November 10, 2002

The Stock Market as a Ponzi Scheme FAQs

The more I think about this, I feel like some paranoid nut spouting conspiracy theories. The problem is that for the life of me I can't find the flaw in my logic. Since the stock market bubble burst, with so many CEOs and other executives coincidentally cashing in their stock just before the crash, I have noted some similarities with the classic Ponzi or pyramid scheme. I have not been alone in this. However, as I consider the matter carefully, I can't see any important difference at all. The inescapable conclusion is that the stock market, as it operates today, is a pyramid scheme that would be shut down in a minute if somebody tried to start it up as a new enterprise. The plan to divert Social Security money into the stock market lends a new urgency to this question.

I found this definition of a pyramid scheme on the SEC Web site.

"In the classic "pyramid" scheme, participants attempt to make money solely by recruiting new participants into the program. The hallmark of these schemes is the promise of sky-high returns in a short period of time for doing nothing other than handing over your money and getting others to do the same.

The fraudsters behind a pyramid scheme may go to great lengths to make the program look like a legitimate multi-level marketing program. But despite their claims to have legitimate products or services to sell, these fraudsters simply use money coming in from new recruits is used to pay off early stage investors. But eventually the pyramid will collapse. At some point the schemes get too big, the promoter cannot raise enough money from new investors to pay earlier investors, and many people lose their money."

Consider then how the stock market operates. Read the above paragraphs substituting "stock Market" for "pyramid scheme". Investors are lured into the market with the prospect of high returns. What you hope for is that lots of other people will want to buy the same thing that you got, thus driving the price up. What you buy is nothing that is of value in and of itself. You can't eat it or fix your house with it or enjoy its beauty. You just hope that new participants are recruited into the scheme so you can sell out at a profit.

Stock Market Ponzi FAQs:

Q: Don't you own a share of the company when you buy stock?

A: In theory, yes. If you are a billionaire you might own enough stock to actually control the company. Your 100 shares gets you no voice in how the company is run. The only actual right you have is the right to sell out to new recruits to the scheme.

Q: What about dividends?

A: Most companies don't pay dividends. They would rather push the stock prices up. People used to own stocks in order to share in the profits via dividends. But the dividends are mostly a small part of the reason to own stocks. We wouldn't care about the Dow if we were in it for the dividends.

Q: Don't stock offerings serve an important purpose in raising capital for companies?

A: The primary purpose of stock offerings is to create a feeding frenzy in the market, drawing in new recruits and driving the stock price up so the insiders can profit. Private channels are much more important ways to raise capital for new ventures. By the time it gets to the stock market, they are just trying to bring in the chumps.

Q: Stock prices go up when companies show a profit and down when they lose money. Doesn't this show that there is something substantial behind stock prices?

A: Hello! Where were you during the tech bubble? From on down, lack of profits did not dampen the rising stock prices. What investors care about is whether other investors will buy a given stock. This depends on "investor confidence". Stocks are bought and sold on a short term basis by the big investors. They will buy a stock when a company does better than expected because they expect others will do the same. This is true even if the news is that the company loses less than expected. Investors will run from a company that makes a profit but a little less than expected in a given quarter to one that loses a little less than expected but still loses.

Q: Who benefits?

A: Many ordinary Americans watched their saving skyrocket during the 90s. Some of them actually got their money out before the crash. The big winners, however, were the insider traders. Ken Lay made millions of dollars by manipulating Enron's stock price and then selling out his shares just before the crash. Although the headlines went to Enron, this pattern was not all that unusual. Many companies used "creative accounting" to lie about their profitability and lure in new investors to push the price up.

Q: They couldn't all be crooks?

A: Maybe not, but consider this. Most CEOs are paid largely in stock options. This means that they can only make obscene incomes if they drive the stock prices up. So, they will do almost anything to drive stock prices up.

Q: What happened to regulation?

A: Good Question.

Q: But seriously ...

A: OK. The SEC requires that companies submit audited financial statements. Auditors are supposed to independently evaluate management figures and give their stamp of approval only if the books really reflect reality. Auditors, such as Arthur Anderson, have found that they are under tremendous pressure from their corporate clients to rubber stamp management's claims. Companies are not eager to pay higher audit fees in order to increase the chance that an audit will come up with unfavorable results. Auditors have been fired for delving too deeply. Meanwhile the SEC is supposed to be overseeing this process and conducting its own investigations but it is underfunded, especially compared to the corporate giants they are supposed to be investigating. Under the current administration the top posts in the SEC are held by people with close ties to the corporate world who seem uninterested in meaningful regulation.

Q: How does all this affect me?

A: Most pension plans are heavily invested in the stock market, so they are vulnerable. Worse yet, companies have largely switched to 401c(3) individual investment plans that encourage us to invest our pension money ourselves. This really puts us at an unfair advantage vis a vis the "big boys". People are watching their pensions evaporating before their eyes.

Q: At least I'll have Social Security?

A: That depends on Congressional action to insure that there are actually sufficient funds available when you retire to pay your benefits. Proposals to convert a portion of Social Security into individual accounts to be invested in the stock market can be seen as another attempt to lure more chumps into the market so that they can be fleeced.

Q: Isn't that a little extreme?

A: I told you I was feeling like a paranoid nut about this. You tell me where I'm wrong.

Q: Sure, the market is down now, but it will go back up again, won't it? After all, stock prices fluctuate but over the long run they always go up.

A: Just remember that the only reason stock prices go up is that there are more buyers than sellers. As long as there are new recruits to the scheme it can keep going but as the SEC says about pyramid schemes in general, "At some point the schemes get too big, the promoter cannot raise enough money from new investors to pay earlier investors, and many people lose their money." There is nothing more substantial than a lot of PR behind it all.


Eep² said...

See here for a similar blog post.

Anonymous said...

Mark Cuban was making this exact same point back in 2006 -- BEFORE the calamity...

Eep² said...

Note the date of this blog post is "November 10, 2002"...

Money Talk said...

I agree with you! And many people are putting their hopes on this ponzi scheme. Most of them will lose their money. That is a mathematical fact.

I have suggested a fix, you can read under "Executive Compensation".

The idea is to NOT tax dividends. And tax capital gains at a prohibitive rate. This way the concept of getting rich by selling high to the next sucker will not be there. When you own a company, you will only make money when it pays you dividends from real earnings, not price gain due to manipulative executive statements.

This way executives short term effect (if there is any), or the perception of it will be removed. Speculation will end. People will want to own honest business that make money and not chase the hype.

Anonymous said...

Stocks transactions should be taxed to minimize the ponzi effect,i.e you sell $1000 dollars woth of stocks you pay $100 dollars tax.