We initially despaired when Ted Cruz and AOC got into a dustup holding hearing about the short squeeze controversy focused on trading app Robinhood and GameStop. Elizabeth Warren has now weighted via a letter to the SEC (embedded at the end of this post) and a follow-up round of media appearances. The wee problem is her intervention comes off as if she’s trying to get in front of a mob and call it a parade.
While Warren’s missive does ask some good questions, it’s not remotely as tight or pointed as letters I’ve seen from her in the past while she was head of the Congressional Oversight Panel, or at the Senate, when seeking answers from the Fed, Treasury, and the SEC. It may simply be that she and her staff have usually focused on consumer finance, as in credit products and banking services, and the stock market is less familiar terrain.
More important, her questions demonstrate an underlying confusion about the objectives for having publicly traded stocks, which in fairness reflects confused American policies.
The only real justification is to lower the cost for companies to issue new stock to raise funds for their operations. The reason for having liquid secondary markets is to facilitate these new issues, meaning provide for price discovery and assure investors that they can exit their position down the road. Even through the business press, taking its lead from self-interested parties like intermediaries, touts more liquidity as ever and always good, there’s pretty much no evidence for this view. In fact there’s counter-evidence. As we wrote last week:
…while this story has entertainment and perhaps even educational value, the fact that it’s getting any traction in DC is confirmation of how backwards our priorities are. Since the crisis, there have been boatloads of economic studies on secular stagnation and other ills of advanced economies. Despite the joke, “You can lay economists end to end and never reach a conclusion,”: a surprisingly large number depict overfinanicialization as a drag on growth. Even the IMF concluded that the country representing the optimal level of financial “deepening” was Poland circa 2015, and more financialziation was productive only if regulations were strict. Those conditions haven’t been operative in the US for quite a while.
On top of that, the most unproductive activity is secondary market trading and asset management. The US stock market has a very high level of secondary market activity compared to primary investment, as in companies selling stock to the public to raise new funds to expand their business. You don’t need anything approaching this level of liquidity for companies to be able to price and sell new shares, as the success of large (by the the standard of the day) IPOs and stock offerings of seasoned issuers back in the stone ages of high priced stock commissions attests. The fact that it’s twice as easy to become a billionaire in asset management as in tech shows the degree to which money manipulation is sucking activity and talent away from Main Street to Wall Street.
As we’ve discussed, the SEC has pursued some objectives at the expense of others. As we saw, starting from our early years on Wall Street, when dinosaurs strode the earth and spreadsheets were prepared by hand on green accountants’ ledger paper, the agency has fetishized liquidity when there is every reason to think that’s benefitted Big Finance over Main Street. Even though the simple computation of trading activity shows average stock periods of around 11 seconds, various analysts try to exclude various types of profitable churn to come up longer average holding periods for “end” investors that are still on the order of months. By contrast, in my childhood, the average holding period for a stock was nearly two years.
This picture is made worse by years of super low interest rates. They have most benefitted businesses where interest rates are the biggest cost, meaning financial firms and leveraged speculators. And the agency has bizarrely allowed practices like corporate stock buybacks, high frequency trading, and dark pools.
I keep referring back to the 1994 Harvard Business School article by Amar Bhide, Efficient Markets, Deficient Governance, in which he argued:
Rules to ensure accurate and complete disclosure, the incarceration of insider traders, and the elimination of shady trading practices may actually hurt U.S. managers and stockholders.
Bhide believes that common stock is inherently unsuited to be traded on an arms’ length, anonymous basis. It is a legally weak and ambiguous promise: you get a vote which doesn’t mean much and can be diluted at any time, you get dividends if the company makes money and decides it’s doing well enough to share, and it is a residual claim on assets. The only way to make this sort of investment intelligently is if you are privy to the company’s strategies and budgets and can assess its management. But that information is competitively sensitive and can’t be made public. So Bhide argues that the only way to invest in common equity sensibly is to have a venture-capital type relationship, as in be regularly involved in management discussions.
Stop a second and understand what this means. Public company stock investors don’t have the information they need to determine what a company ought to be worth and therefore decide whether to invest. Perhaps they can sound bets only in extreme cases: when a company is way too cheap or way too pricey. So the notion that the market is efficient, and therefore stock prices are “true” in some abstract sense is a dubious. While efficiency does imply that stock prices may reflect all available information but critical information will always be missing. So equity investing has a considerable “garbage in, garbage out,” element.
I was once at a dinner party hosted by Financial Times US Editor Gillian Tett, where the crowd was mainly financial journalists. Late in the evening, Bhide said there should be no public stock markets. Everyone there (but me) went on tilt, yet no one could mount a reasoned rebuttal. It was ideology and finance bafflegab.
So back to what the SEC thinks it’s supposed to be up to. The Securities Exchange Act of 1934 calls for consistent, extensive, and timely disclosures, and to a high standard:
It shall be unlawful for any person, directly or indirectly..to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.
The so-called ’34 Act also bars insider trading, requires insiders to report their ownership stakes and disgorge any short-term trading profits to the company.
Finally, the SEC is tasked to discourage “manipulation and sudden and unreasonable fluctuations of security prices.” Um, GameStop and all those short squeezes sure look like the agency messed up. To stop wild and crazy prices, the SEC bars trades that manipulate prices, like sham orders and rumors of bid rigging, or create a false impression of of active trading as well as making material false and misleading statements.
If you read Warren’s short letter, you can see she is concerned about market manipulation and wonders if the supposed little guys (who she points out might not be so little) were engaged in collusion that might still might not be illegal under vague and outdated rules:
Although “[f]ederal securities law prohibits market participants from misrepresenting a company’s prospects to artificially affect its share price,” there is a troubling lack of clarity regarding who the major market participants are in this case and the degree to which their activities may be coordinated. With many of these traders “cloaked in anonymity, there is no way of knowing whether messages touting GameStop come from average Joes – or scam artists executing a ‘pump-and-dump’ stock scheme.”
Admittedly, Warren later seeks more information about both the shorts and the WSB types:
a. Did the sharp rise in GameStop’s share reflect changes in the company’s fundamental value? If not, what drove these changes of GameStop share prices?
- To what extent did large investors, such as hedge funds like Melvin Capital Management, and their short positions impact the fluctuationof GameStop’s share prices? Did any of these practices violate existingsecurities laws?
- To what extent did online message boards, such those on Reddit, or broader social media amplification impact the fluctuation ofGameStop’s prices? Did any of these practices violate existingsecurities laws?…
4. What steps will the SEC take to update and implement rules defining market manipulation? Please provide a detailed timeline.
However, the Senator also too often displays a touchingly naive view that market prices somehow reflect fundamentals. Has she managed to miss the slaughter of value investors in the ZIRP era? Even in less bubbly times, none other than godfather of investing, Benjamin Graham, said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” And if you combine this with Keynes, “In the long run, we are all dead,” you may not last long enough to see those properly-weighed prices.
It’s also disappointing to see Warren do a mere hand wave on systemic risk. Mind you, so far I see no evidence of any so far (as in leverage on leverage or seriously undercapitalized players who are also systemically important). But if she were semi-serious, she’d at least name the vector experts have been worrying about for quite a while, which is central clearinghouses. You see no mention of them.
Warren also felt compelled to strike a populist pose, which comes off (charitably) as overegging the pudding:
These wild fluctuations are just the latest indication that many private equity firms, hedge funds, and other investors, big and small, are treating the stock market like a casino, giving little consideration to the companies, communities, workers, and consumers that may be affected by these risky bets. The recent chaos reveals a clear distortion in securities markets, with benefits accruing to investors that do not clearly benefit the company’s workers, consumers, or the broader economy….
The manipulation of share prices may exacerbate inequality and the impacts of the ongoing pandemic-related economic collapse. While investors work to outmaneuver each other in search of short-term profits, working families continue to suffer, underscoring the growing disconnect between the stock market and the real economy. For example, millions of workers have lost their jobs or left the workforce altogether amid the pandemic and economic collapse, but “America’s 614 billionaires grew their net worth by a collective $931 billion” in the roughly seven months following the beginning of the pandemic.14 The rapid growth of economic inequality is, in large part, due to the disproportionate impacts of surges in the stock market, which has rebounded dramatically since the onset of the public health emergency. The stock market is not reflective of real economic conditions felt by communities across the country, and traders treating securities markets as casinos exploit these growing disparities.
Gambling in Casablanca? Whocoulddanode?
Hasn’t someone clued Warren that the price of a company’s stock generally matters way way way more to the C-suite than Joe Employee? That’s because for most companies, selling stock to raise dough is an infrequent event. The biggest sources of corporate funding are, in order, retained earnings, borrowing, and share sales. And in aggregate, public companies have been slowly liquidating, as in net saving rather than investing, as we pointed out in a Conference Board Review article in 2005.
The exceptions to this general rule are:
If the employee works for a financial firm with weak or declining bond ratings, since financial firms are borrowing all the time (they usually have some to a lot of short term debt) and a weak rating means they really ought to shore up their equity base soon (see what happened to AIG and the monolines as examples of how quickly a doom loop can kick in).
If the employee works for a non-financial firm that has a lot of maturing debt and similarly has shaky bond ratings
If the employee either by having a mendaciously-designed 401(k) plan or questionable investment judgement, is heavily exposed to his employer’s stock1
Nevertheless, Warren does get props for refraining from short-bashing. Not only do short-sellers get information out about companies that their managements would rather have you ignore, but banning short selling, interestingly, does not help the stocks of beleagured companies, contrary to boardroom urban legends. Various studies determined that the prohibition of shorting of big bank stocks in the runup of the financial crisis did more harm than good.
Warren connects the rise in stock prices during Covid to widening inequality. Valid observation, but asking the SEC to fix it is barking up the wrong tree. As readers know, it’s a combo of the America’s Covid rescue plans doing more to help the rich than the little guy, and the Fed running in to push interest rates back to the floor, which turbo charged stock and real estate prices. But Warren seems unwilling to accept that the wealthy-favoring monetary and fiscal interventions would elevate asset prices further from there already lofty levels.
Yes, Warren can argue that stocks are seriously overpriced, and even the IMF agrees with her. But Saint Greenspan deemed stock prices to be irrationally exuberant in….drumroll….1996, before the dot com mania really took off. So the fact that stock prices are too high by plenty of sensible standards does not mean they can’t go higher.
Warren took her GameStop gaming/Covid suffering combo plate to the press, which did get a lot of play, particularly on the Sunday political shows. She seems to be trying to straddle selling the necessity of a big Covid bill along with her upset about the stock market casino. Linking them at least allowed her to debunk the bizarre assertion by poors-hater-in-chief Leon Cooperman and his buddies that all of the GameStop buys were funded by young layabouts gambling with their stimulus checks:
And in some of her interviews, she’s including stock buybacks in her list of things for the SEC to address. From Politico:
The Massachusetts Democrat likened today’s stock market to a casino, where she said big-money players are manipulating the markets through measures like pump-and-dump and stock buybacks to inflate stock prices.
So perhaps Warren will become more sure-footed as her staffers get a better grasp of the issues. But right now, she looks a bit wobbly.
1 Investment advisors warn sternly against having significant holdings in your company’s stock because you are already at risk by working there. And before you say, “Oh, but we can judge well if our company is a good bet,” Enron and Bear Stearns both had very high levels of employee shareholdings at the time of their collapse.00 Warren to SEC on GameStop