crash the market. Big traders who are always leveraging up and maximizing the number of trades/hacks they make will always put the system at risk. We need to recognize that they do not serve much of a purpose other than to add substantial risk to the global economy. That their stated value add of liquidity does not compensate the US and World Economy nearly enough for the risk of collapse they introduce into the system.
Wall Street as a whole needs to be in the business of creating capital for companies and selling shares to investors who believe they are shareholders. The Government needs to create incentives for this business and extract compensation from the traders/hackers for the systemic failure level of risk they introduce.
There will be another crash, because there are too many players looking for the trillion dollar score. They can’t all win, yet how many do you think wouldn’t risk everything, even what is not theirs, for that remote chance to score big ? Put another way, there is zero moral hazard attached to any trade. So why wouldn’t traders take the biggest risk possible ?
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Hi Mark
This is a very cogent note which could do a lot of good if expanded a little and published in other places with a larger audience.
Best wishes,
Alan
Comment by alanone1 — May 9, 2010 @ 11:49 am
You hit the problem squarely on the head; the only people who know what is really going on are the traders. Further oversight and/or lower taxes while two extreme solutions to this knowledge deficit that exists only sweeps this problem under the rug. An economy where education serves financial lubrication is the key to this big league swindle occurring daily on Wall Street.
Comment by EJ Prince — May 9, 2010 @ 12:54 pm
Mark, I am not sure if this will be done soon i.e regulating wall street to go back in the business of creating wealth for the companies.
I dont recall exact figures but for Goldman Sachs High Frequency trading constitutes 5B in profits. I would suppose thats the case for other companies i.e generating lot of revenue. So these companies would be highly against these regulations.
Following is an argument that i heard on MarketPlace some time back about financials vying for bailout money and indeed they got the bailout.
All these financial companies hire pressure groups/individuals who seem independent and are not employed by the financial firms. These guys will pressure the Washington against reforms and laws that go against companies interest. Washington bails out or lets the laws be that the companies continue making money. Companies make money so they pay these pressure groups millions. So they continue the pressure.
(I dont intend to say i am against bailout or anything but wanted to bring about a point why its so difficult to bring about the change you mentioned).
So the first change Washington should do is make the pressure groups independent of the financial firms.
Comment by snahar — May 9, 2010 @ 1:09 pm
I still get the feeling Wall St.will win at the expense of stupid people who give their money willingly to investment companies.
Then they hope like hell being in stocks,funds and other equity based investments,will help them in retirement.Good luck.
But I don’t think government intervention will help.They’ll make it worse.Frankly they don’t have the political will to do the right thing.Nor do I want the government to run the stock market.
They’re already screwing with bonds and treasuries.The debt loads from other countries on these bonds could literally cripple good hard working people.
Hell,what do I know? I keep my money away from equities.Do what Mark says and at least keep your money safe.
Takes a lot of balls to screw with the market,and that’s what Goldman Sachs and company will do.So hats off to em!
Mark
Comment by mdgrove500 — May 9, 2010 @ 1:22 pm
Guys: The danger with NOT being invested in equities/the market is that WHEN (not if, but most definitely when) inflation comes back to rear its ugly head, your money is not “safe.” Its value will get whittled away consistently and that’s not opinion, it’s inevitable fact. At issue for me is that not long ago, you could invest in solid, low cost mutal funds—even relatively low risk index funds—and buy individual stocks in a few good dividend paying companies—and have a pretty good chance of increasing your wealth and preparing for retirement. Money in a bank or mattress (they’re paying about the same interest lately) will not grow enough to help wage slaves like me working in the private sector—-with no pension or government stock pot to dip into. Lately, I’ve come around to thinking that maybe I should take some of my investments out of the market and buy some real estate, which seems to be on sale. I’m not a dummy, but this stuff is way over my head. If it’s a little complicated even for people like Cuban, just think what it feels like to people like me.
Comment by dcangelo — May 9, 2010 @ 2:43 pm
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Mark,
I agree, Wall Street has moved far away from its initial mission.
However, the exchanges are all privately owned and operated entities, they can do what they like. Also, I think that all of the investor protection regulations that have been added over the years make it difficult for Wall Street to serve its original purpose. Lastly, the relationship between corporation and investor has been disintermediated largely by online brokers who hold securities in street name.
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