In Who’s Interest?

The current protest, known as “Occupy Wall Street”, has engendered a growing number of epithets from the far right. Paul Krugman called it: “Panic of the Plutocrats.” The conflict arises from the fact that the interests of the plutocrats and the interests of the general investors are at odds with each other.

The Plutocrats that Krugman mentioned are comprised of three groups: The first group is the Brokerages who make more money as trading increases. Most of the stock analysts, who make recommendations, work for the brokerage firms and are prone to recommend trading as opposed to investing strategies because these increase the profits of the brokerages that they work for. Included in this first group are the stock brokers themselves who make their living off the numbers of trades they receive commissions on. The second group is comprised of the traders who have a shorter perspective and merely buy and sell based upon small movements in share prices. Neither of these groups adds any real economic value to society. They engage in financial asset swaps ignoring and some times discourage real value creation because it can lead to short-term reductions in profits. The third level of plutocrat is made up of corporate executives who, along with the boards of directors, are charged with looking out for the interests of the shareholder. There are, however, two classes of common stock ownership in most publicly traded companies. Looking out for the interest of two separate classes may lead to mutually exclusive goals.

The two groups of share holders may be classified as the investor and the trader. The investor has a long-term perspective wherein stock is purchased on the basis of expected growth and profitability over time. The trader, on the other hand, is looking for short-term profits that will lead to rapid rises in the company’s share price resulting in a rapid resale of the shares. The value of a company’s shares is often thought of as the discounted present value of future profits. The conflict between the two classes of shareholders comes from the fact that a trader puts an exceptionally high discount on future earnings thereby reducing the present value of those earnings. The trader wants it all now. As a result, a trader will put pressure on companies not to reinvest in themselves because reinvestment could lead to short-term profit reduction and leave less cash available for current distribution to the trader. This is exemplified by the last time the government allowed a tax free repatriation of foreign earnings (As of 2003)_. Companies, rather than investing in new plant and equipment, engaged in Stock Buy-Back programs which merely raised the price of stocks so traders could cash in. This lack of reinvestment is the same as disinvesting. In other words, by not reinvesting, the firm is headed toward a long-term decline. This is in direct opposition to the interests of the longer term investor.Update Jan 2019: The analysis of the 2017 tax law for 2018 shows that companies continued to use repatriated cash for stock buybacks and dividends rather than Capital Investment. 

Executives and boards are under severe pressure from broker/analysts to maximize short term profits. There is however a positive relationship between higher risk and high returns. Needing higher returns means that managements are constantly engaging in higher risk activities. Boards, looking out for the interests of traders rather than investors, issue contracts to executives that reward the high risk/return trade off and insulate management from the potential downside if the risks don’t payoff as projected. On top of all of this, companies can leverage profits up through increased borrowing. The downside is that the company is stuck with fixed cash payouts during an economic downturn. This could be harsh enough to force the company into bankruptcy. Traders don’t care. They are usually in and out so quickly that they have made their profits before the collapse. It is the investor who is stuck with worthless stock.

UPDATE AS OF 12/16/11: The New York Times has an article - "Amazon Says Long Term and Means It" which points out my contention that the market is dominated by organizations with short time horizons and therefore punishes firms such as Amazon because it has a long time horizon."Whatever they might say about long-term shareholder value, this is simply too much for many of today’s investors, many of whom are hedge funds, pension funds and institutions who measure their results — and earn their pay — based on quarterly benchmarks. “If you look at the average length of ownership of a stock, the period is declining,” Mr. Devitt said. “Amazon is marching to a different drumbeat, which is long term. Are they doing the right thing? Absolutely. Amazon is growing at twice the rate of e-commerce as a whole, which is growing five times faster than retail over all. Amazon is bypassing margins and profits for growth.” Also, according to another section of the article: " In October, when Amazon reported strong third-quarter revenue growth and earnings that were pretty much what the company had predicted, but indicated it would be spending more to support continued growth, investors hammered its stock. Amazon shares dropped nearly $30, or 13 percent, to $198 a share in just one day, Oct. 25. "

In addition, short-term profitability can be increased by reducing the company workforce. This lowers cost in the short-run but, because the layoffs are often aimed at higher paid workers, also means that the most skilled and productive workers are lost. In addition, historical knowledge is lost and firms end up repeating past mistakes because nobody still around remembers that certain activities did not work. On a national level this approach leads to falling real incomes, high levels of unemployment, and slow growth with high volatility in the value of 401ks.

Looking at all of this, is there any wonder that there is a growing anti-Wall Street movement in this country? Although the Occupy Wall Street movement has not expressed its discontent in the terms described here, the problem has gotten so bad that the participants have developed a visceral understanding of the underlying cause of the economic problems facing us all.