The dangers of free stock trading

I noted recently the crazy things being done to inflate the stock market. It’s good in a way that the Fed and Congress are trying to keep Americans from feeling the oppressive weight of our economic collapse. We may have gotten a $1200 one-time payment and perhaps some extra unemployment compensation. But the biggest beneficiaries of government largess are clearly businesses, generally the large types.

But it’s not just any businesses. Small businesses may have gotten some short-term loans, but those that are publicly traded are getting huge shots of adrenaline thanks to government. The government has decided that markets are apparently too big to fail, so it’s going to insulate investors from its risks.

When markets begin to notice the actual underlying economy, the Fed usually comes to the rescue and creates a whole lot of money used to buy assets. This happened again just yesterday when the markets started to slip. With the supply of these stocks reduced, the price will artificially go up. This mostly explains why the stock market has nearly fully recovered from February and March’s downturns.

Along the way a lot of rich people got a whole lot richer. America’s billionaires added an estimated $434 billion to their fortunes during the pandemic. A lot of rich people were like me and saw the crisis coming when the first COVID-19 case was diagnosed. So they sold high and bought when prices were deeply discounted in March. The Fed was so alarmed by falling stock prices they righted the situation for them by buying stocks at inflated prices.

Most of us don’t directly own stocks. If we do, they are in retirement accounts and not easy to manipulate. I don’t own any stocks directly. They are all mutual funds and EFTs. Why? It’s because I seek safety in market trends. Buying in a pool limits risks, even if it may flatten rewards. Part of this strategy also includes not getting too overleveraged in any type of asset. Previously I was 50-50 on bonds and stocks. Now I am 60-40 bonds and stocks. So I made some profit from all of this, but it was a modest one.

Not so for our more moneyed class. Confident that the Fed will come to their rescue if things turn south, they are willing to buy and sell stocks directly. They look for drops like last week’s five percent plunge as a buying opportunity. They know the Fed will respond.

But there is arguably a new factor at work: millions of new day traders most of who arguably don’t know what the hell they are doing. Brokerages have generally stopped charging a commission to sell stocks. So anyone can now buy and sell stocks at no charge from their local smartphone. You don’t even have to buy full shares anymore. These companies will also allow you to buy fractional shares. So if you want to own just $5 in Amazon stock, you can do that. Since it’s currently trading around $2600 a share, fractional shares allow anyone to buy in.

These stock brokerages still make money. They make it from the cash balances in your accounts. This money gets loaned out, and I doubt it is FDIC insured. Some pay a tiny interest rate on these balances, like .01% APR. You could do a lot better keeping this cash in FDIC-insured banks instead, and there are some like Ally Bank (that I use) that pay a respectable interest rate.

Some Americans, particularly those doing reasonably well, saw their $1200 stimulus check as a reason to dabble in day trading. This “play money” has become investment money and may also be contributing to the high valuation of stocks at the moment. It’s arguably led to some crazy things. Lots of people are investing in bankrupt companies like JC Penney and Hertz, pushing up these stock prices when they may be dissolved and the stock could become worthless. “Sexy” stock tracking symbols also seem to be disproportionately overvalued. Some investors see a sexy stock symbol and with no other analysis figure they should own some of it.

So I’m not too surprised given that the Fed won’t let markets collapse and that people can now easily buy and sell stocks with no fees that markets are doing so well. At some point though you have to wonder if this house of cards will collapse.

Last week’s drop shows that investors occasionally wake up and realize, “Gosh, these stocks I own are risky and way overvalued! COVID-19 is not going away and we are in a deep recession that seems to be here for the long term. I should sell!” And they do until the Fed comes to the rescue again.

But at their core many of these assets are minimally wildly overpriced and are arguably junk. I sure wouldn’t be buying in financially stressed companies like Carnival, Delta Airlines or Hertz right now. Maybe I would buy some Delta stock if I were looking twenty years down the road. It is the world’s largest airline carrier so if any airline is likely to survive the crisis, it will. Some are betting the same with Hertz: it’s one of the original car rental brands, and it’s everywhere so even though it’s in bankruptcy court, it has to survive somehow and eventually be profitable, right? The government won’t let it fail, right? Well, maybe. But it remains a risky investment because demand has collapsed and the company is wildly overleveraged.

Or it could be that our economy is being wholly upended and that includes our markets too. It makes sense that some companies, like Amazon and Walmart, are doing so well. They are relatively well positioned to prosper in a new economy where delivery to the home can be done profitably. Investing in companies should be based in part on their agility, as well as a healthy cash balance sheet.

Yet so many companies are overleveraged with debt and offer a business model equivalent to the milkman of a hundred years ago. Investing in these companies is risky. I wouldn’t do it, but our smartphones let us make micro mistakes like this every day, at no obvious short-term cost.

Sell

I won’t claim to be an economist or financial wizard. I don’t bother to try to time the stock market. I buy in mutual funds in good times and bad times, hoping that general growth in mostly proven funds will mean I won’t eat dog food in retirement. So I was buying in March 2009 when stock indices reached their Great Recession bottom and I am still buying funds today, albeit steadily and incrementally.

That’s one way to make money in the stock market: keep buying in good times and bad and count on general growth for appreciation. That’s the boring and safe way to make money from the market, as long as you do it in the long term and keep plugging away. Hopefully you are not buying crappy stocks, funds and bonds, but ones with decent track records for beating the market.

The other way to make money is to follow the maxim: buy low and sell high. The smart people with capital were doing just this in March 2009. They were fearlessly investing while others were willing to part with their stocks for just about any screwy lowball price others were willing to bid. Oh my God, the world is going to hell. Gotta turn this stock into cash right now and maybe survive the next Great Depression. That was the wisdom of those times, just four years ago. People were chasing their fears and their fears told them to horde cash. As I noted in June 2009, stock in the bluest of blue chips, General Electric, briefly fell below $6 a share that month. GE, like many stocks, was crazily undervalued. Those with cash and nerve should have been telling their brokers to buy GE in bulk. If they had, and I wish I had enough spare cash to buy it, they would be sitting pretty right now. On March 5, 2009 you could buy GE common stock for $5.88 a share. Today four years later it closed at $23.67 a share. That’s an appreciation of 403% in just four years, or 100% appreciation per year, on average. It was, as I said then, a crazily great investment. Granted this is not as high as GE stock has ever gotten. On June 22, 2001 right before the tech sector collapsed GE traded at $51.86 a share. It was crazily overvalued then.

Most likely GE stock and the market in general are suffering now from irrational exuberance as well. Stock prices are inflated, largely because the Federal Reserve is keeping interest rates artificially low. While the Fed has no immediate plans to change this policy, you know it cannot last forever. In fact, some are speculating that even if the Fed continues to keep interest rates low, the market will correct this artificial imbalance through inflation. Inflation happens when too many dollars are chasing too few tangible assets. With nowhere else to put money in hopes that it will grow, people are buying stocks. This tells me that stock prices are inflated. But also I can sense they are inflated. I can tell from the anemic growth in our GDP, the 7.7 percent unemployment rate and median wages that continue to fall. While increasing stock and home prices will help stimulate growth, if it comes it will come much later, and it is likely to only help stocks reach their current valuation, not actually meet their current valuation.

March 2009 was, in retrospect, the time to buy and hold. Arguably, March 2013 is the time to sell and profit. Convert that valuation into cash, while other irrationally exuberant buyers are willing to buy your stock at inflated prices.

Of course if you followed the crowd and sold stocks and funds in 2009 and are buying them now again in 2013, you are guilty of two things. First, you are guilty of being like most everyone else: following the herd. There is some comfort perhaps in that you were not alone because your neighbors were doing the same thing, which is one reason their net worth (and likely yours too) fell. Second, you are being stupid a second time. You are the bottom fish that the bigger fish are about to consume. They are picking your pocket, not the one you have now, but the one you think you will retire on. You are buying what is likely to be overvalued stock in the long term. Why are you doing this? You are probably doing this because you cannot make a decent return for your cash by having them in savings and money market accounts. You are frustrated and you see the stock market surging up 26% in one year and you are thinking, “I deserve a piece of that action”.

And you do, but you are probably chasing an illusion. There is a stock market correction coming. I cannot tell you if it will be this month, this year or five years from now. But it’s not too hard to see that it is coming. Economic growth is anemic and profit depends on growth. Growth also depends on people having more money to spend. While the rich do, they are a tiny part of the populace. People like you and me are probably watching expenses like a hawk.

What do you do if you have been following the herd? My suggestion is to stop buying stock, most of which is dramatically overvalued at the moment, and put that money in a cash account for future investing. You are unlikely to get much appreciation for your investment, but you are likely to lose money buying stocks. Wait for the next market correction, when the stock indexes have lost a third or more of its value. Then steel your nerves and buy, probably in blue chip stocks. Then hold and sell many years later when the signs are clear the market is overvalued again. That’s when you lock in the profit.

If you did buy GE stock in bulk in March 2009, you are probably smart enough to do what you are already doing: selling it and converting it into cash for future buying opportunities. In general, if you have genuine appreciation for your stocks and bonds as a result of buying them low, now is the time to lock in your profit. Profit may also be found in selling your house. In most markets it is a seller’s market and prices have fully recovered from the Great Recession. If this is true in your area, your house is mostly equity, and you want to lock in that wealth, selling your house may make sense. (Of course there may be capital gains and other tax implications from doing this. Consult a financial adviser before doing this.)

Will I be doing any of this? No. As I mentioned, I don’t time the market. I invest regularly and I invest long term. If you are not this kind of investor though, look at your portfolio carefully and note those funds that now are valued significantly more than what you paid for them. Unless there are some special circumstances for these particular stocks and funds for future growth, now is the time to sell them and convert them to cash. Most likely you will find this to be a very profitable experience.

Where did all my money go?

Those of you who dared to read your brokerage statements probably have the same question that I did. Where the heck did all my money go? Some of my mutual funds are worth half what they were two years ago. Given the current dropping stock market, I am likely to see further losses in many of my funds.

If I had put my money into AIG stock then yes, I would expect to be able to get just pennies on the dollar. However, I own mutual funds. The whole point of owning mutual funds is to spread out the risk. Some stocks in the portfolio are bound to suffer but it should not matter because other funds will gain. It should all balance out somehow.

The short answer is that the financial industry came down with a bad case of the flu. Pretty much all of them are in the hospital and are being pumped with fluids from the U.S. Treasury and the Federal Reserve Board in the hopes that they will recover. Then they can resume that voodoo that Wall Street used to do so well: showing regular returns for investors.

This begs the question: how did they all come down with the flu and the same time? Here too we sort of know the answers. As best this non-economist can figure out there were two root causes. First, the Federal Reserve Board under Alan Greenspan had a low inflation policy, even at the cost of keeping credit artificially cheap for unusual lengths of time. This had the effect of encouraging borrowing and made it possible for many of us to live far beyond our means. This helped facilitate the second root cause: ever more complex financial securities tied to cheap credit provided to risky borrowers. They became popular because they required no government review. They had the effect of hiding the risk of investing in these securities while giving the cash-rich places to invest money that would otherwise go under a mattress or earn next to nothing in a bank account. They looked reasonably safe because they were packaged like a mutual fund and thus presumed less risky.

Like someone whose diet consists of nothing but nachos and cheese dip, there is eventually a day of reckoning. One day you find your bowels obstructed, your blood pressure high and your cholesterol levels are through the roof. The world now has all this and more. We gorged ourselves mindlessly on bad debt. Our coaches (Congress, President Bush and the Federal Reserve) encouraged us to consume even more nachos and cheese dip. Now we weigh five hundred pounds and can hardly move from side to side in our hospital bed. In fact, the orderlies are having a hard time moving us to change our bedpans.

It is technically possible for a five hundred pound man to get back to a slim one hundred fifty pounds with a diet lasting many years, but the odds are heavily against the patient. Once you are used to a diet of nachos and cheese dip, it is hard to eat salads. You might think though that those who are providing us the food might be at least providing us with healthy food. As best I can tell, when it comes to the financial industry, with some caveats, the answer is you are allowed to serve as much junk food as you want.

I looked up what it took to establish a bank in Virginia, the state where I live. You definitely need a lot of starting capital. You also need five directors who set the bank’s policy. In addition, you need to hire a CEO. Virginia does not specify criteria for such a manager, although it suggests:

a suitable background and adequate training, a strong, well documented record of accomplishment in banking at a comparable level, a capacity for leadership, familiarity with the current banking environment, analytical ability, and a realistic outlook.

State chartered banks in Virginia also are required to undergo a “supervisory examination” no less than every three years. However, the state does not actually audit the bank. In fact, it goes out of its way to calm potential fears of the bank owners:

Although in some instances fraud has been discovered during the course of a supervisory examination, detecting dishonesty is not a primary purpose of an examination. An examination is concerned with a bank’s financial condition, its compliance with the various laws and regulations and the soundness of its operating policies; it cannot be relied on to detect fraud and embezzlement.

Presumably, before a bank charter is approved, Virginia will at least give it a sniff test to see if it smells, but it is clear that in Virginia’s case bank supervision is mostly superficial. Moreover, there are no requirements that I can find that the bank’s managers must have actual banking education. (I was hoping for something more than “I know how to use Quickbooks”.)  On the federal level, most banks choose to be FDIC insured. Presumably, this brings some federal scrutiny, but clearly not enough to keep many of these institutions solvent. Even if the criteria are clear, enforcement can be problematical. Moreover, as the Washington Post reported recently, banks can and do “shop around” for friendlier bank regulators. It suggested that the federal Office of Thrift Supervision is one of the more lax federal banking regulators.

If my limited research is correct, banks can be managed and run by people who aren’t necessarily even qualified bankers. Even if they have experience in banking, it is not clear that they need a level of certification to be a banker. I would think the criteria for any banker would include being an accredited Certified Public Accountant. Presumably, a banker needs to know more than a CPA and should have a broad understanding of financial risk, credit worthiness, assets to debt ratios and the like. Maybe they do but apparently, most were asleep during the lectures in MBA School, as they gorged their balance sheets with dubious toxic assets, which were never accurately valued. Given that so many banks are teetering on the edge of insolvency, it is reasonable to think the problem exists both nationwide and worldwide.

Banking regulation may be scattershot but at least it exists. On Wall Street, apparently all sorts of new and creative financial instruments can be created with no government oversight. The Securities and Exchange Commission has many powers, but Congress limits its powers (and budget). Indeed, until recently we wanted to free Wall Street from the tedium of government oversight. By doing so, it was believed that they would be free to whip up the magic of the free market. I understand that if you do not manage a herd of cattle they tend to overgraze or could come down with ailments like Mad Cow Disease. The same appears to be true on Wall Street. All things being equal, Wall Street will look for ways to line their own pockets first and their shareholders’ second. This appears to be exactly what happened.

Where did all my money (and yours) go? Much of it went to buy stocks and funds at prices that were way too high because they were not accurately and independently valued. Much of it also went into the pockets of swindlers on Wall Street who used the money to buy estates in the Hamptons, private jets, and luxury yachts. The federal government largely looked the other way. We investors largely looked the other way too, assuming that we were “safe” if we spread our risk by doing things like investing in mutual funds. However, primarily it was those we entrusted with managing our money that deliberately looked the other way. They were anxious for a big bonus for making quick profits rather than to looking out for the long-term needs of investors. Take my financial adviser. He is a bright guy. He knows how to find a good bet on a mutual fund. Nevertheless, he like most of them was clueless about the size and scope of our current financial disaster. He should not have been.

Supposedly, animals know when an earthquake is coming and move to safer ground. Our financial industry needs to be like this. Our bankers are fiduciaries of a public trust: our money. They should all be certified to the highest standards, maintain current credentials and demonstrate their financial acumen by showing that their funds are invested prudently. They should take an oath to such effect, go to prison if they do otherwise as well as have their personal wealth returned to their customers in the event they fail.

Similar criteria are needed for fund managers. Before creating any fund, they need to demonstrate to the government that the fund accurately states the risk of ownership. Rating firms similarly need to be impartial; in fact, they should be nationalized. Our money is too important to leave its valuation entirely in the hands of the free market.

In short, these investments belong to those who own them. Fund managers are fiduciaries with a solemn obligation to act prudently in the best interest of the owners. Funds are not funny money; they represent real dollars and reasonable expectations of future income. Since they deserve a high level of scrutiny and oversight, these fund managers need sterling credentials, certifications and regular oversight too. As for new financial instruments, they should get an impartial government examination before they are allowed on the market.

These are the sorts of long-term steps we need to take to ensure we are never caught with our financial pants down again. Anything less means that we will see similar debacles like this again.