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Five Simple Steps to Mitigate Risk and Restore Market Fundamentals

We need to restore market fundamentals by eliminating the rewards given to the institutions creating the most risk.

When I started my career as a financial advisor in 1993, the fundamentals of investing were considerably different than they are today – even though they were on the way out the door.

Back then, the fundamental valuation of a company – and its outstanding share of stock – was based on sound accounting practices. Within a reasonable range, you could expect a company to be worth a certain multiple of its earnings (depending on the industry and the influence of the brand), a weighted average of its earnings, a combination of its net worth (book value) plus an expectation of profitability, or simply its net worth.

Those fundamental values directly impacted the value of its outstanding shares of stock. Of course, there were other factors to consider, but the fundamentals were fairly straightforward.

Trending was also a valuable tool in projecting a company’s value. I was never a strong adherent to cycles and trends, but I knew advisors who swore by them, and many still do.

Then, the dot.com bubble happened, and suddenly, companies that produced nothing and had lackluster sales (or no sales at all) were worth millions.

It was mind-boggling.

Today, we can see the same type of mania with companies like Tesla or entire niche industries like crypto-currencies. Even though their values make no sense, I understand how they can happen.

We will never be able to keep “manias” from happening in free markets, but we can stop artificial mania in the form of manipulated market pricing from large institutional investors.

Looking purely at the fundamentals of our economy over the past ten years, there is no reason for the financial markets to be at the levels they are, except for massive infusions of money (think Fed money-printing) and mass manipulation of pricing.

Those two factors have also contributed to what is going to be a spectacular worldwide economic collapse.

In my last post, I provided the necessary steps for the creation of a sound currency. The economic collapse that’s on the horizon will force the world economic community (Bank for International Settlements, Financial Stability Board, International Monetary Fund, and others) to consider such bold options. It will also force the world to consider the impact and future management of market risk and speculation.

As long as public companies exist, a certain amount of speculation will also exist as investors try to determine the future value of their stock, and whether it makes sense to buy or sell…and at what price. Not only is that unavoidable, it builds incentive for sound corporate management and profitability. In short, it’s good for business and the economy.

Allowing speculators to gamble based on speculation alone, however, is not good for business or the economy. Enough money bet the right way can “buy” the market, driving prices virtually at will.

The steps I’m going to propose will chill two central ways market manipulators cheat the system to make money, fixing asset prices and interest rates.

First, we need to address the unfair advantages built into High Frequency Trading and Dark Pools, along with the lack of transparent pricing. These two areas are where the big-shots play and make billions by exerting their influence on the market.

High Frequency Trading (HFT) is basically the computer equivalent of the old-style stock market floor trader. HFT executes trades in fractions of a second, providing far greater efficiency, but the computer algorithms that drive them can also produce erratic market swings, driving profits or creating losses. To the big firms running them, it doesn’t matter, because they make money on both sides of the buy-sell order.

Dark Pools are where large institutional investors trade large blocks of stock virtually off the radar, with the claim that it provides pricing efficiency while protecting the market via price stability. In reality, it prevents price discovery by the little guy (smaller institutional investors) who may profit from seeing the bid-ask pricing structure before the deal is done. By the time the Dark Pool transactions are complete it’s too late.

Combined, they have all but eliminated the ability for individual investors to accurately and actively manage their portfolios without employing robo-advisors that can react to market activity with the same agility as HFT machines.

Therein, lies the main problem. It’s virtually impossible for the little guy to manage proactively. Everything in the automated world is reactive. It places the entire investing world at the mercy of a select few who control both the trading and pricing mechanisms.

Second, we need to address the structure and impact of derivatives. In short, a derivative is not a stand-alone investment. They’re contracts based on the performance of underlying assets. That said, not all derivatives are bad. Some are good. But, some are extremely bad. Since this area of the financial world is so complex, I’m going to split it into subsequent steps.

So, third, allow me to address what I would classify as organic derivatives: Options and Futures.

In my opinion, options should be eliminated altogether. If not eliminated outright, 24-7 access to live options contract information should be banned, because it directly impacts the market pricing of the underlying securities. It’s the ultimate tail wagging the dog scenario. Instead of simply speculating for or against success or failure, the purchase of large options contracts can actually drive success or failure.

Options are another mechanism used by the large institutional investors to manipulate the market. They can bid the market up or down at will, for a fraction of owning the underlying investment, by purchasing or selling large options contracts. I don’t see a way to keep that information private while maintaining its viability as an investment, so I say ban them.

For certain commodities, such as, agricultural products or precious metals, I think futures contracts play a vital role, because they allow the market to anticipate pricing based on critical factors affecting a specific region (weather, natural disasters, low crop yields, etc.). However, futures contracts in the financial sector allow the same potential for outright market manipulation as options contracts and need to be banned. Again, just my opinion.

Fourth, allow me to address synthetic derivatives, such as, Credit Default Swaps and Collateralized Debt Obligations. Since the parties that create these types of convoluted investments are the same ones who (1) manipulate the market legally through the mechanisms already covered, but more importantly, (2) manipulate the market illegally through interest rate and price fixing (see my post concerning monetary reform), they should be banned for that reason alone.

Credit Default Swaps are arrangements based on the potential of a borrower defaulting on debt. They’re perceived as “insurance” against default, but they wouldn’t exist if (1) the underlying risk exposure was reasonable, and (2) if there wasn’t the potential for a windfall when a default occurs.

Here’s the problem: Banking institutions who generate credit (by placing depositors’ funds at risk) also created these financial instruments that allow them to profit when credit is not repaid.

No conflict of interest there…

When everything goes well, the financial institution wins. When things go bad, the depositors are placed in jeopardy, but the financial institution still wins. I can hear the banksters laughing…

Collateralized Debt Obligations are bundled investments, typically combining multiple risk classes of bonds or mortgages, and although they aren’t all bad, they lack transparency, so the potential for misrepresentation associated with them is problematic, because an investor may not necessarily understand the underlying risk. They may think they’re placing their money in the equivalent of a safe, A-rated, asset-backed investment, but the underlying instruments may be far from it.

These synthetic derivatives were at the heart of the 2008-2009 financial crisis.

If we learned anything from that crisis, it should have been the need for massive reforms to our monetary system (money creation, banking, and shadow banking) and the inherent risk of our financial markets.

Risk exists. There’s no escaping it. But, it needs to be managed in a way that prohibits exploitation by the ones responsible for creating it.

Fifth, we need to eliminate the potential for interest rate risk and manipulation by requiring all bond contracts to be negotiated and collateralized debt instruments. The bankers who currently set interest rates could essentially be taken out of the loop. Each negotiated contract would have the terms set directly between the investor (lender) and the company or municipality (borrower).

Free-market competition would either drive real transaction costs (fees and interest rates) down or allow them to increase as market conditions warrant.

To add an added layer of protection, the underlying asset should be valued at a mark-to-market basis, meaning it fluctuates in real time based on market influences. If the underlying collateral decreases in value beyond an acceptable range, one of two things could happen: (1) the bond arrangement could be terminated, with the underlying assets used to satisfy the outstanding debt, or (2) the borrower could pledge additional assets to secure the necessary value.

Done properly, default risk would virtually disappear, because the borrower would have a vested interest in repayment, eliminating the need for synthetic derivatives, such as, Credit Default Swaps or Collateralized Debt Obligations. It would also prevent the type of swindle that happened to GM bond holders, because their investment would be backed by secure assets rather than a simple promise to repay, and subject to current bankruptcy liquidation procedures.

Those are my ideas. What say you?

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