Monday, March 16, 2009

The Stock Market Is Evil

Damn. Jon Stewart scooped me. But I'd like to expand on one part of his interview with Jim Cramer in which Jon questioned the very idea of sitting back and making 10% - 30% margin on an investment.

First of all, I'd like to qualify headline. The stock market doesn't have to be evil; it's just its current manifestation is. Most of the market's action is in the secondary market — that is, not IPOs in which you buy from the company in question — and dividends are a minor, or often nonexistent, part of the deal. That's the evil part of the stock market; it's also the main part of the stock market.

When you buy stock in a company, you're almost never buying it from that company. Instead, you're buying it from some third party, and you're probably doing it in the hope that the stock's price will go up so that you can sell it to another third party at a profit.

The problem with this transaction is that you've made money without adding any service or product of value. That's an inherently untenable system: it's a bubble.

The rest of this post is just more ranting; the above paragraph is the crux of my argument. When you get money without contributing anything of value to anyone, there's a problem. It's always a moral problem, and it almost always ends up in a pragmatic one, too.

Like any other bubble, the stock market works great until it breaks. When things are going well, the market has the general understanding that stocks should generally go up; when people freak out, the stocks generally go down. But whether the stock market is losing money or gaining it has no direct affect on its underlying companies cash, operating efficiency, product line or anything else core to the business. That disconnect is a problem.

How did we come to this? Abstraction.

At IPO, stocks that earn dividends make perfect sense. The company needs capital, and to raise that money it offers partial ownership in the enterprise. You buy a small part of the company and are thus entitled to a share of its profits.

Here's where it gets interesting. When a company is young or not doing well, the risk in that trade is high. To make shares more alluring, and to reflect the fact that you're taking a risk, companies offer their stocks at a low price. That makes sense, and it also makes sense that if the company starts doing well and you want to sell your stock, you should expect to sell it at a higher price; that reflects the smaller risk involved in partially owning the company, which is now stable and doing well. After all, its profits are higher and more regular, and that makes it more valuable to have a claim to a portion of them.

But it doesn't take long for that to get out of hand. Soon enough, most of your profits come from buying low and selling high, with the dividends — the share in the company's profits — getting eclipsed in the transaction. Before you know it, companies abstract away those dividends, and the market is now buying and selling shares that are actually virtually meaningless except insofar as they can be bought and sold at fluctuating prices.

Shares have now become a highly volatile fiat currency: they're only worth whatever we consider them to be worth. Fiat currencies are prone to fluctuations in value, and that's usually seen as a necessary evil; most money is fiat, for instance, and governments spend a great deal of effort in trying to keep its value as stable as possible by curbing inflation and the like.

Keep in mind that I'm by no means against all financial systems. If the main value in stocks were their profit shares — that is, if they were really treated as partial ownership in the company — then I'd be in favor of the system. Likewise, I think loans are a great idea: if I have a bit extra cash, and someone else needs a bit of cash, it's perfectly reasonable for me to give him my surplus and for him to not only pay me back later, but to add interest to make it worth my while.

We just need to remember the fundamental value of what we're holding. A share should represent part ownership in a company; a loan should represent one party helping another with the understanding that the backscratch will be returned. When abstraction lets us forget that, and trade on items not based on their intrinsic value but only in the hope that we can trade them again later for a magical profit, that's when we have a disaster waiting to happen.