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 served as Chief Economist at the U.S. International Trade Commission from 1993 to 1995. He is an economist and professor at the Smith School of Business, University of Maryland.