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.

An economy based on free junk

Loss leaders are hardly a new concept, but they seem to be growing in importance. The idea behind a loss leader is that a company gives one product or service at a loss, or minuscule profit margin, in the hope that it'll attract customers who will then also buy more lucrative products. For instance, the price of a ticket at a movie theater barely covers the theater's expense of showing you the movie. Their profit only comes in when you buy concessions.

There are times when a loss leader is appropriate, but in many cases, the consumer ends up losing. Moviegoers have to deal with the sounds of popcorn being crunched and candy wrappers being rustled during quiet parts of a movie.

Part of the reason that loss leaders are gaining in momentum is that the Internet has come with a culture of free things. Try to think of how many sites' services you pay for on the web — I'll bet you could count them on one hand, and probably on one fist. Or, think of how many times you heard music, legally or not, without paying.

But someone still has to get their money, and the mechanism for them to do so sometimes hurts the product. Consider music. I've already complained that music numbs our brains, but now that artists are finding it harder to sell tracks, they're starting to use them as marketing tools. Snoop Dogg's Landy in my Egg Nogg was commissioned by Landy's maker to promote the drink, for instance. A platform already skilled in numbing our minds is being tuned towards manipulating them.

Newspapers have had a loss-leader model for years: they made almost nothing from selling newspapers, and instead got most of their revenue from advertisements and classified ads. That created conflict (or at least the potential for it) between the papers' editorial and sales departments. It also meant that newspapers were vulnerable when classifieds moved to craigslist, which is one of the biggest reasons that newspapers are struggling even as our thirst for news is at an all-time high.

Sometimes the loss-leader model makes sense. Cell phone service providers heavily subsidize phones and make their money through your phone bills. That works because you're essentially taking a loan for an expensive piece of hardware and paying it off as you pay for the service.

Generally, the loss-leader model makes the most sense when the loss leader and the profitable product are closely related — when they're both used for the same common end-goal. This is the case in cell phones, printers (where the money is earned in selling you ink) and Shai Agassi's plan for electric cars, in which the cars themselves are free but the electricity costs you. The end goals there are communicating, printing and driving, respectively.

But even in these cases, there's a potential for the system to hurt consumers. Apple's iTunes store is a loss leader for the iPod (Apple still profits from iTunes sales, but not nearly as much as it does from the iPod). For years, this made Apple consenting if not complacent to record companies' insistence that the music come with anti-piracy encryption — which also, as it happened, meant it was only possible to play that music on iTunes or an iPod. Apple was happy, record labels were happy, and consumers had less freedom.

Of course, the proliferation of loss-leader models isn't just companies' fault. We the consumers buy into it, sometimes insistently. We'll go to a movie theater and pay $10 for a ticket and $7 for a popcorn and soda, but we'd refuse to buy $15 tickets and $2 snacks. That's maybe the saddest part about this system: we're losing out not because some CEO is trying to bilk us, but because we wouldn't have it any other way.