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Thursday, November 12, 2009

Volatility, Price Determinism and the Market Defense

So my accounting professor has just gotten to the unit on pension plan accounting. In a nut shell it works like this: Pension plans have two components. The first, depending on how the benefits are defined, the company pays into the pension at a certain rate. This rate is determined by, among other things, the actuarial data on each employee, and the mood and capability of the company to pay. The second component is accounting for those paid-in assets, which are usually placed into a trust, managed by another entity entirely.

Accounting for all securities is a hairy business. I mentioned this a bit in my last post, when I asked you all if you knew the difference between Trading Securities (TS), Available for Sale securities (AFS) and Held-to-Maturity (HTM) securities. Net Income, one of the most important pieces of investment information is determined by all streams of income, but operating income is usually based on making money on what the company "does." However, very few companies keep too much cash on hand: it's a waste of money that could be out making more money. But cash (value of the dollar notwithstanding) is relatively stable. Trading in equities is a volatile business, particularly in the last three decades. Since all large companies invest their cash, the trick is to account for investment income when it's earning money, and shielding the income statement when it's losing money. I think my professor would argue that point, that is, investment volatility is a fair argument for companies looking to keep their net income stable--in good times and in bad. The way to do that is to report gains and losses in Other Comprehensive Income--which gets aggregated into Net Consolidated Income. In otherwords, not Net Income.

But this is where my political persuasion comes into play. Trading in equities is a risk. Why should companies get a pass because they made a poor investment, or worse, because they chose to make an investment at all? That's heresy in my business, securities litigation (though I'll explain why that is not true momentarily.) Which leads me to another issue. In economics we talk about how prices are determined--to wit--the more market players, the more accurate the price. The short-sellers, and all traders, argue that the constant trading of these stocks creates the fairest price.

My question is this: Is it really fair to include buyers of an item who buy, not because of perceived value, but who buy simply to reverse the sale in hours, days, or months? I think there is another component to value, that isn't obvious in the market mechanism--and that is longterm value. Again my whole philosophy comes down to timing. If half the market for a product represents people buying a product just to sell it hours later, does that really reflect the actual value of the product? It calls to mind the SEC banning the split-second trading made possible by speedy computers. Where trading on the difference between prices minute to minute, second to second can make a lot of money, consistently.

I guess the question is really the volume of these sorts of trades. If, like prior to The Depression, cartels were specifically driving up prices of certain stocks, something made blatantly illegal by the Exchange Acts of 1933 and 1934, then these prices are clearly inflated. But the SEC monitors that stuff pretty efficiently, so let's say that's not the case. So then that would mean that the value of the market prior to October of 2008 was the actual value of the market, and that prices are currently undervalued across the board. My own investment strategy banks on that assumption. But is it really true? If the entire market was inflated from 2005 to 2007, then the market really is at it's true value now.

But let's get back to accounting for a minute. The volatility of the market is greatly enhanced when people buy-to-sell in a narrow time frame. I think the inflation of the past few years has a lot to do with companies providing online trading facilities by which the ordinary investor can trade without the benefit of having an account manager at an investment bank. It only makes sense for large cap companies to have finance divisions (GMs finance division was the only group that made money in the last three years) if the overall value of the market continues to climb. Which was a ludicrous assumption, particularly when matched against BLS statistics of the last decade. So why should these companies get this sort of investment earnings protection?

When I buy into a company, I'm buying into it because I think that they are selling a product which will be bought. Not that they will take my capital and use it to finance their own investment strategy. Unless of course, I'm invested in a bank, or investment bank, in which case, really I'm betting on the market--not the company at all.

I'll close with why I think, given my feelings above, I think investors still need to be protected. It's not whether or not you lose money: it's a question of good faith. And that faith is based on truth and competence. If a company fails to demonstrate either, they should be liable to the investor for their malfeasances.

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