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Economic Policy, Complex Adaptive Systems, Human-Computer-Interaction and Managerial Psychology: Popular-Index Ecosystems

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Indices, Index Funds And ETFs

Abstract

During 1990–2017 there was substantial debate about the nature and extent of earnings management by companies included in popular stock indices (such as S&P-500, Nikkei-225, MSCI-1500 and DAX-100 companies). These popular indices have created “Popular-Index Ecosystems,” which are a critical economic policy issue because they increase systemic risk and financial instability, and they affect managerial psychology and group decisions in large and medium-sized companies. This article contributes to the literature by (i) providing evidence of, and surveys in, endemic earnings management, asset quality management and tax evasion by “Popular-Index companies”; (ii) characterizing “Popular-Index Ecosystems” and the effects of such systems on the business climate in general; (iii) introducing new theories of corporate governance, managerial psychology, networks and risk.

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Notes

  1. 1.

    See: Dietrich, C. (April 17, 2017). “Investors Follow the Herd as 10 Big Stocks Power Market’s Gains: Ten big stocks are exerting an unusually large influence on the S&P 500 In 2017, the latest sign that the herd instinct is alive and well on Wall Street.” Wall Street Journal. https://www.wsj.com/articles/investors-follow-the-herd-as-10-big-stocks-power-markets-gains-1492469729?mod=e2fb

  2. 2.

    See: Vigna, P. (Apr 25, 2017). “Nasdaq 6000′s ‘Fast Five’ a Sign of an Aging Market.” Wall Street Journal. https://blogs.wsj.com/moneybeat/2017/04/25/nasdaq-6000s-fast-five-a-sign-of-an-aging-market/?mod=e2fb

  3. 3.

    See: Fink, R. (August 2014). Earnings management now a no-win proposition – Investors are providing smaller rewards for positive earnings surprises and bigger punishments for negative ones, according to a new study. http://www.fiercecfo.com/story/earnings-management-now-no-win-proposition/2014-08-13

  4. 4.

    See: The Economist (August 1, 2015). Roaring ahead – Exchange-traded funds have overtaken hedge funds as an investment vehicle. http://www.economist.com/news/finance-and-economics/21660169-exchange-traded-funds-have-overtaken-hedge-funds-investment-vehicle-roaring?fsrc=rss%7Cfec?fsrc=scn/tw/te/pe/ed/roaringahead

  5. 5.

    See: Davis, P. (August 18, 2015). China Down Another Six Percent and U.S. Earnings Smell Like BS. http://www.huffingtonpost.com/phil-davis/china-down-another-6-and_b_8003516.html?ncid=txtlnkusaolp00000592

  6. 6.

    See: Strumpf, D. (Sept. 15, 2014). “Companies’ Stock Buybacks Help Buoy the Market Share – Repurchases Are At Fastest Clip Since Financial Crisis”. Wall Street Journal. http://www.wsj.com/articles/companies-stock-buybacks-help-buoy-the-market-1410823441

    See: Cox, J. (July 2, 2018). Companies buying back their own shares is the only thing keeping the stock market afloat right now. https://www.cnbc.com/2018/07/02/corporate-buybacks-are-the-only-thing-keeping-the-stock-market-afloat.html

    See: Fox, J. (March 6, 2018). The Big and Possibly Dumb Buyback Boom - The Trump tax cuts have given corporations plenty of money to play with; Share repurchases may not be the best way to use it. https://www.bloomberg.com/view/articles/2018-03-06/the-big-and-possibly-dumb-boom-in-corporate-share-buybacks

    See: Derousseau, R. (April 20, 2018). Why Stock Market Buybacks Should Make Investors Nervous. http://fortune.com/2018/04/20/stock-market-buybacks-nervous/

    See: The Economist (Sept. 13, 2014). Share buy-backs: The repurchase revolution—Companies have been gobbling up their own shares at an exceptional rate. There are good reasons to worry about this. Available at: http://www.economist.com/news/business/21616968-companies-have-been-gobbling-up-their-own-shares-exceptional-rate-there-are-good-reasons. This article stated in part: “……In the decade before America’s housing bubble burst, Home Depot, an American home-improvement chain, spent heavily on building new shops to meet rampant demand for everything from taps to timber. For every dollar of operating cashflow the firm generated, it ploughed back 65 cents into capital investment. The financial crisis hit hard, and demand for some products has yet to recover fully. Sales of kitchens are only 60% of their peak level. But Home Depot has evolved into a very different kind of beast. Its capital investment has fallen by two-thirds and it is investing heavily in something else: its own shares. Since 2008 it has spent 28 cents of every dollar of cashflow on dividends and a further 52 cents on share repurchases. In June it took advantage of low interest rates to issue a $2 billion bond partly to pay for more buy-backs…… That story, of sluggish investment despite low interest rates, and huge share repurchases, is broadly true of all of corporate America. The companies in the S&P 500 index bought $500 billion of their own shares in 2013, close to the high reached in the bubble year of 2007, and eating up 33 cents of every dollar of cashflow. ……. but buy-backs have usurped dividends as the main way listed American firms give money back to their owners, accounting for 60% of cash returns last year...……Even in Europe and Asia, where dividends tend to be venerated, buy-backs have become more common in the past decade. Tencent, a Chinese internet giant whose billionaire boss, Ma Huateng, has a seat in the National People’s Congress, now regularly repurchases its stock. The conservative champions of Japan, including Toyota, Mitsubishi and NTT DoCoMo, are buying their own shares at a record rate. Today no chief executive can ignore buy-backs. They are an idea that has conquered the world.…… Repurchases by firms in the open market, the main type of buy-backs today, used to be banned. America loosened its rules in 1982, Japan in 1994 and Germany in 1998. …… The real world varies from what the textbooks say. Since interest paid on debt is tax-deductible, whereas interest earned on cash is taxable, by increasing its net debt to finance buy-backs or dividends, a firm cuts its tax bill. And of course, increasing the firm’s indebtedness makes it riskier. Buy-backs and dividends can also boost perceptions of a firm’s value……..”

  7. 7.

    See: Weil, J. (August 21, 2001). Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate. The Wall Street Journal, http://www.wsj.com/articles/SB998339424717089333

  8. 8.

    See: Blackrock (December 2014). Dealing With Divergence – 2015 Investment Outlook. Available at: https://www.blackrock.com/corporate/en-us/literature/whitepaper/bii-2015-investment-outlook-us.pdf

  9. 9.

    See: Stockman, D. (Jan. 14, 2015). It’s Earnings Season – So Here Come The Crooks, Led By Alcoa. Available at: http://davidstockmanscontracorner.com/its-earnings-season-so-here-come-the-crooks-led-by-alcoa/

  10. 10.

    See: Wilshire (2014). Wilshire Consulting Report on Corporate Pension Funding Levels (Apr. 3, 2014). Available at: http://www.wilshire.com/media/23551/wilshire_2014_corp_funding_rpt.pdf

  11. 11.

    Telesurtv.net (Oct.2015). Report: 3 Out of 4 Fortune 500 Companies Avoid Paying Taxes – Corporate tax dodging is causing cuts in public investments and services. Available at: http://www.telesurtv.net/english/news/Report-3-Out-of-4-Fortune-500-Companies-Avoid-Paying-Taxes-20151006-0034.html

  12. 12.

    See: Garver, R. (Oct. 2015). How Fortune 500 Companies avoid paying $620 billion in Taxes. http://www.thefiscaltimes.com/2015/10/06/US-Companies-Have-Staggering-Amounts-Cash-Offshore-Tax-Havens

  13. 13.

    See: US Public Interest Research Group And Citizen’s For Tax Justice (2015). Offshore Shell Games 2015 – The Use of Offshore Tax Havens by Fortune 500 Companies. http://ctj.org/pdf/offshoreshell2015.pdf; or http://ctj.org/ctjreports/2015/10/offshore_shell_games_2015.php#.VhPhG_lVhBc

  14. 14.

    Source: US Public Interest Research Group And Citizen’s For Tax Justice (2015). Offshore Shell Games 2015—The Use of Offshore Tax Havens by Fortune 500 Companies. http://ctj.org/pdf/offshoreshell2015.pdf; or http://ctj.org/ctjreports/2015/10/offshore_shell_games_2015.php#.VhPhG_lVhBc

  15. 15.

    See: Durden T (Feb. 2010). Accounting Gimmicks Have Boosted The Collective S&P 500 Cash Balance By Over $150 Billion Since The Start Of The Crisis. http://www.zerohedge.com/article/accounting-cash-gimmicks-have-boosted-collective-sp-500-cash-balance-over-150-billion-start-

  16. 16.

    See: FactSet (March 15, 2015). Buyback Quarterly. http://www.factset.com/websitefiles/PDFs/buyback/buyback_3.16.15

  17. 17.

    See: Francis, T. (June 2011). A Tale Of Two Paychecks At Mckesson & CA. June 13, 2011. Available at http://www.footnoted.com/my-big-fat-deal/a-tale-of-two-paychecks-at-mckesson-ca/

  18. 18.

    See: GE (2009). Shareholder Proposal #4. Available at http://files.cwa-union.org/Investor/Dividend_Policy_for_Executives_-_GE_2009.pdf

    See: GE 2007 Proxy Statement, Shareowner Proposal. Available at http://www.ge.com/ar2006/proxy/sprop5.htm

  19. 19.

    The following companies’ corporate scandals were among the largest in the world: Australia and New Zealand Banking Group (Australia; https://en.wikipedia.org/wiki/Australia_and_New_Zealand_Banking_Group); Australia and New Zealand Banking Group’s manipulation of the Australian benchmark interest rates (Australia; https://en.wikipedia.org/wiki/Australia_and_New_Zealand_Banking_Group); BAE Systems’s bribery scandal (USA; https://en.wikipedia.org/wiki/BAE_Systems#Corruption_investigations); Bristol-Myers Squibb’s accounting scandal (USA; https://en.wikipedia.org/wiki/Bristol-Myers_Squibb#Scandals_and_allegations); Brown & Williamson’s enhancement of the addictiveness of cigarettes (USA; https://en.wikipedia.org/wiki/Bristol-Myers_Squibb#Scandals_and_allegations); Chevron-Texaco Lago Agrio oil field (USA; https://en.wikipedia.org/wiki/Lago_Agrio_oil_field); Commonwealth Bank of Australia’s illegal denial of insured persons’ claims (Australia; https://en.wikipedia.org/wiki/Commonwealth_Bank); Commonwealth Bank Of Australia’s delivery of improper advice to customers during 2003–2012 (Australia; https://en.wikipedia.org/wiki/Commonwealth_Bank_Of_Australia); Compass Group’s bribery of the United Nations (https://en.wikipedia.org/wiki/Compass_Group#2005_United_Nations_misconduct_incident); Corrib’s gas controversy (Ireland; https://en.wikipedia.org/wiki/Corrib_gas_controversy); Deutsche Bank’s Libor scandal (Germany; https://en.wikipedia.org/wiki/Libor_scandal); Duke Energy (USA; https://en.wikipedia.org/wiki/Duke_Energy#Taxes); El Paso Corporation’s price fixing scandal (USA; https://en.wikipedia.org/wiki/El_Paso_Corp.#Price_fixing); Fannie Mae’s earning management and accounting controversy (USA; https://en.wikipedia.org/wiki/Fannie_Mae#Accounting_controversy); FlowTex (https://en.wikipedia.org/wiki/FlowTex#Scandal); Global Crossing’s accounting fraud and other offenses (USA; https://en.wikipedia.org/wiki/Global_Crossing); Guinness’s share-trading fraud (https://en.wikipedia.org/wiki/Guinness_share-trading_fraud); Hafskip’s collapse (https://en.wikipedia.org/wiki/Hafskip); Halliburton’s over-charging for government contracts (USA – https://en.wikipedia.org/wiki/Halliburton); Harken Energy (USA; https://en.wikipedia.org/wiki/Harken_Energy_Scandal); HealthSouth’s earnings management and accounting fraud (USA; https://en.wikipedia.org/wiki/HealthSouth); Homestore.com (https://en.wikipedia.org/wiki/Homestore.com); Kerr-McGee (USA; https://en.wikipedia.org/wiki/Karen_Silkwood); Kinney National Company’s financial scandal (https://en.wikipedia.org/wiki/Kinney_National_Company); Lernout & Hauspie’s accounting fraud (https://en.wikipedia.org/wiki/Lernout_%26_Hauspie); Lockheed’s bribery scandal (USA; https://en.wikipedia.org/wiki/Lockheed_bribery_scandals); Livedoor (https://en.wikipedia.org/wiki/Livedoor); Marsh & Mclennan (USA; https://en.wikipedia.org/wiki/Marsh_%26_Mclennan); Merck’s medicaid fraud (USA; https://en.wikipedia.org/wiki/Merck_%26_Co.#Medicaid:overbilling); Mirant (https://en.wikipedia.org/wiki/Mirant); Morrison-Knudsen (USA; https://en.wikipedia.org/wiki/Morrison-Knudsen); Mutual-fund scandal (2003) (https://en.wikipedia.org/wiki/Mutual-fund_scandal_(2003))); Nestle (https://en.wikipedia.org/wiki/Nestl%C3%A9); Nugan Hand Bank (https://en.wikipedia.org/wiki/Nugan_Hand_Bank); Olympus’s accounting scandal (Japan; https://en.wikipedia.org/wiki/Olympus_Scandal); the Options backdating scandal of 2001–2008, which was perpetrated by many exchange-traded companies (https://en.wikipedia.org/wiki/Options_backdating); Panama Papers scandal, which involved the global leak of confidential documents pertaining to the bank accounts and company ownership by politicians and high-net-worth individuals from many countries (https://en.wikipedia.org/wiki/Panama_Papers); Peregrine Systems’s accounting fraud (USA; https://en.wikipedia.org/wiki/Peregrine_Systems); Phar-Mor’s fraud (USA; https://en.wikipedia.org/wiki/Phar-Mor); Qwest Communications (USA; https://en.wikipedia.org/wiki/Qwest_Communications);

    RadioShack (USA; https://en.wikipedia.org/wiki/RadioShack); Reliant Energy (USA; https://en.wikipedia.org/wiki/Reliant_Energy); Rite Aid’s accounting fraud (USA); Royal Dutch Shell’s over-statement of its oil reserves (Netherlands; https://en.wikipedia.org/wiki/Royal_Dutch_Shell); S-Chips Scandals (Singapore; https://en.wikipedia.org/wiki/S-Chips_Scandals); Satyam Computers (India; https://en.wikipedia.org/wiki/Satyam_Computers#Controversies); 7-Eleven Australia (Australia; https://en.wikipedia.org/wiki/7-Eleven); Siemens’s bribery of the Greek government (Germany; https://en.wikipedia.org/wiki/Siemens_Greek_bribery_scandal); Société Générale’s derivatives trading scandal that caused multi-billion Euros losses (France; https://en.wikipedia.org/wiki/Soci%C3%A9t%C3%A9_G%C3%A9n%C3%A9rale); Southwest Airlines’s non-compliance with safety regulations (USA; https://en.wikipedia.org/wiki/Southwest_Airlines); Tyco International’s executives’ theft (USA; https://en.wikipedia.org/wiki/Tyco_International); Union Carbide (USA; https://en.wikipedia.org/wiki/Union_Carbide); ValuJet Airlines (USA; https://en.wikipedia.org/wiki/ValuJet_Airlines); Volkswagen’s non-compliance with emissions regulations (https://en.wikipedia.org/wiki/Volkswagen_emissions_violations); David Wittig’s looting scandal (https://en.wikipedia.org/wiki/David_Wittig); and Xerox’s accounting fraud (USA; https://en.wikipedia.org/wiki/Xerox#Alleged_accounting_irregularities).

  20. 20.

    See: Inagaki, T. & Lewis, L. (May 29, 2016). “String of scandals puts Japanese investors on edge”. Financial Times (London). https://www.ft.com/content/89c00e1c-2263-11e6-9d4d-c11776a5124d. This article states in part: “From carmakers and electronics groups to house-builders and the constructors of the nation’s roads and runways, a government-led transparency drive has accelerated a record surge of accounting and data fraud scandals across corporate Japan. In the five years since a $1.7 billion accounting scandal was uncovered at Olympus, the number of improper accounting cases exposed each year in Japan has nearly doubled. It hit an all-time high of 58 (fifty-eight) cases in the 2015–16 fiscal year, according to Tokyo Shoko Research, which provides data on corporate failures. In many cases, the revelations have shone a light on malpractice and subterfuge dating back years—the legacy of management terrified of failure but left fighting decades of economic stagnation, squeezed costs and a shrinking domestic market…” According to Tokyo Shoko Research, the number of Japanese companies that disclosed improper accounting was about 32 in 2011, 28 in 2012, 38 in 2013, 41 in 2014, and 58 in 2015.

  21. 21.

    Group-F5 (Greater Than $100 billion per year):

    • Environmental Protection Agency (EPA): $353 billion

    • Health & Human services (HHS): $184.8 billion

    • FCC and Telecom Regulation: $142 billion

    • Department of Labor: $116.3 billion

    • Financial Regulation (several agencies): $102.5 billion

    Group-F4 ($10 billion–$100 billion per year):

    • Department of Transportation: $61.8 billion

    • Department Of Homeland Security (DHS): $55.32 billion

    Group-F3 ($5 billion–$10 billion per year):

    • Energy Department: $9.809 billion

    • US Department of Agriculture (USDA): $9.05 billion

    • Department of the Interior: $5.2 billion

    Group-F2 ($1 billion – $5 billion per year):

    • Department of Education: $3.302 billion

    • Housing & Urban Development (HUD): $1.827 billion

    • Department of Commerce: $1.801 billion

    • Department of the Treasury: $1.32 billion

    • Department of Justice: $1.25 billion

    Group-F1 (Less Than $1 billion per year)

    • U.S. Access Board (ATBCB): $851 million

    • Nuclear Regulatory Commission: $414 million

    • FERC: $336 million

    • CPSC: $193 million

    • Equal Employment Opportunity Commission (EEOC): $121 million

    Source: Wayne Crews, “Tip of the Costberg”; working paper.

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    Michael I. C. Nwogugu

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Nwogugu, M.I.C. (2018). Economic Policy, Complex Adaptive Systems, Human-Computer-Interaction and Managerial Psychology: Popular-Index Ecosystems. In: Indices, Index Funds And ETFs. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-44701-2_12

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