One of the most upsetting problems in business and finance is the appearance of a bubble every time a sector of the economy starts to race ahead of the others. The problem is aggravated by the small investors who rush to get into the act believing that what they see is a deal that will keep rising for ever.
When you look closely at the phenomenon, you find that the small investors are the real victims in this exercise as you realize that they are pouring hard earned money into a worthless proposition. Your realization is sustained by the fact that when the bubble bursts, the small investors are the ones who suffer the most. And since the bubbles only develop where the exercise is a zero sum game, what the small investors loose, the fat cats gain.
Investigate the matter deeper still and you will that the phenomenon of the bubble was no accident to begin with but was steered by the intermediaries who stood between the small investors and the winning fat cats. The intermediaries would be the advisors who are supposed to help the investors make good decisions, while the winning fat cats would be the speculators who cash in on the gullibility and ignorance of the ill advised. And most of the time you cannot tell the difference between the intermediaries and the fat cats as they would be one and the same.
Study the history of the phenomenon and you find that after every burst of the bubble, it was discovered that at least one notable intermediary and a multitude of smaller ones were exposed to having materially affected the outcome. And in every instance the notable player would be a financial institution such as a hedge fund, a brokerage house, a bank or a near bank.
All this should lead to the conclusion that a reform of the system aimed at preventing those bubbles from forming and bursting again and again must include regulations that will do more than punish the offending institutions after the fact. They must warn them ahead of time they are treading close to the risky practices that will endanger them and harm the system.
The types of institutions involved here are many and they each have a different sort of operation. Therefore it is impossible to enumerate in detail what regulations should be written for each type. What can be done, however, is discuss what motivates the intermediaries to act as they do and what motivation they use to dupe the small investors so as to get them to put money into a scheme that is bound to go bust.
The motivation is expressed in five words: staying ahead of the curve. To get rich quick the intermediaries need to position themselves ahead of the curve which they do by influencing their clients. And the way they do that is to trumpet the benefits of being ahead of the curve then advise their clients how to get there. But when all is said and done, you find that the clients almost never get there and the intermediaries do.
In any case, the reason why the clients respond favorably to the call of their advisors is because to be ahead of the curve is a natural human desire. But the road is never an easy one because history is better predicted in hindsight than it is in foresight. This means no one knows how to get ahead of the curve when the events are still unfolding, and it is too late to get there after the events have unfolded. Thus people think of the events that come in cycles and position themselves just before the next wave is due to hit.
Alas, where human behavior is involved, the waves cannot be predicted with complete certainty but this does not prevent some people from playing the game or from explaining the events after they have occurred. In fact, some individuals such as gurus, political pundits and economists specialize in making the before-the-fact predictions or giving the after-the-fact explanations or they do both.
These individuals study past behaviors where a large number of people were involved in making an event happen because this is where it can be argued that a tiny element of predictability is introduced into the equation. The individuals make predictions based on a small probability and they can be persuasive enough to find employment with corporations such as those that deal with mass merchandizing and public relations. The corporations hire these people because to be ahead of the curve can translate into big profit and so they defy the logic of good business practices and take a gamble.
One glaring example of a cycle that has a profound impact on our lives is what happens on the stock market where a number of gurus are employed to make predictions. Here, when a new session begins and the trading resumes, every tick of the tape looks random. However, an element of cyclicality emerges when the analysis is done over a relatively long period of time. This should help to make the market predictable but it seldom does. Still, most brokers hire technical analysts to look ahead and predict the market in the belief that this will help them stay ahead of the curve.
To understand why the road to riches in the stock market depends on staying ahead of the curve, we look at the following example: You buy shares in a company at 10 dollars a share and wait for the price to go up but the price goes neither up nor down for a week. The curve representing this performance is a flat horizontal line. You neither make money nor lose it.
You have better luck the following week because the price rises to 11 dollars. You sell and realize a capital gain of one dollar per share which is a 10% profit. You have learned that to make a gain you must buy low and sell high. You look at the curve representing this performance and see that it is a rising curve.
But the market can also drop. Indeed, the most fundamental characteristic of the market is that it goes up and down over and over in a never ending cycle. If the price of the shares had dropped to say, 9 dollars instead of rising, you could have panicked and sold at that price. In this case you would have lost 10% of your money instead making a gain because you would have bought high and sold low.
Sensing that you have become a sophisticated investor, you now want more out of the stock market. That is, you want to buy low and sell high not once but with every cycle of the market so as to keep piling up the gains. Knowing something about mathematics, you know that everything cyclical is a wave and that a wave begins to drop when it has reached the highest point on the curve. It also begins to rise when it has reached the lowest point on the curve.
You wish to take advantage of this knowledge but since you cannot tell when the market is at the highest or lowest point, you can never time it. So you search for a way to make the events run behind you rather than try to run ahead of the events. You conclude that the only way you can do this is to buy before anyone else buys then trigger the rise of the market yourself, and sell before anyone else sells then trigger the fall of the market yourself.
But you have neither the funds nor the influence to trigger the market into any direction and cause it to follow you. And this is when you hit on the greatest idea of all; you decide to become a guru, a broker, a hedge fund manager or an investment banker so as to be in a position to lead the market into making you rich at the expense of those who will listen to you. My friend, you have set yourself on the road to becoming a fat cat.
In the stock market, in real estate or any business where the public is involved, these games and tricks are played all the time by individuals who are custodians of the public trust. But if you add up the corruption committed since the beginning of time in the Third World, you find that the sum total of their corruptions amounts to only a fraction of what happens in a place like the Bayou Group, Enron, WorldCom, Tyco, Savings & Loans or Bear Stearns in a single day. The difference between one and the other is the difference between someone stealing just enough to buy bread for their children and someone stealing more than enough to buy the entire country where the bread thief and the children reside.
Still, this massive corruption is treated like a perfectly legal practice until something goes wrong at which time a handful of scapegoats are gotten rid of. We may never end corruption in the Third World or in America but we can moderate its occurrence by writing new rules for the game. To do that, the financial institutions must be reminded ahead of time they cannot tread close to the risky practices that will harm the system. This is achieved by outlawing the practices that do nothing to facilitate the business but are utilized by the devious to make a quick buck.
For example, when trading on the stock market you can short sell a stock. This means you sell a stock you do not have in the hope that the price will fall at which point you buy it back cheaper and thus make a profit. To do this, you borrow the stock from the broker and return it when you buy it back. However, if the stock rises instead of falling and you do not have enough money to buy it back, you can be sued by the broker and thus risk going to jail.
If the law is changed to make the brokers totally responsible for this sort of transaction and forbid them from going after the clients to whom they knowingly lend the stock, very little short selling will be done. This alone will eliminate as much as 90% of the problems that affect the stock market operations, problems that are manna from the sky for the brokers.
Another practice that should be looked into is the one where the brokers who have the portfolio of their clients in safekeeping are allowed to buy, sell or lend the stocks. The brokers should still be able to do this under a new regime except that if a stock collapses and goes to zero, something different from the existing practice ought to be followed.
What happens now is that the broker is under no obligation to provide the client with a certificate for the defunct shares even though some companies such as those in the mining business can and do come back to life decades after they die. What I propose should happen under the new regime is that the brokers be obligated to provide the certificate to the client or refund the amount that he or she originally paid for the shares. This is only fair because most of the time the broker would have sold the shares and kept the money, and the client gets neither the certificate nor the money.
And given that many of the stocks that suffer this fate would be the ones promoted by the same broker in the first place, the new regime will cut down on the speculation and the churning that these brokers engage in as they play with the clients’ stocks and their money while taking no risk of their own.
Finally, an authority should be created to receive complaints on an ongoing basis from the public about all the small practices such as these because their cumulative effect can cause big time damage to the system. There are hundreds of them that need to be looked into right now and a decision taken about them right away.
That authority will deal with the securities institutions, the banks and all the financial institutions that transact with the public. And because new financial instruments are created all the time, the authority must be prepared to make new rules at any time to correct for every risk that the new instruments bring to the market.