The Ponzi Factor - Introduction

Quandt style LLC presents the Ponzi factor: The simple truth about investment profits by Tom Liu, narrated by Sean Pratt.

All truth passes through three stages: first, it is ridiculed; second, it is violently opposed; third, it is accepted as self-evident. —Arthur Chopin

Our introduction: the most dangerous ideas are those that are true. Read the literature, but don't read too much of it. Read a bit to notice something that everybody is doing wrong. Something that just doesn't feel right. Read enough to develop your intuitions and then trust your intuitions. Don't be too worried if everybody else says it's nonsense. But there is one thing: if you think it is a really good idea and other people tell you it's complete nonsense, then you are really onto something. —Geoffrey Hinton

For a moment, ignore everything you know about stocks, the investment system, and everything that took place over the past 400 years. Imagine yourself in the early 1600s, at a time when no one knew what stocks were yet, but they were about to be introduced as a new investment instrument. You're going to hear two proposals, and I want you to think about how the early investors would have reacted to the introduction of stocks.

Proposal 1: A business owner approaches a group of investors and says, “I'm selling shares of my company. If you invest in my business, you'll receive a note that says you own a piece of the company, and if the business makes money, you'll receive a share of the profits. The note is transferable, so you can also sell it to other investors. If you're lucky, you might even receive more than you paid.”

Proposal 2: A business owner says to a group of investors, “I'm selling shares of my company. When you invest, you'll receive a note that says you own a piece of the company. However, you won't receive any money from the business, and the company is not obligated to pay you anything ever. But you can make money by selling the note to other people. You might get lucky and get more than you paid.”

Now, which proposal do you think early investors would have considered, and which do you think they would have avoided? Which sounds like a legitimate business investment, and which one sounds like a shady scam?

History shows that when stocks were first introduced to investors, they were designed to perform like investment proposal number one, where companies paid dividends and shared profits with investors. But today, the common stocks that are being issued to investors behave like proposal number two, where shareholders receive nothing from the business, and the only realistic way investors can make money is by selling their shares to other investors.

One of the biggest myths about stocks is the idea that profits from stocks come from the earnings and growth of the underlying company. The assumption is when a company makes money, they share the profits with their investors. But in practice, most public companies never pay dividends, and when they make money—which can be millions or even billions—they keep everything.

The reality is profits from stocks come from other investors who are buying and selling stocks. When an investor buys a stock for $10 and sells it for $11, that $11 comes from another investor, someone who will then start hunting for yet another investor who will give him or her $12, and so on.

This is actually a negative sum situation because the underlying company isn't involved in the transaction. The investors are just cannibalizing each other for profits, and there are fees attached to every transaction. It's one thing if everyone acknowledges this negative-sum gambling scenario and people just want to gamble. But the stock market is sold as a positive-sum investment system, and investors believe the system produces more money than they contribute.

This is why most of the money that goes into the stock market comes from pension plans and retirement funds, and why eighteen-year-old kids are allowed to open online trading accounts. Finance professionals will rationalize that it's not all about the cash but also about investing in the hypothesized intrinsic value of the companies and point out that the US stock market has grown to more than 30 trillion dollars in value.

Now, this would be a valid argument if we lived in a world where investors buy stocks for the sake of having stocks and never want their money back, but the last time I checked, investors do want their money back. People don't buy stocks because they love stocks and think, “I love my shares of Google; I want to hold their stock forever and never get my money back.” No, investors buy stocks because they want to make money, and their only objective is to get more cash out of the system than they put into it.

Investment finance is different from other businesses because everyone involved, from the bankers to the analysts to the advisors to the investors and the companies that need investments, all want one thing and one thing only: cash. This is not the case when we look at a normal business, like a restaurant. The restaurant that sells food wants cash, but the people who give the restaurant cash are end users who want food in return, not more cash.

This simple and essential fact is why the logic of investing is incredibly illogical when it comes to stock transactions. The person selling the stock wants cash, but so does the person who is buying the stock. There are no end users; everyone involved wants more money back than they contribute, and no one pays attention to where the money is coming from.

It's probably because no one wants to know where the money is really coming from. The problem is the money investors take out of the system is coming from other investors who are putting money into the system, and the stock market is just a system that shuffles cash between investors. It's a system where current investors' profits are strictly dependent on the inflow of money from new investors, and such a system is also known as a Ponzi scheme.

Most people understand that a Ponzi scheme is a scam, but what most people don't realize is that a Ponzi scheme can also produce a lot of winners. It's not a scam where everyone loses money. A lot of investors who are involved and unaware of the scam can make money too. Bernard Madoff ran the biggest Ponzi scheme to date. After his $50 billion scam was exposed in 2008, investigators found that more than half of his accounts showed a profit. The total amount of money lost in his scam was greater, of course, but as far as the accounts were concerned, more than half of them actually showed a net profit, as in those accounts withdrew more than they contributed.

The fraudulent aspect of a Ponzi scheme is not its inability to produce winners. The issue is in the mechanics and where that money comes from, and how investors who make money are taking it from other investors who also want to make money. One thing that tends to be true about Ponzi schemes and scams in general is that there's always something about the scenario that looks too good to be true.

If you were to look at a chart of Tesla Motors' stock price from 2010 to 2017, it would show how their stock shot up from $20 a share to over $380 a share during this seven-year period. Question: how much money do you think Tesla made during this time? No need to think of an exact number, but do you think they made a lot of money or little?

Answer: Tesla lost $4.3 billion. Tesla didn't make any profit; they didn't break even. They lost $4.3 billion during this period. Now, this is interesting because the early investors who bought into the company in 2010 could have made a lot of money while the company they owned actively bled out $4.3 billion. But how can that logically happen? How is it possible for investors to walk away cash-rich in profits with real money in their hands when the company they invested in never made any money?

In a legitimate investment scenario, that can never happen. Investors should only be able to make money when the company they invest in makes money. However, a situation like this can occur if the early investors' profits are dependent on cash from new investors rather than the performance of the underlying company.

If you ask people in finance how Tesla's early investors could have gotten rich while their company lost billions, they will respond with something vague and infallible like, “The market trades on future information,” or “The price of a stock is a reflection of future earnings,” or “The company has value, and Tesla's going to make money in the future.” The philosopher Karl Popper calls these unfalsifiable statements and classifies them as empirically uninformative pseudoscience ideas that cannot be proven right or wrong.

And in this case, they also assume there are people who can see into the future. Financial professionals are masters at giving unfalsifiable answers, but what they will never allude to is the clear and provable fact that Tesla's investors' profits came from other investors. And the reason why they don't want to acknowledge the obvious is because they don't want to think of the stock market as a system that shuffles money between investors, just like a Ponzi scheme.

I'd even sift through hundreds of companies to find an example like Tesla. I just thought of some popular companies that everyone probably knows, checked to see if they had a nice-looking chart, and looked into what they reported to the Securities Exchange Commission, the SEC. Tesla was the second company I investigated to find such an example.

If the stock market is similar to a giant Ponzi scheme, then why are there so many textbooks on stock analysis? Why is it taught in schools? And why do finance academics and professionals treat it as something legitimate? Do not underestimate the power of fallacies. The sad truth is falsehoods and immoral practices can be treated as normal and routine and persist for centuries before corrections are made.

Remember that it took humanity thousands of years to realize that human slavery is a barbaric practice that is not essential to a functioning economic system. The investment finance industry, especially the portion that deals with stocks, is primarily built on fallacies.

The reason why finance professionals do not see the stock market as a Ponzi scheme is because they believe the credibility for an idea rests on repetition, tradition, and people who recite it rather than proof, logic, or facts. The first fallacy, when I believe, the most fundamental falsehood that leads to other false ideas is the notion that stocks are equity instruments that represent ownership.

Finance professionals will argue the stock market can't be a Ponzi scheme because the value of a stock represents value in a company, and ownership instruments are being exchanged in the transactions. But there's practically no truth to this idea because the value of a stock has no legitimacy. It is just an arbitrary number derived from a Ponzi exchange process, and the value is not backed by anything.

A share of Google can trade around nine hundred dollars, but Google explicitly states in writing that the par value of their stock is only 0.001 cent. Google also says they do not pay their investors any dividends, and their Class C shareholders have no voting rights. So if you own a share of Google, you won't receive any money from Google's business activities; you won't be allowed to vote on any corporate issues, and Google isn't obligated to pay you anything more than 0.001 cent for that share you bought for nine hundred dollars. Does that really sound like a legitimate ownership instrument?

If I mail you a chair that was missing three legs, the seat cushion, and the backrest, whatever I sent you, can I really call it a chair? For a value to have legitimacy, there must be someone or something in place to back that value. The value of the dollar is backed by the United States government. The value of a house is backed by the intrinsic physical value of the house itself. But the value of stocks is not legitimately backed by anyone or anything.

The idea that today's common stock represents the real intrinsic value of a company is a baseless and unproven idea. And if people are selling such an idea to make money, then it is also a fraudulent idea. The reason why stocks are assumed to be equity instruments comes from history and what was described in proposal number one. Before the nineteen hundreds, stocks paid dividends. History shows that stocks were designed to be legitimate equity instruments with a profit-sharing agreement between the shareholders and the companies they owned.

Capital gains, the Ponzi profits from other investors in the buy low, sell high gamble, was meant to be a secondary form of profit. It was never meant to be the primary or only way for investors to make money. Stocks were not intended to be Ponzi assets that are destined to be shuffled between investors indefinitely, but they mutated in a very disturbing way over the past century.

Finance people refer to stocks as equity instruments, but it's nothing more than an artificial label. Today's stocks are fundamentally different things from the equity instruments they once were. The second fallacy, which is a product of the first fallacy, is the idea that an asset value of a stock is the same thing as cash.

When people see a share of Google that's trading at $900, they'll just assume that's $900 in real money. However, cash and asset value are nothing alike; they are from two entirely different worlds of our reality. The value of a stock is just an idea. It's just a thought, something completely imaginary, which is why the price can rise and fall sharply at any given moment.

The price of a stock is essentially backed by no one. There is nothing in writing that says Google is obligated to repay their shareholders $900 or anything close to that number. On the other hand, real money is an instrument for trade that is designed to serve as a medium of exchange for goods and services. It is in both physical and electronic form, and for the most part, it is finite and traceable.

You can carry it in your wallet or store it under your mattress. It's legal tender that is issued and backed by the government, and it's what investors ultimately care about. As of September 2017, the NASDAQ and NYSC had a combined value of over 30 trillion dollars and growing, and here I am writing a book about the imminent demise of the stock market.

The reason why this astronomical number and potential future market growth doesn't concern me is that a 30 trillion dollar market value means investors believe they are entitled to possess 30 trillion dollars in real money. But there is only one point six trillion dollars of cash circulating in the US economy and three point eight trillion dollars in existence in the entire US economic system, which includes the money in your wallet right now.

If the 30 trillion dollar value—or even a fraction of it—had any truth to it, we would be able to close the market tomorrow and send investors home happy with their stocks and all that value. But we all know what would really happen if the market closed tomorrow: every investor holding stocks would be in a world of hurt trying to realize the value of their stocks without the inflow of cash from new investors.

Stocks are priced in terms of cash, but they are virtually worthless unless they can be converted into cash. The third fallacy is the idea that the stock market is positive-sum for investors and the system produces more wins than losses. This idea is essential to the existence of the investment finance industry because it lets finance firms label their products and services as investing rather than gambling.

However, the positive-sum idea is an unproven assumption. The obvious way to validate the positive-sum assumption is by adding up all the money investors have won and lost over the years and see if that sums up to something positive. But that's not possible because no one knows how much money people have lost. There are no databases that track investor losses, and no one knows how much investors have been winning or losing over the years.

Another way to validate the assumption is to follow the cash flow of a typical stock transaction and see how the money that enters the system can exceed what investors contribute. But we did that earlier, and it shows a negative-sum scenario. The main reason why people think the stock market is positive-sum is that they believe in the second fallacy and think people must have made money because the stock market has grown to thirty trillion dollars.

But a real positive-sum situation needs to consider the wins and losses of all the investors—not just the early investors but also the last investors, those who are holding 30 trillion dollars of imaginary money that doesn't exist. I started Mike passionately watching CNBC and studying stocks at a hedge fund. I believed in the investment system, and I still believe there is a need for financial services from banks, savings and loan programs, insurance products, and tax advisers.

There are legitimate investment activities that involve tangible assets like real estate and debt instruments like bonds, which are also used to help businesses raise capital. There is value in the efficient allocation of capital, but there is a massive difference between agents who helped connect investors with companies and agents who make commissions by shuffling money with imaginary instruments.

There is something fundamentally wrong with the assumption that we can create an infinite amount of imaginary paper like stocks, which have no legitimate promise of repayment from anyone, and turn those stocks into real cash or tangible assets that are finite and limited in quantity. My skepticism of how the investment system works started in school, in classes on economics that talked about the benefits of trade.

Exchange of knowledge and debt instruments all made sense. Those ideas weren't perfect and always produced both winners and losers, but the logic behind why those ideas could net more winners felt reasonable. And more importantly, as imperfect as some of the ideas were, they were still trying to address real problems that arise naturally, like how to feed a growing population with limited resources.

In contrast, finance academics are trying to solve artificial problems created by other people in finance. There's nothing organic about the stock market and situations where investors can make money while the company they owned lost billions. When it came to classes with topics involving stocks or other forms of synthetic financial instruments, something about the logic always felt wrong, as if something deep and fundamental was completely missing.

I saw a lot of dollar signs and textbooks representing the value of stocks, but I also knew that stocks are fundamentally different from real dollars. You can't take a share of Google to the grocery store and get food with it. But when the books attached the dollar sign to asset values and made it look and sound like it could, something just didn't feel right about that.

At first, I just ignored those concerns because they seemed so basic. It was unimaginable to think that a prestigious industry like finance, with so many well-educated people, could be going about their day-to-day activities without acknowledging the difference between an imaginary asset value and real cash currency. I just assumed that all those smart people on Wall Street must have known what they were doing and thought, "They are experienced, and I'm just a novice. I must be missing something. I'm sure I'll figure it out later."

But the more I learned about the investment system, the more I realized that these simple fundamental questions are completely unanswered and brushed off as unimportant. The industry focused on developing sophisticated asset pricing models and other convoluted ideas built on top of layers of complications and assumptions, but basic foundational questions like "Is the stock market even positive-sum for investors?" and "Are stocks even legitimate equity instruments to begin with?" were ignored entirely and didn't interest anyone.

It wasn't easy to accept at first, but over time it became impossible to ignore and deny. The industry is built on the fundamental assumption that money can grow on trees and that it is possible to create cash by shuffling ambiguous promises. Yet they never did anything to validate this assumption.

The author Michael Lewis did a remarkable job exposing operational fraud through his books titled "The Big Short" and "Flash Boys." His book shed light on the inner workings of elaborate and complex deceptions in the industry. My goal is to explain one pure deception that makes up the infrastructure of the industry: something obvious, but something we've all been taught to ignore.

This book is not just another story about how some people in finance pulled off yet another scam, nor is it about how banks and complex systems are broken and riddled with conflicts of interest. Instead, it will elucidate something far more fundamental: the origin of investment profits and show why the stock market itself, even in the absence of insider trading and other headline-worthy crimes, is a scam at the foundational level.

I am certain the reason we have highly improbable market crashes, which can instantaneously wipe out trillions in market value, and an endless list of compliance and economic issues is because systems like the stock market are not legitimate structures to begin with and are not designed for investors to prosper.

I think everyone can agree that there are two inherent characteristics when it comes to a scam: one, someone made a lot of money; and two, something about the scenario doesn't make sense. Tesla's stock shot up from $20 per share to more than $380 per share, so someone made a lot of money. This also happened while the company lost $4.3 billion. You be the judge: if the stock market is similar to a giant Ponzi scheme, and it's as obvious as tracing the cash flow of a typical stock transaction, then why is it legal? Why are companies allowed to issue Ponzi assets, and why are finance professionals allowed to sell them to investors? Where are the regulators, and why aren't they doing anything about this?

Unfortunately, I have no answer for this. I don't know how the SEC can ignore such apparent issues. My best guess is the regulators are either in denial, confused, or just plain stupid. And I use the word "stupid" with great care and caution.

If you look at the SEC's website, you will find blatantly contradictory information. In one area, they define a Ponzi scheme as an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. But in another area, they advertise the following as a way for investors to make money through stocks: capital appreciation, which occurs when a stock rises in price.

From my experience, the biggest scams are legal in practice. It's the stuff that regulators and newspapers don't focus on because they are constructed from the ideas taught at universities and treated as quotidian positions in the job market. Those who engage in these activities don't look or sound like criminals. They have beautiful offices in prime locations and advanced degrees from respected schools like Harvard, UC Berkeley, MIT, and the like.

They are female, male, young, old, Asian, white, black, Hispanic, Middle Eastern, etc. They have great work ethics, and most of them are not bad people. But good people can do bad things without realizing it, and intelligent people can choose to remain ignorant of their own reality. People are much too intelligent to be brainwashed, but we can be miseducated, and it's tough to unlearn something after we've learned it.

The real problem is not Wall Street, which represents the finance industry at large, but the universities that teach unproven ideas so people can work on Wall Street. Finance professionals have been programmed to think of imaginary instruments as things with real intrinsic value, but it is the universities that are programming these false ideas without validating them.

A great inspiration for why I decided to write this book is Dr. Nassim Nicholas Taleb. His book titled "Fooled by Randomness" helped flip a switch in my head and changed the way I thought about the industry. I read the book in 2008 while I was working for a hedge fund that was racking up fictitious but legal accrual accounting profits while the financial system at large was on ferment-funded life support.

Dr. Taleb's book validated a lot of what I already suspected about the investment industry, but the thing that really hit home was knowing that there was someone else out there who didn't think like the rest of the industry did. And realizing that sometimes the entire world really is crazy just because you think differently doesn't mean you are wrong.

My critics will say this is the work of a conspiracy theorist, and my words are more likely to bring trouble than success. But the annoying thing about truth is it's hard to ignore after you see it, and it really bothers me when our world's biggest scam artists are lauded as the world's wisest investors and innovators.

Now, the nice thing about truth is it's not concerned with criticism. Truth is grounded in logic, and logic will transcend the test of time. Whether people realize the truth today, tomorrow, or centuries from now, the truth in these pages will be realized because knowledge evolves towards what is true.