Worst game in town?
The decline and fall of the Canadian stock market
It’s a slow afternoon on the floor of the Toronto Stock Exchange, so slow that the order clerks are playing cards. Gathered around their trading posts like dog teams around stationary sleds, the floor traders stare up hungrily at the statuesque girl in a group just entering the visitors’ gallery. Drawing herself upright, she disregards them with the aplomb befitting a new trainee at Wood, Gundy Ltd., Canada’s largest stockbrokerage, the secret halfsmile of a watched female playing on her lips.
A floor trader calling out his orders across a crowded floor is the way the public thinks of the stock market. Yet TSE traders are usually mere employees of brokerage houses, earning $10,000 to $20,000 and fairly low down in the hierarchy—unlike the New York Stock Exchange traders, who must be seat holders on the exchange and are often partners in their firms. Hence the TSE traders’ significantly ineffective resistance to plans to replace their traditional function in matching buy and sell orders through open outcry on the exchange floor with a computer that will unemotionally sort out orders piped to it via terminals in brokerage offices all over the country. The Computer-Assisted Trading System (CATS) is scheduled to be functioning experimentally this spring. Its related information service, CANDAT II, has already filled brokerage offices with huge, glowering TV screens, rendering the traditional ticker tape obsolete. This Canadian-designed system reputedly leads the world. But the traders are unhappy. They doubt that CATS will ever be able to duplicate the intuitive assessment of market mood the traders can make by listening to the sound of trading.
Yet the advent of CATS is a relatively minor symptom of the storm of change that has overwhelmed Canadian stock markets and the whole investment industry of which it has traditionally been the linch pin over the past 10 years. “The stock market game is over,” flatly declares Gary van Nest, president of Triarch Corporation, the merchant banking arm of Brascan Ltd. The old Toronto Stock Exchange Industrial Index, for example, is currently skulking in the mid-170s, approximately where it was a decade ago, although, thanks to the intervening era of inflation, the total value is now that much less.
For all the capital gains they have received, many investors during those years might just as well have buried their money in the ground. That would have been safer than going into the market in, say, Octo-
ber, 1973, when it reached 238, before plunging to 150 a year later. And among the myriad smaller stocks not included when the index is calculated, but dear to the hearts of small investors, the damage was even worse. In 1969, for example, it cost eight dollars to buy one share in Hy’s of Canada Ltd. The price is now around $2.05, but the price of the restaurant chain’s massive steaks so beloved of the Bay Street subculture has risen by approximately 90%.
What the hell is the matter with the stock market? The anguished question is asked not merely by investment industry professionals, whose numbers have dwindled sharply since 1970, but by their customers as well. No longer do investors crowd downtown offices watching the tape at noon, as they did 10 years ago. But they still remember their losses, darkly. Just as it was in the years after the Great Crash of 1929, a whole generation of North Americans has reeled back from the stock market, burned and bitter. Equally at a loss are the men who run Canadian industry, which has always in the past relied on the stock market for financial fuel. Since this creates jobs, everyone in the Canadian economy is, even if unwittingly, an investor in the stock market.
And this investment is not limited to material prosperity. The appalling performance of the stock market in the past 10
years is still imperfectly understood. To some extent, it’s typical of the market’s endlessly histrionic nature, revolving from euphoria to despair like a windmill’s sails, apparently without ever learning. Beyond this, however, it begins to look as if the stock market is being undercut by an obscure but fundamental change in the way the economy operates. Economies are ultimately the product of ideas and cultures, Karl Marx notwithstanding. Stock markets arose in the brilliant dawn of open societies, in Europe and North America. Their fall may portend the Western democracies’ troubled dusk.
In a capitalist economy, the stock market traditionally has fulfilled the same function as the heart does in the body. It is the organ responsible for pumping blood, or capital, to where it is needed. The theory is simple. A company whose product is in short supply charges high prices, makes large profits, and investors compete to buy its stock. That firm can then issue more stock to get capital for expansion, and other companies entering the field can sell ^ their stock more readily because of the § other company’s example. Conversely, if 5 the company is unprofitable, investors will | sell the stock and its price will fall.
The efficiency of any economy depends upon what economists call an optimum allocation of resources—putting money where it does the most good. The stock market facilitates this because of the speed and ease with which investors are informed and can act—literally from minute to minute. Of course, individual investors can be wrong. But the stock market is the sum of all their opinions, and professionals possess an almost mystical belief in the market’s ability to anticipate the twists and turns of the economy. Even the much-maligned speculator plays an essential role, rather similar to that of a scavenging coyote in the ecology of the bush. He clears up the market, by buying and selling at times when the prudent investors are doing the opposite.
Only a small proportion of Canadian industrial capital was ever raised through the stock market—but it was crucial. A corporation needs three types of money. Shortterm cash requirements can usually be borrowed from the firm’s friendly (but very cautious) bankers, secured against some asset. Slightly more daring investors can be talked into lending money longer-term, in the form of bonds, with the principal and interest guaranteed and given priority. But ultimately, someone has to stand in the front rank by putting up “equity.” Equity capital is not guaranteed, and the equity investor accepts the risk of seeing his money utterly wiped out if the company
fails. But he also owns a share of whatever is left after debts are paid if the company succeeds. Like Napoleon’s Old Guard, equity is the key unit around which the whole financial battle is fought. And the crowning glory of the stock market has been its ability to recruit equity as and when required. Until now.
Much of the trouble with the market today goes back to the so-called “equity cult” of the early Sixties—the belief that by buying and selling common stock actively investors could achieve much higher rates of return, through dividends and capital gains, than by sitting on a pile of safe but
boring bonds, which paid low interest and remained almost totally inert. It was basically the same as proposing to cross a fast river by jumping from one to another of the logs floating down it—logically possible perhaps, sometimes easy, but appealing as a policy only to a generation that had not seen its fellows smashed to a pulp in 1929.
“The Sixties were absolutely mad,” says Michael Ryan of Vancouver. “It was one of the major delusions of recorded financial history. We had salesmen, high-school dropouts, earning $50,000, $80,000 a year. We made a piss pot full of money.” Ryan is a tall, bespectacled hawk with long, thinning hair and a wild taste in clothes. He is now vice-president of the Vancouverbased brokerage house of Pemberton Securities Ltd., into which he folded his own small brokerage house in 1974, just as everyone woke up.
By thç, late 1960s, the traditional Canadian preference for bonds had evaporated in the stock boom. That in turn was supported by a long economic upswing and a flood of new money looking for “performance”—faster than average growth. As a result, a whole cohort of able young financial analysts made their fortunes offering to manage the eager public’s money, successfully for a time, in mutual funds—the investment version of a collective farm based on selections of common stocks. But even apart from the dangers inherent in
common stocks, temporarily forgotten, and the inadequate number changing hands each day, which made it difficult for large investors to trade, the awkward truth remained that it was by definition impossible for everyone to get above-average performance from their investments. That it took so long for this to dawn is one of the insights into human nature offered by the study of financial markets. In March, 1969, the member firms of the Investment Funds Institute of Canada had $2.9 billion dollars under management. By the end of 1976, the figure was down to $1.8 billion. United Financial Management used to have more than 1,200 salesmen. Today, it has none.
By the early Seventies, the equity cult was in its final frenzy. A new set of heroes carried the performance banner: the brokers who provided institutional investors with high-quality investment advice, often groups of people who seceded from larger companies to form their own specialized brokerage houses (“institutional boutiques).” The most famous is Loewen, Ondaatje McCutcheon Ltd., formed from a rib of Pitfield, Mackay Ross & Co. Chris Ondaatje, a tall gazelle-like figure with an intense wariness of journalists, is one of Bay Street’s more exotic figures: once a Financial Post salesman of legendary ferocity, he is a scion of an old Anglo-Ceylonese family, an ex-member of Canada’s Olympic bobsled team, and author of a sensitive autobiographical novel about the invest-
ment business. Now, in 1977, with lower commissions and investor disenchantment, the boutiques’ future looks grim, and even Loewen, Ondaatje, according to firmly denied rumor, is considering returning to the womb of a larger, more diver-
sified house. (Greenshields Inc. is the most-mentioned candidate.)
The fate of some less-celebrated brokers has been far grimmer. In the past year, at least six members of securities firms in Toronto have killed themselves. At the same time, the brokerage profession as a whole will probably have to face considerable changes in the future. Although they have
not yet been forced to negotiate the commissions they charge on each trade competitively, as in the United States— where the stock market has recovered significantly in the past year—overall commissions have been pressed down relentlessly. The larger transactions now bring in only a third of the comparable 1969 rakeoff. Ominously, so many Canadian investors are taking advantage of the cheaper trading offered in the United States on the numerous key Canadian stocks listed on exchanges in both countries that competitive negotiations may be unavoidable here anyway. In 1969, 100 member firms had seats on the Toronto Stock Exchange. Today, there are 74, well over half of whom are the products of mergers or takeovers. A TSE seat sold for $ 132,500 in 1970; recently the price was down to $20,000.
Amid the wreckage of a typical financial collapse was the little-noticed fact that, in one sense, the market had been working only too well. For long periods in recent years, the Canadian corporate sector, like an exhausted athlete whose system starts to break down his body’s cells in the search for oxygen it can no longer extract from his own blood, has been consuming its own capital. This is because of the combination of unprecedented inflation and historic cost accounting which, by failing to allow properly for depreciation and inventory replacement, had corporations in effect paying out capital as earnings and being taxed on it. In 1970, no one seemed to realize this—except for the market, which in its mysterious way sensed the truth, and dived for the floor.
Beyond that, there is a growing belief that the net of taxation, exemptions and subsidies that Ottawa has dropped over the economy is beginning to twist it away from the stock market. For example, the Canada Pension Plan forces Canadians to disgorge money they might otherwise have saved, and even invested in stocks. That money is now spent on the citizens’ behalf on various government programs. Moreover, the taxation system encourages an individual to own a home and to put money into bonds and Registered Retirement Savings Plans before trying the stock market, where dividends and capital gains are taxed.
As a result, private capital formation is lagging. This shows up in reduced economic growth and fewer jobs. Ottawa’s instinctive response to this is to intervene directly in the economy through agencies such as Petro-Canada or the Department of Regional Economic Expansion. Apparently a pork barrel in the hand is worth more than a healthy economy under the bush. Even the corporate response pressure avoids the stock market. Banks are looking for ways to extend money to corporations by using tax breaks and various government trade finance plans. They are also getting bolder about longer-term loans. Canadian companies may end up, like their Japanese rivals, heavily depend-
ent upon debt, the stability of which is inscrutable to outsiders. There is already a similar dispute here as to whether corporate taxes deferred because of further investment should be regarded as a form of equity.
What happens next? One theory is that Canada will develop a West German-style financial system, with a nominal stock market, and all investment decisions tossed around like a football between a few, giant all-purpose institutions. This is certainly possible. Canadian banks virtually own the brokers already, through extensive loans, and could easily handle their functions. But it would involve a host
of potential conflicts of interest—for example, between a bank’s corporate clients and its role as an adviser to investors considering the corporations’ stock. Perhaps what will happen will be a less blatant encroachment by financial institutions into each other’s territory, as trust companies become banks, banks and brokers start venture capital firms and brokers such as Midland Doherty Ltd. offer petroleum drilling fund packages that are really tax shelters for individual investors and have nothing to do with the stock market.
Much less discussed is the possibility of a South African type of solution, with the major mining companies supplementing
the stock market as a source of equity for smaller companies, INCO Ltd., Canada’s largest mining company and the largest nickel producer in the world, has put more than five million dollars into minority positions in 14 small companies since 1975, and has recently set out to look for more.
No doubt a Canadian compromise will emerge. The stock markets across the country will unite as an electronic trading network. Brokers will reluctantly negotiate commission rates competitively, and in doing so condemn many of their fellow firms to death. More investment decisions will be taken by the government, subject to periodic financial crises, and by large institutions. Ottawa will continue to act in the belief that business has to be shown how, with agencies such as the Federal Development Bank, which will as a rule lose money in a socially responsible (and electorally profitable) way. Canadians will revert to their long established predilection for lending money rather than buying equities, and capital will continue to be imported, amid grumbling, from the United States. But obvious catastrophe will be avoided. And the stock market, in J. P. Morgan’s famous phrase, will continue to fluctuate.
But more feebly. The stock market has always been a form of institutionalized uncertainty, where investors look after themselves and opinions fight it out. It is the product of an age where all theories could be considered against the empirical yardstick of success, whether investing according to chart patterns or astrology. It is a symbol and a symptom of political pluralism, the idea that society works best when individuals pursue their own objectives as they see fit. Where the governing elite is imbued with supreme confidence in its judgment, backed with the moral fervor that overrides contrary evidence—the totalitarianism incipient in all bureaucracies—the stock market is an unbearable reminder of the fallibility of reason and authority in the face of unruly reality. The leading edge of government incursion is made up of the provincial regulatory agencies, of which the Ontario Securities Commission has (not without protesting yelps from the other provinces) become dominant. The osc models itself on the U.S. Securities and Exchange Commission. Significantly, the merging of the functions of judge, jury and prosecutor common to both U.S. and Canadian agencies was recently attacked by Monroe Freedman, Dean of Hofstra University Law School at Hempstead, New York, and a noted civil libertarian, as an example of “the supreme corruption of the legal system.” It was comparable, he suggested, in its own small way to what happened in Russia under Stalin. The martini-slurping broker, waiting in blind hope for the stock market to recover as it eventually did after the Great Crash, is, unlikely as it seems, a flower of freedom, now lightly touched by frost. <7