According to the Financial Times (June 16, 2009), the British Chartered Financial Analyst Institute recently polled its members and found that 77% either “strongly” or “very strongly” disagreed that investors behaved rationally.

	On the road to Damascus ...

This, of course, is consistent with the Irrationality Axiom which is one of the foundations of Capital Flow Analysis.

The Times article goes on to say,

The shift [in thinking] is significant as the assumption of efficient markets is the cornerstone of calculating the value of everything from stocks to pension fund liabilities to executive compensation. … However, the trend appears to reflect a wider intellectual swing. In the past three decades, the global asset management industry has been dominated by the so-called “efficient markets” hypothesis, which has given birth to ideas such as the capital asset pricing model, that portrays investing as a trade-off between risk and return.

Rejection of the Efficient Market Hypothesis has far reaching implications for the structure and management of capital markets, including Modern Portfolio Theory, the use of betas, the justification for index funds, and the M&M Theories.

See: Fallacies of the Nobel Gods.

I suspect that the British CPAs did not come to change their views suddenly, as a result of the Crash of 2008 or a blinding light on the road to Damascus, but rather, like most of us, came to discover from working in the real world that much that is taught in college is nonsense.

Secretary of the US Treasury, Timothy Geithner, has informed Congress that the Obama administration is preparing to submit proposals for reform of the US financial market. This is an attempt to enact measures that will avoid repetition of the Crash of 2008, by reducing “systemic risk”.

Although billed as one of the most significant reforms of the financial system since the New Deal, most observers are skeptical that substantive change will ensue.

A one-party, slap-dash reform with an Obama brand

The historic models for effective financial reform were the Glass-Steagall Banking Act of 1933, the Securities Act of 1933, and the Securities Exchange Act of 1934.

	Ferdinand Pecora (1933)

The financial market reforms of the New Deal lasted for over fifty years and were emulated in other markets throughout the world. These reforms were based on two years of work by the US Senate Pecora Commission that spanned two administrations and had bipartisan support.

The Pecora Commission received testimony from many sources and findings were well-publicized over a long period, allowing solid public support for real reform to develop.

In contrast, the Obama “reforms” are being concocted in secret, within the US Treasury Department, to be rushed through the Pelosi-Reid Congress, already famous for passing substantial legislation in the dark of night, without even reading the text.

A missed opportunity looms

There is consensus that financial reforms are necessary and that events like the Crash of 2008 are to be avoided in the future.

However, there is no wide consensus as to the root causes of the market failure or what should be done.

To reach such consensus, extensive non-partisan hearings would be required, with hundreds of witnesses and with time allowed for opinion to form as to causes and cures.

The only model we have for financial market regulation are the patchwork of agencies, put together over a half-century ago, when investor demographics and market structure and technology were entirely different from today.

A few basic questions to be explored, not currently being considered, are:

• How to protect investors when responsibility is diluted through a chain of fiduciaries?
• How to prevent financial institutions from becoming too complex to manage and regulate?
• How to adjust the tax code so as to support the interests of long-term investors in an inflationary environment?
• How to protect investors against equity dilution through stock buybacks, options, and mergers and acquisitions?
• How to limit dangerous speculative behavior on the part of depository institutions?
• How to regulate money market funds which have become, in effect, depository institutions?

Undoubtedly, some measures being proposed by the Obama administration will be useful.

However, the opportunity for real reform is likely to be missed.

Capitalism is simply not on the Obama agenda

President Obama was not elected on a platform that endorsed free-enterprise capitalism. Instead, his goals are universal health care reform, “green” energy, support for labor unions, and bigger government.

At the same time, the US Congress, dominated by entrenched fiefdoms supported by gerrymandered districts and rights of incumbents, has financial policy firmly under the control of the very people who were most responsible for the current crisis: Barney Frank and Chris Dodd.

There is no spirit of bipartisanship. Instead, there is a rush to push measures through, willy-nilly, without due consideration or backing from the general public.

President Obama has never given a major speech in defense of free enterprise or the capitalist system. Indeed, he has no roots on this side of the economic spectrum. His political support comes from the extreme left.

It is possible that this could change, but highly unlikely.

Federal Reserve flow of funds table F.107 (Rest of the World) showed that foreign investors — that for many years had been the primary support of US bond and commercial paper markets — were conspicuously absent.

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In 2006 and 2007, the net annual flows of foreign investment into US financial assets were $1,831 billion and $1,685 billion, respectively. In Q1 2009, these flows, on an annual basis, had fallen to only $14.4 billion — down 99.2% from the 2006 levels.

These foreign investments, largely the result of the continuing US trade deficit with the rest of the world, have been the essential element in financing US government fiscal deficits, residential mortgages, commercial paper (credit cards, auto loans, etc), and corporate bonds.

Foreign holdings still at all time high

However, despite the retraction in Q1 2009, foreign investment in US financial assets is actually at an all time high. Foreigners simply can not get rid of their massive holdings of US financial assets over night.

Federal Reserve flow of funds table L.102 (Rest of the World), shows foreign investment in US financial assets as $16.8 trillion in Q1 2009, compared to $16.0 trillion in 2007 and ‘only’ $7.7 trillion in 2002.

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The trend indicated by flow of funds table F.107 is a movement from financial securities and bank deposits into direct investments and “miscellaneous assets”, such as real estate. This is a logical reaction to the profligate financial behavior of the Pelosi-Reed Congress and the Obama administration.

The world votes on Obama’s ’spending is stimulus’ plan

Inflation is now widely feared and financial assets like bonds and commercial paper do not offer protection.

As the Obama administration moves forward into even greater deficit spending with its trillion dollar health plan, it would be reasonable to expect foreigners to continue to move away from conventional financial assets, seeking safer havens.

This will drive interest rates upwards and bond prices down, making economic recovery more difficult. Corporations that continue to borrow to support stock buybacks will eventually pay the price — or at least, shareholders will.