5 Investing Challenges for the Next Decade

Pleasure can be supported by an illusion; but happiness rests on truth.

~ Sébastien-Roch Nicolas de Chamfort

Update: This post was included in the Money Hackers Carnival #117 posted at Engineer Your Finances. Thanks!

Monday’s post dealt with some of the ways in which today’s market climate is Not Business as Usual. I’d like to expand on that today with a bit more detail on some of the issues I mentioned. Many of the 5 challenges I’m going to address are double-edged swords. They can be productive market forces, but also have the potential to create enormous problems for our financial system.

5 Double-Edged Swords for Investors

Each of these factors is, in some way, interrelated with the others. Each one has been with us for quite some time and may persist much longer. Each has been the subject of numerous warnings and conspiracy theories over the past decade, all of which have been largely ignored. Perhaps most importantly, each of these factors has the potential to, individually or collectively, morph into a perfect storm that could cause major problems for our economy and our investments.

1.  Debt

I won’t spend a lot of time on the debt issue as it’s been covered very well here and elsewhere. I’ve written many times that global debt tallies at the government, corporate, and consumer levels are much too high. Modest amounts of leverage can help us achieve goals like economic stimulus, business growth, and home ownership respectively. At higher levels, however, these benefits become illusory as the debt must be serviced and eventually paid off.

The end of Phase I of the financial crisis was punctuated by a huge bounce in stocks. Boyd Erman wrote earlier this week about the possible emergence of credit crunch part deux in This Credit Crunch Seems So Déjà Vu. In the article, he speculates that “Credit Crunch II could be pretty ugly to watch”, but “as bad as it could be, there’s a sense that in the broader world, many remain unaware.” That’s part of the reason I’m writing this series.

2.  Complexity

There are many ways in which our economy and our markets have become much more complex over the past few decades. This is the double-edged sword of technological advancement. No one wishes they still had to wait on the phone to speak to a broker or access data via reams of ticker tape.

While innovation has made investing easier for retail investors, it has also enabled professionals to devise new ways to make money using computer models and advanced financial products like derivatives. Derivatives, as the word implies, are financial products that are based on or derived from others. This is where the illusion of derivatives comes in. They aren’t always backed by real capital. AIG was effectively bankrupted because it could not pay out the money it owed on CDS it had written on failed institutions.

There are many types of derivatives, but I would like to focus on credit default swaps (CDS) here. CDS are basically a form of insurance. Suppose you hold the bonds of a company or country. If that entity goes bankrupt or defaults on that debt, you, in theory, should be left with nothing. The value of the bonds goes to zero and of course, interest payments cease. CDS are insurance contracts that those who hold bonds can take out in case of default. Those who wrote the CDS have to pay out if default occurs.

The main problems with the credit default swap market are its size and complexity. As the graphic below shows, the CDS market dwarfs all other markets. Further, CDS have become increasingly complex, to the point where we have CDS on CDS. Problems in this market can very easily lead to domino effects that cause ripples, and occasionally very large waves in other markets. This is how they can have very dramatic effects on your investments.

This problem is not new. Warren Buffet famously called derivatives financial weapons of mass destruction many years ago. (Ironically, he is now involved in them himself.) Alarm bells have been sounding on the dangers posed by this unregulated market for decades. In response, they have only grown. We need to regulate and shrink the CDS market before it causes more severe problems.

3.  Transparency

Another problem with the CDS market is the lack of transparency. These instruments are not traded on an exchange and very few people know very much about them. It’s not a stretch to assume that most people who own mainstream investments like mutual funds are completely unaware that CDS exist, never mind what they are or how they might dramatically affect their money.

Another nebulous market factor, also a product of technological innovation, is algorithmic trading. It is also called high frequency trading (HFT) or black box trading. With access to very powerful computers, many large financial firms hire programmers to devise trading strategies based on computer models and technical market indicators that can be implemented automatically by computers.

The high frequency versions of these systems can execute trades in milliseconds. This can provide needed liquidity to the market. But problems can arise if too many of these algo systems buy or sell all at once, creating a waterfall or domino effect as prices crack key support or resistance levels. There is some speculation that this type of phenomenon may have played at least a partial role in the flash crash of May 6, 2010. (Here’s A Closer Look at the 1000 Point Dow Plunge if you’re interested in the nitty gritty.)

The main knocks on HFT algorithmic systems are that retail investors are largely unaware that they exist, and that they might be used by more sophisticated players to secure an unfair advantage in the marketplace. Some would go so far as to call this Computerized Front Running and Financial Fraud, while other conspiracy theorists would take it even further, inferring that the markets are rigged. These views seem pretty extreme to me, but they’re out there.

4.  Trust

You can see how the factors mentioned above might lead to an increasing erosion of trust in the marketplace. No one wants to play a rigged game. I’m not privy to the inner workings of the financial system, so there’s no way for me to know if fears of fraud and manipulation are well-founded or not.

Trust is the foundation of our financial system. It cannot function for very long without it. Every transaction depends on the understanding that the promised goods or services will be delivered and that the receiver of these products will pay for them as agreed. When you put money in a bank, you trust that it will be there when you want to take it out. You get the point. Trust is not an optional component of our financial system. It’s a lynchpin that we definitely don’t want to pull.

5.  Rule Changes

It’s hard to play any game if you don’t know what the rules are or they keep changing. All of the factors mentioned above are likely to lead to regulatory reform. On one hand, these reforms are necessary and overdue. On the other hand, markets dislike uncertainty. We have seen the circus that regulatory reform debates can become. We have also seen trades nullified as a result of the flash crash. These events do not instill confidence in market integrity.

In fact, some of the problems that we’ve experienced have resulted from a combination of rules that are inadequate and those that are not enforced. There has been a bit of a wink and nudge approach to financial regulation for decades now that has lead to a lot of lip service but no teeth. Further, the trillions of stimulus dollars spent by governments were supposed to buy time to fix the structural flaws in the system. To date, that hasn’t happened.

Can you think of any other challenges investors might face over the next few years? Do you have any advice for politicians on financial regulatory reform?