Taking Stock / A Word to the Wise Ahead of the Next Financial Meltdown

In February 1994, the Tel Aviv Stock Exchange began to slide. Inside a year, stock prices had halved and the aggregate value of all the companies listed on the TASE had shrunk to NIS 120 billion. Three years later, the capital market had regained the lost ground, but it was a time that investors and traders will remember with a shiver for years to come.

Seven years later came another crash - this time not a local event, but a global one that began with the explosion of the Internet bubble. That global crisis was exacerbated locally by the second intifada. The combination was one of the longest, most painful recessions that Israel has ever known. Within two years, the combined market value of all listed Israeli companies had shriveled to a mere NIS 90 billion.

Then, in January 2008, markets worldwide wilted as the subprime crisis, which began with dubious loans to dodgy American homebuyers, spread from America's shores to infect the rest of the world. Tel Aviv's stock indices lost about 13% inside that month. Yet the mood in local capital market circles remains bizarrely merry. Trading turnovers are gigantic. Companies are raising money and Israel's economic growth is expected to run somewhere between 3% and 4% this year.

Here is a statistic to give one pause amid the gaiety. How much value did Israel's listed companies lose in January? About NIS 100 billion, that's how much. Or about as much as in the previous two crashes. But there's mathematical sense in the difference in sentiment.

At the end of 2007, the aggregate market value of TASE companies was NIS 900 billion, more than three times the figures as of the end of 1993 and 2000. Thus that 13% drop in January 2008 was equivalent to a 50% drop in 1994 or 2001.

The increase in Tel Aviv's aggregate market cap doesn't only reflect rising prices on the stock market: It also reflects the expansion of the market. More giant companies are listed in Tel Aviv than in the past. More Israeli companies that listed for trade on Wall Street have dual-listed at home, too.

Even more impressive than the stock market's growth is the soaring market cap of non-government bonds - corporate bonds. In 2000, that was a NIS 10 billion market. Today, it's a NIS 270 billion market.

What that means is that the public's financial assets are gradually shifting from stocks to corporate bonds.

The proportion of stocks in the public's asset portfolio was 28% at the end of 2007, passing the proportion in ordinary bank deposits for the first time in Israeli history. Corporate securities - stocks and bonds - now comprise about 40% of the public's portfolio.

If you had suggested 10 years ago that half the public's money would be placed into stocks, you would have been met with a look of bewilderment mixed with terror. The public's savings? Pensions? In (shudder) stocks? Perish the thought.

But the truth is, it's only right and natural. When the public isn't putting its assets into corporate Israeli and foreign securities, its alternatives are government bonds and bank deposits. That's what we were doing 20 years ago: Short-term and long-term investments alike were mostly in government bonds and bank deposits, and the banks were pretty much the only game in town for companies seeking to borrow. In recent years, though, Israel's capital market has taken giant strides forward. Financial mediation is no longer the fief of the government and the banks; it has moved to the capital market, which has meanwhile opened up to the world.

Stock and bond markets have great advantages as financial mediators compared to the state and the banks: They allocate resources better and more efficiently. But they have disadvantages too, and unlike the downsides of financial mediation by the government and banks, they are glaring. The markets are transparent as glass, and when a crisis comes and billions melt away, investors can see who gained from their losses. And come the next recession, Israelis will feel this disadvantage personally, because it will be the first time that major chunks of their pensions have been invested in the stock market.

The public had a taste of pain to come in January, when certain provident funds saw as much as 8% of the value of their managed assets vanish, thanks to horrible management mistakes: Hoping to trounce the competition, the fund managers bet on high-risk instruments, and lost. And that's just the start. Soon, investors are going to discover that some investment managers are gouging them on fees.

When stock markets are booming, investors mistakenly figure that 2%-3% a year in management fees is reasonable. When the markets stagnate or retreat and some start doing math, they discover that over decades, inflated management fees have cost them huge chunks of the profit that the stock market was supposed to bring them. And derivative-related scandals are inevitable; so are crooked brokers and greedy managers.

Bad things happen. People must accept this. But the next crisis will be different, because so much of the public's assets are in the stock market. Risk-haters will have to adjust their strategies based on the understanding that provident funds aren't safe as houses, and that the main beneficiaries of "management insurance" (bituach minahalim) are the insurance companies.

Regulators must step up their supervision of people managing other people's money and not hesitate to brandish criminal charges at miscreants. Brokers must grasp that in downturns, the public's tolerance of their greed and mistakes will be lower than ever before - because the stock markets of 2008, 2009 and 2010 aren't the venue of a few foolhardy individuals and speculators; the whole public is in there. And it is the way of the public to take it, and take it, and take it, until it can't take it any more. And then it will raise its voice in a maddened howl of anger.