What’s Wrong with the Stock Market?

What’s Wrong with the Stock Market?

April 14th, 2009

The problem with the stock market started back before the end of the 18th century—in 1792 as a matter of fact. This was when the stock market as we know it was born under a tree in lower Manhattan. It was there and then that those who first bought and sold stocks as a business got together and formed what became the New York Stock Exchange. From those beginnings, an industry was born that has grown to be one of the most powerful and financially influential in the world.

Transaction-based Compensation – the Wrong Dynamic
Actually, the problem arose from the fact that these people made their money not from any appreciation in the value of the investments they bought and sold but rather from just putting buyers and sellers of those shares together. They profited from the transaction itself. To this day, the majority of brokers receive their compensation as a result of the purchase or sale. It makes no financial difference to them whether their customer gains or loses.

I don’t mean to imply that, just because these people fill a need and are compensated for doing so, they’re bad people. Certainly the existence of this industry is what makes the ownership of stock feasible for the average person. It’s responsible for elevating common stock to the level of liquidity that allows us to own it without fear of being stuck with it when or if we choose to sell it. And it certainly makes it much easier for us to buy those shares when we wish to. If we’re interested in putting our money to work for us in what is arguably the most lucrative manner possible for the least amount of risk, we can’t get along without this industry. But, the difference in perception and fact between what a broker does or is qualified to do and what the uninitiated think he or she is qualified to do is a major source of the problem.

In the beginning, the whole idea of shares was just that: sharing in the fortunes of an enterprise. Where it might be difficult for a company or individual to come up with enough money to finance all that was necessary alone, sharing the business with others in a fashion that limited their liability and exposure to only the amount of money invested was a great way to obtain the necessary funds. Anyone who wanted to participate in a business—sharing both the rewards and the risks—would buy shares and hold them as legal documents that vouched for their entitlement to a proportionate share in the fruits of that enterprise’s operations. Originally, therefore, folks bought shares because they thought the business would be profitable one and they wanted a piece of the action.

The formation of a ready market for stocks, while it performed a very useful service in terms of liquidity and convenience, had a serious side effect. So easy was it to trade that the perception of what a share of stock really was became obscured, giving way to the notion that the stock, like currency, had some intrinsic value that could vary for reasons other than the success or failure of the underlying enterprise.

Easy Trading changed the Nature of the Market
Moreover, the ability to manipulate the perceived value of those shares erected a persistent barrier between those that manipulated it and those that didn’t. It was de rigueur for unscrupulous traders to spread rumors appealing to the fear of the uninitiated, driving down the price of a certain stock, and furnishing an opportunity to pick up a large position at that favorable price. And then it was an equally simple process for those same individuals to spread favorable rumors that appealed to the greedy, drove up the price, and resulted in a great selling opportunity for those who then owned it. Not until well into the 20th century, after the devastating crash of 1929, was there a real effort to address that issue legislatively and make such activities illegal.

However, there was—and is—no way to legislate the greed and fear out of the stock market. Those are still its basic drivers. In fact, as recently as within the last decade, a young kid from New Jersey managed to make nearly a million dollars when he flooded the Internet with glowing stories about a penny stock he had selected for his venture. Unwitting investors bid up the price of the stock with no more to go on than his fiction; and he made a killing.

Disconnect Between Value and Price Creates Bubbles and Busts
The very same dynamics of greed and fear were responsible for an even more spectacular event that impacted millions of shareholders. The appeal of the dot.coms, most of them with no visible means of support—and the technology companies that depended upon them for their burgeoning customer base—inflated one of history’s biggest bubbles. Investors, eager to make a killing, continued to bid up the price of the stock in those companies with no regard for or even any understanding of the factors that comprised their underlying value. This was what the Street refers to as the Greater Fool Theory: “I may be a fool to buy this stock at this price; but I’ll find a greater fool to take it off my hands for more than I paid for it!”

The market of course collapsed when those companies—like Wiley Coyote racing off a cliff only to discover he had nothing under him—learned the hard way that a company had to earn money to live. The extent of that collapse went well beyond rational concerns about the profitability of the affected companies, being exacerbated in large measure by irrational fears growing out of the September 11th, 2001, attack on New York’s World Trade Center and our country’s bellicose activities following that tragedy.

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