Market Solutions to Conflicts of Interest
With the Enron collapse making headlines, all the usual suspects in government and the media are beating the drums for more government regulation of the financial world. As a result, we are hearing specious arguments about alleged "conflicts of interest" amongst brokerage firm equity analysts.
This issue is spearheaded by a ruthless New York plaintiff’s lawyer, Jacob Zamansky, who has filed several frivolous lawsuits against brokerage firms. Falling stock prices, like Enron’s, are put forth as "proof" that brokerage firms recommend bad companies in order to rip off retail investors.
Building on these suits, gullible reporters heaped bad press on Wall Street and gave credibility to the conspiracy theory that stock analysts have hyped stocks in favorable research reports and on television so that their brokerage firms could win lucrative underwriting and merger advisory business from the same companies.
Zamansky is now a virtual celebrity, appearing on television frequently as an "expert" on alleged Wall Street corruption (receiving free advertising in the process). Congress even held investigative hearings on the matter, threatening Wall Street with new rules and regulations if it didn’t shape up.
Whether or not a conflict of interest exists on Wall Street is not the main issue. When stripped of its pejorative tone, the term really implies that equity analysts will prosper if their employers are successful at marketing the products they sell, namely stocks and bonds. That this comes as a revelation to government bureaucrats only underscores their ignorance of the very business they are supposed to be regulating. The real agenda is power, and the bureaucrats want more of it.
Let us assume that equity analysts are biased in their recommendations. What this means is that they are more prone to recommending that investors buy stocks in the hope that their prices will rise. For several years prior to the Greenspan Bubble, most stocks did in fact rise. At that time, nobody complained that analysts were biased on the upside--especially those who are criticizing analysts today. (The Fed, Congress, and all the bureaucrats in Washington, D.C., were too busy taking credit for the bull market.)
Stock analysts had become the equivalent of rock stars. Retail investors tuned in to CNBC to hear more hype about the New Economy from Merrill Lynch’s Henry Blodget or Morgan Stanley’s Mary Meeker. Ratings for CNBC were sky high, everyone was euphoric, and the viewers were getting pop investment advice for free on the tube.
Sure, the investment banks were attracting business from the same companies they were touting, but nobody was complaining as the NASDAQ soared like a rocket. In fact, it was hard for an analyst to get invited on CNBC if he didn’t claim that Amazon.com’s stock price was going to the moon.
It was only when the Bubble burst that people started crying their crocodile tears. With losses piling up in their portfolio statements in late 2000 and early 2001, unhappy investors became easy prey for unscrupulous lawyers who offered them victim status and a villain to blame for their troubles. Instead of running to buy stocks online as soon as an analyst uttered positive comments on CNBC, viewers turned off the television, and some of them started signing on to Jacob Zamansky’s class action suits.
Fortunately, the market has solved this problem before the government could get involved. Viewership of CNBC is way down, as consumers have soured on the research analysts. Henry Blodget left his job at Merrill, in disgrace, his services as an Internet analyst no longer valued. (The lawsuits against Meeker were thrown out of court.) Investors are learning to do their own homework, and to be skeptical of "free" investment advice. Where they once considered themselves great stock-pickers for cashing in on free advice, day-trading investors now have realized that research analysts are not soothsayers.
It is also becoming clear that the case against Wall Street research analysts was overstated. In the relatively short time that has elapsed since the Bubble burst, it appears that the analysts were inept at recommending stocks.
But the bigger picture tells a different story. A recent study of more than 4,000 brokerage firm analysts published in the Journal of Finance found that the most highly recommended stocks outperformed the least-recommended for fourteen years in a row. The streak only ended in 2000 when trends changed.
The critics’ ignorance is also on display in their accusation that brokerage firms fail to advise the outright sale of stocks. It is true that Wall Street analysts very rarely advise investors to "sell." When analysts don’t like the prospects of a company, they use euphemisms like "market perform" or "hold."
The niceties may indeed be a means of pacifying companies the brokerage firms do business with--though all stocks receive this treatment regardless of whether they are paying clients. Even with this convention, however, analysts have ways of sending sell signals to the markets. A brokerage firm’s downgrading of a stock to a lower rating usually triggers a sell-off--even though the word "sell" was not used.
None of this is to suggest that bias does not exist on Wall Street. I have no doubt that some securities analysts are biased in favor of their own coverage. In fact, everyone in the financial game is compromised by some form of self-interest. Companies and their underwriters want stocks to go up. Investors want their stocks to go up. Even Jacob Zamansky, the crusading lawyer, wants more clients to sue their stockbrokers. Everyone is biased in some way, and it is pure utopian folly to pretend that conflict of interest can be eradicated.
The enemies of capitalism argue that only an enforcement bureaucracy can help--that free markets are incapable of providing decent and unbiased investment advice. Yet time after time, the government tries to fix a problem by implementing a flawed solution which either creates a new problem or makes the existing problem worse. Eventually, markets must be deregulated again in order to work properly. The Glass-Steagall Act--enacted to forestall other alleged conflicts of interest between commercial bankers and investment bankers--is a case in point.
The free market started developing solutions to the bias problem long before greedy lawyers and windbag politicians decided to demagogue the issue for their own aggrandizement. A search of the Web produces numerous alternatives to the giant brokerage firms.
Indeed, the stock market already discounts the buy recommendations of brokerage firms that do investment-banking business with the firms they’re recommending. Firms like First Call and Bulldog compile consensus recommendations, so investors need not rely on a single self-interested analyst. On Wall Street, investor expectations for a company’s quarterly earnings are almost always based on consensus forecasts.
Another option investors have is to use independent research houses, which dig into the financial statements of companies and render objective opinions. They do not use research as a supplement to brokerage and merger advisory services. All they do is sell research reports, on the free market. The question of bias or conflict of interest is less of an issue. The investment community relies on such independent research as a natural check on the giant investment banks. This research is typically more expensive, but higher in quality.
Rather than getting stock tips on television, serious investors can and should do their own homework by learning to read the financial statements of public companies. Similarly, they can utilize mutual funds, in which an expert portfolio manager picks the stock. They have numerous options.
Professional victimologists see bad investors as victims of biased research. But they ignore the fact that smart investors have plenty of chances to avoid bad advice. What the losers got taken in by was the Fed-induced Bubble, not someone else’s bad research. Those who would impose additional bureaucratic restrictions on Wall Street only penalize everyone to protect the gullible.
James Sheehan is a financial professional in New York. He is the author of Global Greens (Capital Research Center, 1998), a book that documents government funding of environmental extremist groups. Send him MAIL, and see his Mises.org Articles Archive.