For a More Stable Stock Market

The stock market is an ideal place to save for retirement. Over long periods of time, stocks pay more than bonds, CDs or other interest-bearing instruments. This is as it should be. Any fixed income security must base its payout on a conservative estimate of corporate revenue or other underlying income source. Stocks capture the windfalls, the home runs. Since windfalls are hard to predict, you have to invest over a long period of time to have good odds of cashing in on them. Long periods of time are the name of the game for retirement. The arrangement is ideal…

Ideal as in idealism or ideology, alas. In the real world stocks crash. One could work around this bug with a diversified portfolio of stocks save that the crashes are often correlated; the entire stock market can plummet from time to time. For the young a stock market crash can be a good thing: a crash is a sale on corporate equity. But for those of us with greying hair, the prospect of a market crash is frightening indeed. It’s enough to send one off shopping for annuities, or a congressman amenable to raising Social Security benefits – and taxes.

Take that, young whippersnappers!

George W. Bush spent his post 9/11 political capital trying to partially privatize Social Security. The proposal took off like a lead balloon. Small government conservatives take note: if you want to privatize the retirement system you either need a right wing dictatorship a la Pinochet, or you need to do something to stabilize the stock market.

Fortunately, the latter option is easier than you might think.

Cutting the Positive Feedback Loops

Stock prices fluctuate. They should fluctuate. Opinions on the value of a corporation’s equity change with economic conditions and management decisions. We don’t need laws limiting how much a corporation’s stock price changes in a day. And we don’t need to eliminate computerized trading, derivatives, or other bugaboos du jour.

We do need to gently discourage momentum trading. Momentum traders make the market behave like an underdamped filter (think car with bad shock absorbers).

But more importantly we really need to crack down on is positive feedback in the market. Positive feedback makes the market downright unstable. The market goes from being an allocator of capital based on distributed knowledge to a game in and of itself – an expensive game that can wreck the economy and make socialism look like a good idea.

Today, we offset positive feedback with mounds of regulations and armies of regulators who are tasked to be disinterested, benevolent, wiser than the collective knowledge of the market. The results are predictable: the stock market was made useless as a capital source for small corporations, and it continues to crash anyway.

We can do better.

The Evils of Margin Buying

The catastrophic stock market crash of 1929 can be traced to one practice, and one practice only: stock buying on thin margins. This is not to say that there weren’t other factors driving the stock market bubble of the 1920s and subsequent crash. I won’t claim that Federal Reserve policy was optimal or even acceptable. Nor will I defend the Smoot-Hawley Tariff Act or other policies of the day. We were probably due for a recession even without margin buying. But without highly leveraged margin buying the stock market crash would have been nowhere near as bad what happened in our timeline.

Margin buying adds positive feedback to the market. Once you have positive feedback, any external driver – be it drought, diplomatic crisis, or Federal reserve policy – can wreak havok on the market. Back in the 1920s you could buy stocks for 10% down. If a stock traded at $10/share you could pick up a share for merely a dollar. If the price went up to $11/share, your equity doubled, and you could buy another share. Every 10% uptick allowed you to double your position! Stocks became more affordable as the price went up. This is diametrically opposite to the negative feedback loop Adam Smith described with his Invisible Hand metaphor. As a result, the stock market of the 1920s did not behave as a self-regulating system.

What goes up, must come down. When a stock went down in 1929, those who maxed out their leverage were subject to margin calls. They were forced to sell. They were bullish on the stock and selling with both hands – so much for the market reflecting the collective knowledge of its participants. The more affordable a stock certificate became, the more certificates were put on sale. The bubble popped, and many traders went bankrupt, unable to pay back their margin loans. Bank failures followed. Capitalism became unpopular.

Today, ordinary investors have to put down 50% to buy stock and must maintain at least 25% equity in order to avoid a margin call (see here). The markets are more stable than they were in the 1920s, but still not stable enough to replace Social Security.

The Evils of Short Selling

Short selling is not evil because it pushes stock prices down per se. When a stock is priced too high, it should be driven down, and those who do the driving should be rewarded accordingly. Short selling is evil because it too introduces positive feedback into the market – much like margin trading. Indeed, short selling is a form of margin trading, where the trader borrows stock vs. money to buy stock. Otherwise, the dynamics are similar.

If you short a stock and the price goes down, you now have more equity which you can use to short the stock further. The more a stock price goes down, the greater the supply of stock for sale on the part of short sellers. Once again, we have a dynamic opposite to Adam Smith’s Invisible Hand. (With an uptick rule in place, the positive feedback is dampened a bit. Equity goes up as a stock goes down, but you cannot use that equity until the stock comes back a bit.)

What goes down can pop back up. Should a stock rise in price after short sellers have maxed out their equity, the shorts get a margin call and have to buy. For thinly traded penny stocks, this can produce dramatic short squeezes, where the price can go up severalfold as traders bearish on the stock are forced to buy. Once again, we have the exact opposite of price discovery.

Discouraging Debt-Leveraged Stock Trading

So, should we outlaw margin trading and short selling outright? For low capitalization stocks the answer is a screaming “Yes!” If the SEC doesn’t quash the spirit of thethe 2012 Jumpstart Our Business Startups Act with overregulation, then the predators will converge. If we create a special set of rules for the resulting micro cap stocks which completely forbids all margin trading and short selling, we can safely live with deep-pocketed traders manipulating prices. Bid up a share price through aggressive buying and all you’ve done is given a windfall to those who got in earlier. Dump your shares and you are simply holding a fire sale on your investments. Reglators can focus on the crooks who issue shares in bogus companies.

For the bigger cap corporations we might not be quite so heavy handed. A couple of nudges from the tax code might suffice:

  1. Eliminate the tax deduction for margin interest. Treat debt based stock buying the same way we treat running up your credit card or buying a new car with time payments.
  2. Treat borrowing against an appreciated stock as capital gains realization. When you borrow against the value of your stock portfolio, you are tapping into the benefits of any appreciation. It’s time to pay the tax man. This hits especially hard if we treat capital gains as ordinary income as I propose with The Simple Income Tax. (Of course, we also set the cost basis upwards when we do this, leading to lower taxes in the future when the stock is finally sold.)

We probably needs some dampers on margin trading by investment banks and other institutions, but I have to do my homework before making any serious proposals. While I have read plenty on stock trading and personally lived the nightmare of owning a declining stock on margin, I have yet to do any investment banking. More to come later.

A Boring Stock Market?

Without leverage, stock trading becomes rather boring. For those building their retirement nest egg, this is a good thing. For professionals traders it is not.

I could be a grumpy puss and tell the professionals, “Too bad. If you want to gamble, go to Vegas.” But I won’t. A more interesting stock market gives professionals reasons to do research. And if traders aren’t making money off small market movements, the market will get choppier – like an over-damped filter, to put it in signal processing terms.

Fortunately, we can safely allow highly leveraged trades through stock options – as long as the options are fully covered. I’ll detail the mechanics and conditions in a future article. Stay tuned.

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