The Investor

Metrics of Deceit

Can investment decisions still be made in the face of such rampant dishonesty?

By 6.17.10

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Now for some additional thoughts on the economy and markets:

* There is no science without measurement, said Lord Kelvin. Likewise, there is no meaningful study of investments without knowledge of certain measurements. These include book value, earnings per share, and revenue in stocks. They include credit worthiness and ability to pay coupons in bonds.

But if these metrics are simply fiction, if they are made up, this makes meaningful investment analysis difficult, if not impossible. If these metrics are simply fiction, but are sworn to as fact by "reputable" entities, this makes meaningful investment decisions even more difficult.

Unfortunately, this is the situation we have found ourselves in during the Drexel/Milken junk bond scam, the high tech scam, and most recently the banking and mortgage scam. In all of these cases, completely phony measurements were distributed, and these caused disaster when they were trusted. They still overhang markets and a lingering, meaningful recovery in faith in markets would be greatly facilitated by concrete steps to ensure that these metrics are real.

These would, in my view, center around meaningful enforcement of existing anti-fraud laws. Every law needed to curb every abuse that has happened in the past thirty years is already on the books: they just need to be enforced. Doing that with a will by the SEC would be far more meaningful than drastic shakeups in the financial regulatory structure. At base, all financial misconduct is fraud and laws against it are already there, once again.

* Warren Buffett has famously said that in the short run the market is a voting machine, but in the long run, it is a weighing machine. The truth that Warren Buffett is a stupendously successful investor is proof of his brilliance.

But recent events might allow for some qualification of his insights: the long run in markets is composed of an almost infinite series of short runs. For any investor with a finite time horizon, this makes investing in stocks extremely hazardous. This is perhaps why Buffett's mentor, Ben Graham, reportedly declared near the end of his life that the stock market was simply too risky and that most people should stick with treasury bonds or high quality bonds of other kinds.

In the very long run, longer than most of us have, the market may well be a weighing machine. But what we have learned to our cost is that it is a scale that has a lot of thumbs on it. There are a lot of people in that infinite series of short runs that make up the long run who have the motive and the means to affect the weighing process. They do it whenever they can and derive great advantage from it.

You might look at this from a slightly different angle: certain big trading houses routinely report large profits on trading. This should be impossible in a really free market, just as it should not be possible to beat the house at poker in a consistent way in Las Vegas.

But if a player can see the other players' hands, in my pal Phil DeMuth's phrase, he has a very good chance of beating the house and the other players fairly regularly. We now know that this is happening, that certain traders are in essence trading against their clients, and that it greatly distorts the investing process. This, too, is a form of fraud, and could be punished under anti-fraud laws.

These are disturbing problems (at least to me) in a world where there are already too many disturbing problems.

Human nature, man as a frequently deceitful and larcenous creature, has a great effect on economies and on investing.

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About the Author

Ben Stein is a writer, actor, economist, and lawyer living in Beverly Hills and Malibu. He writes "Ben Stein's Diary" for every issue of The American Spectator.