About the time of the "flash crash" of May 6, 2010, many small investors appear to have left the U.S. stock markets, according to a recent Wall Street Journal article. The Financial Reform Bill, passed and celebrated with much fanfare last week, is sometimes thought to help bring those investors and their cash back into the equity markets. This articles takes a close look at the likely causes underlying the investor exodus, the Bill and its probable effect on investor behavior.
First, a bit about the Bill. The Financial Reform Bill is certainly an accomplishment for the current administration. Earning a consensus on the complicated subject of financial regulation is a coup in its own right.
By carefully reading through the text of the Bill itself, however, one may surmise that the Bill is really designed to benefit the U.S. Securities and Exchange Commission (the SEC) the most. The Bill gives the SEC the authority it needs to collect and analyze information on market activity, to gain more control over the regulation of commodities, futures (currently regulated by the Commodities and Futures Trading Commission), other non-equity securities, as well as large hedge funds with assets under management exceeding $100 million. The Bill also imposes tighter capital requirements on banks, but only the largest banks, those with total capitalization of at least $500 billion. Smaller banks (and in the U.S., one can open a bank with as little as $10 million in capital), are largely left to their own devices in the Bill.
While it will probably take the SEC another year to interpret and implement the Bill into actionable regulatory items, some implications for investors are already predictable. According to the research I conducted during my PhD studies, stricter SEC regulation typically reduces volatility in the financial services sector, stabilizing stock prices of financial services firms. Reduced volatility, in turn, will translate into lower volatility for major stock market indexes, such as the Dow Jones or the S&P 500, infusing some confidence into investors. Yet, it remains to be seen whether the stability of the market will be enough to entice investors to bring out their cash.
And the rationale for the investors' reticence is simple. While many a traditional broker blames the investor exodus from the markets on the latest technological innovations, like high-frequency trading, many investors have taken out their cash out of stocks for more prosaic reasons: concerns about deflation and the dire financial situation of their local municipalities.
Due to deflation, every $1000 kept in cash from the beginning of April 2010 through the end of June now has the purchasing power of $1004 ($4 increase) in comparison with April. In other words, an investor who held on to his $1000 cash from April through the end of June can buy $4 more in average goods now than he could in April. In comparison, an investor who kept his $1000 in the S&P 500 from the start of April through the end of June lost $9 in his investment over the same period, reducing his original $1000 to $995 in nominal terms and to $991 in deflation-adjusted April purchasing power. Naturally, as long as deflation continues and the S&P 500 generates return insufficient to cover deflation, stuffing cash into one's mattress is an attractive "investment" strategy.
Then there is all this mess with the municipalities. To finance even the most basic local services, such as public schooling and garbage collection, the local governments rely on municipal taxation of its residents. Due to the high unemployment rate lingering in the U.S. economy, tax revenues were pitiful in the past couple of years, draining government coffers. And while the Federal government can always solve this situation by printing more money, municipalities' two options are 1) issuing additional debt, and 2) cutting public services. Some municipalities have such a low credit rating that they have to resort to option 2. Now imagine investors facing the following option: whether to invest the money into the stock market or to have the money in cash or bonds in order to pay for their basic daily services, like children's school arrangements -- avoiding the stock market clearly takes the upper hand in this situation.
Overall, however, things are likely to look up in the stock market, at least until the Fall Elections. According to the latest research by Axel Dreher and Roland Vaubel (Journal of International Money and Finance, 2009), the governments have tools at their disposal to create temporary bursts of economic activity. Predictably, these bursts are often summoned ahead of elections to buoy voters' confidence in the incumbent politicians. As a consequence, the U.S. investors are likely to see solid returns in the markets through October 2010. Yet the future of the markets beyond the election date is highly uncertain, regardless of whether the Financial Reform Bill is acted upon or not.