THE STOCK MARKET AS PONZI SCHEME

Posted on May 7, 2004 by Dave Pollard
(Warning: some financial math ahead.)

s&p 500
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. Voilý, 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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15 Responses to THE STOCK MARKET AS PONZI SCHEME

  1. David says:
    May 7, 2004 at 12:45

    May I ask how you are investing your money? :-)Seriously, I’d like to know. What do you recommend?

  2. Dave Pollard says:
    May 7, 2004 at 16:15

    David: A mix of things — partly investing in building my own new business ‘The Caring Enterprise Coach’, partly in GIC’s/CD’s, I still have some money in RRSPs (IRAs) invested mostly in Ethical Stocks, but mostly I’m invested in our house in a very desirable area on the Oak Ridges Moraine. If I had more, or could legally move the retirement funds out of what are ironically called ‘blue chip’ securities, I’d probably buy land or a rental property in an area where real estate prices are still relatively reasonable.

  3. hans says:
    May 7, 2004 at 19:37

    Great advice. Invest in hard resources like land, or in yourself (via your own business, or education).

  4. Jon Husband says:
    May 8, 2004 at 11:00

    Thanks, Dave. You’ve managed to articulate in an organized logical fashion what I’ve believed, and told myself in private conversations in my head) for a long time.I wonder how many people, deep inside their selves, actually think that some version of your story is the truth, but just actually go along with all this because of the lack of awareness of solid alternatives (to playing the game everyone else is playing) – or fear.See first comment. I’d like to know too – what I’ve figured out for myself so far is keep expenses as low as possible while still living a life you want to (in whatever societal context you are in or choose), and seek investments that seem to describe a sober philosophy whilst still acknowledging the Ponzi-like overall field of play.I mean, if it does eventually collapse, then only shelter, ability to find food and water on an ongoing basis, and community (physical and psychological) will matter, along with an ability to stay out of harm’s way.And, are you predicting or forecasting ? I remember your stated aversion to prediction and prophecy.

  5. Seb says:
    May 9, 2004 at 05:48

    Billionaire blogger Mark Cuban wrote about the stock market, similar echoes – http://blogmaverick.com/entry/2252572946170125/

  6. Babak says:
    September 4, 2005 at 20:58

    What you say regarding the nature of Wall Street is mainly true (investment bankers, IPOs, conflicts of interest, etc.) However, to then say that the stock exchange is a ponzi scheme is a non sequitur.The stock market is a necessary part of our economy and provides many positive benefits. Namely, it allows an entrepreneur to diversify their assets (by selling shares of their business); it allows for price discovery (vital to a market driven economy) and it allows for young, capital hungry enterprises to tap into the financial resources they need to grow. No economy could reach an advanced level nor function as ours does without the mechanisms of a stock exchange that allow buyers and sellers, capital users and capital providers, risk mitigators and risk takers to meet.I would encourage you to learn more about the stock market as you seem to be an earnest student of life and have an open mind. I will also point out that Google didn’t really have a choice about going public. There is a law in the US which requires a company that reaches a certain financial size to go public. This is not widely known, so I don’t blame you that much for not knowing about it.Cheers

  7. Dave Pollard says:
    October 20, 2005 at 22:38

    Babak: Uh, no, there is no such law. In fact some huge companies are in the process of going private. I do know a fair bit about the stock market, seeing as I did work in the industry. As for the necessity of a stock market to the economy, if it was run honestly and transparently, instead of as a Ponzi scheme, it would do the economy a great service. But as it is run, it just makes the economy terribly fragile.

  8. Babak says:
    November 4, 2005 at 11:30

    Dave, I’m sure you’re a very knowledgeable person. As I said before, I’m not at all surprised that 99.9999% of people out there don’t know this law. Its rarely invoked. But it does exist. Please see section ‘g’:http://www.law.uc.edu/CCL/34Act/sec12.htmlSince registration with the SEC was legally enforced, this meant that Google would have to divulge a lot of information they would rather not. They rightly decided that the cost of doing so would be best offset by atleast getting something in return (namely gobs of money exchanged for a portion of equity). Rarely if ever does a company forced by section g *not* go public.And regards to the stock market and the economy, I respectfully disagree. The stock market creates a tremendous amount of flexibility acting as a shock absorber for the economy. Could it be better run? Sure! But to say something as over the top as ‘its a ponzi scheme’ is to lose all credibility.Cheers

  9. Tom says:
    December 4, 2006 at 13:54

    Let’s not forget that since 1971, currency has lost any relation to reality. The stock market may continue to “climb” due to currency inflation, even though it is unproductive, and often counter-productive. and furthermore, this currency manipulation represents a greater threat to the individual than do taxes.

  10. Alex says:
    June 25, 2007 at 01:04

    No offense, but I’m curious what part of the financial industry you worked in, because the assumptions and finance you use to base your conclusions on are basically junk. It’s quite possible to make a case the market is overvalued, but 75% overvalued? In other words it should be trading where it was 25 years ago, before a ton of growth and technological innovation.You can dislike corporations, how they run, exxon mobile profits, ect but that doesnt change facts. For starters, you cant get hung up on PE’s, they are only a rough guide to valuation, and at least use a forward PE (the market’s PE is closer to 15, which is the historical average, not 20).More importantly you choose to use earnings to discount out. This is totally incorect, as you said equities discount expected FCF, not earnings, very different things. I’m not really following the logic of how you turn 55 into 22, you shouldn’t be looking at book value for a forward valuation nor can you use the discount rate to get earnings from it.You should be using a two stage DDM that incorporates both dividends and buybacks. If you go here you can see how a top valuation professor does this. http://pages.stern.nyu.edu/~adamodar/It’s interesting to frame the market as a ponzi scheme, there were a few good articles in 2000 about this, but the market is no longer (at least severely) overvalued and surely will not collapse as you insist.

  11. Robert says:
    May 11, 2008 at 09:21

    Dave, I have been waiting for YEARS for someone to come along and verify what I have seen and known all along. Thank you for this write up. I try to educate myself on finance and schemes like MLM and the stock market, but coming from you makes it all worthwhile to read and know the years of educating myself was not all for not.

  12. Steve says:
    October 30, 2008 at 09:22

    10-30-08This article is great reading! I would add that a rational investor would look at the dividend yield rather than corporate earnings. Viewed that way, the market is even more of a joke/Ponzi scheme.I challenge the commenters who believe the market is NOT a Ponzi scheme to explain exactly WHY it is not. Dave has put forth a detailed explanation that it is wildly over-valued from a fundamental perspective. I agree and feel he has not even put forth the best argument: Pathitically low yield compared to other, less-risky investments.Arguing, as Alex does, that the market is not over-valued because now it is lower than it was in the throes of the 2000 bubble, simply makes Dave’s point. Those who try to determine value based on what the market was yesterday are simply relying on the last fool’s opinion of value. The other metrics mentioned by Alex simply don’t matter to a fundamental analysis if the stock in quesiton pays no dividends, as is so often the case. So, all those metrics are great for baffling the general public, but those of us with finance degrees, logic, statisitcis and math skills know that ‘figures lie and liars figure.’ Alex’s arguments remind me of the ridiculous metrics put forth to justify the insane prices of tech companies during the internet stock bubble. From a fundamental viewpoint, a stock is an investment and should be valued based on the income it generates for the investor. Anything else is just gambling.Thanks for the great article!

  13. Ian says:
    February 15, 2009 at 18:37

    Thanks, this has been a very clear discussion of the topic.

  14. Vlad says:
    October 15, 2009 at 23:59

    Yes, the stock market is a ponzi scheme…absolutely. It’s the trading of an essentially worthless commodity (a stock certificate) for money in hopes that the same stock certificate will be worth more at a later date.However the author’s premise and logic is totally baseless and contrived. $55 earnings vs $22…all total BS. The $55 earnings is an average composite earnings of the S&P500 index, it’s actual earning per share per year…whether it’s due to leverage or deleverage or big tits doesn’t matter, that’s what is actually earned. Now one can argue that the standard multiple assigned to stocks of ~20x earnings is outrageous, that’s a valid argument. But what it really comes down to is a fundamental tenant of capitalism: supply and demand. That’s why when a company buys back it’s own stock it is a completely valid (and some may argue almost pious) way of doing business in that they are enriching current shareholders by decreasing the supply of stock on the market as well as increasing the percieved health and confidence of the company by way of increasing it’s financial stake in the business.Indeed, a stock certificate is only worth what the last person who bought it paid for it, but as long as greed exists in humans (which will be forever) and there is some monicum of trust in the financial markets (which I’m sure has a much shorter half-life than greed) there will continue to be a demend and even premium paid for stock in well performing companies. That is unless and until Obama and the rest of his corupt cronies have their way with our capitalist system… raping her and fully commiting to capital redistribution aka socialism!Yes, the stock market will crash again one day. Probably sooner than it took the most recent crash to re-emerge…and that’s why I watch the market every day. Because after politicians, there is by far one group of people who deserve absolutely no trust and all the scrutiny in the world….wall street bankers!

  15. Vlad says:
    October 16, 2009 at 00:00

    Yes, the stock market is a ponzi scheme…absolutely. It’s the trading of an essentially worthless commodity (a stock certificate) for money in hopes that the same stock certificate will be worth more at a later date.However the author’s premise and logic is totally baseless and contrived. $55 earnings vs $22…all total BS. The $55 earnings is an average composite earnings of the S&P500 index, it’s actual earning per share per year…whether it’s due to leverage or de-leverage or big tits doesn’t matter, that’s what is actually earned. Now one can argue that the standard multiple assigned to stocks of ~20x earnings is outrageous, that’s a valid argument. But what it really comes down to is a fundamental tenant of capitalism: supply and demand. That’s why when a company buys back it’s own stock it is a completely valid (and some may argue almost pious) way of doing business in that they are enriching current shareholders by decreasing the supply of stock on the market as well as increasing the perceived health and confidence of the company by way of increasing it’s financial stake in the business.Indeed, a stock certificate is only worth what the last person who bought it paid for it, but as long as greed exists in humans (which will be forever) and there is some modicum of trust in the financial markets (which I’m sure has a much shorter half-life than greed) there will continue to be a demand and even premium paid for stock in well performing companies. That is unless and until Obama and the rest of his corrupt cronies have their way with our capitalist system… raping her and fully committing to capital redistribution aka socialism!Yes, the stock market will crash again one day. Probably sooner than it took the most recent crash to re-emerge…and that’s why I watch the market every day. Because after politicians, there is by far one group of people who deserve absolutely no trust and all the scrutiny in the world….wall street bankers!

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