The Virtualization of Everything

The justification for the stock market is supposed to be that it is an efficient source of capital for entrepreneurs who need to grow their businesses, as well as a path to liquidity when these entrepreneurs need to sell their businesses. Indeed, before organized exchanges developed, raising capital or selling a business involved a complicated search for counterparts and suffered from a lack of competition among potential investors.

Great! But who are the modern-day counterparts, and what is their incentive to provide capital and liquidity?

They may be speculators, whose trading (or gambling) is made easier when the prices of companies’ shares are posted publicly and continuously. The idea originated with the early commodities markets. Farmers, for example, typically needed to sell their estimated crops ahead of the actual harvest, either to lock in attractive prices or to secure needed working capital. Their counterparts were either consumers of the products who also wanted to lock in what they considered attractive prices or, more frequently, pure speculators gambling that the price would go up. In fact, it has been argued with some credibility that speculators are an essential part of well-functioning markets, by providing liquidity and ready bids.

But I believe that there is another legitimate constituency for the stock market.

In a free economy, it is entrepreneurs who create wealth and generate the economy’s growth. Savers, who do not wish to, or cannot, be entrepreneurs, can participate in this growth and wealth-creation by investing along with entrepreneurs – in the stock market.

Today this may sound a bit theoretical. But when I entered the money-management business in 1969, it was much closer to reality. Many large or even medium-sized companies were directly or indirectly employing a significant proportion of the local population in “company towns.” Everyone either had worked or was still working for the company, or at least had friends and relatives working for it. Many locals faithfully used the company’s products. And it was not unusual that many also had known senior executives from a young age. Local savers routinely and naturally invested their savings in something they knew: the shares of the local company.

Lavish options were not yet widespread, but senior executives usually had accumulated some ownership of company shares. They, along with a large and loyal constituency of local shareholders, were much less vulnerable to outside influences than exist today: Activist portfolio managers, hedge funds, and large private-equity firms were rare. Share ownership was much more stable, there was much less turnover in the stock market, and the implementation of long-term business strategies was possible.

Of course, from its start in the ’80s, the growth of outside interference with corporate management was of a shorter-term financial nature: “You have too much cash on the balance sheet”; “Borrow more and buy-in your own shares”; “Return capital to shareholders”; etc. But this trend was much aggravated, in my opinion, by the concurrent development of “financial engineering” and, among an incessant flow of new products, the creation of many “weapons of financial destruction.”

I don’t recall the exact time frame, but it all probably started with options that were initially “covered” (i.e., supposed to hedge existing investment positions) – either to reduce volatility or to delay taxable capital gains – but soon were trading “naked” (i.e., without underlying positions in stocks). Then, asset-backed securities were invented: They could be more volatile or of lower quality than a plain vanilla bond, for example; but with the backing of an asset like the mortgage on a property, they were deemed to be more solvent while paying a higher rate of interest. Soon, more-complex securities were created, which allowed investors to purchase only the stream of interest payments from a bond but not the principal, for example. From there it was full speed into synthetic investments, which the Dictionary of Financial Terms (Lightbulb Press) defines as follows:

A synthetic investment simulates the return of an actual investment, but the return is actually created by using a combination of financial instruments, such as options contracts or an equity index and debt securities, rather than a single conventional investment. For example, an investment firm might create a synthetic index that seeks to outperform a particular index by purchasing options contracts rather than the equities the actual index owns, and using the money it saves to buy cash equivalents or other debt securities to enhance its return on the derivatives.

And, eventually but probably not finally, this trend led to the subprime catastrophe, largely responsible for the financial crisis and Great Recession of 2007-2009. Debt instruments had been collateralized with mortgages of widely different qualities, but which their financial engineers managed to have rated AAA (top quality) by the leading rating agencies. The instruments were so complex and had so many different “manufacturers” and distributors that it has taken months and years to find out who was entitled to what money – if any – and who owed that money.

Of course, there is no use crying over the past or fighting change and progress. In fact, some shaking-up of the comfortable status quo that the U.S. economy and financial markets had reached in the late 1960s was probably desirable. But I am concerned that, with the more recent virtualization and synthesizing of everything financial that has followed, the stock market has lost its close link to the “real” economy and has become more of a gigantic casino.

When I occasionally visit large trading rooms these days, I hear traders, some of whom could not even spell a company’s full name, betting millions of dollars on stocks that they identify only by their ticker symbol. As a matter of fact, just this morning (January 15), Business Insider reported that the penny stock of a traffic-equipment company with just 89 employees, called Nestor but trading over-the-counter under the ticker “NEST,” had surged 1900 percent because people confused it with NEST, the full name of a high-tech thermostat company that Google had just announced it was purchasing for $3.2 billion!

And I am also concerned that the broader public of savers and investors is overly impressed by the promises of guaranteed results and limited risks: the magical “black boxes” promoted by today’s financial-marketing departments. Many of these products cannot possibly be understood by a majority of their buyers. Just this week, we received the portfolio of a new client from a very reputable major institution, which cannot be suspected of trying to defraud investors. But confuse them?

One of the holdings in that portfolio was a “Buffered Accelerated Market Participation Security.” The (partial) explanation on one of the promotional materials retrieved from the Internet was as follows: [Obviously, this is not an offer to sell anything.]

For investors who seek a particular Market Exposure and who believe the corresponding Reference Asset will appreciate over the term of the Buffered AMPS, the Buffered AMPS provide an opportunity for accelerated returns (subject to a Maximum Cap). If the Reference Return is below the Buffer Value, then the Buffered AMPS are subject to 1:1 exposure to any potential decline of the relevant Reference Asset beyond -10%. If the relevant Reference Asset appreciates over the term of the securities, you will realize 200% (2x) of the relevant Reference Asset appreciation up to the relevant Maximum Cap. If the relevant Reference Asset declines, you will lose 1% of your investment for every 1% decline in the relevant Reference Asset beyond the -10% Buffer Value.

I am not sure that I fully understand how it works. But regardless, is this investing for the long-term by participating in the economy’s growth and wealth-creation?

I seem to remember, some time ago, an experiment where very young toddlers were asked to pick stocks. Obviously, since they knew nothing of the stock market, they picked stocks of games they played with; food they ate or drinks they drank; or their parents’ cars. Things they knew.

And they outperformed the market.

Maybe today’s would-be sophisticated investors should borrow a page from the Toddler’s Guide To Investing…

François Sicart


This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice, nor is there any guarantee that any projection, forecast or opinion will be realized.

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