USA stock Market - Ponzi Scheme ?

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Last Updated: Tuesday, 03 May 2022 03:27

Published: Sunday, 28 June 2020 16:42

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USA Stock Market - Is it the GrandMa of all Ponzi Schemes ?

We all have seen insane returns that stock markets in USA have provided since the existence of mankind. The first question that comes to mind is what is in it that has driven such returns compared to other assets. Is it really true that we have found a machinery that delivers a return which leaves everything else in dust. Or is it just a Ponzi scheme run by the Government (i.e Central Bank of the Government) to generate those returns?? Let's explore it !!

Stock Market basics:

Let's check our stock market basics from articles in stock market section. Stock Market is comprised of companies that have gone public. By public, we mean companies that have decided to have common people as partners in their company. So, if a company X which is owned by some individual Y decides some day that it wants to additional partners in company, then individual Y starts selling some percentage of his shares to other individuals. Those other individuals then become partners of the company, as they hold some percentage of company's shares.

Stock Market returns:

Let's look at stock market returns since stock markets cme into existence in USA.

Stock market returns are  relevant after 1980 since a lot of things have changed since early 1980's. The gold standard was taken off by the US in early 70's which allowed the US govt to print as much money as needed. 401K accounts came into existence in late 70's which allowed lots of money to flow into stock markets every year. Interest rates have been declining since early 80's and have been at 0% rate since 2009. That in turn has dictated what kind of returns we get in stock market.

Do Stock markets really generate anything?

What we haven't paid attention to is that a significant number of people are employed by equity markets. First there is this government agency SEC that needs a lot of people to monitor these public companies. Then these companies themselves which go public, have to hire a lot of people to file paperwork to SEC, have investor relations team, conduct investor conferences, distribute material to investors, etc. Then there are auditing companies which go and audit these public companies. On top of these, there are big exchanges where trading of these stocks happen. Then there are mutual funds, index funds, and thousands of other funds managed by teams of people who get individuals invested in stock market. Finally, the biggest component of stock market are investors themselves comprising of millions of people across the country who buy and sell stocks.

So, there are at least few million people in USA who make their living off stock markets. Do they really create anything of value in the whole process?

Well, on surface, all these people either trade a piece of paper all day,  or help in trading it. What if the company is not public? Well, in fact if none of the companies are public in the first place, would it change anything? Probably not. The company would still make about the same profit and same revenue, irrespective of whether it's owned by one person or millions of people. Whether it's traded daily or not, whether it's price is going up or down doesn't matter at all to the functioning of the company.

So, what are these millions of people doing every day involved in the stock market. They aren't producing anything. They can just do nothing, and there won't be any difference in the things that the society is producing. So, these people are part of fake economy. Fake economy is where you leave your home everyday to dig a hole in 1st half of day, and then fill up the hole in the 2nd half of day. You come back home tired after a day's work, but you didn't create anything for anyone in the process. Yes, it's possible you get paid for that job, especially if the job is paid for by printed money. In a free economy no one would pay for such a job, because no one would be able to get customers to buy this product (of digging and filling holes every day).

What drives Stock Markets:

1. Debt and interest rate:

The money in system that can be used to buy any asset drives the price of that asset. Same is true for stock market. If the GDP of a country is $20T, that means $20T worth of money was spent. In a country like USA, the total salary of all people combined is about $10T (as per IRS data). A part of this $10T of total income goes into stock market. But money can also be taken on debt, and that debt can be used to buy stocks. Or alternatively, people can use debt to buy their basic necessities (as food, house, car, etc), and use their own money to buy stocks. It's the same thing where you see everything in USA being bought on debt.

As a wise person once said "If you are buying anything in America with cash, you are in idiot"

This can result in a lot of money in the system that can be used to buy stocks. However this debt has to be paid back at some time in future. So, when this debt will need to be paid, then stocks will come back at their regular price, since debt just inflated stock prices for a certain period while the debt remained in system. However if the debt can always be rolled over, and is never supposed to be paid off, then the stocks can remain at elevated levels, and can keep on going higher and higher for ever, if the debt keeps on growing higher.

Now everyone could get debt, but there is a interest cost with amassing debt. If the interest rate is high compared to the return you can get in assets, then it would make very little sense to take money on debt and buy stocks with it. In a free econmy, interest rates will adjust to a level where the return from safe assets (as stock market) is about the same as the interest rate on debt. This is because if the interest rates are lower than the return in stock market, then the person will put the money into stock market instead of lending it to someone for a lower interest rate. At the very least, interest rates in any free economy should match GDP growth rate, since GDP growth rate indicates how much more money came into the system. So, if the rest of the money is growing by let's say 5%, then your money that's stored in any form (whether as deposit in bank, as house or as stock) should also grow by 5%. In such a case, there is no point taking on debt to buy an asset, since the interest cost of debt is the same as the return on any asset. Infact, the return on asset will be lower than the interest rate on debt, since interest rate on savings will match the GDP growth rate. Interest rate on debt will always be higher than the interest rate on savings.

In a nutshell, in a free econmy it's impossible to leverage and generate consistent returns in buying any asset.

But what if there is a third party with unlimited cash that can give you debt at much lower rates than the GDP growth rate. Welcome the Federal Reserve (The Fed) to the party. They can print money and start lending money to people at much lower rates, and keep on rolling over that debt till eternity. Then this debt money can drive up stock markets. To top it off, the more you leverage, the higher the returns you can make. Look at bullet 3 for more details on The Fed.

2. 401K and other retirement accounts:

In early 1980's, retirement accounts as 401K came into existence, which allowed stocks to be bought for your retirement. You were able to soak away as much as 20% of your income into these retirement accounts. As it happened, most of the money in these retirement accounts started going into stock markets. As the interest rates started moving lower since 1980's, more and more of the money in these retirement accounts started going into stock market. 401K accounts became a permanent source of money for stock market. In the section on "usa economy", we saw that about 50% of the stocks are owned by people in their retirement accounts, while other 50% is owned by people in their personal account (from IRS data for year 2017). So, if we take away retirement accounts, then 1/2 the money supply going into stock market will be cut off immediately.

3. Government's unlimited  support:

In any country, central bank (controlled by the govt) has the money printing authority. They can print as much "national" currency they want, as the currency is owned by the govt. In USA, Federal Reserve (Fed) is the Central Bank, which can print as many dollars as it wants and sees fit, and give it it to whoever it thinks is the best person or entity to receive this newly minted money. There's no one to question it because central bank have unlimited power, since they are part of the govt (unless the government changes law to deprive itself of such powers, but why would they do that).

By law, Fed actually has three mandates. According to the Federal Reserve Act, Section 2a, its goals are “maximum employment, stable prices, and moderate long-term interest rates.” Fed tries to keep unemployment under 5% (as that is considered full employment), inflation between 1%-2% (so that money doesn't lose value), and moderate interest rates (so that they don't go out of whack with inflation)

decides how much return they want to generate via their money printing:

Why is this stock market return unsustainable without government support:

As of Dec, 2019, stock market in USA has a valuation of about $34T. That means the value of all the stocks in USA combined is $34T. Almost all of these stocks are owned by US individuals ultimately (i.e they might be owned by funds, which are ultimately owned by individuals). So, US population has a total stock asset of $34T. The total wages, salaries as reported by IRS for 2017 was about $7.6T, while total AGI was $11T. If we assume that $1T out of this AGI was stock market income (i.e dividends, capital gain from sale of equities and distribution from retirement accounts), then about $10T of income of people is available to be put into stock market.

GDP grows at about 5% per year in USA. The stock market has grown by about 10% per year since 1980's for the last 40 years.

So, in the next 40 years, let's see where the GDP and the stock market will be. Since GDP is about $20T and is growing by about 5% per year, GDP will be about $20T*7=$140T. However, stock market which is at $34T will grow to about $34T*45=$1600T. At that time too, people who have put money now will start exiting at the rate of 3% per year, implying about $50T of money will be pulled out of stock market every year. So, $50T of money will need to be put into stock market just to keep it at that level in year 2060.

It's unsustainable for stock markets to grow at 10% per year. What will need to happen is that GDP (i.e extra printed money) will need to grow at 10% (the same rate as stock market), or stock market will need to grow at 5% (the same rate as GDP). If stock market grows faster than GDP, then that money will come back into the system as capital gains and feed back into the economy resulting in higher GDP. However if the GDP grows at 10% (i.e money in system growing at 10%), then at some point all prices will start going up at very close to that rate (unless govt specifically controls food and rent inflation via subsidies).

People will say that stock market is risky, but you have to realize that stock market in USA is the safest asset because it has the full backing of US Federal Reserve. In 2010, Alan Greenspan