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Executive Pay Caps: Be Careful What You Wish For


Regulatory overreach will have severe market consequences.

Be Careful What You Wish For

By all accounts, the concerns expressed in my prior 2 Minyanville articles, Bulls Out of Momentum and Advice for Stressed-Out Bears, as well as several recent blog postings, appear to be working out. Stocks -- fully valued with suspect technical-analysis credentials -- have stalled, and are likely headed toward a range-bound summer, with winners and losers producing a zero-sum period of returns.

If this comes to pass, the decision on what to do over the next few months, how to exploit a mini range-bound/sideways market, becomes a priority for actively managed portfolios. On this matter, I'll have some ideas in next week's article. What I want to touch on now is something that has far more serious consequences for the market: regulatory overreach by the US government. More specifically, the current attempts by congressional Democrats to dictate pay policy for financial-service firms.

I get this argument, which focuses on the systemic risk posed by both greed and by the pro-cyclical dynamics it can engender. Together, they can wreak havoc on the market and the economy as a whole. It's understandable that financial-services compensation creates the need to "dance while the music's playing," thereby exacerbating natural economic pro-cyclicality (and creating bubbles). From a public-policy perspective, this needs to addressed.

But the answer to the problem proposed by congressional Democrats and supported by the White House has very ominous dimensions - along with unintended consequences on valuation models investors use when incorporating regulation into the valuation mix. Allow me to elaborate.

Regulation's Impact on Valuation Models

One of the core tenets of fundamental valuation is the role of governmental regulation and the probable impacts it may have on corporate growth and profitability. In most cases, this dynamic is viewed strictly on a sector and/or industry basis. The thinking goes, that the greater the regulatory chokehold of government, the lower growth and profitability is likely to be.

Viewed within this traditional, narrower, analytical light, the actions contemplated by the Democrats and the Obama administration look troubling at best, and restricted to the confines of the industry in question. In normal times, this would be the case. But these are hardly normal times. The role of the financial-services industry to the health and well-being of the economy (global and domestic) has been demonstrated to great painful effect. So, what should an investor make? What signals are sent by such attempts by government to micro-manage an industry?
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No positions in stocks mentioned.
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