Fire Sale

Everyone Must Go!

Last week's financial sector meltdown certainly feels like a game changer to me. For one thing, capitalists are now on record as no longer believing in the power of the free market — or, rather, admitting it has an awesome power, greater than they expected, and therefore it needs some care and feeding — and tacitly admitting that needs to come with oversight.

The Tom Toles cartoon said it best. It showed a fireman, dressed sorta like Uncle Sam, pulling a Wall Street fatcat from a burning building, who is saying, "Wait! Let me go back and save my needlepoint 'Government isn't the solution, government is the problem' inspirational wall hanging."

I have no doubt that the Republicans, as adept as they are at self- and other kinds of deception will choose to remember this crisis differently, and much will depend on what happens over the next two weeks or so. But I for most people the meltdown last week demonstrated, once and for all, that unbridled market forces, "the invisible hand of the market," cannot, by itself, bring about all the good things that we want — especially if that includes stability.

Although I have a standard disclaimer on my site that "My thoughts/opinions ≠ My employer's thoughts/opinions," I also rarely post about anything related to business or technology, so that disclaimer should be fairly obvious. But in this case, I'm going to wonder aloud about some financial and business principles that I should restate clearly are just my own musings, and not at all the opinions of my employer.

Perhaps even more importantly, I should add the warning that I understand the financial world just enough to be dangerous to myself, but don't have the capital behind me to be very dangerous to too many others. So chalk up my ignorant statements here to just that, ignorance.

But my basic, overall take is that the financial industry got completely divorced from reality. "Wall Street got drunk," as George W. Bush famously said when he thought all the cameras were off. Got drunk and started have hallucinations is more like it. This quote, from David Leonhardt's excellent piece "Bubblenomics" in this past Sunday's Week in Review section of the Times, sums it up perfectly:

Benjamin M. Friedman, author of "The Moral Consequences of Economic Growth," recalled that when he worked at Morgan Stanley in the early 1970s, the firm’s annual reports were filled with photographs of factories and other tangible businesses. More recently, Wall Street’s annual reports tend to highlight not the businesses that firms were advising so much as finance for the sake of finance, showing upward-sloping graphs and photographs of traders.

"I have the sense that in many of these firms," Mr. Friedman said, "the activity has become further and further divorced from actual economic activity."

Exactly. The actual banking system — where we deposit money in a bank for some small interest and banks make money by loaning it out to other people at higher interest — and the actual economy for that matter — the stuff of balance sheets and income statements — needs to be the primary means of wealth building for the country or, frankly, we're doomed.

I don't know if short-selling, for example, is a bad thing or a good thing. Or a morally neutral thing. I've heard people say that it provides liquidity in the market — increases what's out there to be bought and sold, in other words. And everyone points out that it was short sellers who first clued in that Enron's finances were a house of cards, and their selling Enron short led to deeper examinations of its financial health and ultimately, uncovered, the mess. That may be. But it's also investing merely as gambling. It allows you to sell a stock you don't yet own. If the price drops, you make money; if it goes up, you lose money. (Basically the opposite of going "long" as an investor.) But unlike going long — buying a stock because you expect its value to increase — short selling allows you to play the market with that stock but not own it until the transactions are totaled up.

Short selling is a headache for companies — who, admittedly, only want their stock to go up, even when it probably shouldn't. But my problem with it is that it further divorces the investment from the thing being invested in. It's like "Beginning Derivatives 101," with the "investment" merely being a prediction and a bet to make money on it. And that, I think, is the overall problem with our financial house today.

Another example: a lot companies don't pay dividends. Now, that alone wouldn't have saved us from this crisis, although a company that can't or won't pay the owners may not have all its ducks in a line, either. I know, I know: many companies, like Berkshire Hathaway, don't pay dividends, they reinvest the profits back into the company, and people who got in early there have made fortunes with the rise of their value of their stock. But at some level I have to ask: is there anything tangible connected to the ownership of the stock, or is it merely the perceived value that someone is willing to buy it for that makes it of value?

I know the answer to that. Gold has no intrinsic value, and yet we've still got survivalist whackjobs out there who want our currency tied to it. And the money that's been made (and now lost) in the stock market for so many people has not primarily come from dividend payouts, not by a long shot.

All of that is probably okay. As long as, theoretically, a payout could be made, or if we sold all the assets I'd get some small part of the proceeds, then that's as good as an actual dividend. And gold may not be "worth" any more than granite except because someone else says it is, but at least it's a thing. What worries me about what's happened to the financial system is that we've flopped the importance of the actual economy with a shadow economy of placing bets on the actual economy. We look at balance sheets and cash flows and buy stock in a company — even though there is absolutely no connection to the activities or even income of the company and the rise or fall of its stock.

Here's a modest proposal. But first, some background, again from that excellent article by Leonhardt:

The classic measure of whether the stock market is overvalued is the price-earnings ratio, which divides stock prices by annual corporate earnings. At the height of the bubble, in 2000, companies in the Standard & Poor’s 500 Index were trading at 36 times their average earnings over the previous five years. It was the highest valuation since at least the 1880s, according to the economist Robert Shiller.

By 2004, surprisingly enough, the ratio had dropped only to about 26, still higher than at any point since the 1930s. At the start of last year, it was still 26.

But after the market closed on Friday, the ratio was down to roughly 17, which happens to be about its post-World War II average. At least by this one measure, stocks are no longer blatantly overvalued.

So here's my proposal, or call it a musing:
What would be the downside of establishing price floors and ceilings for a stock based on its P/E ratio? Say (for the sake of the argument) a 5/1 floor and a 25/1 ceiling? That would leave the vast majority of stocks unaffected. Checking the Google Finance stock screener, I see that it lists 141 stocks (out of 3,606) with a P/E ratio of 5 or less — and 17 of those have a negative P/E ratio. So maybe something has to be in place to account for those, for whatever reason they're trading so low. On the other hand, it shows 855 stocks with P/E ratios above 25 (one solar-related company as high as 4900.) In fact, Google, the providers of the stock screener, show a current P/E of 28.27.

In theory, a high P/E ratio is investor's confidence that a firm will make a lot more money in the long run, hence making this stock of such value. But given the way we've changed "investing" into "gambling," it's now really only investor confidence that the price will keep going up, and the "E" part of the equation be damned, or at least ignored.

If we had a floor and ceiling on P/E ratios, I don't know what the impact would be, to be honest. Nor what the correct such floors and ceilings should be: 0 and 30? -5 and 40? The stock market would be far less exciting, I'm sure. There'd be a whole lot less volume traded. IPOs would have to be rethought and reconfigured.

Or make it a further ratio to volume, and let the companies themselves decide on an annual basis by a vote of shareholders? If you choose a -10 to 50 range for your P/E ratio, 24-hour trading volume for your stock is held at a smaller number than if you opt for a relatively tight 5 to 20 range. Once it hits its allowable number of trades on the exchange, trading on that stock is halted for the day.

Or maybe we don't worry about P/E ratios, but we worry about day traders and those turning the stock market into a casino. That would mean getting rid of short selling and, probably, also requiring that a stock be held for one bell closing before it can be sold. Or maybe we do both. Maybe we find a way to outlaw — or at least outlaw public companies — from tradiing in investments that are two, three, and five or more steps removed from actual things — real estate, shares in companies, metals, bonds, commodities, etc.

Obviously, I don't really know. And none of my goofy proposals around P/E ratios and trading volumes would have solved this particular problem. And do I know what the floor or ceiling rules for P/E ratios should be? Of course I don't. And the primary philosophical objection would be that "no one can know, so we should let the free market decide." Except, as we've seen now in the past few weeks, the free market doesn't know either. So — and here's the actual proposal — why don't we let democracy decide?

Or is that exactly how we got to this problem? I'm not sure. Fortunately, Barney Frank is far smarter about this stuff than I am.

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In the political realm of all this, I have to point out the difference between these two candidates, based on their remarks on the economy last Friday, September 19:

• Barack Obama's remarks


• John McCain's remarks

I found these two examples very enlightening. For one thing, one of them is laying out four principles that any bailout should include, but said he'd withhold details of any plan to keep from politicizing what was being worked out between the Treasury Secretary and the Congress. (Now that we've heard the details of Paulson's plan, all three pages of 'em, Obama could probably be allowed to let loose with his commentary on it, if he hasn't already.)

The other (that would be McCain) bounced all over the map, making up new regulatory agencies even while he complains about the number of regulatory agencies. And, as part of that, he thinks a good "generalist" regulatory agency would be far more effective than the "specialist" agencies. I guess, by that line of thinking, there's really no need for all those cabinet positions, either, is there? Let's have the Treasury Department manage our federal prosecutors, the Navy, public forests, and gun licenses. (Oh, wait: they actually did do that last one for decades, until the Department of Homeland Security was created in 2002.)

And he yet again yelled for the head of the head of the SEC, Christopher Cox — basically for no reason other than wanting to blame someone and look "mavericky."

But more importantly, look at how McCain took this opportunity to basically campaign against Obama, blaming him for the crisis (somehow). Obama, on the other hand, took this speech as an opportunity to say that he, John McCain, President Bush, and the Democrats and Republicans need to come together to come up with a workable plan to this financial crisis. And that was essentially the extent of his remarks about John McCain.

Now which of these two men exhibited leadership?

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Finally, are we seeing a trend here? The Bush Administration ignores a warning — "Bin Laden Determined to Attack Inside the U.S." — and Al Qaeda attacks the United States. George Bush then says the only way to address this crisis of vulnerability is to give his administration sweeping powers, and Congress must act immediately to provide those powers. From that we get the Patriot Act.

Then Saddam Hussein — who was provided financing, agriculture credits, dual-use technology, chemicals, weapons and intelligency by the Reagan and Bush I administrations — was deemed a growing threat following the US-Iraq war (see "yellowcake"), and George W. Bush again demanded sweeping powers, a blank check that would total hundreds of billions of dollars, and no oversight from Congress so he could prosecute a "preventive war" (see "Bush Doctrine").

Now we're facing the worst financial crisis in 80 years, brought on by the deregulating glee with which the Republican administrations of the past three decades treated matters economic and financial. And the solution is yet again to give the Bush Administration a blank check totaling hundreds of billions of dollars and refusal of any oversight (or it will ignore the oversight).

There really wasn't any question before last week, but last week will add at least another two decades (to the at least five decades we were already guaranteed) to any kind of historical reassessment of George W. Bush:

Worst. President. Ever.