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A Little Revolution…

May 18, 2009


Good morning. The market had its first losing week in a while last week, but not horrible. The SPY was down 4.27 on the week, from 92.98 to 88.71, leaving it down 4.5% on the week and 1.7% on the year. Some of the sell-off last week was due to a huge supply of new issues, as many of the large banks and some others went out to raise new capital. The good news is that most were able to find new sources of capital at these levels, so at a lower level the market is still performing its main function, providing capital to those firms in need. I suspect it is not all that bullish, for instance, for Ford and many banks to be able to sell new shares at these low prices, but it does put a sort of floor in and is much more positive than the alternative of not being successful. The VIX had a slight up tick for the down week, from 31.19 to 33.11, but having said that, the continual selling pressure on volatility in individual stocks continues. Many of the option spreads we were able to find a couple of months ago with individual stock volatilities in excess of 200 are no longer available, and even the relatively mild sell-off in financial stocks this week did not move individual volatilities up to anywhere near where they had been. It may be a long time before we can sell volatilities again at the levels seen in March. Too bad, that was fun. See what can happen when you have funds in a crisis and others do not.

Class warfare? That is surely the buzz phrase of the week. Is it real, and, if so, is it justified? You hear the term every time someone tries to change tax policies, every time anyone tries to throw one of the old boys off a non-functioning Board, even in ongoing talks regarding health care reform. Certainly the people dominating the airwaves on business television have noticed some (what they perceive to be, anyway) attacks on their constituency and are in huge defense mode. On the other hand, many probably agree with the Thomas Jefferson line “A little revolution every now and then is a good thing.” What is happening, and is a little reform (or revolution) not only justified, but also needed? The answers, or even the questions, are on many levels. On the macro level there can be little doubt that a greater percentage of income has found its way to the upper ten percent, or one percent, of the population in the last decade. It gets a little murky, given the market corrections of 2000-2001 and last year, whether that trend is continuing on a total wealth level, but it certainly had been happening.

On a corporate level there can be no real debate that the power and monetary returns have become increasingly concentrated. Some Boards are populated with large percentages of CEO’s of other companies, and (to no ones great surprise given the Board makeup) returns to CEO’s have continued to move to unprecedented levels. Without debate as to whether these people are “worth” there can be little argument that CEO pay has increased from a common 1970’s level of 10 to 20 times the wage of the average worker to sometimes several hundred (or even thousand) times the pay of the average person today. I remember a long time ago hearing a story from an annual shareholder meeting of a large company (I think Boeing, but memory is fading) where an elderly lady asked for the floor and then pointedly ask the CEO why he thought he was worth more than a hundred engineers. I don’t think there was any real answer, just some spin (meaning BS on the south side).

Forgive me for throwing out a term from my Economic past at the University of Chicago, I believe from Nobel laureate Milton Friedman. Someone had asked him a question regarding executive compensation (thank God since most of us were having trouble keeping pace with the calculus of the supply curves he was quickly putting on the Board ‘yes, blackboard, no whiteboards or laptops’). He went on to explain an economic concept known as pure Economic Rent, which essentially says that for people of immense talent there really is no compensation that you can give them (or that they could ever use or accept). For instance, he went on to say, there is no number that a firm could give Edison to adequately compensate for the hundreds of inventions, there was no real salary U.S. citizens could have given Roosevelt during the War, or maybe General George Marshall or some others. Maybe there is no way Apple could really pay Steve Jobs what he is really worth, or could ever use. There are people like that, just as in baseball there are those that transcend the ordinary (Babe Ruth, Ted Williams, Willie Mays, add your favorite). We all know that there are some CEO’s (and other people) of such ability that they can walk in to a place and immediately have the vision and people skills to provide light where there had only been darkness, but we all know that it is very rare. The point is that virtually the entire current CEO crop all are getting paid like Edison or Roosevelt, but the overall performance has been more like Mickey the Mope. When you have Boards made up of mostly other CEOs even the slowest among us realize that a ridiculous raise or package given to a CEO at one company becomes the new standard for the other CEOs, and really you have just given yourself a comparable raise. I am sure most baseball players would like to have the Arbitration Committee composed of other players, every win for the player means a raise down the road for you.

The “paid a lot for a little” is at is the essence of the “class warfare” from the point of view of the average working investor. No one really knows what the right “number” should be for these CEOs. They do see that the deal is rigged. One person gets an outrageous package, and soon thereafter a carefully selected compensation consultant walks into the next Boardroom and hails it as the “new standard” so that person’s package follows. No one stops to say, “If we were to put an ad in the paper looking for someone to manage our utility (for instance) for $5M a year (as opposed to $50M) we may be surprised at the strength of resumes we might receive”. They, the average investor, also sees that the performance of a lot of these people over the last several years has been horrendous, they are not Edison or Roosevelt, maybe we would be insulting Mickey the Mope. Look at the business cycle performance (from last trough to this trough) of the homebuilder CEO’s (and others). It could not have been worse, no feel for when the market was getting over-saturated, no restraint on buying new land at the top, really no real decision making of the type you would hope to see out of a person describing himself, and paying himself, like Edison. Other people just see massive amounts of pay heading towards these under-performing people and no even hint of blame, certainly no idea of “Maybe I was not worth the multi-millions because the place is now virtually bankrupt.” At least a baseball player earning $10M and hitting .250 is liable to express some remorse for his performance gap. CEOs think they were, and still are, entitled for some reason. To the rest of the world they have no credibility whatsoever, and really are guilty of fraud. That is the truth, not class warfare.

Solution? Fix the Boards somehow. Get some regular people, not professional Board sitters and other CEO’s, on these Boards. Do not let the Company pay for the campaign of the slated candidate while the person running from the outside pays his own (even Congress can’t pull that off). Get some backbone and morals, somewhere. Has it really reached the point where the only way this block on the Boardroom door can be broken is by the government? If so, don’t start screaming “Socialism”; you did it by putting up the block at the door. Let’s hope we don’t get there.

As for the market, it looks to me like a trading range for a while. I think a lot of the fear of last March has been removed from the market in the short term, meaning that the absurd (and very profitable) premium levels seen last March are a thing of the past. It does seem to me that there is a pressure on the economy, even tough we are in the short-term out of crisis mode the current level in terms of job loss and GDP loss is not sustainable. Losing over half a million jobs a month takes .5% of the jobs out of the economy per month, several months in a row takes a cut out of GDP that will become an increasing weight on any recovery. This action last week regarding auto dealers is especially troubling, as many are actually ongoing businesses still profitable in the horrible environment they have found themselves. I am not debating whether there might be too many dealers in some areas, but some accounts of small towns essentially built around the dealership (paying in some cases 40% on the town’s taxes and employing 10-20 people, and sponsoring most little league teams) makes you wonder about how positive it is to yank the plug on them. In any case, I think we, as investors, need to remain protected, keep selling calls closer to the money than usual, and hope that lack of real improvement by fall does not cause a further market decline. If we do not see some real improvement by August, I think a few extra puts going into the end of the year might be a good idea. Let’s hope they are not necessary.