(Warning: some financial math ahead.)
A Ponzi scheme,
named after its early 20th century inventor Carlo Ponzi, is a form of
pyramid scheme. Basically it involves selling a nearly worthless
security to a small group of investors, with the promise of great
returns if they promote the security to more investors, and so on,
ideally, forever. Like any pyramid scheme or chain letter, of course,
it eventually collapses when it runs out of suckers. The first ones in
get rich, and the last ones in (much greater in number) get shafted.
As we all know, the stock market is focused on the short term, and
fluctuates wildly in response to a single quarter's earnings, external
economic events, even rumour. If you look at it holistically and
long-term, however, it has all the markings of a century-long Ponzi
scheme, the most lucrative, and potentially most devastating, in
history.
Let's take a look at the US S&P 500 as a surrogate for the entire
stock market, the entire market for equity securities of listed public
corporations. The index goes back to 1917, but was revamped in the
1940s and recalibrated so that the index for the average of 1941-43 was
10. It slowly rose to 100 over the next 50 years, and then to 1000 over
the next 12 years.
This broad index earned, in 2003, about $55 per average share of the
component securities, using GAAP (generally accepted accounting
principles). So at its current level of about 1100, it has a P/E
(price-to-earnings) ratio of about 20. That means investors are willing
to pay $1100 now for a share that will theoretically 'pay back' $55
next year, and hopefully successively more in future years, to justify
the 'present value' of $1100. To think of ir another way, it's like a
bank charging you $55 this year, $65, say, next year, and so on for at
least 50 years, as 'interest' on a loan of $1100. The 5% interest in
the first year isn't very attractive for such a risky 'loan', but since
future 'interest' will be dependent on (hopefully rising) earnings,
there is the prospect of a very lucrative return eventually.
So the S&P 500, like all equities, is said to 'discount expected
future cash flows'. A general rule of thumb says that the P/E ratio
approximates the annual expected growth in earnings, so that means the
investor in the market is expecting earnings to grow by close to 20%
each year, essentially forever.
How is that possible? Well, it isn't. Earnings grow because (a) prices
increase, (b) costs decrease, and/or (c) volume increases. In a 'free'
market economy, prices are determined (theoretically, now) by
competition -- new competitors will enter the market, and/or existing
competitors will adjust their prices, to the point that their return on
invested capital is just high enough to justify the investment risk.
That level, in a low-inflation economy where the alternative
'risk-free' investment in GICs and bonds is only 2%, is roughly a
modest 7%, with the extra 5% compensating the investor for the risk
implicit in equities. And, in the long run, volume can't increase --
there's only so much market for anything, and once it's saturated,
earnings should therefore level off at a flat rate.
Let's suppose we've more or less reached that state now. Let's also set
aside the fact that the $55 earned last year by the average share is
likely considerably inflated -- there are undoubtedly some more
undetected Enron-type exaggerations out there in some of these 500
companies, and GAAP allows capitalization of stock options and other
near-fraudulent practices that significantly overstate 'true' earnings.
Is the $55 a fair return on investment in these companies? To answer
that question we need to calculate what the investment is. According to
the S&P, this $55 represents a 17% return on investment. In other
words, the net assets or 'book' value of the average share is $55/17%
or about $325. We already indicated that a reasonable return, given the
risk, was 7%, which on $325 would be about $22 per share.
Why are stocks earnings $55 per share when in a 'free' market they
should only be earning $22? To answer this we need to look at the three components that make up ROI (or more correctly, return on equity -- ROE). These three components are: Margin (profit/sales), Turnover (sales/assets), and Leverage
(assets/equity). Leverage can be inflated by excessive borrowing, which
companies can get away with in times of low interest, but which
boomerang when interest rates spike. Leverage can also be inflated by
stock buy-backs, where the company essentially uses excess cash flow to
buy back its own stock and hence increase the value per share of the
remaining stock -- but this is a form of cannibalization, and leads to
the same imbalance between debt and equity. Neither is sustainable.
Turnover can be increased by lowering inventories, factoring and
off-balance-sheet financing, but ultimately tops out -- you need to
have a certain amount of money tied up one way or another in assets to
be able to run an effective business. So you're left with Margin, which
ultimately is the only explanation for the enormous ROE of $55/share,
when in a free competitive market someone should be willing to accept $22/share.
The truth is that the market, and big corporations, are far from
efficient. Many industries are heavily subsidized by governments to the
tune of billions of dollars in kickbacks -- er, I mean, support
payments -- per year. Big corporations also work as oligopolies to
prevent smaller companies from entering their markets and charging more
reasonable prices for their products. We, the consumers, are in fact
paying $55 for goods and services that could be sold for $22 and would still
provide the corporations with a very reasonable return. If and when
government subsidies end, oligopolies are broken up, and the market for
goods and services truly becomes free and open, the S&P 500 should
then generate $22/share each year, a 7% ROE, still an attractive return
in a low-inflation economy.
So we have a number of factors at work, conspiring to drive up stock
prices in the unsustainable illusion that double-digit growth can and
will continue forever, or at least until we're dead and it isn't our
problem anymore. We have big corporations earning exorbitant returns,
two and one half times a reasonable level given the risk, paid for by
the taxpayer and consumer (the same people who then take what's left of
their meagre paychecks and invest it, with insane trust in the brokers'
unsustainable recommendations, in the stock market). And we have a P/E
ratio that is already assuming that these wildly inflated, taxpayer
subsidized, price-gouging levels of profit will continue to rise even further, at close to 20% per year, forever. Voilà, Ponzi scheme, par excellence.
Let's do the math. Take the $22 per share that big corporations should
be earning per share in a properly regulated and open market.
Acknowledge that the assumption that these earnings are going to grow
in the future, when markets are saturated, consumers, corporations and
governments are already buckling under grotesque and unprecedented debt
loads and cannot afford to buy or pay more than they already are.
Discount that annual stream of $22 of earnings for 50 years at a
reasonable 7% discount rate. Know what you get for the fair value of
the S&P 500 with these calculations? About 300.
That is what, when you strip out the growth hype, the subsidies, the
price-gouging, and the unsupportable P/E valuation, the S&P 500
should be trading at. Not 1100.
Eventually the Ponzi scheme will collapse. There may yet be time to con
yet more foolish investors into believing that it will rise from 1100
to 1500 to 2000 or 5000 or higher, and if investors can be duped into
believing that's what shares are worth, that's what they'll trade at.
This scheme has been running for a century, and made many people
millionnaires. But eventually we, or our children or grandchildren,
will realize that the S&P 500 should be at 300, and since stocks
always trade at what people think
they're worth, that's where the S&P 500 will end up. The millions
left holding the bag will lose most of their life savings, their
pensions, everything.
(Oh, and if you change the assumptions about inflation and interest
rates, the above valuation doesn't change. Future values and discount
rates both go up proportionally, so the inflation-adjusted present
value stays the same.)
Even the brokers can see the writing on the wall. They will now try to
convince you that by wise investing you can 'outperform the market' by
buying low and selling high, even if the market is ultimately doomed to
do no better than go sideways. This is another great variant on a Ponzi
scheme. It's the stuff that has hooked the new breed of gambling
addicts called 'day traders'. For every investor whose holdings
'outperform the market' there will be, of course, at least one loser.
But the magic of Ponzi is that it's always the other guy, the next guy, the not smart enough guy,
who will get burned. You'd be better to play slot machines or buy
lottery tickets -- at least the potential payout isn't overstated by
250%.
In addition to the perpetual-growth Ponzi scheme, and the 'outperform
the market' con, brokers also make scads of money from IPOs -- initial
public offerings. As James Surowiecki has elegantly pointed out,
the IPO is a scam by which an aptly-named 'syndicate' of investment
firms ('underwriters') buy a mass of shares from the company 'going
public', at about half the price per share they know they can flog them
to gullible investors, many of whom rely on these very brokers for investment advice.
They then dump their shares on these investors, knowing that the price
will promptly drop back close to the IPO price. The underwriting
brokers get rich, and the unsuspecting customers get burned.
That's the reason Surowiecki and others, most recently Lawrence Fisher
in yesterday's excellent analysis over at our mother ship Salon.com,
have urged Google, potentially the most lucrative IPO of all time, to
screw the brokers and either sell all the shares directly to the public
by auction, or, even better, not to go public at all, and save the
delirious investors the grief they will suffer when they find out
Google has no direct line to God, and hence isn't worth a million
dollars a share.
Eventually we, or our descendents, will learn (or have no choice but)
to 'just say no' to dysfunctional stock markets and all the evils they
breed. Until then, we'll continue to be addicted to short-term
thinking, the illusion of perpetual growth, paying too much for
everything we buy, subsidizing public companies with our taxpayer
dollars, downsizing and outsourcing and offshoring as 'productivity
enhancement', and putting up with the atrocious greed, corruption and
devastation of insatiable global corporations that pull the strings of
politicians like puppeteers, all in the name of 'maximizing shareholder
value'. It's addictive gambling with a staggering cost, it's insane,
and it's fraud.
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