Computers and the Internet Made the Markets Historically Stupid!

I have a degree in systems engineering and am a huge fan of technology – BUT the computer and the internet have unraveled our financial markets and made us really stupid. In fact, our unbridled adoption of these technologies has caused our markets to regress back to the days of the great Dutch tulip bubble when there was no good analysis or information, only relative speculation and emotion.To provide some foundation for this assertion, allow me to put forward my qualifications. As mentioned above, I am and engineer, a bona fide techie who started his career building stuff like fusion reactors. I’m also an MBA and former senior partner at Robertson Stephens – the leading global technology and Internet investment bank in its day. I was a 100% enthusiast as we brought public such firms as E*trade, TeleBank, Insweb, Knight Trading, MeVC, Multex, Omega Research and PayPal – all financial services firms that used the internet to change the industry. The final highlight on my abbreviated qualifications is that I am married to a PhD who has published several books on financial markets.So, how can it be a bad thing to have computers to run advanced financial valuation models? How can it be a bad thing to have stock trades be executed immediately on the net and only cost $5 instead of $100? How can it be a bad thing for mutual funds and individuals to be able to trade directly and anonymously for pennies on the net? How can it be a bad thing to have all public company information available for free to everyone? Of course the answer to any one of these question taken independently is: “All of these innovations were beneficial adding efficiency and leveling the playing field.”It is when we examine the combined impact of all of this innovation on our financial markets over the last decade that we see the result was massive collective stupidity. (For those of you who would like to suggest that greed is the culprit – I will assert that that function has been constant since the beginning of time and is irrelevant in explaining the source of this crisis)Here’s how it went down. Step 1: Introduce the computer for financial modeling. This OK at first as the models can be understood by experienced financial professionals and add real efficiency. BUT – over time the models grow in complexity as do the financial securities so the math PhD’s running the model are the only one’s who really have a clue and the experienced bankers who have judgment and broad training (Dick Fuld?) are relegated to either being silent or pretending they understand. Sounds a little like “The Terminator” – but you know it happened. The greed at Lehman was a constant – but the stupidity went off the charts.Now let’s add the Internet. Step 2: “Free” retail stock trading via the net. The good news was added efficiency and a leveling of the playing field. This also welcomed every one of P.T. Barnum’s widows and orphans into the market regardless of training or qualifications. What a surprise that we had a bubble in 1999 – good year for casinos too. One side effect of “free” trading is that Investment Banks could no longer afford to pay brokers or analysts top dollar to provide expertise and advice – but who cared because these guys were just greedy overpaid middlemen and besides all the information an investor needed was available for free.  So out goes experienced professionals who had reputations to rely on and in comes 100% access for all to company info and analysis via EDGAR, Yahoo, Raging Bull. Great –we could all get GAAP statements on companies like Enron, Bear Stearns, Tyco, Lehman – so who needs advice.Of course it wasn’t just the little guy who changed trading behavior – some hedge funds and mutual funds figured out that they could trade directly and cut out the middleman too. Those that didn’t figure it out were told by regulators to cut out the middleman because having a long term relationship with a broker that includes dinners and even fancy wine was clearly criminal when you could trade thru a blackbox for pennies.My argument is simply that we embraced the sophistication, efficiency and anonymity of computers and the Internet and disposed of the judgment, experience, training and long term relationships. We did this in true American fashion without debate or consideration on the impact on markets which had been built on social contracts and trust.As we see treasuries sold with negative yields – I hope no one would debate that we have a total collapse of trust in our financial markets. I would never argue that the solution is to abandon innovation.  However, the hands that help rebuild our capital markets will need a better understanding of the role of technology and the role of relationships in capital markets if we are to cure our historic stupidity.

Posted on December 16, 2008 in Insights