The Stock Market and its Dark Secret

Stock Market - don't be the Investor

Many people are interested in stocks. Some are traders, some investors and some are both. People in the stock market are generally optimists, else they wouldn't dare to risk there money. It is fair to say that both, traders and investors, believe in what they are doing and probably both think that they know it better than the other side. Here are some methods investors are using to put their money at work:

Look for chart patterns suggesting that a stock has become abnormally cheap and at the same time will likely go up from where it is now.
Be a fundamentalist, analyze and examine every data that comes out of a company, and then buy only cheap at a reasonable price.
Make global judgements about the economy and hit the right turning point for a general entry into the market to elegantly avoid analysing details of pea size.

Buy the broader market with index funds, based on the idea that overall the stock market reflects the ongoing advance in the world and thus stock indices are doing well long term.

Delegate the work of making investment decisions to a professional, who, because being a professional, should outsmart the market.
Most investors adhere not only to a single pure form of these strategies. They rotate between them, they try different flavors of them, they mix things up, they even start an investment with one strategy and close it with another. Or they started trading and end up with an investment. Nonetheless, all these behaviors seem to have good arguments. These rational looking strategies and huge stock price advances picked and presented by the media probably cause the general belief that investing in the stock market will make people wealthy. Now let's consider an uncommon view of the underlying mechanism.

The stock market - a table with six players

In the middle we have Mr. Doe, the private investor. Left to him sits a professional fund manager and at the right there is a professional money manager for individual clients. Let us refer to all of them as the investors. On the other side of the table we have a broker, a market maker and Mr. Company. We could add in the middle of both groups the trader, but in this model we want to examine the relation of the investors to the "sell side".

These opponents are all doing what the market does, they are exchanging stock shares and bank notes, putting them on the table and taking them away at times. Let us concentrate on the money only, after all the money is the only thing that counts. Neither has the table a hole through which money could vanish, nor does money rain onto it. All money put onto or withdrawn from the table has to go through the players' hands. Let us have a look at the broker's hands first.

The broker only sells and always wins

He charges a fee for simply forwarding an order from the investors to someone else. All that without risk and pain, and after doing so he pockets a fee. He can't make a loss, so with a bunch of marketing tricks he animates everyone to give him as fast as possible a new order. Important here is, what he does with regard to the table. He never puts money onto it, he only takes money away.

The market maker is the strongest trader

He is the one who takes the other side of a trade and makes a mostly riskless business with the spread, the difference between buy and sell price. Furthermore, he has state of the art equipment, which he watches like a hawk all day in a big room with others doing the same, hoping that many hawkish eyeballs are seeing more than single prey's ones. The market maker is known to be in a strong trading position, as he works for a big company with real money, which other traders fear.

With the capital behind him he is able to drive prices up and down, enticing euphoric investors into high prices and shaking out trembling ones with a loss at low prices. For example, the market maker likes to initiate breakouts. He is buying low within a price range that he even may have formed for that reason, bringing the price to the upper edge and selling higher into the following rush of buyers, who may falsely interpret this breakout as a signal. The same game can be played with first fuelling a trend to an exaggerated level and then bending it around and initiating a swing into the opposite direction.

If investors fall victim to these traps they are called sometimes the "weak hands", because they are doing the opposite of what real investors are supposed to do, namely buying cheap and selling higher, never or on changing fundamentals only. They are confused investor-traders, market participants who mix trading and investing strategies in an uncontrolled manner, a sure way to burn money. One extreme is the trader who misses his stop and decides at much lower prices to become an investor and the other one is the investor who finally becomes weak and sells with a severe loss. The worst case is oscillating between both extremes.

Some badmouthing tongues even argue that market makers make money with illegal insider information, front running or stock pumping. Not enough with that, they are said to create up- and downgrades, something like home made news, just to influence supply and demand of a stock to force its price to a level where they can sell or buy with more profit or a smaller loss. If it is not the market maker himself doing these things, he may have his buddies whispering with him through chinese walls and violating well-meant laws. Overall the market maker seldom makes a loss, on average, he always wins. To make it short, he also takes only away money from the table.

The stock market is a real gold mine - for Mr. Company

He has a special seat, with a big sign above it, on which is written -on his side so that the investors won't always see it- "Capital source". The other side of this sign could be labelled "Capital drain", but that would lower the mood, so it only says "Welcome". Mr. Company comes to the table right away from the printing press, with a big chunk of newly created stock certificates - paper, which he dumps on the table while cashing in tons of money. Will he ever give this money back? Hehe, stupid question, no he won't. The alternative for him is to borrow money by issuing bonds, which he obviously thinks of being more expensive in this case than selling paper. After all, in the bond market he would have to give back what he borrowed after paying interest for it.

In few cases a company not only survives but also prospers. Then, in the far distant future, it is expected to pay back something to its investors. Mr. Company can ignore such an expectation for a long time or even for the whole lifetime of the company. There is no law requiring him to fulfil it. But he can do so by paying a marginal dividend or by buying back directly some shares from current holders, preferably when stock prices are low. That looks good and may cost him no money at all, because there are some nice ways to offset such payments:

First, while making these payments, he can do a secondary offering. Mr. Company simply comes back to the table and dumps again a chunk of paper on it. Sounds primitive? No problem, he can mask the operation a bit.

He does it just a bit before or after the phase of payments, preferably after his company has experienced a good time, its reports and news have been tuned to sound even more optimistic than usual and its stock price is relatively high. Selling high and buying back lower the own shares is a fine additional business for a company.

Or he creates sort of options by printing the words "warrant" or "convertible bond" on the paper. That means that he starts two dumping actions, one now for the option paper and one later in the future for exchanging the option paper for the original paper, cashing in twice.

Even better, he splits off a part of his company, declares it being a new one and sells paper with a new company name printed on it.

If he is lazy, he simply distributes paper with the old name to the employees of his company. He can pay smaller salaries this way. Employees get shares proportional to their importance, meaning that he gets the biggest share, because he considers himself being most important. Instead of one big, many smaller lots of paper are now sold at the market.

There is another rare and special case how money comes back from Mr. Company, a cash paid take over. Another Mr. C arrives at the market and buys with real cash all paper of Mr. Company from their original investors back. But often this other Mr. C got himself at least part of the money from the market, so that only a fraction really comes back.

Stock market operators behind the scenes

Actually Mr. Company is supported by two other gold mine diggers. The investment banker helps carrying Mr. Company's paper chunk to the table. With much trumpeting he praises its quality as an investment. If the investors are still skeptical, the market maker, with his many tricks, makes the new stock's price going up. Then the private investor loses all doubts and shoves the missing tons of money over the table to Mr. Company and his investment banker. The investment banker's risk is that he projects too big a chunk of paper, so that he effectively has to play the role of the investor, at least temporarily. But that happens rarely. Mostly the investment banker just gets his fixed percentage of the sale from Mr. Company. Seen as an entity both will of course always drain money from the market during this initial public offering.

Mr. Company's second supporter, the venture capitalist, got beforehand his own chunk privately from Mr. Company in exchange for money, hoping that Mr. Company raises the seed and is invited by the investment banker to the market eventually. He may even get a chunk from Mr. Company later when the stock is already on stage, typically for a better than the price at the market. In both cases he hopes that he can sell his chunk for a profit, which may or may not come true, but at the market he will never do anything else than selling his shares and raking in money.

So we have three gentleman at the table taking away money. Some do it gently but constantly, some more raid-like. Finally the taxman appears every now and then, grabs some money from the table and out of the trouser pockets of everyone and grins. Of course he never puts money onto the table either.

What about our three investors? They are fighting for who has to pay the least amount of money to feed the other side. We know that the fund and money managers are acting on behalf of the private investor. They get a riskless payment from him for this fight, so it is not really that important for them whether they lose more or less.

It looks as if poor Mr. Doe is the real loser in this game. Interestingly he has a different perception of this.

But I already made a nice gain with stocks!?

This seems to be a paradox. Yet it is none. The table view of the stock market is a totalized one, a view which cares only for averages. Of course there are many individual investors having made their profit in the market, but on average the private investor is the big loser. He just doesn't know it yet.

There have been market makers, who suffered big losses, which they never recovered, because they went broke. There have been also brokers going out of business, because their clients made losses that they couldn't repay. But these are single failures. On average both are working businesses.

Of course there are also companies caring for their shareholders with buying back stock shares and paying dividends with every free cash they earn, not offsetting these payments with tricks the private investor is not aware of. But the times have changed. One century ago a stock company was strongly expected to pay out a high dividend. Back then all stocks of large companies had dividend yields higher than the one of bonds, reflecting their higher price risk.

Fast gains vs inner value

Today stocks are more seen as speculative vehicles. Their price swings are bigger and the IPO market works mostly decoupled from expected dividend payments. For a long time new companies do not pay a dividend at all, arguing that the money is better put into further growth. When finally dividends are flowing, they are much smaller than they used to be, decades ago.

To get the real picture of what comes back through dividends one has also to take the inflation into account, which often eats up dividend rates completely. Add to that the long delay of the first dividend payment after the IPO and the small percentage of companies that make it to this point and it becomes clear why so many start-up entrepreneurs want to become a Mr. Company.

A second point of confusion is what happens away from the market. The market maker and the broker may have to pay a hefty monthly bill for their equipment, salaries and rent, so that they only break even. A venture capitalist may enthusiastically invest in any nonsense idea he hears of, so that he overall makes a loss. Mr. Company may have the wrong concept, not enough talent or too much competition, causing him to burn all money and go broke. Perhaps he is a genius and his company is a fantastic growth machine.

All that is not important for the table model of the stock market. Even a rising price of a stock doesn't matter. It looks like the investor side is winning in this case, but alas, high prices are only tempting Mr. Company to sell more shares instead of buying back his paper. The only question that counts in the table model is: Does a player's money flow from or to the market?

A negative-sum game

The futures market is called a zero-sum game, because for every contract traded, there is a buyer and a seller and what one wins must be paid by the other. There is the proposition that the stock market is a positive-sum game, because over a long term, let's say some decades, stock market indices went up. The table model suggests that the opposite is true. For the private investor it is a negative-sum game. How can that be?

Over time problematic index stocks get replaced by fresh ones with brighter future perspectives, so indices are distorted. But the main reason is simply that all the owners of stocks own paper but not money. If they all wanted to exchange their paper into money to get what the ever rising indices promise, these indices would drop to zero immediately. The stock market is basically a pyramid scheme, which implodes eventually, sometimes self-induced, sometimes triggered by external events.

More often it implodes only partly for some stocks or temporarily and so that not all stocks recover. Every general bear market and every crash of an industry shakes out numerous stocks, but the indices look still well in the long run, which may be one reason why all this is so hard to believe.

You think people like Warren Buffet are constantly disproving the stock market table model? First, Warren Buffet is unique and for every investor similar to him one could find a myriad of not so savvy or lucky ones. Yes, this has also to do with luck. Picking the one that is truly outstanding out of the millions of others is equivalent to spotting trading chances in hindsight. With regard to Buffet there is something else. He has already difficulties to sell many of his holdings, because there is a growing number of Buffet or Berkshire Hathaway imitators. So, contrary to the first impression, he is probably the best example of an individual investor that demonstrates at least aspects of this phenomenon.

The dark secret of the modern stock market

Back to the beginning and the smart looking strategies how to beat the market: Will they not allow you to make money in the stock market? The sad answer is, the private investors and their professional helpers are essentially fighting for a positive piece of a negative cake. The odds are against the investor. Planning the exit of all positions and selling regularly, in other words becoming a trader, would improve his situation. Of course, this is not easy, either. You are still facing the competition of the market maker and his many dirty tricks. He has the advantage and you and other traders are still trying to eat a negative cake.

To overcome this tough environment a trading method or system is necessary. Don't expect to be able to fend off the systematic advantages of others with impulsive decisions. Moreover, you have to have an edge. At least some elements must set your trading apart from what others do. The market constantly adapts itself to the wisdom of the crowd. A working system has to meander around the various traps of the market and still center around a real imbalance and exploit it. Traps and imbalances are hidden. If they were obvious for everyone they wouldn't exist.
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