Cracks in the Economic Mirror

cracked glassWhy not come out and say it? Wall Street is not your friend. At least it’s not your friend if you are among the group casually known as American Workers.  I know, much has been said about our “Nation of Investors” and how millions of Americans have a stake in the financial markets.  [SEC] However, all that palaver papers over the obvious.  Wall Street’s financial markets are dominated by institutional investors, and such connection as the average American does have is often limited to the tertiary strings which attach to retirement savings accounts and pension funds.

There are forces which generate revenue for Wall Street investment houses that have a negative impact on those American Workers, for example — when Walgreen Inc. decided to eschew a corporate inversion, keeping its headquarters in Chicago the Market pounced and instead of rewarding the company for maintaining its American identity and retaining its American workforce at the Chicago HQ the Wall Street Wizards dumped its stock. [CBS]  More examples?

Merck, Cisco Systems, AOL, HP, Citigroup, Bank of America, and Wells Fargo — all companies which were rewarded by Wall Street for cutting expenses (read employees). [MoneyCNN] Cost cutting (read layoffs) will be rewarded because…? If revenues are at least stable and expenses are reduced there will obviously be more profits for shareholders.  If Wall Street has an anthem it must be “Onward Shareholder Value.”

The problem with marching to this tune is a loss of corporate focus.  Henry Ford’s big idea was to manufacture automobiles.  Merck may be the oldest pharmaceutical company in the world, beginning with Friedrich Merck’s purchase of an apothecary shop in 1668 — a firm which grew to sell the first commercial small pox vaccine in the United States in 1898. [Merck]  Henry Wells and William Fargo started their San Francisco business in 1852 offering banking and express services. [WF] In each of these instances the founders, whether a middle western mechanic, the descendents of an apothecary owner, or the bankers during the Gold Rush, opened their doors to provide products or to deliver a service.

A firm gets to be an institution by providing goods or services, sold to people who need or want them. There is no other way to build a business.  However, when the management of a company is more interested in the stock price than in the goods or services rendered to the public we start to see the cracks in the system.

The mythology takes over — We, say the managers, must guarantee to our shareholders (owners) the highest possible return on their investment.

Crack Number One:  How long must one wait for the return on the investment?  We have a relatively recent example of what happens when the management of a commercial enterprise decides to cash in on quick returns instead of waiting for long term results. Back in 2003 CBS News asked “Who killed Montana Power?”  The short answer is the management. Montana Power management took a blue chip company, a formerly solid investment, a source of economical electric power, and transformed it into … a disaster.

Crack Number Two: Institutional and professional investors aren’t investing in long term corporate strategies which they expect to grow over the next 90 years. They are instead attuned to the quarterly reports, the earnings estimates, and the pronouncements of the analysts.  Volatility, not stability, is the key to high and quick returns. Stability protects long term investors, volatility rewards short term speculation. [BusIns]

Crack Number Three:  When the Finance Department meets the Production Department who wins?   In the 1990s the financial sector accounted for about 20% of all corporate profits, by 2011 the sector rebounded from the Mortgage Meltdown and accounted for approximately 29% of all corporate profits. [HuffPo] The process happens in the remainder of the economy as well. Consider the recent information coming from General Electric.

The company’s industrial division (medical equipment, oil & gas drilling equipment, aircraft engines, locomotives, and gas turbines) reported revenue increases of 9%, its oil and gas revenues were up an impressive 25%, its financial services were up 7%.  In fact, the financial services end of the business, Synchrony Financial, is to be spun off getting GE out of the private label credit card business by 2015. Oh, and by the way — the corporation is planning to get rid of its appliance manufacturing. “Mr. Immelt made a promise to investors that the company would expand its industrial businesses and get rid of non-core segments.” [MBN]

The company formerly synonymous with nearly all things electrical is going to profit from selling off its private label credit card operations and dropping the appliances end of the business.  There’s nothing intrinsically wrong with the evolution of a corporation moving with the tides to stay profitable — but this does illustrate how a firm can move from manufacturing into financials as a core segment of its business.

Meanwhile there are several Wall Street investment banks no longer in existence that were enamored of generating fast revenue in derivatives markets and moved with another tide — out to sea.

Crack Number Four: Insert the hedge fund managers here.  Its one thing to argue for shareholder activism when speaking of the managers of pension funds, 401(k) funds, or the like, it’s quite another when the shareholder activists are hedge and wealth management types.  The Harvard Business School issued a report (July 9, 2014) coming to the following, rather depressing conclusion:

“As in prior research, we find positive announcement-period returns of around 4% to 5% when a firm is targeted by activists and a 2% increase in return on assets over the subsequent one to five years. We find that activist directors are associated with significant strategic and operational actions by firms. We find evidence of increased divestiture, decreased acquisition activity, higher probability of being acquired, lower cash balances, higher payout, greater leverage, higher CEO turnover, lower CEO compensation, and reduced investment.”

We can lump “increased divestiture, decreased acquisition, higher probability of being taken over, more debt, and less investment” under the general category of short term interests.

What is a pension fund or 401(k) administrator to do?  If pension funds, both public and private, are to be invested in corporations increasingly likely to be managed for short term revenue results, and those results are all too likely to be hinged on a swinging door of price volatility; and, if corporations are more likely to be managed with an eye toward the financials, coupled with increased divestiture and greater leverage — how does one invest for the long term in a short term environment?

So, here comes the dilemma.  The fund managers and administrators may decide to swim with the sharks — to go along with the short term investment strategies and applaud the volatility of the financial markets.  However, we’d have to ask: Does the very volatility of the markets or the acquisition of more indebtedness actually work against the best interests of the people who are paying into those retirement or pension funds?

Those who are now working, expecting retirement benefits or pension payments, seem to be at the mercy of a financial sector which rewards their layoffs and applauds the divestiture of their firms.  The message is reflecting from a cracked mirror: If you are lucky and the financial markets are up on your 65th birthday you can retire — If not?

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