Centre Street Cambridge Corporation

Private Investment Counsel


January 2010

The financial markets generated well-above-average returns in 2009, confounding the expectations of most market analysts who, like the rest of us a year ago, found themselves in the midst of a calamity unmatched since the 1930s. Many people are mystified at how markets defy not only expectations but economic realities as well, rising sharply or plunging painfully for no logical reason. However, a review of some recent history illustrates that this phenomenon has occurred repeatedly. In early 2000 for example, people had high hopes for equity investments due to their impressive returns for nearly twenty years. Nevertheless, the next ten years proved to be the worst decade in several for stocks. In the “noughties,” Wall Street became enamored with fixed-income derivative products, predicting they would widely diversify risk and promote increased lending at lower costs. The debt binge that followed turned to bust in 2007, revealing that risks had become concentrated in unexpected places. Feeding the fixed-income boom were various types of mortgages, taken out by borrowers who believed house prices could not fall—not a wise assumption as it turned out. In a more general sense, the “great moderation” of the last decade, when market volatility subsided, reflected a belief that risks in the financial system itself had declined. So-called “risk premiums”—that extra return investors demand to purchase riskier assets—declined to record low levels. As everyone now knows, vast amounts of wealth have been laid to waste owing to the re-emergence of risks that had been swept under the rug of modern, “creative” financial products.

Continuing this list, we could go back centuries. This offers little encouragement to making year-end predictions, except to suggest that we look for the opposite of what markets and soothsayers expect for the New Year. So what might be in store going forward? Investors have been fleeing U.S. stock funds, even as the popular averages rose dramatically out of the depths of last March, and have eagerly embraced bonds and “emerging market” equities. Perhaps we should look for less enthusiasm for bonds (and higher interest rates as a result), as well as setbacks in the dicier foreign equity markets while U.S. stocks continue their bullish run. It may turn out that the tremendous deficits being run by developed-country governments, widely feared to portend fiscal crises down the road, will be dealt with in a reasonable fashion after all, or the view promoted in certain influential financial circles that returns on stock market investments will be subdued for the foreseeable future could be overly pessimistic. It is amusing to speculate on these matters, but in the end uncertainty always reigns. The prognosticators could even turn out to be right this time!

The financial doom and gloom many expected a year ago has so far proven to be unfounded as equity markets in the U.S. ended the year with gains ranging from 23% to 45%, depending on your choice of index, well above the 9-10% long-term return on stocks. The rebound from the lows in March was even more spectacular (the S&P 500 alone gained 65% from the bottom), and individual stocks in hard-hit sectors such as banking saw values multiply. Those who took “beware the ides of March” to heart lost out as the middle of that month proved to have been an exceptionally good time to buy stocks. The stocks of the “riskier” variety of companies—small capitalization issues, for example, did best. Likewise, in the bond markets, which saw some of the strongest gains in any market last year, “junk” prevailed. Such gains are not uncommon on a rebound from sharp declines, but stocks would still need to rise another 30% or so to regain the high water mark of late 2007.

Meanwhile, it seems that one consequence of the economic and market recovery has been a flagging of interest in true financial system reform. This may be unintended, but it wasn’t unpredictable. Charles Munger (Warren Buffett’s business partner and a political conservative), in a Washington Post article published last February at the height of the crisis, expressed pessimism about the possibility of change owing to the influence of financial interests on the political sphere. Munger’s concerns about politics were not misplaced; a recent International Monetary Fund study demonstrated a close correlation between lobbying by U.S. financial firms and poor lending practices. Incidentally, Munger’s piece also implied a rather dim view of certain Wall Street trading operations. He claimed that society would be better off if the people engaged in such activities were driving taxi cabs instead. We would add that this suggested career change might aid the public purse as well, since in all likelihood cab drivers pay higher tax rates than hedge fund jockeys. On the other hand, former hedge fund managers might find the change disconcerting, since passengers, unlike many hedge fund clients, can end the ride whenever they like.

Another Form of Inflation

An oft-repeated quote of Benjamin Franklin’s—“We must all hang together or assuredly we shall all hang separately”—describes a level of responsibility and commitment that stands in sharp contrast to that resulting from a key flaw in modern corporate governance—the lack of “skin in the game” on the part of senior management, a problem we have written of repeatedly in the past. It was clear to Franklin and his colleagues that their commitment to the enterprise on which they had embarked carried with it certain personal risks; the idea of “limited liability” was out of the question. Today’s corporate titans not only enjoy limited personal liability for the consequences of their mistakes, but inflated notions of their own value, combined with weak oversight by owners (shareholders), has resulted in annual compensation that can equal several times (and often much more than) the lifetime earnings of the average taxpayer whose generosity has been called upon to rescue their higher-valued fellow citizens, most notably in the banking sector. As if that were not enough, the managerial class has also insulated itself in other ways from the hard discipline of capitalism and, indeed, the very vicissitudes of life. In a certain industry known for its abysmal management practices, executives have made off with tens of millions of dollars in bonuses and severance payments while leaving it up to the taxpayers to foot the bill for unfunded employee pension plans. In other cases executives enjoyed guaranteed returns on their pensions—up to 12% annually—at the same time rank and file employees, whose 401Ks are exposed to the ups and downs of the markets, wonder whether they will ever be able to afford to retire.

Good managers deserve to be paid well, but given the level of taxpayer subsidy that exists throughout the economy—through tax breaks, deductibility of interest, military protection, and, currently, through low short-term interest rates—it is not unreasonable to question the fairness of these special awards and “incentives,” particularly their one-way nature with no “claw-backs.” It is unfortunate that it takes a financial crisis, recession, and high unemployment to bring such issues to the fore. Perhaps that is because U.S. taxpayers have so far been spared the spectacle of a former bank executive cavorting around a posh estate on the Riviera while their counterparts in the U.K. forked over twenty billion British pounds to prop up the bank the executive left on the brink of collapse. That may be because the beneficiaries of U.S. taxpayer support are more discreet, or American tabloid newspapers less inquiring.

Additionally, the ability of an executive to take home annually enough wealth to fund his or her descendants for several generations has serious repercussions for corporate governance. Among them is the probability of attracting individuals who are more interested in getting as much personal compensation as quickly as possible than in promoting the long-term health and growth of businesses which are the engines of wealth creation not only for themselves, but also for shareholders and the society at large. This rampant greediness is seen most dramatically in the compensation arena where, aided and abetted by consultants, managers demand “competitive” compensation packages and “retention” payments to keep them from going elsewhere. More fundamentally, however, wealth divorced from long-term responsibility and risk exacerbates the “agency problem” that plagues publicly-traded companies, where ownership is diffuse and unable to keep close tabs on management whose control over information and administration gives it the power to promote its own interests ahead of those of the other stakeholders. Having received princely sums from compliant boards of directors, managers’ fates are no longer tied to those of the companies they serve, releasing them to essentially become free agents, bouncing around to whoever bids for their services with the most attractive compensation scheme.

Theoretically, capitalism is a system that rewards ingenuity and effort. Under capitalism, entrepreneurs who create new goods and services that are widely useful and demanded can and deserve to become as rich as Croesus in compensation for risking everything in the endeavor. Most corporate managers are bureaucrats who risk little and who all too often have guaranteed themselves comfortable lives regardless of how well the businesses do, thereby short-circuiting capitalism’s discipline. They deserve to be compensated accordingly.


Dennis Butler, MBA, CFA