The Rules, Part XXIII

A Ponzi scheme needs an ever-increasing flow of money to survive.  Same for a market bubble.  When the flow’s growth begins to slow, the bubble will wobble.  When it stops, it will pop.  When it goes negative, it is too late.

Here’s how a Ponzi scheme works for the promoter:

Prior Net Assets + Receipts + True Investment Earnings (if any)  – Withdrawals – Expenses = Net Assets

But this is what it looks like to the investor:

Investor Prior Net Assets + Receipts + Reported Earnings – Withdrawals = Investor Net Assets

The investor’s view of the assets is higher than the actual assets by the cumulative difference between reported and true investment earnings, and cumulative expenses. The promoter wants to keep the good times rolling, and keep the ratio of actual to investor net assets as high as possible.  But to do that requires additional receipts, and a lack of withdrawals, which in turn requires an attractive reported rate of earnings, higher than what could be ordinarily achieved. But the higher the reported rate of earnings goes, the further behind the promoter gets.  Also, at very high levels, the authorities take interest.  At very low levels, the Ponzi dies.  Part of the evil genius of Madoff was striking the balance.  He also did four other things:

  • Soft-peddled the marketing so that it was like joining an exclusive club.
  • Discouraged withdrawals by saying you would not get back in (for some).
  • Deluding regulators into thinking that it was a front-running scam.
  • He did not rake off much.

Most Ponzi schemes die rapidly because of the greed and impatience of the promoters.  All Ponzi schemes eventually fail. So how does this relate to market bubbles?  With a market bubble, the increase in market values significantly exceeds the increase in intrinsic values.  This could be due to a number of factors:

  • Players see that borrowing to chase a rising asset is a winner.
  • Promoters make it easy to do for inexperienced investors.
  • An easy monetary policy lowers financing costs, aiding bubble financing.
  • Players seek stock gains, and disdain debt claims.
  • At the end, investors have to feed the asset to keep it afloat, giving up current income to support the “asset.”

Positive cash flow into the bubble asset class supports valuations for a time, the cash flows driven by momentum, but eventually positive cash flows are overwhelmed by negative cash flow from an overvalued asset class. My advice: avoid speculating on momentum, particularly after it has gone on for a few years.  Put a margin of safety first in your investing, such that you will always be around to invest in the future, no matter how bad the  investment environment is.