If you like volatile markets, then the first decade of this century was made for you. In the early part of the decade, we witnessed one of the most spectacular run ups - and then sudden collapse - of a market sector that was deemed to be the wave of the future. We saw speculative and highly leveraged bubbles and we were plagued by more scandals than you can count on two hands. The government stepped in multiple times to initiate new legislation and ultimately bailed out key industries at the core of our financial structure. All in all, the first decade of this new century was probably not what most investors were expecting and, although there were valuable lessons to be learned, most would be happy if it just got tucked away in the history books. (Find out what to look out for when trading during market instability. Check out Tips For Investors In Volatile Markets.)
Roller Coasters and Rockets
First and foremost was the high level of market volatility, which was not limited to the typically riskier areas of the markets. The overall major stock market indexes experienced significantly more volatility than previous decades. We also suffered extreme levels of volatility in currencies, bonds and even commodities. While all of these markets are no strangers to volatility, it does seem that the rules have changed a bit.
Supply and Demand Vs Fundamentals
For example, in the early part of the decade, supply and demand were the only forces driving stock prices as the fundamental characteristics no longer seemed important. There were new investors entering the markets and newly minted day traders salivating at the potential to make millions from the next IPO or buyout. The glut of demand for stocks, specifically technology and internet related issues, moved prices to astronomical levels. To throw more fuel on the fire, many investment firms, banks and brokerage houses provided the investment banking services to take companies public and then sent out strong buy signals on those same stocks through their analysis arms. The unwinding of the Glass-Steagall Act allowed speculation and conflicts of interest to be major factors in driving stock prices.
Of course we all know how supply and demand works. In hindsight, more of us should have seen it coming as the market deviated away from fundamentals. As soon as the demand slowed for these speculative stocks, the prices plummeted and took the house down with them.
Lie, Cheat and Steal
How could we sum up the lost decade without infamous scandals, scams and frauds? You can clearly see patterns emerging with the conflicts of interest on Wall Street during the dotcom boom, ultimately bleeding into other speculative financing at Enron, Worldcom and Tyco. It's almost impossible to believe the collusion that must have taken place to pull off such large-scale debacles. The players included the accounting firms like Arthur Anderson and possibly investment banking firms that have escaped exposure. These were three of the most famous corporate scandals, and most people were either touched directly or indirectly by one of them. For some, it meant their savings or retirement was totally wiped out. (Learn how financial fraud got started, read The Pioneers Of Financial Fraud.)
Cooking the Books
Another major contributor to the speculation and volatility was the push for financial institutions to produce top and bottom line results. One of the fastest ways to produce instant income (and fees) is to create new and innovative concepts and products. We stood by and watched the expansion of the now famous off-balance-sheet financing, which was traditionally used on rare occasions to create tax efficiencies and other short-term benefits. What most people didn't know at the time was that off-balance-sheet financing is a great way to just flat out lie. Companies created false and misleading statements that trickled down to the analysts who issued glowing opinions and strong buy ratings – without knowing that the growth they were trumpeting was a result of voodoo accounting.
It seemed that as soon as those tactics went to the wayside, there were new pushes to step up the repackaging business. Many may have thought this was a new way to pool investments. Mortgages and other loans have been pooled since banks and other lenders started selling their loans after initiating them. The repacking process of all sorts of loans steamrolled throughout the entire decade and ended with a bang when it was pushed to the brink. CDSs also made a strong impact on our economy. These were initially just another tool used for hedging and adjusting portfolios. Once investors started to use these thinly-traded derivatives in a speculative nature, the house once again came tumbling down. The market soon realized that it had leveraged most of its investments beyond stable ground and the end was near. Behind the scenes, the real estate market that was helping fuel the pooling and packaging schemes was also ready to topple. When it did, it made for a historic crash. (For more information of credit default swaps, read Credit Default Swaps: An Introduction.)
Uncle Sam Intervenes
The next decade will hopefully be a rebuilding decade to say the least. While markets have historically been left to stand on their own, government intervention was inevitable. The Sarbanes-Oxley Act had a significant focus on keeping corporate scandals to a minimum. The requirement of having CEOs and key financial players sign off on financials was a giant step toward linking responsibility and management. While the premise sounded great, whether it will be effective in the long run depends on the honesty of those who sign off. There has been substantial regulation on Wall Street to reduce the conflicts of interest. Analysts and investment bankers have been required to further separate their lines of duties. While this has been somewhat effective, it sure didn't take long for hedge funds to jump in the front of the line with their thinly regulated industry and steal the show. And, as we all know, the Madoff scandal helped us close off the decade with the largest Ponzi scheme in history.
You might wonder if the bailouts of the latter end of the decade and all the new regulation under consideration will work. Reducing the Federal Reserve's powers, creating an actual exchange for OTC derivatives to trade under the scrutiny of watchful eyes, and restricting and taxing executive pay and bonuses might be steps in the right direction. We can only hope that they will help reduce some of the rampant speculation and abuses of the past decade. The government always seems to be repairing what is broken instead of looking ahead. It looks like it's going to depend on the industry, the regulators and the inherent greed associated with investing to return to some sort of normalcy. (Some argue that when the free market fails to protect consumers, government regulation is required. For further reading, see Free Markets: What's The Cost?)