Thursday, August 25, 2011

Stop the Roller Coaster! The Casino is down the road in Atlantic City!

So, how is your neck feeling? Do you have whiplash yet from all of the gyrations in the stock market? We have been up, down and all around over the past several years so much that any picture of economic stability in our financial institutions changes more often than the weather (except in Texas where you can be pretty sure that it never rains anymore). Take a look at these snapshots of performance of the Dow Jones Industrial Average. Over the past 10 years, the DJIA is up 5.96% (610.32 points). This is okay given the economic shocks that we have seen (recession, housing bubble, etc.). But take a closer look inside the ten years and we see that the last 5 years have experienced a drop of 4.66% (530.37 points); the past year has seen an increase of 547.95 points (5.32%) and year to date, the DJIA is down 308.41 points (2.66%). Don’t even get me started on what has happened over the past 2 weeks; starting with the S&P downgrade!!! I don’t think I have enough pepto to keep my breakfast down when I look at all of this. On top of all of this, Gold is down over $100 over the past 2 days!

A lot of this volatility in the markets can be attributed to what I believe is a fundamental change in what the equity markets were formed to do. In their infancy, the equity markets were developed to provide companies with access to capital to GROW THEIR BUSINESSES, enter new markets, develop new products, EMPLOY MORE WORKERS. Investors would look into the fundamental operating and strategic vision of management and their ability to develop and enhance LONG TERM SHAREHOLDER VALUE. Corporate information was analyzed by investment houses, considered along with external economic market conditions and capital raising/investment decisions were based on in depth analysis of the likelihood of long term success. The federal tax code also rewarded long term investment decisions by taxing gains on investments held over a year at lower rates than ordinary income. Management was compensated on long term value enhancement that laid the foundation for constant innovation; not worrying just about the next quarter’s results. Then came the internet…

Do you ever notice that too much information can be a bad thing? Without the discipline to sift through earnings results and market developments, investment decisions can go horribly wrong. But with instant access to the markets, anybody can find the easiest way to make a quick buck. Over the past several years, “trading on technicals” has become the primary investment strategy for individual investors who have access to the internet. They don’t have to understand a company, only follow the money flowing to or from it. Technical trading primarily follows money flows. If the large investment houses are buying or selling large volumes, smaller investors jump on board, taking equity or option positions to leverage the current movement in the stock. It is somewhat like, no, it is exactly like book making at the race track. Race odds get wider if little money is moving toward a particular horse/team and odds get tighter if money is moving toward a team. The odds have no real bearing on who will win, only on how much money is flowing where. Sure, you can say that the smart money knows where to go, but haven’t we seen a lot of upsets and long shots winning lately? Experts, indeed. Also, the large fund complexes have taken advantage of this through bloc computer trading that can move millions of shares from buy to sell in nano-seconds. This volatility leads corporate management to make decisions that may help a company in the short run, but harm long term value creation. If this quarters’ numbers are up due to massive cost cutting that will harm the company in the long run, the short term buyer (maybe a day to two weeks) doesn’t care. The company beat estimates and the stock price will go up and management’s stock options are in the money so here comes that house in the Hamptons! New companies look to going public as a way to cash out their founders’ equity instead of growing the company over the long run. The attention span of the market is in dire need of some Ritalin.

This is where the tax code can help. By taking a larger bite of taxes from trading profits for shares held for a shorter time, fewer trades will happen, less volatility will occur in the marketplace and management will look toward long term value creation because market feedback will be more in tune with longer term investment holds. Overall, I would propose a sliding scale of capital gains taxes that would reward long term capital formation and steady growth. Starting at 40%, capital gains rates would fall by 8% for every year an investment is held until all investments held for at least 5 years would carry ZERO CAPITAL GAINS TAX (40% for positions held less than one year, 32% for 2 years, 24% for 3 years, 16% for 4 years, 8% for 5 years and 0% thereafter). I would also propose direct offsets to income 100% of all realized losses from market trading instead of capping the losses to the extent of gains in the marketplace. This direct offset is necessary from the standpoint that a sale at a loss would have occurred either when investor liquidity needs outweighed a long term hold strategy or if fundamentals at the company warranted taking a loss.

By re-tying management decisions to long term value creation instead of next quarter’s results, investors large and small will take longer term positions, stabilizing the stock market, the employment market and the economy as a whole. The tax code exists to provide economic incentives to the market to make decisions that are in the best interests of the nation as a whole. Remember “E Pluribus, Unum” From the many, one. If you want to gamble on money flows, take the turnpike from Wall Street to Atlantic City. Let’s get the craps tables out of the board rooms.

No comments:

Post a Comment