Saturday, March 17, 2012

"Watchman, What of the Night"


Why investors need transparency in their investment’s and yield. Aivars Lode

SATURDAY, MARCH 17, 2012

By STEVEN M. SEARS
In an excerpt from his new book, Barron's Options Editor Steven M. Sears explains why new financial regulations do little to improve the lot of individual investors. How to use history to get a leg up on the market.

In 1953, John Kenneth Galbraith was finishing his history of the 1929 stock market. He needed a title for the final chapter of his book, The Great Crash. Somehow he came across verse 11 of Chapter 21 in Isaiah: "Watchman, what of the night?" It was a fitting title. In less than eight pages, Galbraith described how new laws, including the Securities Act of 1933 and the Securities Exchange Act of 1934, would better regulate Wall Street. But the chapter mostly detailed how politics and other realities would insure those rules fell short of their promise, and their spirit.

Galbraith likely never imagined just how far short those rules would fall. Those depression-era laws, forged when Franklin Delano Roosevelt was President, now loom like monuments immune to the technological and financial innovations that have changed the fundamental nature of markets and Wall Street. The stock market of 1929 bears no resemblance to the stock market of 2012, which will not resemble the stock market of 2052.

In 2011, in the shadow of a financial crisis that rivals the Great Crash in scope and destruction, but lacks a suitable poetic sobriquet, the federal government once more enacted laws to rid the market of self-destructive behaviors that nearly led to its destruction. The watchman has seen this before. His answer to the eternal question, as contained in Isaiah, offers as little solace as Galbraith's conclusion: "Morning is coming, the watchman replies, but also the night."

History always repeats in the financial markets, and individual investors need to be aware of that history.

The market will, of course, recover from its excesses, and it will, of course, fail again. The birth of every bull market will always occur in every bear market. Laws will always be passed. And those laws will fail to prevent another crash while burdening businesses with the expense of complying with massive regulatory requirements destined to be circumvented, if not outdated, shortly after they are passed.

The laws will do little to improve the lot of the individual investor. The primary beneficiaries will be law firms and management consultants, who will reap huge profits helping corporate America implement, interpret—and likely step around—more than 2,000 pages of new laws passed after the credit crisis. By 2011, Debevoise & Plimpton, one of Manhattan's top law firms, was charging $100,000 to write a 17-page letter that explained the meaning of "bank-owned hedge fund."

Davis Polk & Wardwell, another top law firm, that hired top SEC market regulators before and after the crisis, charged clients a $7,500 monthly online subscription fee to track the Dodd-Frank amendment's progress. The amount of money expected to be spent on technology to comply with new rules is simply stunning. From 2011 to 2013, the Tower Group, a technology consulting and research firm, estimated firms would spend more than $3.8 billion.

This is a dim view of Washington's regulatory response more than cynicism. It is warranted by history. The Sarbanes-Oxley Act of 2002, passed in reaction to corporate accounting frauds at companies—including Enron, Tyco and WorldCom—failed to prevent or anticipate the subprime credit crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010, will similarly be humbled, and perhaps even embarrassed, by the extent of its own shortcomings, despite the bombastic vow in the act's 16-page executive summary to "Create a Sound Economic Foundation to Grow Jobs, Protect Consumers, Rein in Wall Street and Big Bonuses, End Bailouts and Too Big to Fail, Prevent Another Financial Crisis."

BUT EACH NEW CRISIS SHOWS that the regulatory regime is permeated with gaps. "Money is like water; it will find its way to those holes," says Pippa Malmgren, who served as President George W. Bush's special assistant on economic policy—and is now president of Canonbury Group, a London-based consulting firm that advises financial firms on the impact of political policies on the markets.
The Bottom Line

An estimated $3.8 billion will be spent be spent on technology to comply with the new Dodd-Frank regulations. The big winners are law firms and consultants, not investors

Perhaps the next financial crisis will occur in the foreign exchange market that is increasingly trying to lure investors with promises of quick riches. Maybe the next crisis occurs in the futures market, where some brokerage firms are trying to persuade investors to invest in gold and silver futures to diversify into different asset classes. Maybe the next crisis occurs in the municipal bond market or in the fast growing exchange-traded fund industry—or in some area of the financial market that has yet to be invented by Wall Street's financial engineers.

All that is certain is that another crisis will occur. It will occur someplace unexpected. It will hurt many people, many of whom can ill-afford to be hurt again by another financial crisis. Those people will be hurt the worst. They will be lured to buy just before the game ends. They will hold on throughout the worst of decline, hoping for the stock market to bounce higher so they can at least break even. But that will not happen when they most want it, or need it. This will panic them, and they will sell right at the bottom just as the stock market readies to advance.

From The Indomitable Investor: Why A Few Succeed In The Stock Market When Everyone Else Fails, by Steven M. Sears. Copyright 2012 by Steven M. Sears. Excerpted with permission of the publisher, John Wiley & Sons (www.wiley.com).

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