Despite it’s recent setback due to the impending fiscal cliff, the stock market has doubled (DJIA) since it’s low of 6500 in March 2009.
However, what has been missing in the rebound is the individual investor, also referred to as the retail investor.
Volume has been very low indicating the rally has been largely due to institutional investors, minus the individual investor.
Why is this occurring? There are multiple reasons but all are because the retail investor feels the deck is stacked against them and the stock market is nothing more than a glorified casino.
The first blow was in the late 1990s when the dotcom boom was starting. Internet-based companies reported revenues through the roof, but most had no earnings. Retail investors ignored that important fact, believing that rapid growth alone would boost earnings eventually. Unfortunately, that never transpired. Most Internet start ups never turned a profit. The Internet bubble crashed shortly after.
Second of all, the accounting scandals of former Wall Street darlings Enron and WorldCom contributed to investor skepticism.
These two big companies used ‘creative accounting’ to overstate earnings, conceal debt and deceive investors resulting in their stock price eventually dropping to zero.
In 2001, after a series of revelations involving irregular accounting procedures bordering on fraud perpetrated throughout the 1990s involving Enron and its accounting firm Arthur Andersen, Enron suffered the largest Chapter 11 bankruptcy in history (since surpassed by those of Worldcom in 2002 and Lehman Brothers in 2008).
Large accounting firms like Andersen had an obvious conflict of interest in both underwriting these securities and also preparing the financial statements. This was further exacerbated by supposed neutral stock analysts issuing a “strong buy” on a stock when they were actually hired by the company to pump up the stock.
The retail investor became understandably apprehensive to trust a company’s financial statements after this debacle. The one silver lining is it lead to the passing of the Sarbanes-Oxley Act of 2002. The Act mandated a number of reforms to enhance corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud.
Third, the Mortgaged Backed Securities also known as derivatives was another accounting trick, which lead to the collapse of large brokerage firm Lehman in 2008 and later the crash of the housing market. Because multiple sub prime mortgages were packaged together into one security, it was hard to scrutinize what one was buying.
This instrument was really a house of cards further enhanced by the lack of transparency from the credit rating agencies. They could’ve prevented this whole housing collapse, but they were hired by these brokerage firms to give these derivatives a Triple A rating, when they knew they were probably worthless. This obvious conflict on interest should never been legal.
In the easy-money years, millions of consumers took out mortgages they didn’t comprehend and bought houses they couldn’t afford. When the bubble burst, it triggered a massive wave of foreclosures, nearly bankrupted the Wall Street firms that packaged the loans into securities, froze credit markets and pushed the economy into a punishing recession.
When the credit markets froze in the fall of 2008, this resulted in the federal government providing loan guarantees to GM and Chrysler. They also bailed out insurance giant A.I.G. along with several big banks including Citibank.
This predictably caused the stock market to free fall before bottoming out in the spring of 2009.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010 by President Barack Obama. The legislation set out to reshape the U.S. regulatory system in a number of areas, including but not limited to consumer protection, trading restrictions, credit ratings, regulation of financial products, corporate governance and disclosure, and transparency.
The Bill provides a new safeguard that, at least in theory, should allow the government to close a failing company and prevent a taxpayer-funded bailout.
This Act might not have been necessary if the Clinton administration in 1999 had not repealed the Glass–Steagall Act, which had prevented commercial banks from co-mingling their banking side with their more risky investment side. In other words depositors funds were put at risk with the banks’ stake in purchasing the aforementioned mortgaged backed securities.
This lead to the FDIC increasing a depositor’s account balance insurance from $100,000 to $250,000.
The fourth reason, individual investors are still spooked about buying stocks is high frequency trading which caused the flash crash in May of 2010. These wild gyrations in the market have resulted in continuing volatility. Many institutional investors are using this type of high speed automated trading to buy and sell stocks, which enables them to capture the maximum selling price while buying at the minimum price.
Most experts suspect the leading cause of the market’s trouble is the rise of new types of computerized trading that allows some market participants with the best access to stock exchanges to distort short-term trading.
The non-transparency that stems from high-frequency trades, which can happen in milliseconds, makes tracking the trades virtually impossible. Some estimates have high-frequency trading accounting for about 70 percent of all market activity.
Most troubling is how computers are giving sophisticated investors with the best digital access to the markets a leg up over regular investors in ways modernization was supposed to do away with.
These four reasons why the retail investor is absent in participating in equity markets presents a long term problem. The gap between rich and poor will only continue to widen, because historically over the long term stocks have performed better than other types of investments.
But you can’t blame the average person from being scared to trade stocks. When you have multiple cumulative scenarios that caused recent market crashes, it’s only human nature that one would feel skittish that the game is rigged against them.
This further exacerbating cynicism proves that the passe motto of “What’s good for Wall Street is good for Main Street,” is as outdated an axiom as calling your stock broker for their unbiased opinion on what stocks to buy.
Retail investors may as well just go to Las Vegas and play craps, roulette or blackjack. They know going in that they’ll probably lose, but at least they’ll have fun doing it.