Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

November 29, 2010

Have Stocks Become a Sucker Bet?

With corporate profits breaking records, Wall Street anxiously anticipates the return of the individual investors to the stock market. It may be a long wait, because the little guy may have concluded investing in stocks is a sucker 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 February 1998, the S&P 500 first closed above 1000. From the first quarter of 1998 to third quarter of 2010, corporate profits were up 203 percent but the average daily close of the S&P 500 was up only 7 percent-about one half percent a year.

Buying stocks does not seem to pay anymore, because most of the increased value created by higher profits has been captured by hedge funds, electronic traders, private equity funds, and aggressive M&A shops, free standing and at major 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.

However, too much of a good thing-electronic trading and aggressive hedging-can be disruptive. Look at the costs imposed by the May 6 Flash Crash or defensive tactics by corporate managers besieged by unwarranted shorting. 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 and Keoghs, real estate prices in the Hamptons and luxury goods sales at Manhattan's finest stores soar.

Hedge funds, electronic traders, private equity and M&S shops do act on information that is obtained through careful, legitimate research but as ongoing SEC investigations into insider trading and published reports on electronic voyeuring indicate, critical competitive information is obtained through unethical and perhaps 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.

It all sounds preposterous, but consider that J.P. Morgan and Bank of America went through the entire third quarter without a negative trading day-no losing days on proprietary trades. Unless you believe in perfection, something stinks about the information they are using.

If someone is winning all the time, then someone else is losing. That's the ordinary investor.

Stocks have become a rigged game.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.