The Wall Street Veil of Secrecy

While the vast majority of stocks have been going down for three years now, ‘short sell’ candidates are still abundant, suggests C. Alexander Green. Especially given the rally we’ve had off the October lows. But will you here about them from your broker? Not likely.

What your broker is not telling you is costing you a fortune. I’m not talking about 12b-1 fees or the Mt. Rushmore-size internal expenses on the annuity you own. Those are merely termites that gnaw away steadily at your assets each year.

I’m talking about top-notch investment intelligence, here. Your brokerage firm has this information and refuses to share it with you…even though its brokers use it themselves to make hundreds of millions of dollars every year. Why?

Well, this Wall Street Journal headline from last week is the beginning of an explanation: "Wall Street Fines May Top $1 Billion."

"Regulators from the New York state attorney general’s office," Writer Charles Gasparino explains, "the Securities and Exchange Commission and others are discussing fines against Wall Street that could total more than $1 billion, as they head into the final stages of a broad investigation into whether securities firms misled small investors with faulty research during the stock-market boom of the 1990s."

High-profile cases have already been splashed across the financial press. You’ll recall, for example, Merrill’s head Internet analyst, Henry Blodget, privately referring to his department’s "strong buy" recommendations as "dogs," "powder kegs" and "pieces of junk," among more descriptive phrases unfit for print. And Citigroup analyst Jack Grubman upgrading his rating on AT&T to help get his twins into an exclusive pre-school in New York City.

As the SEC’s investigation moves forward, more bodies like these are likely to float to the surface. In all, Wall Street firms are looking at total fines that will likely exceed the $1 billion civil settlement in 1996 to resolve charges of price-fixing on the Nasdaq. But what does this have to do with Wall Street firms withholding crucial investment intelligence?


You may be aware of the potential conflict that exists between your desire to make money and your broker’s desire to make a good living. But that pales in comparison to the conflict of interest that exists between a major brokerage’s retail clients and their investment banking clients.

On Wall Street, it makes getting an honest opinion on a stock about as easy as Tom Hanks’ dental work on "Cast Away." It doesn’t matter how large your brokerage account is, or how long-standing your relationship, it’s a drop in the ocean compared to the business your major brokerage seeks from the Fortune 500 companies that raise billions in capital through the nation’s stock and bond markets.

Wall Street’s biggest firms are endlessly wooing these companies. And the last thing they need are competitors bringing up the unpleasant fact that their research departments have a sell recommendation on the client’s stock. That would do nothing to grease the wheels of commerce. So… brokers recommend selling virtually nothing.

"Of 6,000 recommendations made by Wall Street firms during 1999," John C. Bogle, founder of the Vanguard Group founder recently commented, "one study found only eight recommended ‘sell’." Eight sell recommendations. Five thousand nine hundred and ninety two buy recommendations. (I won’t point out that 1999 also happened to be the premier selling opportunity of the past two decades. That would be impolite.)

Investment banking clients can’t stand to hear the words "sell" about their shares – around which both their pension value and option compensation revolve. Likewise, you can bet a broker saying "sell short" is tantamount to volunteering to serve with Custer at Little Big Horn.

That’s the real reason why you’ve never seen a short recommendation from a major Wall Street firm. That’s why most brokers have never entered a short sale order in their entire career. And that’s why your financial advisor is likely to advise you that selling short is "too risky." It is…but first and foremost, for his firm’s investment banking division.

The reality is that Wall Street’s firms will never tell the truth about the companies they cover, especially when their opinion is negative. Instead, as I’m sure you’ve noticed, they hide behind fuzzy language, using terms like "neutral" or "reduce" instead of standing up and just saying "dump it." Other firms use obscure index-related terminology like "marketweight" or "underweight." Both are lily-livered ways of saying a stock is unlikely to outperform the market averages.

All this obscure terminology demonstrates that Wall Street still bows down on one knee before their big investment banking clients. (Sorry if that knee also happens to be on your chest.) Of course, Wall Street firms deploy billions of dollars of its own capital selling short every year. Trading departments are shorting the bejesus out of every troubled company it can find. After all, it is incredibly profitable.

Any investor worth his salt knows that stocks go down a lot faster than they go up. That means the profits come quickly. And while the vast majority of stocks have been going down for three years now, the pickings are still excellent. Especially given the rally we’ve had off the October lows.

Here’s how you can find suitable ‘short sell’ candidates… and bank profits despite the Wall Street veil of secrecy. When screening the 8,000 public companies for short candidates, the process is the very INVERSE of what 99% of all investors are doing. Rather than looking for an undiscovered gem that will soar in value, you look for troubled companies. What gets me excited, for example, is a stock whose 90-day moving average bears an uncanny resemblance to a drunk going down a flight of stairs.

For the most part, a good short is grappling with serious fundamental problems, is already in a confirmed downtrend and has been issuing earnings estimate revisions – downward. If a company meets all three of these qualifications, it might be worth a closer look. Then, any one of the following telltale signs indicates the company is really in trouble: low profit margins, high debt levels, paltry operating income, high price-to-book values, lofty prospective P/E’s, troublesome litigation, signs of management incompetence, negative returns on equity, unfavorable institutional activity and, of course…insider selling.

That’s a lot of homework – but it’s worth it. For instance, most investors have found this to be a difficult year. But in 2002, double-digit profits were still to be had as these big name corporations got hammered by the market: Eastman Kodak, Merrill Lynch, Qwest, Siebel Systems, Hewlett Packard, Halliburton, Sealed Air, FleetBoston, and Linear Technology, among hundreds of others not so well known.

It’s unfortunate that Wall Street categorically refuses to share its short-selling intelligence with retail clients. But, in a positive way, it reduces the competition for great short-selling ideas.

Best Regards,

C. Alexander Green,
for The Daily Reckoning
December 5, 2002

Editor’s note: Mr. C.A. Green, a fifteen-year Wall Street veteran, is Investment Director of The Oxford Club. In addition to writing on global investing for Wall Street Week’s Louis Rukeyser, he is the chief strategist for the Oxford Short Alert, a trading service designed to root out Wall Street’s most fundamentally unsound companies.

Is it beginning to seem like old times, or what? We refer to the period of unadulterated hallucination known as the New Era, which lasted roughly from 1995 until the end of the century.

One of the great things about those days was the idea that Alan Greenspan, the world’s best-known public servant since Pontius Pilate, wouldn’t let it end. The central banker was supposed to have "the Greenspan Put." Like the red restart button on a furnace, Mr. Greenspan’s ‘put option’ gave him a way to keep the economy heating up – simply by lowering interest rates.

Imagine Abby Cohen’s disappointment when Greenspan finally went down into the basement during the cold days of January, 2001, pushed the button – and nothing happened.

What to do? Well, push it again! And again. And again.

Now, he’s pushed it 12 times…to the point where there’s not much room left to push. As in Japan, short-term rates are "effectively zero" already, since the cost of short- term credit is now lower than the inflation rate.

Still, the "Greenspan Put" is "alive and well," says Merrill’s Richard Bernstein. Investors seem to think that the 12th try was a charm…that finally, Mr. Greenspan had found the perfect overnight rate for bank borrowing. There’s a warm glow in the Wall Street firebox, they note…and the radiators throughout the entire economy are beginning to clank and hiss.

We’re not so sure. Auto sales dropped 13% in November; Ford reported sales 20% lower. GM stock fell 5% on Tuesday. Worldwide, there’s a huge glut of automobiles – which is driving down prices. Year to year, auto prices are down 1%.

And now tells us that builders are having to work harder and harder to make the sales. They are adding landscaping, larger decks and kitchen upgrades – anything to avoid lowering prices.

The Mortgage Bankers Association expects the rates of growth in house prices and refinancings to be cut in half next year. Housing prices have been rising at about 9% per year; next year it will be only about 4%, says the MBA. And this year, $1.4 trillion worth of mortgages were refinanced. Next year, the figure will be closer to $700 billion.

But don’t worry about it. If the "Greenspan Put" fails to do the job, Fed governor Bernanke told the world two weeks ago that the Fed will do whatever it takes to avoid deflation (and keep the economy rolling.)

Oh what a weird and wacky world we live in. It is as if all the economic sages from Say to Smith to Keynes to Friedman had been reduced to a simple, corroded logic:

Economies are nothing more than people getting and spending money. If you want more getting and spending…make sure people borrow – so they’ll have no choice but to keep getting. And make sure their money loses its value, so they’ll want to spend it as fast as possible.

The Fed encouraged borrowing by cutting short-term rates. Householders jumped at the chance to bury themselves under bigger mortgages and zero-percent auto financing.

Now that they’ve cut rates as far as they can (if they cut any more, money market returns could go negative, with operating costs higher than earnings)…the Fed is looking at ways to destroy the currency. We don’t doubt they will find them…but maybe not as soon as most people seem to think – more below…



Eric Fry, reporting from Wall Street…

– The Dow slipped for the third straight day, as the blue- chip index dropped 5 points to 8,737. The Nasdaq fell 19 points to 1,430. The bulls refer to the three-day retreat as a "healthy correction," while the bears are afraid to call it anything other than "welcome relief."

– Semiconductor stocks – conspicuously strong performers over the last two months – have been conspicuous losers over the last three days. The SOX Semiconductor index tumbled nearly 6% yesterday after a Morgan Stanley analyst highlighted what should have been obvious to everyone: semiconductor stocks have rallied a tremendous amount, despite the fact that growth prospects in the industry have improved little, if at all…Ditto for the entire stock market.

– Meanwhile, gold is quietly gaining ground. The yellow metal added to its $2.70 gain on Tuesday by climbing another $1.90 yesterday. An ounce of gold now fetches about $323.10 per ounce.

– Worker productivity grew much faster in the third quarter than originally thought, according to the Labor Department’s latest facts and figures. The government agency reports that productivity rose at a brisk 5.1% annual rate – the strongest showing since 1973…Does anybody really believe this stuff? Measuring "productivity" in a service economy like ours seems a bit like measuring love. What is the appropriate standard for measuring love? Total hours in the bedroom? Minutes of conversation per hour of mealtime? The argument-to-embrace ratio?

– Likewise, productivity does not lend itself to measurement. And even if, by some fluke, the Labor Department happened to measure this financial love correctly, there’s nothing about this information that would tell an investor whether he should buy 100 shares of IBM or buy municipal bonds…

– Beware the "anti-bubble." That’s the warning from two "econophysicists" at the University of California, Los Angeles (my alma mater). According to the esteemed Professors Didier Sornette and Wei-Xing Zhou, "The actions of investors tend to produce waves of behavior, leading to self-reinforcing phases of bull or bear markets – bubbles and anti-bubbles."

– Based on current wave patterns, Sornette and Zhou say they have detected the "unmistakable pattern" of an anti- bubble, the opposite of a speculative bubble. (Is there anything these guys won’t do to get tenure?) Further, the provocative econophysicists predict that a growing anti- bubble will leave the US stock market about 30% lower at the end of 2004 than it is today.

– "This anti-bubble describes the bearish phase when stock market traders sell, sell, sell, as the stock market begins to slide into recession," Prof Sornette explains. Those of us without doctoral degrees might refer to this phenomenon as a "bear market."

– Bill, you’ll be happy to know that the UCLA professors support your theory that the Japanese stock market, advanced by about ten years, bears a striking resemblance to the US stock market. As the Financial Times explains, "[The professors’ research] reveals a remarkable mathematical similarity between the US market’s ups and downs since 1996 and the behavior of its Japanese counterpart, with an 11-year time shift."…Spooky.

– The curious similarity between the Japanese economic experience of the early 1990s and the US economic experience of today has tempted many market observers to conclude that the US economy is hurtling toward deflation, just like the Japanese economy of a decade earlier.

– I disagree. Deflation is a possibility, to be sure, but certainly not an inevitability. To the contrary, in the US, inflation is a way of life, especially when times get tough. It is as American as apple pie and monster truck races, and it is an expedient "cure-all" for a nation as heavily indebted as ours. We’ve got the world’s reserve currency and we can print as many as needed to alleviate economic pain and suffering within our borders. What better way to satisfy a mountain of debts than to print the money with which to repay them?

– What’s more, our beloved Federal Reserve chairman has stated repeatedly that he would prefer to err on the side of inflation, rather than risk deflation. And he’s certainly walking the walk by slashing short-term interest rates and aggressively boosting the money supply.

– Net-net, deflation is a bad bet…More tomorrow!


Back in Paris….

*** Et tu, Eric?

The question is settled, or at least that is what everyone says. Just as Greenspan was supposed to be able to revive the economy with rate cuts, now he’s supposed to be able to destroy the currency by ‘cranking up the printing press."

The Bernanke speech seemed to close the file on the inflation/deflation debate. Bernanke told the world – including foreigners, who hold more trillions of dollars’ worth of U.S. assets – that the Fed would not permit a more valuable currency. How would it avoid it? By inflating as much as the situation required. There was effectively ‘no limit’ on how much inflation the Fed could create…or would be willing to create…in order to avoid deflation, he said.

"These people may be misguided," writes Bill Gross, " their policies might eventually do more harm than good, but I believe them. They will not allow the U.S. economy to deflate as long as the current regime (read: "Greenspan’s Fed") is in power."

Yesterday, Gross joined James Grant, Steve Sjuggerud, and many other prominent analysts and economists, including our own Eric Fry, concluding that there was no longer any question of deflation. In their minds, it was as if German central banker Hugo Stinnes had announced to the world in the early 1920s that Germany intended to destroy the deutschemark in order to skip out of its war reparations. From August of ’22 to November of ’23, consumer price inflation rose by 10 to the 10th power…so that by the end of November, a single dollar was worth 4.2 trillion marks.

And today’s printing presses are even faster, they note. End of conversation.

Paper money never holds its value for long. We don’t doubt it. But today’s money is not even paper. When it goes bad, you cannot even wallpaper your bathroom with it; money today is mostly electronic. People measure their spending power not in piles of paper, but in digits on a bank statement, credit card bill, or money market account. And guess what. It is as easy to knock off a digit as to add one. Decimals go in both directions.

We don’t doubt that the government will eventually destroy the dollar. But it still would not surprise us if a spell of deflation and recession destroyed millions of investors first. More to come…!