Tuesday, April 22, 2008

Free Market Ideology: The Danger to Real-Time Investors

If you are a middle-class investor protecting a family, you should learn as much as you can about "free market" ideology. It's a set of faith-based beliefs that shapes the financial industry in general and the corporate philosophies of many companies whose stock you purchase. If you think you can safely invest for your family without critically examining how this faith-based economics affects the managers of your investments, you are a sheep headed for a shearing.

The central element in free market ideology is a utopian vision of society in which economic activities can be pursued with little or no government regulation.

Concretistic descriptions of a free market can be found all over the internet. Wikipedia's is a bit more sophisticated:

A free market is a market in which prices of goods and services are arranged completely by the mutual consent of sellers and buyers. By definition, in a free market environment buyers and sellers do not coerce or mislead each other nor are they coerced by a third party.

Say Again? Buyers and sellers do not mislead one another?

On April 17, 2008, two stories ran in adjacent columns of the New York Times business section. The position of the articles invites the attentive reader to wonder, "Has American business leadership deteriorated to a point where executives are expected to deceive and mislead as a normal part communication with shareholders?"

The centerfold story: Patience Wears Thin: G.E.'s Shortfall Calls Credibility Into Question

For seven lean years, Wall Street has given General Electric and its chief executive, Jeffrey R. Immelt, the benefit of the doubt.

...Now, in the wake of a surprise earnings shortfall last week, Wall Street's patience has run out as the stock has plunged to its lowest level in four years.

...Shares of G.E. closed at $32.23 on Wednesday, down from about $37 a week ago, and off sharply from where they were before Mr. Immelt took over on Sept. 7, 2001.

For Mr. Immelt, the problem now is not just the earnings disappointment — the consensus estimate for the first quarter was 51 cents and G.E. reported 44 cents — but a looming credibility gap. On March 13, he assured investors the company was on track to meet its profit targets. And in December, he told analysts that G.E.'s goal of earnings growth of at least 10 percent in 2008 was "in the bag."

..."I've been covering the company since 1996, and I've never seen a miss this big," said Nicole Parent of Credit Suisse, who had rated G.E. as her top pick but downgraded it to neutral after the earnings report...

When the news broke shortly after 6 a.m. last Friday, Mr. Tusa said: "I was on the train, and I almost fell out of my seat. It was a shock — people thought it was a misprint."

...Even defenders of Mr. Immelt admit that the juxtaposition of the rosy predictions and the ensuing shortfall have shaken the reputation of G.E., which is the sixth-largest American company by revenue as well as a barometer of the broader economy.

The adjacent story: Retailers Get Stingy With Data

J. C. Penney says the tumultuous economy is making it impossible to predict earnings over the next year. Macy's asserts that providing monthly sales information is too distracting and confusing. And Starbucks argues that annual profit estimates are unnecessary.

In American retailing, less is suddenly more — at least when it comes to giving investors the sort of financial information they have long expected from companies.

Faced with an economic slump, a growing number of national retailers are abandoning the longstanding tradition of reporting monthly store sales and forecasting annual profits.

The stores say that they are eliminating outdated practices that encourage short-term decision-making and can confuse investors.

But many Wall Street analysts and investors, who rely on these numbers to gauge a company's health and the mood of the American consumer, are crying foul. The motive for providing less financial insight, they suspect, is to avoid issuing embarrassing numbers in the middle of a recession, numbers that can drive down a company's stock price.

So far this year, Starbucks, Macy's, CVS, Caremark and Jos. A. Bank have ditched one or both of the financial reporting practices that were once standard in retailing.

And on Wednesday, J. C. Penney joined the list, saying it would stop offering annual profit estimates, known in the industry as guidance, at least for now. (It will still provide monthly sales and quarterly profit estimates.)

Myron E. Ullman, the chief executive of J. C. Penney, said that with the housing market in turmoil and gas prices surging, "there is not enough visibility to give something meaningful."

The analysts who track J. C. Penney and the rest of the retail business can barely contain their frustration with all the lip zipping. "Withholding information is not what investors want," said Bill Dreher, a longtime retail analyst at Deutsche Bank Securities. "They want clarity."

A tough economy, Mr. Dreher added, "is a time to be more communicative, not a time to deprive us of guidance or clamp down on information."

How does this affect you? It's simple!

You can't make good investment decisions about companies whose executives camouflage the company's state from its investors!

Look at the situation of a buy-and-hold investor who trusted Immelt in December when he said 10% earnings growth was "in the bag" or trusted him in March when he said the company's profit targets were on track. On April 10, that investor's GE closed at $36.75. On April 11, after the earnings report was issued, Frugal Ben bought some GE for $32.

Today, the stock is trading at $32.25. Ben is happy enough with that. The stock pays a 3.25 % dividend yield which allows Ben to wait for the first good selling opportunity so that he can dump this speculative puppy.

The trusting investor lost about 13% of his investment overnight. If he needed to sell now, he's screwed. To break even, he has to wait until the stock appreciates almost 15%.

Free market dupes often argue that stories like the above confirm the effectiveness of a deregulated market: Eventually, the dupes tell us, misrepresentation or concealment gets discovered without government intervention and the market corrects the problem. This sort of wacky reassurance misses the point and is of no use to retail investors! You are not and never will be the market as a whole over an infinite period of time. You're the investor who gets robbed today and all too often cannot make up the loss over the rest of your investing lifetime.

The free market utopia pops up all the time in our political discourse but is rarely recognized for the faith-based reification that it is.

Few people would be taken in by the wackiness when someone says "Vote for me! I want to eliminate all government regulation concerning car thefts. We don't need that kind of regulation, we need freedom! We live in a country where the general economy keeps improving. You will be better off in the future than you are now. So, if your car is stolen, eventually you will recover from the loss."

If that doesn't play, why should one believe a free market utopian who promises, "Vote for me! I want to eliminate all government regulation concerning corporate investment misrepresentation. We don't need that kind of regulation, we need freedom! We live in a country where the general economy keeps improving. You will be better off in the future than you are now. So, if your investment gets whacked 13% or 50% or even 100% because executives deceived you, eventually you will recover from the loss."

When you shop for a house, you enjoy some protection because the seller is required to truthfully disclose information in response to your direct questions about house defects. Why should the situation be different when you shop for a stock?

Frugal Ben Says:

Inoculate yourself against simple-minded arguments from free market extremists. They are preachers of a utopian fantasy irrelevant to real middle class people. Teach yourself to think critically about their assurances that an unregulated market helps investors.

In the real world, investors are entitled to accurate information about what they are buying. We cannot trust executives to provide such information in unregulated markets. By the time the market catches on to cheats, irreversible damage to middle class people has already been done.

You will never have perfect information when you make an investment decision.

On the other hand, you are entitled to good information - that is, information free from distortion rooted in incompetence, irresponsibility or outright deceit.

In short, you are entitled to market regulation that guarantees transparency from prima donna executives.

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