Current Lessons for U.S. Equity Investors

Overpaid CEOs, Unethical Officers and Consultants Betray Investors

Million of American investors, many of them older people on fixed incomes who rely on income from stock investments, lost a major part of their wealth in 2002. This wasn’t a random movement in the market or a cyclical change, it was due to the outright malice of a number of bad-actors, and a system designed to protect them, that failed How does it look at the beginning of 2004?

Lesson No. 1: The problems revealed by the scandals were widespread and systemic, not just the result of a few bad apples spoiling the barrel. While only a few CEOs will go to jail - perhaps too few- the breakdown was endemic to both the corporate and financial systems. Many CEOs, not just a few, are shamefully overcompensated for the slightest success and protected from punishment for failure. Many, not just a few, accountants, stock analysts, attorneys, regulators, and legislators failed, to one degree or another, to ensure the accuracy of financial statements and the free flow of honest data in the markets.

Lesson No. 2: Regulation matters. The failure to set rules in new markets cost investors and consumers billions of dollars. The absence of virtually any regulation in energy-trading markets led to false shortages, fake trades, huge profits, and enormous financial and still-uncounted economic losses in California. Deregulation should not mean anarchy, deceit, and greed hiding behind a twisted interpretation of Friedmanian economic theory. Markets need clear rules and policing to be open, transparent, and fair. Having the free choice Milton Friedman teaches is predicated on the market manifesting integrity.

Lesson No. 3: Market Analysts can be Corrupted. Analysts who sit in on board meetings, go on road shows, mislead individual investors, and feign objectivity on TV, but get paid for generating investment banking business are being corrupt. Separation of financial activities, solid Chinese Walls and, above all, serious managing of conflicts of interest are crucial to the honest operation of capital raising and investment in the economy.

Lesson No. 4: Board of directors count. The most important check on CEO behavior is the board of directors. The breakdown of boards as shareholder representatives and advocates, was a major cause of corporate scandal in 2002. Many boards suborned outlandish CEO demands for millions of options, personal loans, re-pricing of underwater options, loose accounting, and in the case of Enron Corp., deliberate abandonment of the corporate code of ethics. Independent board members heading audit and compensation committees are essential to the proper functioning of companies. Separating the function of CEO and chairman, who oversees the CEO, should also be mandatory for all publicly traded companies.

Lesson No. 5: We know a lot less than we think we know about economic policy. Supply-siders and deficits, interest rates, and growth, but neither side has the economic theory or data to prove it’s right. The failure of economic theory to guide decision-makers on key economic issues makes policy making extremely ideological and partisan. This usually leads to finger-pointing and non-productive argument.

Lesson No. 6: Deflation is the new enemy. Our grandparents knew this from the ‘30s, but we’re only discovering it now. Technology, higher productivity, greater competition and globalization (read: huge imports from China), plus inflation-fighting monetary policies, have combined to send many prices lower, perhaps too low. Companies have difficulty generating profits, partly because they can’t raise prices. Without officially saying so, the Fed has gone into deflation-fighting mode, flooding the economy with money cutting interest rates, and allowing the dollar to fall 5% on a trade-weighted basis this year. The result? Non-oil commodity prices and prices for imported consumer goods are slowly rising, helping companies to rebuild their profit margins.