~ No Job 1:1

Martha Stewart has become the most publicized CEO in the world. Unlike most CEO’s, millions of people recognize her name and her face. Even men recognize her. In the funniest scene in Dave Barry’s novel, “Big Trouble,” a crook hiding on the ground encounters a rare breed of frog, which then sprays him in the face with a hallucinatory liquid. The crook then encounters a dog. The dog has the face of Elizabeth Dole. Problem: Elizabeth Dole’s face is not recognizable to most people. So, in the movie version, we see Martha Stewart’s face attached to the dog.

Mrs. Stewart is one of those rare CEO’s who has been created by the media. Oprah Winfrey is another. Bill Gates is famous, but he was not created by the media. Warren Buffett is not a household name.

When her conviction was announced, it was front-page news. It was lead story news on the evening TV news and the “Today Show.” Women know who she is, in the same way that they know Oprah. When Mrs. Stewart hit the judicial brick wall, the whole country heard the crash.

We are getting all sorts of messages by way of the media.

She is a control freak who lost control. She was greedy, and her greed cost her a fortune. The bigger they are, the harder they fall. No one is immune to the Federal government’s long arm. Mean gals finish last.

There is a far more important message from this incident. The message is applicable to tens of millions of Americans. This message has not gotten through and is unlikely to get through.

It is this:

The perceived capital value of the stock market is an illusion, and that illusion can be exposed at any time by a seemingly trivial event.

MARKET CAPITALIZATION

When Martha Stewart sold her ImClone shares, the capitalized value of her own company was somewhere in the range of $2 billion. Today, it is closer to $500 million. Yet there has not been a wave of panic selling. The reason why we know there has not been a wave of panic selling because the biggest holder of the shares is Martha Stewart. She is not selling.

The sell-off has taken place, in the language of economists, at the margin. There have been more sellers of shares at the pre-ImClone scandal price than buyers at that price. So, the price of her stock has fallen, sale by sale.

Each time a sale takes place, it establishes a new price, or at least adds pressure to establish a new price. Each new price for one share establishes a new price for all of the existing shares. This in turn establishes a new capitalized value for her company. The capitalized value of her company is the price of the block of shares sold most recently multiplied by the number of shares outstanding.

As the bad news about her future has been released, headline by headline, the number of shareholders who are willing to accept a lower selling price increases. But the vast majority of shareholders in her company are not willing to accept a lower price. They think that things will turn around. They think that this is the bottom. Headline by headline, they have been proven wrong. But they still refuse to sell. So, there has been no panic sell-off.

A CALL FROM YOUR BROKER

Which piece of information would have been more valuable to a portfolio manager of a large mutual fund located in (say) the Bahamas, who was willing to break U. S. securities law and operate with inside information, which is illegal? (If you want to read a book on why it should not be illegal, read Henry Manne’s “Insider Trading and the Stock Market,” which was published in 1966 and which hardly anyone has read — unfortunately.)

There is no question that the second piece of news would have been more valuable to anyone with an entrepreneur’s abilities. The fund’s manager would know that word would get out fast about ImClone. He would be unlikely to be able to sell enough shares fast enough to make any money. But the news about Martha Stewart could have been easily converted into money. Sell her company short. The hit to her company would probably be greater than the hit to ImClone: larger capitalization. No one would know about her illegal action for weeks. “She is going to get caught eventually.” So, day by day, sell her company short. He would have made a fortune.

The loss of capitalized value to Martha Stewart’s company has been dramatic. ImClone has bounced back. Hardly anyone got hurt when she sold her shares of ImClone. That was the point made by Prof. Manne [MANee] almost four decades ago. The person who acts on inside information has an information advantage over the handful of people he sells his shares to, but the vast majority of shareholders do not suffer from this sale. If they do suffer, it is from the facts on which the insider was selling his shares. This bad news would have gotten out anyway. But in the case of shareholders in Martha Stewart’s company, they have been badly hurt by the prosecution of Mrs. Stewart for something that seemingly had nothing to do with the company.

Of course, it had everything to do with her company. She is the company, in the same way that Oprah is Harpo, Inc. The company’s capitalized value is the expected stream of net income to be produced by her, discounted by the prevailing rate of interest. The company branded her. Then she got branded by the government: “convicted criminal.”

WHEN CAPITAL GOES “POOF”

The government’s prosecutors have tried to send a message to corporate leaders: “Don’t break the law.” They sent a much louder message to the stock market: “Don’t expect us to make any legal decision in terms of its likely effect on capitalized value.” The prosecutors are more interested in scaring senior corporate officers than they are about scaring investors. Yet they do this officially in the name of investors.

The number of people who can say they were harmed by Martha Stewart’s sales of $60,000 of ImClone shares is hardly worth comparing to the portfolio effects of the government’s prosecution of Mrs. Stewart. If the insider trading law had specified that Mrs. Stewart must pay double restitution to the people who bought shares from her, they would be happy. The millions of investors who were holding, and are still holding, shares in her company would also be happy.

The great irony is that the insider trading laws do not compensate the supposed victims of the illegal transaction: those few people who bought their shares from the insider. Instead, the government imposes fines on the seller. Then the government pockets the money — a tiny fraction of the money spent to prosecute the seller. The victims must then sue the seller in civil court to recover damages. But mere double restitution will not be enough to compensate the trial lawyers, who demand one-third of everything collected. (Note: the Bible specifies double restitution: Exodus 22:4. But the Bible isn’t good enough for the trial lawyers.)

If you think the American justice system is messed up, you have understood one of the messages from Martha Stewart. When we call it the criminal justice system, we have used the correct adjective. When we call it civil justice, we haven’t.

THAT QUIET SUCKING SOUND

I have said that there has not been a wave of panic selling. There should have been. The company’s capitalized value has collapsed. The source of the company’s expected stream of net income is going to jail.

I suppose I should bewail the loss of $1.5 billion in capitalized value. On paper, this is what the Martha Stewart affair has cost investors, of whom Mrs. Stewart is the largest. Investors who had shares in their retirement portfolios are now going to have to work an extra month or year or decade to make up for the losses they have experienced.

Yet I can’t get too excited about this. Why not? Am I a cold-hearted man? Can’t I see what has happened? Can’t I feel their pain?

The answers are no, yes, and no. No, I am not cold hearted; yes, I can see what has happened; and no, I cannot feel their pain. That is because I feel too much pain on behalf of tens of millions of lambs headed for the slaughter, who are going to feel a lot more pain than Martha Stewart’s investors did. The pain that the Stewart investors have felt is going to be multiplied across the boards. I will not be one of them, I hope, but the economic fall-out will be unavoidable for most Americans. I will get hit by the after-effects.

The disappearance of $1.5 billion has received little media attention. The media focus on Martha the control freak, Martha the crook, Martha the liar, Martha the emotionally distant. What really bugs me is Martha, the woman who is as old as I am but who looks ten years younger. But none of this is either here or there in the larger scheme of things.

What should be in every discussion of her case is the ease with which $1.5 billion in capitalized value went poof. No muss, hardly any fuss, and whammo: the wealth disappeared. Or did it? Was it wealth? Or was it the illusion of wealth?

I think it was the latter. It was the illusion of wealth created by a stock market where investors assume that most people will never sell. “The market always goes up in the long run.” Really? If so, then what has happened to Martha Stewart’s shares had better be an anomaly. The disappearance of all that capital was so easy, and it happened so quietly, while everyone was discussing Martha the Whatever, that those who think the stock market always goes up had better show us why this case really is an anomaly.

Yes, the company had capitalized one person’s income-producing ability. But didn’t the experts know that this was a risk? Didn’t they know that people get old, die, and make other mistakes? Didn’t the mutual fund managers know enough not to buy the shares of a company that hinges on one person? Of course not. They bought. They used formulas. “Random walk giveth, and random walk taketh away.”

It did not take a wave of panic selling to whack the dreams of everyone who owned shares in her company. All it took was a series of headlines. These headlines convinced a tiny minority of share owners to sell. Down, down, down went the price of the marginal shares, the imputed value of the remaining shares, and the capitalized value the company.

What if there had been a real panic?

BUBBLE, BUBBLE, TOIL AND TROUBLE

“It does not take a large number of sellers to collapse the value of a company.” This is the message from Martha Stewart.

The creation of stock market profits for tens of millions of American families has been the accomplishment of these factors:

The illusion of the stock market’s capital value, meaning wealth, is today universal. Analysts look at Martha Stewart’s case and conclude, “It’s an anomaly.” Buy why is it an anomaly? Did too many people buy shares based on the expected net income of one person? Yes. But they did invest. Nobody warned them of the risk. Nobody imagined that the company could be hit this badly. If something is inherently risky, as the investment in one person’s brand is, then why doesn’t common sense prevail? It did not prevail. The portfolio managers blew it.

It took few sellers to inflict horrendous losses on the investors who decided not to sell. The buy-and-hold people sat there and did nothing. The result was a disaster.

People are looking forward to their retirement. They have great expectations regarding their future net income. Yet they are paid dividends that are not much higher than mutual fund expenses. They are as blind to the implications of this as the investors were who bought and held shares in Martha Stewart’s expected net income stream.

Can’t they see what is coming? No. They know that they cannot live on dividends. They know that their future income from their stocks will depend on their ability to sell their shares into that legendary market that always rises. They do not apply their knowledge of what happened to Martha Stewart’s shares to their own portfolios. They have not received the message from Martha Stewart. And what is that message? This:

It does not take a large number of sellers to collapse the value of a company.

The perceived capital value of the stock market is an illusion, and that illusion can be exposed at any time by a seemingly trivial event.

CONCLUSION

People believe what they want to believe. Stock market investors want to believe that they will be able to live off of their dividends, which are zero now, plus the capital value of their sold shares. They think that there will be buyers for their shares when they retire. What buyers? Most people who own shares own them in their retirement funds. It is the baby boom generation that was sufficiently future-oriented to bid up the price of the shares. “Sell!” “To whom?”

Millions of investors also believed that the Martha Stewart brand name was somehow separate from Martha Stewart. They assumed that Martha Stewart was as permanent as a Kennedy in politics in Massachusetts. She wasn’t.

Be realistic. As Will Rogers said about stocks: “Buy stocks. They’re going up. But if they don’t go up, don’t buy ‘em.” Or words to that effect.

March 13, 2004

Gary North [send him mail] is the author of Mises on Money. Visit http://www.freebooks.com. For a free subscription to Gary North’s newsletter on gold, click here.