Sizing Up the Next Crash

Laszlo Birinyi of Birinyi Associates believes 21st-century markets are prone to systemic failure and that 1990s structural reforms haven't worked

The following is an excerpt from the author's October, 2007 report, The Next Crash.

Wall Street and Main Street will remember and chronicle the 1990s for a variety of reasons: the emergence of the Internet, the boom and bubble, excessive valuations, and eventually a bear market. It was also a time of reform, as new rules, regulations, and practices led to what we might term the deregulation of financial services.

Somewhat like what had happened in telecommunications and the airlines, the landscape emerged far different than what had existed. Our focus and interest is on the equity markets, but the revolution on Wall Street has affected other markets as they became significantly larger, expanded their products, and introduced new measures and techniques. The new measures include: Regulation FD; Sarbanes Oxley; decimalization; extended trading hours, crossing networks; electronic, online trading; and ETFs and other instruments.

These measures were undertaken under the guise of protecting the individual investor from biased or prejudiced research, unsavory operators, scrupulous corporate officers, and accountants whose alleged objective was not to conform to "standard accounting practices" but rather to "what do you want it to be?" We were concerned at the time of their introduction that many of the proposals and measures were political, expedient reactions to real, but isolated or limited problems or circumstances.

Disenfranchising the Average

Our concern today is two-fold. First, the markets of the first decade of the 21st century are prone to systemic failure as a result of technological innovations and utilization, rapid growth of sophisticated, but not necessarily vetted, instruments, and other changes in the wide world of finance. We will readily note that this is not solely a function of Wall Street, but also reflects the quickened pace of the overall environment, lower cost of technology in all its forms, the continuing demise of the manufacturing/operating economy to one of finance and service, and so forth.

Secondly, we believe that the various structural reforms of the 1990s have not achieved the desired effect with regard to the individual and have in fact disenfranchised, even more so than before, the individual who might work 50 hours a week, have 2.5 children, and cut his lawn on weekends. Instead they have provided the affluent and institutional investor with even more of an opportunity to enrich himself.

On the first point, we're concerned about the large number of system failures and computer glitches that appear to receive little or cursory attention. For example, on Feb. 27, 2007, there was a 230-point drop in the Dow Jones industrial average because of "an error in the calculation." Again, on July 26, 2007, the Dow average was not calculated from 2:55 p.m. to 3:08 p.m. Eastern Time because the system was "overloaded." It should be disturbing that these events occur, and the implicit hope that this will not happen during a significant crisis or period of stress is naïve.

Derivatives and Other Instruments

We are not alarmists and we are not predicting a market meltdown. Rather we are concerned about the potential for a major disruption, which would then be the subject of analysis, legislative hearings, and finger pointing.

An issue that could lead to another crash is that of derivatives and other instruments. We are admittedly negative about the subject in part because of our experience in 1994. At the end of 1993, our Wall Street Week picks included a put on the Hang Seng Index. The Hang Seng complied with our hopes and declined 30% that year but our put (in the form of a warrant; ETFs were unavailable) also declined 30%.

Derivatives concern us as several examples of seemingly innocuous instruments have had major impacts.

The Japanese market, for example, might eventually have declined because of bad loans, inflated real estate, or some other fundamental factor, but the "smoking gun," inflection point, or pin prick, was—we contend—the introduction of put warrants, which were a huge success in terms of activity and performance virtually coincident with that market's peak. The warrants, available only offshore, allowed investors to both hedge and take a negative view of that market, which they surely did.

Quality of the Data

Financial futures, derivatives, and ETFs have benefited distributors, consumers, and, in some, but not all, instances, producers. The mortgage-backed, mortgage-related, and CDO issues of June and July, 2007 are other instances of the reality that it is a long way from the laboratory (or design lab) to the market place. As exchanges seek growth and new opportunities, our concern is that their basis or expected results will largely be on past events, which, as we all know in the stock market business, is often unrelated to future ones.

Our concern is that many strategies and packages are based on historical data, relationships, and analysis. Increasingly, we question the depth and quality of the data employed in so doing. For example, in 2004, S&P understated the total return of the S&P 500 by 37 basis points, a fact that S&P was reluctant to acknowledge. And we've found that virtually every story on stock buybacks understates the amount and extent of activity.

We believe that individual investors have not benefited from the various new regulations and products. It was the hope and intention of officials in the 1990s to take away the institutional advantage. We believe that the net effect has made life and investing more difficult and more complex for the individual.

Away From Paternal Corporate Relationships

For one, weighted fund returns, as many have pointed out, lagged average fund returns in the 1990s. From 1990 to the market peak in March, 2000, mutual funds returned 10% on average annually, vs. nearly 18% for the S&P 500 index. When we extend that analysis, we find the situation has not improved. From 1990 to April, 2007, mutual funds have gained 5.16% on average each year, vs. 11.4% for the S&P 500.

One of the discernible trends in American business has been the shift from a paternal corporate relationship to one where the employee is increasingly in charge of his own health and retirement benefits. In the case with retirement, the traditional, defined benefit plan has been replaced or augmented with 401(k)s, IRAs, and self-directed plans. Figures from the FRB report that the average balance for those between 55 and 64 in 401(k) plans is $60,000, far below what they will probably require upon retirement. At a time when financial advice and services are probably more critical than ever, the markets of the day are generally less responsive to individuals.

Stock research is becoming less valuable and visible. And there have been numerous stories questioning whether investors ultimately benefit from ETFs, long-short funds, and other new instruments.

We can proffer no detailed solutions, but investors should recognize the risks—beginning with the regulatory void.

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