I’ve always heard people refer to the stock market as being rigged and/or a scam. But is there any truth to this? I’m gonna lay forth my argument and let you decide for yourself. I find it pretty interesting that the people I’ve heard say this are usually people that don’t really understand the markets. They’ll go as far as to compare trading and investing to shooting craps in Vegas. I will admit that there are some who implore tactics that could be likened to gambling, but here we’re going to be discussing the subject matter at hand.
So — the question is: Is the stock market a rigged game? Before I can entertain that question, here’s a story I heard some time ago. The person stated that the stock market was setup for the wealthy to speculate on shares of companies and after they realized a profit on their investments, dump their shares on the unsuspecting public. My response? Yeah — that’s pretty much how it works but that’s only half the story. You have two groups of players in the markets, the informed and the uninformed. Informed refers to the wealthy investors and those in the know, usually the institutions. Uninformed refers to the general public who have no idea what’s taking place on the inside. The uninformed is the only who’s usually left holding the bag after the informed liquidates their winning positions. FYI: For the remainder of this article, I’ll reference both crowds as informed and uninformed.
How could the informed continue to unload their investments on the uninformed, especially for so long? This is because the uninformed, for the most part, don’t understand the market or the business cycle. Let me explain briefly and simply what both cycles are. The market cycle is made up of four periods: accumulation, markup, distribution and markdown. Let me elaborate briefly on each.
1. Accumulation: During the accumulation period in any market, institutions are slowly buying over a period of time. They buy in a way that makes prices look dull and uninteresting. As it relates to the business cycle, this typically occurs during a period of recession after the economy has hit rock bottom. The price of everything is cheap and the informed who’s usually sitting on cash will start accumulating assets.
2. Markup: This is when the price of those accumulated investments begin to rise. In the business cycle, this is referred to as the expansionary phase a.k.a recovery which occurs after interest rates are lowered in order to stimulate the economy.
3. Distribution: The distribution phase is when the institutions begin to slowly scale out of their investments. Why slowly? Because they don’t want to create a panic of selling. This is also when you begin to see bullish stories in the media about a market. The public sees these stories and begin to buy into that market. This is perfect for the informed players because they now have willing buyer of the instruments they wish to unload. The public hears of a rising market and decide that they want to start buying as well. After all, the markets are hitting new highs, right? So it has to be a sure thing! And the institutions are more than happy to sell their holdings to them. Not only do informed sell their positions, they’re also short selling during this time. During the business cycle, this is when the Fed begins to raise interest rates, thereby tightening the money supply.
4. Markdown: The markdown phase refers to the period when the market begins to sell off. The business cycle refers to this as the contraction phase. The uninformed (the public) who was once enthusiastic about their investments begin to watch in dismay as the price of their investments take a nosedive. This is because they bought at the top of the market and the informed is now selling as fast as they can. I mentioned earlier that the informed usually initiates short positions during distribution periods, but it is during the markdown period that they realize great profits on their shorts!
That’s always how it goes and as you can see, the uninformed is always too late. But why is the uninformed always too late? Wouldn’t they have learned their lesson by now? Well — the uninformed usually has a bad habit of listening to the noise in the markets. Meaning, they listen to the financial media, their friends, and anyone else. But little do they know, by the time the news of a rising market hits the public, the move is almost over. News usually doesn’t hit the public until the major players decide that they want to liquidate. In fact, that’s the main reason that the news even broadcasts those stories, to entice the public into buying so that the major players can have someone to buy their holdings. But all in all, the public listens to those sources and get blindly involved.
Speaking of the financial press, it’s not uncommon for them to report one thing while something completely different is actually taking place. For instance, in the beginning of 2013, the press was pushing the idea that the fiscal cliff deal could send the markets plunging. Many people bought into that idea and began shorting everything they could find. On the other side of those trades were the institutions, who knew ahead of time that there would be no collapse. In the end, short sellers were punished because the market continued to rise and is still rising as we speak. To counter an impending collapse, many people were buying gold futures and ETFs. But since there was no collapse, gold plunged from a December high of $1,755 an ounce down to it’s current price of $1,338 — gold dropped as low as $1,179 in July of this year. Investor John Paulson (who gain notoriety to his $10 billion dollar profit by betting against the subprime crisis) lost $736 million on his gold bet.
Let’s now discuss the role that the institutions play in this. It is also not uncommon for institutions to sell securities to an investor and to also bet against that same security. This doesn’t have much of an effect on the small investors because institutions are only interested in taking money from other institutions. Goldman Sachs, JP Morgan, Hedge Funds, etc. aren’t worried about taking money from Joe Smith who’s at home trading with an account size of $50,000. They want to take money from other multi-billion dollar institutions. To do this, they sell securities to those other investors and take the opposite side of that trade. This is what occurred during the subprime crisis of 2008. In short, they sold mortgage-backed securities to other investors and were also betting against those same securities. When the market went south, they made a killing. It’s pretty much the same way when small traders deal with their brokers — their brokers will take the other side of a Forex trade or a Futures trade hoping to profit from the spread AND a losing position.
Which leads me to now discuss….. Some have also accused High Frequency Traders of making the stock market an environment that is rigged for certain players to win. But this is nonsense because HFT firms usually buy millions of shares of stock and hold them for a few seconds in hopes of getting a move of a few cents in their favor and will dump the shares. It hardly sounds like HFTs are rigging the stock market. This may affect day traders but not someone who trades a longer time frame. The way I see it, HFTs actually provide liquidity. It is because of them and other market markers that a person can get in and out of a position so quickly.
Conclusion: Is the market rigged? I wouldn’t say that the market is rigged in the sense that its set up for only members of a certain group to win. If that were true, there wouldn’t be any wealthy small traders and investors.
By the way, when I say “small traders/investors,” in terms on Wall Street, this could refer to someone who’s a multi-millionaire since the big players on Wall Street start in the billions. What it comes down to is learning how market cycles work. That way, you will know when to be in the market and when to be out (or you’ll know when to be long or short since you can make money when the market is rising or falling). It would also help to stay away from the financial media because it’s all noise. Don’t get me wrong, I do check the news around the world and so do many other players but I don’t trade based on what they report. And that is the mistake that many would-be traders and investors make, that of trading based on what they’ve heard on CNBC. Some talking head may have been hyping up a particular stock and people rush out in droves to buy it for no reason other than a guy on CNBC talked about it. It’s just best that you do your own research and manually keep track of economic indicators. By doing that, you will be able to form your own analysis of where the markets may be headed and make wise decisions.