More Smoke than Mirrors

From the Desk of The Rigorist

The New York Stock Exchange is in the news, and here, at least, I can add light instead of heat.

There is a general confusion in discussions regarding “investment” in publicly held corporations as the ones traded on the NYSE due to a semantic sloppiness in common English.  I will start small and end large, from the understanding of investment we all have, to circumstances where such small ideas have no meaning.

Let’s start with a guy with an idea.  He has no money but he’s got an idea.  Maybe he’s Bob Ederer of Ocean Springs, Mississippi, the third-generation of a netting manufacturing family in Chicago who only needs machines to assemble and a place to run them.  Perhaps he’s Tom Kossen of Jackson, Mississippi, a diesel mechanic without formal education, but a salesman nonpareil who sees the potential in on-site standby power generation systems.  Instead of taking on debt which would bankrupt their businesses in their meager beginnings, they sell equity, partial ownership of their endeavors.  If we have the wit and the foresight, we will buy all that they offer, INVESTING money that they will in turn invest in machinery and inventory.

Straightforward and simple so far, eh?

10 years pass and the value of our investment is now 10 fold what we paid.  There is another guy with another idea. Steve Yobs or Cobbs or something like that.  He has no money but he’s got an idea.  We’re changing ponies and our investment is put up for sale. Yippeeki-yay!

Joe Blow buys our equity at a premium no less, expecting increases in value and distributions of profits beyond the extra he pays.  This is where things start getting weird.

So, how much of the money that Joe Blow “invests” does Bob or Tom get to use for machinery or inventory or anything else that would increase the value of the business?

That’s right.  They get nothing, nada, zero, zilch, the big ROUND number.  They get a brand-new guy at their stockholder meetings who knows nothing of their business, interested only in a quick return.

Joe Blow isn’t investing, he’s speculating.  We call it investing, I believe, because this sort of thing is the closest regular folk get to the real thing.

10 years pass, and 10 more, and 10 more.  The value of our original equity could be worth almost anything depending on what management wants the accountants to say.  Bob and Tom have long since cashed out and retired.  Previously authorized but un-issued stock has been sold.  New preferred classes of equity have also been issued.  There have been stock splits and buybacks.  The number of stock owners has gone from a few to a few thousand , and no one owns a majority interest anymore.

It is that last element which qualifies this business to be traded on the New York Stock Exchange.

The price of a single share has been set blissfully free from stodgy calculations of the underlying  value it represents.  The double taxation of dividends has made “profit” into a dirty word, a vulgarity to be avoided.  The stock price rises and falls on the hopes and fears of people more strongly influenced by the morning news and the phase of the moon.  That’s not hyperbole, that’s what professional stock traders call “technical stock price analysis.” JFGI.

“Investors” gain and lose fortunes without affect to or effect of the business at issue.

So what are we to make of the rise and fall of the aggregate price of single shares of stock of 40 businesses classified as “industrial” traded on the NYSE? That is the definition of the NYSE Dow Jones index, you know.

Up 450, down 500, the only thing it means is a bunch of people have got their panties in a wad, and the MSM can mesmerize an audience with the drama long enough to sell soap.

Be very careful with the conclusions you draw from stock exchange indices.

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6 thoughts on “More Smoke than Mirrors

  1. First, welcome back!

    Now to your post. You correctly point out the tenuous relationship between the value of a stock and the value of the underlying company. Many factors beyond a company’s value affect stock price. Goldman Sachs for example, deliberately posted positive figures earlier this week in an attempt to shore up the sagging Dow and the news was met with a decline in stock price. Goldman was not immune to the overall climate of panic.

    However, one cannot use the apparent arbitrariness of stock price to ignore the fact that deregulation has hurt our financial markets. I’m no expert on this but one concrete example was the lifting of limits on short selling. If some financial experts are to be believed, short selling was a major factor in the sudden demise of Lehman Bros. This is a problem of deregulation.

    This brings us back to good ole John McCain, who in the past few months hasn’t been able to figure out whether he is a “regulations” guy or not. This week, he appears quite clueless. All Obama has to do is fart and he looks like a financial genius comparatively.

    So, does the drop in the Dow mean the sky is really falling? Well, no. But we ignore the underlying factors leading to that fall at our own peril.

  2. Rutherford,

    As a Classical Liberal in matters of Natural Human Rights, I see the kind of regulations that Obama would favor as the greatest credible threat to our financial markets from here to the horizon. Where McCain is clueless and clumsy, Obama is skillfully malevolent.

    The open financial market, like the Internet, is by its nature an adult environment. It is and should be a dangerous place for children and fools.

    Taking your statement regarding the demise of Lehman Brothers as given, it is an unambiguous sign of the health of our financial markets. Selling short is an extremely high risk act which can’t be rationally attempted without “insider” information. Lehman Brothers fall no more indicates a failure of our financial markets than a child’s fall from a unicycle indicates a failure of gravity.

    Separating of the operation of financial markets from their participants, as I do the operation of gravity from silly children, I challenge you to name the regulation whose loss has harmed them.

  3. “I challenge you to name the regulation whose loss has harmed them.”

    Rigorist, my laymens understanding is that there was a time when you could not short sell if the shares you were borrowing to sell did not actually exist. This was a restriction on short selling that kept it at least to some degree, under control. This restriction evaporated and with no restrictions on short selling, companies like Lehman could be short-sold right out of existence. Now, again I admit my understanding of this stuff to be introductory at best. I welcome any knowledgeable traders to weigh in on the specifics here.

    But I can speak authoritatively to your general premise. In finance, as in sociology, you seem to overestimate the ability of average people to police themselves and protect themselves. So many times in our discourse, you have objected to governments role in protecting its citizens. A totally “free market” is financial anarchy. Regulations must be in place to keep unscrupulous people in line. Just as regulations must be in place to curb the behavior of bigoted bosses who discriminate in hiring.

    What the liberal understands, and what the conservative refuses to see is that we are not as highly evolved as we might like. There are those among us who will, if left to their devices, abuse others among us. The role of government is to protect the honest from the dishonest, the abused from the abuser, the common man from the military-industrial complex. I can either assume that conservatives have an incredibly rosy view of mankind or I can assume that conservatives want limited government so that they can game the system and keep the advantage. The jury is out for me on this one.

  4. Oh and I forgot to mention that the parent who knowingly lets his child ride a bike without any preparation is an irresponsible parent. The child’s fall is not the fault of gravity, but the fault of that child’s supervisor.

    While I’m here …. Allen Taylor, welcome to the blog. I’m glad you like what you see and I hope you keep reading!

  5. Rutherford,

    I am no anarchist, and I have in fact found an answer to my own challenge — of a sort. There are regulations whose loss has harmed the market, the prohibition of government participating in it not the least. The game, any game, is harmed when the referees get to play.

    Analogies don’t serve well on the Internet. Nuances and specifics, easily mangled by the careless writer or intended for the careful reader, are lost in a conversational forum. My intention was to separate the participant from the system, and I relied upon a fond memory for an image. No, I never learned to ride my father’s unicycle, but I still have it set aside. Let’s set aside the analogy, likewise, until we can discuss the child as someone other than each other.

    ~~~

    What the conservative understands, and what the liberal refuses to see is that government, a collection of people no different than ourselves, is no more evolved than we. Those among us who will, if left to their own devices, abuse others among us are even more prevalent in government than in general society, being attracted to the power to exercise their vices.

    The role of government is to protect the honest from the dishonest — and the dishonest from the honest, the abused from the abuser — and the abuser from the abused, the common man from the military-industrial complex — and the military-industrial complex from the common man. Have we not seen the evil men do in the name of good? Have we not rejected vengeance as Justice? Have we forgotten that the military-industrial complex is but common men?

    I can either assume that liberals have an incredibly rosy view of mankind or I can assume that liberals want unlimited government so they can game the system, using the power of armed men with “legal” license, and keep the advantage. The jury is out for me on this one.

    Actually, that’s not true. There are liberals of both kinds and others besides, I’m sure.

    ~~~

    Re: selling short

    http://en.wikipedia.org/wiki/Short_selling
    http://en.wikipedia.org/wiki/Uptick_rule

    I find Wikipedia entries can be generally trusted within the range of their references. Caveat emptor.

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