Sizing Up the Next Crash

(page 2 of 2)

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.

Biriny is the president of Birinyi Associates .