Critics Add Fed, SEC to List of Suspects Behind the Stock Hype

Is Uncle Sam a stock pusher?

The finger pointing had already begun before the stock market suffered its $2-trillion mid-April swoon, capped by April 14’s record plunges of 616 points in the Dow Jones industrial average and 355 points in the Nasdaq composite index.

The usual suspects in creating what some call a technology-stock bubble have been, in no particular order, Wall Street investment bankers and equity analysts, online brokerages and their nonstop advertising blitz, Internet message boards, twitchy day traders, “new-economy” academic theorists and, of course, the financial media.

But the federal government? Haven’t officials such as Federal Reserve Chairman Alan Greenspan been wringing their hands for years about speculative fever in the markets?

“Ironically,” says University of Texas law professor Henry Hu, “government has contributed to the very ascent in stock prices that it is worried about and paralyzed by.”

Hu contends that the Fed and the Securities and Exchange Commission unwittingly have helped establish what he calls “a stock-based investor religion,” whose adherents believe that the risks of stock ownership can be eliminated simply by holding shares for the “long term.”

Stock-market history shows otherwise, Hu asserts, but he acknowledges that it is a tougher case to make in a market that has seen an almost unbroken climb since 1982.

Hu is not alone in his concern. A number of economists and legislators, for instance, have urged the Fed to focus on price stability and let the stock-market chips fall where they may.

Other critics say government regulators--and their private-sector counterparts at the Financial Accounting Standards Board--haven’t been tough enough on accounting abuses that let companies overstate sales and profits or otherwise befuddle investors.

In a paper titled “Faith and Magic: Investor Beliefs and Government Neutrality” in the current Texas Law Review, Hu argues that both the Fed and SEC have departed from the neutrality required of them in their roles as market regulators.

The Fed’s history of intervening in financial crises has bred a dangerous belief among investors that there is little risk in the stock market because the Fed will come to the rescue, Hu says.

For example, the Fed, through its Federal Reserve Bank of New York, helped organize the 1998 private bailout of a giant hedge fund, Long-Term Capital Management.

The central bank also injected liquidity into the markets through three quick interest-rate cuts after a sharp stock-market downturn in October 1998, much as it had done after the Crash of 1987.

The Fed’s actions, in Hu’s view, have created the equivalent of what the insurance industry calls a “moral hazard”: Just as an over-insured home may make the owner prone to playing with matches, a stock-market safety net may make investors throw caution to the wind.

Meanwhile, according to Hu, the SEC has failed to be even-handed in its mission to educate the investing public. In ways both subtle and overt, the agency encourages consumers to consider stocks superior to other investments, Hu contends.

He says that the SEC’s disclosure requirements for mutual funds can lead investors to misunderstand the risks they face in the most popular form of stock ownership.

He also finds a pro-stock bias in some of the SEC’s consumer-information brochures and online educational materials.

The SEC requires mutual funds to disclose their one-year, five-year and 10-year investment performance, compared with such benchmarks as the Standard & Poor’s 500-stock index, Hu notes.

However, according to Morningstar Inc., a mutual fund research firm, more than half of U.S. equity mutual funds are less than 10 years old, meaning there is no 10-year track record.

But more importantly, Hu says, studies have shown that a particular fund’s past performance is less relevant to its risk profile than is the class of securities it invests in.

In other words, investors would be better served by a detailed discussion of the ups and downs of the stock market over many years than by limited historical data on the specific fund they’re considering, according to Hu.

He suggests requiring tables to show how bad things can get, even over extended periods of time. In the worst 10-year period this century, for example, from 1929 through 1938, large-company stocks posted average annual returns of minus 0.89%, while small-company stocks lost 5.7% a year on average.

“The SEC needs to bring the risks of stocks closer to home,” agrees Morningstar research director John Reckenthaler. He suggests using Japan to make the point, noting that Tokyo’s Nikkei stock index plunged a horrifying 63% between mid-1989 and mid-1992 and that even today, 11 years later, it remains 50% below its 1989 peak.

Reckenthaler notes that some funds celebrated three years ago when the Crash of 1987 finally disappeared from their 10-year performance records.

“Every number you see now is pulled from a bull market,” he says, “so you could draw the conclusion, ‘Well, you always make double-digit returns.’ ”

Former SEC Commissioner Richard Y. Roberts, now a Washington lawyer who represents online brokerages, agrees that there probably is a pro-equity bias at his former agency--but he doesn’t have a problem with it.

“Historically, buying equities long term has proven to be a pretty good strategy,” Roberts said.

SEC spokesman Christopher Ullman dismisses the criticism, saying, “If anything, the commission has been at the forefront of efforts to educate people about volatility, the advantages of limit orders and the risks of margin debt and anonymous Internet stock promoters.”

Besides pushing for “plain English” financial disclosure, SEC Chairman Arthur Levitt has led enforcement actions against deceptive corporate accounting and Internet stock fraud, Ullman said.

Throughout his tenure, the spokesman added, Levitt also has emphasized in speeches and other communications that investors should not base their financial decisions on any single source--even an official mutual fund prospectus or an SEC brochure.

“If you’re fixing blame, the SEC is way at the back of the bus,” said William A. Fleckenstein, a prominent Seattle-based money manager who has been bearish on the stock market for years.

“The fact that people believe stocks are a risk-free asset class--that’s Alan Greenspan’s problem, for injecting all this liquidity into the markets, and Wall Street’s problem for having whipped and driven this frenzy,” Fleckenstein said.

The Fed declined to respond directly to the criticisms, but a spokesman noted that Greenspan has repeatedly returned to the theme he struck in a famous 1996 speech when he wondered whether investors’ “irrational exuberance” would inflate stock prices to the point that they could become subject to a Japan-style collapse.

Former Fed Gov. Wayne Angell, now an economist at the Wall Street firm of Bear Stearns, thinks the Fed’s biggest mistake was overreacting to the Crash of 1987.

The danger of focusing on the stock market isn’t so much that of creating a moral hazard as of risking the loss of political confidence in the Fed, which it needs to survive and do its work, Angell said.

Congress has enough trouble with the concept of a highly powerful agency that doesn’t answer to elected officials; it the Fed were to stray from its central mission of keeping inflation in check, some lawmakers would be sure to call its very autonomy into question, Angell explained.

Hu would like to see the Fed forswear participation in any future LTCM-style bailout. He thinks such a pledge would help erase investors’ Fed-as-safety-net mind-set but without actually precipitating a market crisis.

If, as some contend, the Fed has been itching to prove that it can ignore a market crisis, it may soon get its chance.

After the relatively calm, holiday-shortened week just ended, some analysts believe, Wall Street has only postponed an overdue trip to the dentist. For excessive speculation to be squeezed out and stability restored, these experts say, the market probably needs another dose of pain and fear.

If and when it comes, the Fed will get its test.