An open letter from a very knowledgeable reader on speculation (casinofication) and the risk to the financial system / country.

Dear Bill-

I am gravely concerned about the precarious state of our capital markets. I offer my view on those who are publicly giving American individuals what I believe to be horrible advice - and advice that comes unchecked, advice that comes without an appropriate warning label. Allow me to explain.

The Surgeon General clearly marks cigarettes with disclosures about the multiple health risks associated with smoking, those risks posed to the smoker and those risks incurred by people subjected to second-hand smoke.  While smoking a single cigarette will not cause the smoker or those around him harm, with frequent and widespread use, smoking does have onerous longer-term consequences.

Unlike the physical health of the nation, the financial health has no ombudsman to warn of dangerous trends. Left widely unchecked, our purported advisers are seemingly doing more to endanger both the individual investor and the broader economy's long-term health.

Perhaps the two most highly visible dispensers of investing advice, Larry Kudlow and James Cramer are The Marlboro Man and Joe Camel of the financial world. Highly promotional and easily identifiable to the everyman, their advice is taken as truth and blindly consumed. And in my opinion, their advice is hazardous to the health of the American financial system.


To begin with I reference two articles written by James Cramer. (please note these links may not work for everyone) The first one was written Dec. 29, 2000 The second was written April 2, 2004 - (For Rap readers who aren’t subscribers – This link refers to Cramer’s column that championed the investment merits of Taser (TASR), Webex (WEBX), Netlfix (NFLX), Amedisys (AMED), Armor Holdings (AH) and XM Satellite Radio (XMSR.  In my opinion, the articles are eerily similar; just change the ticker symbols contained within. As a point of reference there were 10 companies in Cramer's Dec. 29th 2000 article listed as the "top 10 stocks for who is going to make it in the New World." Now only six still exist. The other four either went bankrupt or were acquired at a small fraction of what they were trading at Dec. 29th, 2000 (ISLD, EXDS, INKT, SNRA). Of the remaining six, the best performer is Mercury Interactive, which is now at 50% of what it was Dec 29th, 2000 - and that is after doubling off its recent bottom(and it currently trades at 45x earnings and has an enormous amount of options expense not presently reflected in its P&L so I would submit its intrinsic value is lower than where the stock is trading today). SVNX on the other hand is at $3.77, down from its Dec. 29th 2000 price of $166.  Even allowing for mistakes made during the bubble, this track record is FAR worse. And blaming this performance on the collapse of the bubble is also a poor excuse, as there were many (few of whom you see on TV) that realized there was a bubble and were explicitly recommending that one does not invest in these types of stocks with absurd earnings multiples and questionable business models.


Now Cramer is certainly a VERY good trader. However, and this is a very important point, and the entire reason for my letter and grave concern, the entire market cannot be made up of traders or the system ultimately fails in spectacular fashion (didn't that just happen post 1999?). Here is why – the stock market amongst other things is a critically important mechanism for allocating capital amongst companies. Companies and industries with good business models and financial discipline should have access to capital at a fair price to help grow their business, and those with poor business models that are destroyers of capital should not get capital and ultimately go out of business (allowing capacity to leave and for good companies to make more money and hire more employees). That is how the system works best.  Otherwise bad businesses stay in business causing industries to suffer overcapacity, lack of profitability, and the inability to hire workers. And decent companies often can't get capital or get it an unfairly high price because all the dollars are chasing sexy industries. This is all a consequence of momentum-chasing stock behavior at any price, as we have just witnessed over the last several years.

Trading, when it is practiced by a small portion of the system, has no real negative affect, as it is too small on the margin to matter. It is similar to pollution or smoking. If a few people do it, pollution is largely inconsequential. If everyone starts polluting, pretty soon there is a big problem.


By definition, anyone given Prime-Time exposure on a major U.S. network to dispense financial advice is assumed to be highly credible by the average American. So when individuals such as Kudlow (Kudlow in my opinion is the macroeconomic version of Cramer's stock picking behavior) and Cramer are publicly extolled and widely presented as dispensing sound investing advice as opposed to trading advice (or just bad advice), it contributes to a larger problem. The average individual doesn't know any better and starts behaving in this fashion. And the average mutual fund manager, who has now just become a performance chaser, also behaves in this fashion to try to keep up. Pretty soon the stock market becomes one giant trade or casino, and it no longer is doing its job of being an efficient allocator of capital. (Alan Greenspan is also contributing to this behavior, trying to use asset reflation as a mechanism for boosting the economy). At least with respect to cigarettes the American Government came to the conclusion that the average American did not realize how unhealthy they were, and slapped a warning label on the products.


As proof of this point, according to a recent Goldman Sachs report, there is currently $3.3 trillion dollars invested in US Mutual Funds. $1.86 trillion is in growth funds, $.72 trillion is in Growth at "Reasonable" Price Funds(little valuation sensitivity and still above market P/E), $.072 trillion is in aggressive growth funds, and only $.183 trillion is in value funds with value being defined as 70% of holdings have less than a market P/E (which really doesn't mean there is value and I suspect the other 30% of holdings is likely going into high beta, high P/E stocks to try and juice performance). Only $.002 trillion is classified as deep value, and the rest is yield or index. So at least 80% of mutual fund money by category is invested with questionable regard to valuation. And this is the choice of U.S. individuals who have decided to allocate their dollars in this fashion. And even after all that has recently happened, why do U.S. individuals continue to behave this way? And why do mutual fund PM's chase performance regardless of valuation? In part you can point to personalities like Kudlow and Cramer encouraging these behaviors. And as I have pointed out (and the bursting of the bubble shows), this behavior ultimately has severe negative consequences for the U.S. economy.


Before either of these guys is cited as a credible source and held up to the public as an individual worthy of dispensing investment advice on national TV, each of their track records and backgrounds should be given an appropriate disclaimer by NBC. Cramer is a TRADER with a questionable history, and his advice has a time horizon of days in my opinion. No one should ever be allowed to think he is dispensing long-term investment advice, as the results of his Dec 29th, 2000 article clearly proves. Kudlow was equally bullish in the year 2000 about the macro-economy and the stock market. In fact NBC should consider (at a minimum) a disclosure making their backgrounds and previous investment commentary clear. It should say Kudlow and Cramer were wildly bullish at the top! But given NBC is owned by GE, and GE seems to smartly take advantage of public equity markets by selling stock, I wonder if GE would ever put a warning label on its paid promoters?


And to make it clear, I have nothing personal against either individual and this letter is not intended to be a personal attack. I have never met them or spoken with them. I do however have something against their behaviors which in my opinion contribute to the destruction of our capital allocation system by continually recommending stocks be purchased at any price (as Cramer's recent April 2nd article proves). This is written out of grave concern for the degradation of the stock market into a casino and the resultant disaster it may cause, which could be worse than the post 2000 collapse. And Kudlow and Cramer are two of the most visible promoters of this behavior. And if one doesn't share my concern about the state of the markets and is just more simply concerned about their own savings - well then also refer to what Kudlow and Cramer were saying at the peak of the bubble - "Buy!"


- A very concerned reader