A great investor once said: “While enthusiasm may be necessary for great accomplishments elsewhere, in Wall Street it almost invariably leads to disaster.” Over the years we have endeavored to adhere to this maxim and one result has been that we are often highly critical of our own industry. In a business prone to bouts of excitement, it is wise to be perennially cautious. We take the process of capital deployment seriously—simply owning a share of stock is not the same as investing—and we have little interest in the marketing blather that typifies so many of the industry’s publicity-seeking “thought leaders.” Our duty is to protect clients and readers from abuse by keeping them informed about certain developments, and teaching them to be skeptical, in order to avoid decisions that could lead to permanent losses. We do firmly believe that Wall Street can be useful as a means of reaching financial goals, but it is undeniably not your friend.
The complexity of finance, the awe with which it is held, and the “priesthood” view of experts contribute to making it difficult for the average person to identify and avoid the dangers lurking there. There are frauds, of which Wall Street history abounds, from “watered stock” in the old days to recurring Ponzi and “pump and dump” schemes that take advantage of ignorance and gullibility. As the Madoff scandal earlier this century clearly demonstrated, well-constructed ploys can be difficult for even experts to detect.
Aside from the outright frauds, the economics of the investment business often operate in ways that the average consumer doesn’t realize are unfavorable to their interests. What may start out as a good idea gets taken too far and is eventually corrupted (a process known in the internet realm as “enshittification”). For example, index funds (or variants like ETFs), which give broad market exposure at low cost, were a great innovation appropriate for most market participants—experienced and inexperienced alike—but index funds based on every conceivable sub-grouping of stocks in the market are less sound. Product extensions that offer, among other things, leveraged bets on the direction of various industry sectors are downright risky, encourage speculation, and entail higher fees. Akin to the notorious behavior of money managers doing “what works” in competition among themselves, the construction of indexes to represent hot new areas of market interest is clearly designed to attract assets, while simply hoping for the best. Too often the customer is left with reduced wealth when such fads come to an end, which they invariably do.
Finally, there are the perfectly legal but speculative methods of cheering on buyers of investment “opportunities.” These might include aggressive earnings projections that encourage a focus on price movement (the ever-present “price target”), and less on capital preservation (a fundamental principle of investing). Such practices are especially egregious in new security offerings, where the motivation to sell is at its most intense.
This year’s action in the tech universe is a good example of the latter, and the inherent conflicts of interest at play have been especially alarming. Intense interest in tech, especially advances in AI with the accompanying high valuations in the stock market, has encouraged some private companies to sell shares to public investors through an initial public offering (IPO). This is perfectly normal and rational; Wall Street’s history is marked by phases of excitement over particular industries, which encourage entrepreneurs to create companies and eventually sell all or parts of them to investors, thereby creating great personal wealth. Many great companies have been birthed this way, but investors in such offerings should always raise the question as to whether any given transaction truly represents an investment opportunity, or a chance for business founders and their backers to use favorable market conditions to cash out and take the money and run. History indicates this process is fraught with risk; if great companies are opened to public participation it’s all to the good, but most newly-minted businesses end up on the dust heap.
The interest in going public has reached a fever pitch this year among unusually large (in the sense of “private market value,” but not necessarily revenues or profits) tech company start-ups, and the dangers buyers of such offerings face are especially acute. All of the tools available to Wall Street in the internet age are being employed to generate excitement and investor interest, and the traditional methods of generating buying interest, such as optimistic revenue and earnings projections, are also on full display. For example, in order to justify the inflated price of an AI-related IPO, one investment bank projected that revenues would multiply 100 times by 2030. This is AI hype on steroids.
In addition, more tricks are being used to conjure up demand and rake in more proceeds from excited markets. In some cases an artificial “scarcity” value is being created by limiting the number of shares being sold to a small portion of total shares outstanding. Not only does this tend to inflate the offering price, but it also leaves corporate control in the hands of a few founders and backers, giving outside investors little say in governance. Great strength of character is required on the part of business managers in order for such arrangements to work out well for minority shareholders.
More egregiously, since the latest new stock issuances are from companies that through their private fund-raising have already achieved large valuations as private entities, stock index providers have been incentivized to include them in important stock indexes, making exceptions to their acceptance criteria and bending rules having to do with “seasoning,” for example (seasoning refers to the process of new issues gaining a history of public market trading over time). The end result is to get these over-hyped, newly public companies into the indexes soon after the IPO process.
Since index funds and fund managers whose investment objective is to “hug” indexes must purchase new index components, this creates additional demand for these already over-hyped issues, and also a source of buying power that enables insiders lurking in the wings—waiting for their opportunity to sell after “lock up” periods—to more easily unload their positions. The interests of bankers, lawyers, selling shareholders, index providers and funds all benefit from this process that generates fees and increases in assets under management along the way. Will the ultimate buyers—the many ordinary savers who buy index funds for broad market diversification—understand the increased risks to which they are exposed, and will they ultimately profit from those commitments? We can only hope so.
* * *
Since the 2008-09 Financial Crisis, Americans’ exposure to the stock market has tripled to about 26% of household wealth and nearly half of financial assets. Since consumer spending accounts for 70% of U.S. GDP, a stock market tumble could have a bigger impact on real economic activity than previously was the case due to the “wealth effect.” Not surprisingly, significant declines in the value of brokerage accounts have a depressing effect on the desire to spend money. Since wealthier Americans own the greatest share of U.S. equities (the top 10% own 93% of stocks, the bottom 50% own just 1%), and since their spending makes up an outsized portion of the total (the top 10% account for about half of consumer spending), a lengthy and sizeable downturn in the markets could have a negative and widespread impact on the economy as a whole.
As it turns out, it’s not just Americans who might be discombobulated by a fall in the U.S. market. Regarding one of the recent U.S. Big Tech IPOs, the Financial Times reports: “In Australia, brokers’ call centers opened emergency hours… There was an investor stampede in Japan. In South Korea unmet demand has become a national scandal.”
Foreign capital has long participated in U.S. markets owing to U.S. markets’ historical “safe haven” status and record of success; foreigners’ profits in U.S. equities now total $13 trillion. Like their U.S. counterparts, non-U.S. investors have heavy exposure to American Tech giants. Across the world 38% of equity portfolios are invested in U.S. stocks, up from 25% a decade ago. As a result, it has been estimated that a setback of an order of magnitude similar to that of 2008-09 could reduce world GDP (ex-U.S.) by about 10%. Might this be yet another incentive for foreign countries to reduce their economic reliance on the U.S.?
The degree to which the world’s financial affairs have become intertwined was demonstrated during the Financial Crisis when small communities in Australia suffered losses when mortgage-backed securities in the U.S. were found to be worthless. Today the potential problems may not lie in complicated derivatives but instead in the spread of America’s “equity culture” to more and more countries, broadening the risk exposure to more people who believe that investing their savings in equity funds is the way to a more financially secure future.
* * *
“The Maestro,” Alan Greenspan, passed away in June at 100. Greenspan presided over the U.S. Federal Reserve Board between 1987 and 2006. Known for his obscure, convoluted language, he gained a reputation for using interest rate policy and central bank resources to soften the impact of market panics including the 1987 market crash and other crises he faced during nearly two decades as Fed Chair. While there were other factors at work as well, to his credit it was a period of strong economic growth and rising stock markets.
Greenspan’s reputation suffered a setback in the aftermath of the Financial Crisis, which some attributed at least in part to his aggressive action to counter market turmoil (the so-called “Greenspan Put”) and to a light-touch approach to bank regulation rooted in his free market philosophy. His response to the 2008 calamity reminds one of the famous line from Casablanca, “I’m shocked, shocked to find that gambling is going on in here.” In Greenspan’s own words: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” What he failed to understand was that institutions, especially stockholder-owned banks, are not people and they have no self-interest. Institutions are run by people who do have self-interest and are impelled by powerful financial incentives to maximize their own wealth. Or, as a former bank CEO famously put it: “As long as the music is playing, you’ve got to get up and dance.”
Dennis Butler, MBA, CFA
Commentary