Based on my time in the markets, I will be sharing my experience and some conclusions that I have drawn about the stock market in general. I am also very much open to others opinion about the same topic. Infact I really hope if someone can paint a different picture in front of me as I am willing to be convinced otherwise, but with a sound and rational logic.
First I will try to draw an analogy between the stock market and a ponzi scheme with the following hypothetical, but relatable example-
For the sake of simplicity, we will neglect time value of money, so we will assume what is worth say Rs 1 lakh now will be of same worth even after 10 years.
Suppose there exists 5 magical trees in my garden. Unlike other trees, these grow money on their branches instead of fruits and leaves. The amount of money on any tree at any point of time depends upon the size of that particular tree.
The trees have their own growth rates which depend upon factors such as the amount of water, sunlight, minerals and care they recieve and also upon their internal structure and composition.
Lastly, we can pluck out all money from a tree only after it has completely grown and matured, which is expected after 25-30 years.
Now let’s consider what happens-
- In the beginning, lot of my neighbours are bewildered and amazed by these trees in my garden. Many of them also offer me good amount of money in return for owning a percentage or stake of these.
Let’s call the trees A,B,C,D,E with tree A the most promising one to grow into a huge size and E the least promising one. Needless to say most of the offers that come at my doorstep are for tree A.
Suppose the total amount of cash in A after 1 year is 1 lakh and one of my neighbour offers me 10 lakh for 50% stake in A. Also suppose I agreed with the deal. Now as per the new owner, he has valued the tree at a p/e (actually p/b or price to book to be more exact) of 20. He is happy however, as he thinks the growth rate of this tree more than makes up and he will get far more in return after 30 years.
The trees however, have defied the expectations and are growing at much faster rate. New offers are now coming, both to me and the new owner of A, and we both keep entering to new deals by selling our stakes partially. The new owners of these trees in turn also does the same with more new participants.
In these initial years, most participants have still the longer picture in focus- new participants are buying because they expect the reward to be much more after 30 years once these trees grow completely. Likewise old participants who are selling their stakes, sell only when they feel the new participant is erring and paying them more than what the tree should be worth or because of the need for cash.
The primary intention however is still to earn money from the tree itself and not from trade.
- Soon that begins to change. After some time, say 10 years, many people from other nearby towns have also become aware of these trees and are trading in the market. Trading also is happening more frequently and there are 1000s of partial owners now of these 5 trees. So far nothing wrong with any of that.
But, the reason why these magical trees have value is simply because years later they are expected to return more money, and thus more the growth more will be their size and hence more will be the money available for distribution. This simple and basic “why” of investing is however started getting lost.
Many of the new investors don’t care about these “whys”. All they know is, there exist some trees whose market price goes up if the trees post, or they are expected to post, good growth rates and their market price goes down if they post bad growth rates. That is all their guide to “how to invest”.
- In the next couple of years, the “why” part of the investing is all but forgotten. The intention of many participants now is to earn money from trading- selling their trees to other people, rather than on earning money from the trees themselves. As a result of this, little respect is shown to the valuation of trees.
So even if tree A is still growing at a good expected rate, its price is rising at much faster rate. Its total market value is already above 60 times the amount of present cash, but who cares ?
The odd ones who actually care, their rational voices are dismissed. Price charts and graphs are thrown around casually to justify irrationality. The argument is as long as there is growth, the price should keep increasing because that is what has been happening since past 15 years, so that should also happen in the next 15 years. Doesn’t matter if too much of coming future growths are actually already factored into the current price.
- By the 20th year, market value of trees have already reached so high, that many earlier investors don’t think the trees will ever be able to return that much money. The bubble has now started to form.
Some of them try to caution about the extreme valuations, but valuations are subjective they are told by other participants. The best they can do is sell their stakes completely and come out. Not that they would complain anyway, because the current price according to their calculations, is offering better deal than what they would get if they wait for the trees to grow fully.
But is this rational ? Are valuations really subjective ? Maybe yes, but only upto an extent. If an investment is expected to give a return of say Rs 50-80, I can understand if someone wants to buy it for Rs 25 and someone else wants to buy it for Rs 45. Heck I can even understand if someone wants to buy it for Rs 79. But I can never understand if someone buys it for say Rs 200 and then says “valuations are subjective” to justify this irrationality.
In this example however, this is exactly what seems to be happening. For instance, suppose a new investor buys 1% stake in tree A for much overvalued price x. If he never sells his stake, the only way to get return on his investment is from the tree itself, which is suppose say half of that or x/2. So the question is why would this investor buys for double the price ? The answer is, as explained earlier, he doesn’t care about this. He cares about the trading, he knows there will be some other person waiting to buy at even higher price from him. Even though, none of this makes sense.
The underlyings in this case, the trees, even though are wonderful assets but has actually no meaning or value now as compared to the price they are trading at. They are now merely trading assets. So what started as a wonderful tree market has now reduced to a giant ponzi scheme, where 1. The underlying has hardly any meaningful value and 2. The return on one’s investment does not depend upon the underlying asset but upon how much it can be sold to the other person.
I left this imaginary example here, you can conclude yourself what would happen in this story later. Do you think this ponzi scheme or bubble would sustain ? All such ponzi scheme bubbles are actually naturally designed to burst.
This post has already gotten long enough and I apologise for it. I will write my views, regarding whether the stock market is also a ponzi scheme or not, in my next post on this thread. Meanwhile, I hope if you can also put forward your thinking and views regarding the same. Also feel free to point if you think I have done wrong analogy.
P.S. The example above was the best I could think to present my arguments by drawing a parallel analogy between the hypothetical tree market and the actual stock market. It is obviously far from exact.