The Clash of the Cultures
When enterprise becomes the bubble on a whirlpool of speculation . . . [and] when the stock market takes on the attitude of a casino, the job [of capitalism] is likely to be ill-done.
—John Maynard Keynes
Throughout my long career, I’ve observed firsthand the crowding-out of the traditional and prudent culture of long-term investing by a new and aggressive culture of short-term speculation. But the personal experiences that I’ve outlined in the introduction to this book require deeper discussion—a broader view, an historical perspective, persuasive data—not only of the problems created by this change, but also of recommendations for fixing the nation’s financial system. Those are the subjects that I intend to pursue in this chapter.
Let’s begin by observing the consequences of the change in the culture of our financial system. When applied to the physical world, scientific techniques have been successfully used to determine cause and effect, helping us to predict and control our environment. This success has encouraged the idea that scientific techniques can be productively applied to all human endeavors, including investing. But investing is not a science. It is a human activity that involves both emotional as well as rational behavior.
Financial markets are far too complex to isolate any single variable with ease, as if conducting a scientific experiment. The record is utterly bereft of evidence that definitive predictions of short-term fluctuations in stock prices can be made with consistent accuracy. The prices of common stocks are evanescent and illusory. That’s because equity shares are themselves merely derivatives—think about that!—of the returns created by our publicly held corporations and the vast and productive investments in physical capital and human capital that they represent.
Intelligent investors try to separate their emotions of hope, fear, and greed from their trust in reason, and then expect that wisdom will prevail over the long term. Hope, fear, and greed go along with the volatile market of short-term expectations, while trust in reason goes with the real market of long-term intrinsic value. In this sense, long-term investors must be philosophers rather than technicians. This difference suggests one of the great paradoxes of the financial sector of the U.S. economy today. Even as it becomes increasingly clear that a strategy of staying the course is inevitably far more productive than market timing, or than hopping from one stock—or a particular mutual fund—to another, the modern information and communications technology provided by our financial institutions make it increasingly easy for their clients and shareholders to engage in frequent and rapid movement of their investment assets.
The Rise of Speculation
The extent of this step-up in speculation—a word I’ve chosen as a proxy for rapid trading of financial instruments of all types—can be easily measured. Let’s begin with stocks and their annual turnover rate, which is represented by the dollar value of trading volume as a percentage of market capitalization. When I entered this business in 1951, right out of college, annual turnover of U.S. stocks was about 15 percent. Over the next 15 years, turnover averaged about 35 percent. By the late 1990s, it had gradually increased to the 100 percent range, and hit 150 percent in 2005. In 2008, stock turnover soared to the remarkable level of 280 percent, declining modestly to 250 percent in 2011.
Think for a moment about the numbers that create these rates. When I came into this field 60 years ago, stock-trading volumes averaged about 2 million shares per day. In recent years, we have traded about 8.5 billion shares of stock daily—4,250 times as many. Annualized, the total comes to more than 2 trillion shares—in dollar terms, I estimate the trading to be worth some $33 trillion. That figure, in turn, is 220 percent of the $15 trillion market capitalization of U.S. stocks. To be sure, some of those purchases and sales are made by long-term investors. But even if we look at what are considered long-term investors, precious few measure up to that designation. In the mutual fund industry, for example, the annual rate of portfolio turnover for the average actively managed equity fund runs to almost 100 percent, ranging from a hardly minimal 25 percent for the lowest turnover quintile to an astonishing 230 percent for the highest quintile. (The turnover of all-stock-market index funds is about 7 percent.)
The numbers measuring stock market turnover include enormous trading through today’s principal market makers: high-frequency traders (HFTs), who are said to presently constitute some 50 percent or more of the total market volume. These HFTs, in fairness, stand ready to provide liquidity to market participants, a valuable service offered for just pennies per share, with holding periods for their positions as short as 16 seconds. Yes, 16 seconds. (This multiple market system, however, has created significant inequities in order execution that demand a regulatory response.) The high demand for the services of HFTs comes not only from “punters”—sheer gamblers who thrive (or hope to thrive) by betting against the bookmakers—but from other diverse sources, as well. These traders may range from longer-term investors who value the liquidity and efficiency of HFTs to hedge fund managers who act with great speed based on perceived stock mispricing that may last only momentarily. This aspect of “price discovery,” namely statistical arbitrage that often relies on complex algorithms, clearly enhances market efficiency, which is definitely a goal of short-term trading, but also benefits investors with a long-term focus.
Yes, HFTs add to the efficiency of stock market prices, and have slashed unit trading costs to almost unimaginably low levels. But these gains often come at the expense of deliberate investors, and expose the market to the risks of inside manipulation by traders with knowledge of future order flows. It is not yet clear whether the good aspects of HFT exceed the bad. But despite the claims that all this exotic liquidity is beneficial, one wonders just how much liquidity is actually necessary, and at what price? Paraphrasing Samuel Johnson on patriotism, I wonder if liquidity hasn’t become “the last refuge of the scoundrel.” There is also an emerging question as to whether, when the markets tumble, the HFTs don’t withdraw their trading, depleting market liquidity just when it is needed most.
A few significant anomalies emerge from the large increase in transaction activity, of which HFT is now a major driver. Trading in index funds has also soared, and exchange-traded index funds now account for an astonishing 35 percent of the dollar amount of U.S. equity trading volume. Such trading has increased systemic risk in equities, increased cross-sectional trading volatility, and led to higher correlations among stocks and rising equity risks (measured by higher betas).1
The benefit of the obvious improvements in liquidity and price discovery created by the current staggering volume of stock trading must be measured against these negative factors. “All that glitters isn’t gold.”
Consider now how these tens of trillions of dollars of stock transaction activity in the secondary market each year compare with transaction activity in the primary market. While the secondary market can be criticized as being highly speculative, the primary market provides, at least in theory, capitalism with its raison d’être. Providing fresh capital to business—let’s call it capital formation—is generally accepted as the principal economic mission of Wall Street. That mission involves allocating investment capital to the most promising industries and companies, both those existing businesses that seek to provide better goods and services at increasingly economic prices to consumers and businesses, and innovators of new businesses that seek to do the same, only de novo. The overwhelming consensus among academic economists agrees that this function provides the rationale for our financial system. But the importance of Wall Street to spurring healthy capital formation is also confirmed not only by the system’s detractors, but by major market participants and regulatory leaders.
- Among investment bankers, Goldman Sachs’s chief executive Lloyd C. Blankfein has worked hard to underline the social benefits of capital formation. While his claim to be doing “God’s work” was a throwaway joke, he has correctly argued that the financial industry “helps companies to raise capital, generate wealth, and create jobs.”
- Among the critics, hear New York Times columnist Jesse Eisinger: “The financial industry has strayed far from being an intermediary between companies that want to raise capital so they can sell people things they want. Instead, it is a machine to enrich itself, fleecing customers and widening income inequality. When it goes off the rails, it impoverishes the rest of us.”
- For an independent view, hear Mary Schapiro, Chairman of the Securities and Exchange Commission: “At the end of the day, if the markets aren’t serving their true function—which is as a place to raise capital for companies to create jobs, build factories, manufacture products—if the markets are not functioning as a rational way for investors to allocate their capital to those purposes, what’s the point of markets?”
But in reality, how large is that capital formation activity? Let’s begin with stocks. Total equity IPOs (initial public offerings) providing fresh capital to young companies have averaged $45 billion annually over the past five years, and secondary offerings providing additional equity capital have averaged about $205 billion, bringing total stock issuance to some $250 billion. The annual volume of stock trading averaged $33 trillion during that period, some 130 times the volume of equity capital provided to businesses. Put another way, that trading activity represents 99.2 percent of what our financial system does; capital formation represents the remaining 0.8 percent. Now, that is a sizable imbalance! What is almost universally understood to be Wall Street’s mission has been aborted.
The issuance of corporate debt is another function of the economic mission of finance. Over the past decade, new corporate debt offerings averaged about $1.7 trillion annually. But fully $1 trillion of that was accounted for by the now virtually defunct area of asset-backed debt and mortgage-backed debt. Too often these securities were based on fraudulent lending and phony figures that were willingly accepted by our rating agencies, willing coconspirators in handing out AAA ratings to debt securities that would tumble in the recent debacle, their ratings finally slashed. I’m not at all sure that this massive flow of mortgage-backed debt is a tribute to the sacred cow of capital formation.
Futures and Derivatives
This huge wave of speculation in the financial markets is not limited to individual stocks. Trading in derivatives, whose values are derived from the prices of the underlying securities, has also soared. For example, trading in S&P 500-linked futures totaled more than $60 trillion(!) in 2011, five times the S&P 500 Index total market capitalization of $12.5 trillion. We also have credit default swaps, which are essentially bets on whether a corporation can meet the interest payments on its bonds. These credit default swaps alone had a notional value of $33 trillion. Add to this total a slew of other derivatives, whose notional value as 2012 began totaled a cool $708 trillion. By contrast, for what it’s worth, the aggregate capitalization of the world’s stock and bond markets is about $150 trillion, less than one-fourth as much. Is this a great financial system . . . or what!
Much of the trading in derivatives—including stock index futures, credit default swaps, and commodities—reflects risk aversion and hedging. However, a substantial portion—perhaps one-half or more—reflects risk seeking, or rank speculation, another component of the whirling dervish of today’s trading activity. Most of this excessive speculation is built on a foundation of sand, hardly a sound basis for our financial well-being. Sooner or later—as the great speculative manias of the past such as Tulipmania and the South Sea Bubble remind us—speculation will return to its proper and far more modest role in our financial markets. I’m not sure just when or how, but the population of investors will one day come to recognize the self-defeating nature of speculation, whether on Wall Street or in a casino.
I imagine that I’m not the only author who, poring over his manuscript yet one more time, gets a huge lift when he comes across a perceptive essay in a celebrated newspaper that (at least to the author!) endorses the ideas in his book, even the most controversial ones. So it was when I read the article in the March 3, 2012, issue of The Economist
. You’ll note that virtually every idea in the excerpt in Box 1.1
on the next page echoes the conclusions I express in these next few chapters.
Box 1.1: The Economist of London Speaks
“Short-Changed—The Stock Market Is Not Fit for Purpose,” by Buttonwood
“The main economic functions of the equity markets are twofold. The first is that savers can participate in economic growth by linking their savings to business profits. The second is to encourage the efficient allocation of capital. These are long-term goals that have virtually nothing to do with the daily fluctuations of the market. The problem is that the regulatory framework has increasingly moved to favor liquidity and trading activity over long-term ownership. . . . The result is an excessive focus on short-term targets. . . .
“Worse still, such frequent reporting has forced bosses to focus on “beating the numbers” at the expense of long-term planning. . . . Performance measures such as earnings per share or return on equity may encourage excessive risk-taking.
“Why haven’t shareholders redressed the balance? . . . (Because) most shares are no longer owned by private investors, but by professional fund managers. Those managers are themselves judged on the basis of short-term measures and on their performance relative to a stock market index.
“In short, the current market structure does not seem fit for purpose. How to fix it is not clear. There is clearly no silver bullet. Rewards for long-term shareholders, in the form of tax breaks or better voting rights, may be part of the answer. Smarter rules on executive pay wouldn’t hurt. Above all, it would help to remember that the stock market serves a wider goal. It is not supposed to be a sophisticated version of the National Lottery.”
The Wall Street Casino
Way back in 1999, I wrote an op-ed for The New York Times entitled “The Wall Street Casino.” It called attention to the negative impact of the “feverish trading activity in stocks.” At the time, daily trading volume averaged 1.5 billion shares, puny by today’s standards. In 2010, the Times revisited the issue with an editorial with virtually the same title, “Wall Street Casino.” It called attention to the even higher levels of speculation that had come to distort our markets and ill-serve our investors.
To understand why speculation is a drain on the resources of investors as a group, one need only understand the tautological nature of the markets: Investors, as a group, inevitably earn the gross return of, say, the stock market, but only before the deduction of the costs of financial intermediation are taken into account. If beating the market is a zero-sum game before costs, it is a loser’s game after ...