The truth about stock market valuation

In this post I am going to discuss some mathematical and logical truths about the stock market and not everyone is going to like what they read.  Still, not wanting to hear bad news does not make it go away.  The head in the sand strategy is a fail.

I'll just jump right in here because there is no good place to start.  The stock market is mainly a Ponzi scheme.  Not 100%, but at least 80-90%.  Before you roll your eyes, consider what a Ponzi scheme is: a system whereby profits paid to the first to exit the scheme come from the most recent to enter the scheme.  This makes the Ponzi appear as a perpetual fountain of wealth as long as there are new suckers coming in the front door.  But when the suckers dry up and those in the system begin to head for the door, the Ponzi collapses.  If you still don't get it, go review the life and times of Bernard Madoff.  Keep this in mind as I touch on the salient details of the stock market.

People put their money into the stock market in the hopes that they will be able to pull more money out of it someday than they invested.  Everyone has the same goal. They hope that their money will "work" for them.  Of course, it takes real work to create new value and money does not do work.  People do work aided by machines.  That is how new value is created.  Making money without doing work is called gambling.  Many people who thought housing could only go up learned the hard way that the profits were a temporary illusion.  People gambled that they would be able to get out of the housing market by unloading their overpriced home onto a greater fool.  At some point the greater fools dried up and the housing bubble went bust.

So where do people think this extra money is going to come from with the stock market?  Does the stock market have some sort of influx of money other than investors?  The truth is that most people have no idea.  They have been herded into the stock market like cattle by government working with corporations just like government herded people into housing by telling people that we live in a "home ownership society" (GW Bush).  By "herded" I mean that people have been pushed into 401k programs and those programs mainly invest in stocks.  The 401k system became law in 1980 and corporations quickly incorporated them into their retirement programs.  Why wouldn't they?  The savings of the employees were going right back into corporate stocks which is where corporate officers make their real money!  Of course they are going to set up a plan to enable this. 

No new value is created without the injection of work and this applies equally well to stock markets.  There are three times where work is actually injected into the markets.  First, when a company does an IPO (Initial Public Offering) of stock, it basically trades the labor of the employees that has taken place thus far for money from investors.  The second way that companies inject work into the stock market (and thus add value) is through share buy backs.  The employees work to create value, the company profits from it, and some of those work-generated profits are pumped back into the market in order to drive share prices higher.  Corporate officers love higher share prices because, again, that's where they make their real money.

Another way that value is pumped back into the markets is via the payment of dividends.  Dividends work basically like share buybacks but with a twist.  The employees work to create value, the company profits from it and some of those work-generated profits are pumped back into the market.  But instead of using the money to buy shares, the company sends cash back to investors.

Because they inject work-generated value into the markets, IPOs, share buybacks and dividends are not Ponzi schemes.  Assuming sufficient value is pumped into the associated shares by these mechanisms, those taking money out of the market via these methods are not depending on new investors bringing their money in so that it will work.  They are thus not counting on a greater fool to come along and pay them more than they paid.  This is the key factor which mathematically legitimizes market value increases based on these mechanisms.

Unfortunately, IPOs, share buy backs and dividends are a small part of the stock market.  That means the lion's share of the market valuation is due to people (and organizations like pension funds, etc.) bringing their money into the market with the hopes of taking more money out than they put in.  This cannot possibly happen when such a small portion of the market valuation is supported by the addition of real value to the system through work as defined by IPOs, share buybacks and dividends.  The vast majority of the stock market is a Ponzi scheme based on greater fool theory. [2014 edit: in hindsight the data now shows that there is an even bigger source of new money into the markets and that is margin debt].

America has had a big population bubble called the baby boomers.  The boomers worked hard and saved a lot of money.  Much of that money was funneled into the stock market.  Boomers were told that it was the responsible thing to do.  They have been told that it makes sense.  But it doesn't make sense at all.  When boomers stop putting money into the markets as they retire, who is going to come along and fill that gap?  There simply are not enough younger workers to make up the difference.

When people buy stocks, the price goes up based on the law of supply and demand.  All the boomers have been buying lots of stocks since the 401k program was created.  This has driven up the price of the Dow Jones Industrial Average exponentially.  But now those boomers are beginning to retire.  They will want to pull money out and that means they have to sell stocks.  Unless enough young people come in to buy the stocks that oldsters will be selling, the stock market must fall. 

That is just how a Ponzi scheme collapses.  The buyers dry up and then everyone who is already in the system is left scrambling for the exits.  The last ones out get left holding an empty bag. There are not enough young people in America to keep the Ponzi pumped while boomers exit.  In addition, young people have high unemployment and lower salaries [2014 edit: "and how!"].   Less new suckers with less invest-able money per sucker and you have the makings of the coming Ponzi collapse of the stock markets.  There is no way around this because math dictates that it cannot end any other way.  Those who say it cannot happen are ignoring the facts just like homeowners ignored the facts as the housing bubble peaked.  The only question is when this will happen and nobody knows the answer to this.  However, it mathematically has to happen before most of the boomers extract their value from the system.  If it is like other Ponzis, things will seem OK until the trap door opens and then everyone will head for the door at once leading to dramatic price declines in stocks.  See the Japanese stock market chart (Nikkei 225) over the past 30 years if you want to know what that looks like.  Keep in mind that the stocks kept falling despite massive money printing and inflation by the Japanese government during that time.

The reason that gold and silver are moving up rapidly is because people do not trust the stock markets like they used to.  Many boomers lost huge portions of their retirement accounts because they bailed out when it crashed into 2009.  Even though the stock market has bounced part of the way back, those who got out and moved their money into metals are never going back into the stock market [2014 edit: note that the subsequent highs in the markets occurred on collapsing volume so I still stand by this statement].  Metals can be volatile too but they can never go bankrupt and the same cannot be said about the stock markets.  Besides, metals markets are very small relative to stock markets.  Metals are likely to benefit from the coming market crash.