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Posted 9/8/2003
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Spitzer's mutual-fund fight deserves an A
The New York attorney general's investigation of mutual funds is welcome news. Most investors had assumed this industry is squeaky-clean. It's about time the truth was exposed.
By Bill Fleckenstein
Lest anybody think we've said our permanent goodbyes to the excesses of the mania, a couple of worthwhile developments last week should set the record straight.
Topping the list: Wednesday's announcement by New York Attorney General Eliot Spitzer that he had uncovered "illegal trading schemes" involving hedge funds and mutual funds. Some of the hedge funds have been buying mutual fund shares at, in essence, the wrong prices. As the scheme was described, these hedge funds profited unfairly by scooping up shares at closing prices after learning of gains in after-hours trading.
I can only applaud Spitzer's investigation and hope it leads to scrutiny of tape-painting, the longest-running, illegal, open secret on Wall Street. Some folks have no use for Spitzer, accusing him of political opportunism rather than a genuine interest in fixing what's broken. But at the end of the day, at least he is attempting to clean up what has been a very sordid mess. I, for one, am grateful for that.
An exchange's excess of largesse
It also appears that William Donaldson, the new head of the SEC, is attempting to clean up some problems over at the New York Stock Exchange. In a scathing letter written Tuesday to Carl McCall, the chairman of its compensation committee, he fired off some rather pointed questions about why NYSE Chairman Dick Grasso, in essence an institutional watchdog, was paid $140 million to watch the foxes outside the chicken coop.
I know that some folks think Dick Grasso's job is to champion the exchange. But when the exchange is also in charge of its own regulation, the potential for conflicts of interest only increases. As we've seen from revelations over the past few years, whenever it's come to conflicts on Wall Street, the money has usually won out. In any case, the situation was outlined rather well last Tuesday in the Lex column of The Financial Times:". . . Mr. Donaldson's 30-odd questions and requests for information are devastating in their detail. The requests for the minutes of the compensation committee meetings during Mr. Grasso's time as chairman and for the names of committee members and how they were chosen may cause embarrassment for those involved. There is no world in which paying the head of a quasi-public institution that has regulatory responsibilities such sums could be acceptable. Detailing the conflicts of interest between Mr. Grasso's paymasters and the NYSE will be particularly painful for the exchange, not least because of Mr. Grasso's questionable directorships.
"The SEC's hint that the chairman's pay might have affected the NYSE's ability to fulfill its regulatory responsibilities is particularly interesting. During his short tenure, Mr. Donaldson has succeeded in repairing the SEC's credibility. Mr. Grasso, in what might have been too long at the NYSE, has now damaged the exchange's standing. The questions are whether the NYSE can retain its regulatory functions and how much cash Mr. Grasso will agree to hand back when he resigns."
What were they thinking?
I don't know that Dick Grasso will resign or hand back any cash. But I have to ask, what in the world were these people thinking when they agreed to such a compensation package? When the news first emerged, I thought that perhaps my shock was a bit old-fashioned. Then, it struck me that the sheer excess of this package offers a perfect vignette for the last five years or so. It also shows how little has changed, as I have been saying, since the bubble burst.
Some reforms notwithstanding, folks' willingness to suspend disbelief and speculate has thrived, aided and abetted by those who ought to know better. Currently, the game of beat the number (otherwise known as the great oxymoron "momentum investing") is all the rage, vs. comparing a company's earnings with its share price. My view that this giant disconnect would end when the second half began early last July has been incorrect. Many of the indices have now marched past the peaks set last June.
In my opinion, this changes nothing. In fact, it just ratchets up the risk of a large dislocation when folks realize that we do not have a self-sustaining recovery. (Some of the underlying weakness is obviously seen in the persistent problems with unemployment.) But until the psychology changes or we actually achieve exhaustion (which could happen literally any day now), folks will continue to play the same game, where in essence nothing matters.
Sounding an alarm on global disequilibrium
The folly of that approach was articulated recently in a brilliant piece by Morgan Stanleys Steve Roach, "Do Global Imbalances Matter?" Id like to share some of it with readers. He has been one of the few people to understand the mania and its consequences. In other words, he's not your typical Wall Street hack economist. His discussion puts into perspective the risks assumed by folks who play beat the number with other people's money, and what they will ultimately face when the psychology changes:
"As the summer of 2003 winds down, the markets are going through a classic cyclical drill. Around the world, financial assets are being priced for recovery, renewed inflationary pressures, and central bank tightening. It's a scenario we've all been through before, time and time again. . . . It's times like this that test any macro practitioner. Resolve and discipline are one thing. But in this mark-to-market world of momentum investing, you can't afford to be wrong for long.
"While I am acutely sensitive to this feedback, I see little in the tea leaves that convinces me to abandon the basic framework that has guided my thinking over most of the past four years. As I continue to see it, the macro conundrum remains very much a tug-of-war between policy reflation and an extraordinary confluence of global imbalances. In the end, it boils down to whether the authorities have the wherewithal to spark a cyclical revival that offsets these excesses.
"There is always the issue of timing -- that fundamental imbalances are more of a distant concern that do not translate into a near-term macro call. While I have to concede that's always possible, I fear that the excesses have now gone to such extremes that vigorous growth in the global economy cannot be sustained. My bet is that today's imbalances are different. Believe me, I know full well that financial markets are now telling me that I'm dead wrong. In all my years in this business, I've never come across such a worrisome and potentially lethal confluence of imbalances. . . . " He then goes on to cite these, most of which I have covered over time. Not surprisingly, I basically agree with his every word.
He sums up:
"Can policy traction 'paper over' the imbalances of a U.S.-centric world? This is where the rubber meets the road, as far as I am concerned. Reflationary policy initiatives are no substitute for global rebalancing. In the case of the United States, another burst of deficit-financed domestic demand will only exacerbate the excesses of debt, saving, and the current account. In the cases of Japan and Europe, competitive currency devaluation will only inhibit the very reforms that are needed to unshackle domestic demand.
"And, at the same time, politically inspired China-bashing can only threaten the global trade dynamic that now plays such an important role in driving world economic growth. That underscores the ultimate irony of the so-called reflation play -- that any policy-inspired rebound may well exacerbate the imbalances of the U.S.-centric world. Financial markets that bet on a quick and easy fix do so at considerable peril, in my view." I agree completely. The risk/reward proposition is totally out of whack. While it may seem fun to bet on the upside for now, which may last a bit longer, after this party ends, it will be worse than when the bubble burst the first time. A lot worse.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At the time of publication, he owned no securities mentioned in this article. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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