What is capitalism?

Most people would probably say something about the free market, creative risk-taking, private property, individual achievement, profit, and so on.

Merriam-Webster’s online dictionary defines capitalism as “an economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market.”

This in turn begs the definition of capital itself, and there are many. The ones I choose, from the same source, are “accumulated goods devoted to the production of other goods, or accumulated possessions calculated to bring in income.”

Notice the key term “accumulated.” This carries a sense of building up over time, not of a quick in-and-out trading profit. Indeed, accountants “capitalize” expenses by defining them as long-term investments rather than one-shot deals.

What am I getting at here? The notion of capitalism should be something centered on long-term productivity instead of a quick trade based largely on the greater-fool theory. And yet Wall Street likes to be thought of as a center of pure capitalism, or at least it did until Lehman Brothers wasn’t bailed out and all hell broke loose.

Is it about long-term investment? Sure, but less and less all the time. Otherwise, how do you account for the popularity of trading vehicles such as the leveraged ultra funds, exchange-traded mutual funds designed to produce twice the daily returns of major indices?

While I used to believe in caveat emptor, I have a big problem with these funds and what they stand for. In fairness to the investment firms that produce them, they will tell the truth if you ask, and they even show it on their Web sites. But they don’t shout the truth loudly enough.

What is that truth?

These funds work against you in the vast majority of circumstances by the very nature of how they are constructed. Let’s take a look at a very simple but very telling example. Suppose a stock is up 25 percent one day and down 20 percent the next. If it sounds crazy, it means you weren’t watching the bank stocks as the financial crisis unfolded. Anyway, that means the stock is unchanged for the two days. (Note: If this doesn’t sound right to you, don’t feel bad. It’s not intuitive, and it sounded wrong to my editor. But it is right, and it’s important to understand. It might be worth working through an example of two to show yourself how the math works).

Now let’s look at a fund designed to produce twice the daily return of the stock. The first day it goes up 50 percent, let’s call it from 100 to 150 to make the math simple. The next day it drops 40 percent, going from 150 to 90. So over the two days, the underlying is flat, but the souped-up security is down 10 percent. That is, quite literally, infinite underperformance.

The reason is that, in order to maintain daily returns of twice the underlying, the ultra fund has to change its content every day. It has to buy when the stock or index goes up and sell when it goes down.

This forces a high-volatility environment to work against you. It only works well in strongly trending markets because, in those cases, what looks like a high buy today turns out to be a low buy tomorrow and even a lower buy the day after.

I think the success of these funds, which are so stacked against the investor, is emblematic of what’s wrong with Wall Street. Instantaneous success, which really has very little to do with the true notion of capitalism, has become the standard. If it isn’t about making money today — the only proper holding period, really, for one of these ultra funds — it’s certainly about this month or this quarter. Hedge funds are judged on how few down months they report, not on how they contribute over a meaningful period to the process of capitalism. I mean this far more as a criticism of many of the investors in these funds than the funds themselves.

In fact, hedge funds with patient investors should be performing exceedingly well, at least relative to the broad equity indexes, through the financial crisis. Why? Because they are better equipped to understand, and buy, the illiquid credit assets underpinning the system. The funds with relatively stable money have been able to buy the paper that benefits from government bailouts.

Where does the average investor go? To the stock (equity) markets everyone hears about on the nightly news and reads about in the headlines. But equity is the first line of defense in the capital structure and the part almost guaranteed to be wiped out in any restructuring or bailout.

The point is that, the way things work, the bailouts are more likely to go to the best-heeled investors. It’s not their fault; they understand the system and allocate their money accordingly. The ones with panicky investors have to sell into the declines that help precipitate the bailouts, while the more patient ones profit.

But this doesn’t mean we need to change the system. Equity is, and should be, an option on the upside of the asset in question. When all’s well, over the long term, equities will tend to outperform other asset classes because of their favorable limited downside/unlimited upside profile. But when you’re in the middle of the mess and that zero downside is looking pretty likely, the long term is not much comfort. That’s the problem with all the academic studies promoting equities as the best long-term investments.

We need to educate people better about the alternatives. Just because something is easy to trade, easy to get in and out of, doesn’t mean it’s the right place to be at any given point. We need people to know how to evaluate their choices and how to make changes if one option clearly dominates another. It’s not good enough for the investments themselves to have stable properties if the people who own them are trading like they are going to zero tomorrow. Perception is far too much of reality.

What does that have to do with capitalism?

If you really want to understand how financial assets perform, you have to think about not only the assets themselves in some abstract sense, but also who owns them. This brings us back to the time horizon issue I argued is central to the real definition of capitalism.

When all the big investment banking firms sold stock to the public, they claimed they did so because they needed stronger and bigger capital bases in order to compete in the new financial landscape.

It can now be safely argued that what they really accomplished was moving risk into precisely the wrong hands. Why? Because public shareholders who set price daily are largely institutional investors who live by a dangerous culture of quarterly performance. Once you make them your ownership base, you have to play by their rules.

Those rules involve hitting ever-growing quarterly earnings targets, designing expectations at just the right levels, and then coming in consistently above them. That is a bad enough framework for companies with fairly predictable businesses — companies like McDonald’s, Costco, and Johnson & Johnson that make and sell things we pretty much always need.

But for firms whose earnings are increasingly dependent on intrinsically unpredictable short-term markets, it becomes more of a game of musical chairs and less a notion of putting capital to work.

So you end up not with assets being deployed for productive long-term use but a strange game of wanting to go the same place the other guy is going. Chuck Prince, the former head of Citigroup, infamously said, “As long as the music’s playing, you have to get up and dance.”

That’s all about not getting caught missing an earnings estimate, all about not underperforming the other guy in the short term. It’s a way of thinking that’s much more consistent, unfortunately, with irresponsible use of other people’s money than with prudent use of one’s own.

It’s no accident that Wall Street bailouts happened when the companies were all public. The pressure to generate investment performance in a non-capitalist time frame is behind much of the problem. The best critics of the system now are rightly arguing that trading other people’s money and being rewarded for being in line with averages is not capitalism as properly defined. True capitalists concern themselves with identifying and satisfying unmet public needs. They think independently and bristle at the idea of meeting consensus expectations.

There are, indeed, true capitalists on Wall Street. But they are the identifiers of new opportunities, the builders of new businesses. Ironically, Bernie Madoff was originally a capitalist. The true Wall Street capitalists are not, for the most part, the individuals who have succeeded in the business, people who have excelled in not rocking the boat.

Chuck Prince is not a capitalist.

To read more on this topic, please see the columns I’ve written for Minyanville.com (free registration required):

The Anti-Leveraged ETF (01/21/09)

Off the Mark: Mark-to-Market Accounting (2/12/09)