By: Sam Vaknin
Editor-in-Chief, Global Politician
The securities industry worldwide is constructed upon the quicksand of self-delusion and socially-acceptable confabulations. These serve to hold together market participants whose interests are both disparate and diametrically opposed. In the long run, the securities markets are zero-sum games and the only possible outcome is win-lose: you lose, your broker wins.
The first "dirty secret" is that a firm`s market capitalization often stands in inverse proportion to its true value and valuation (as calculated by an objective, neutral, disinterested party). This is true especially when agents (management) are not also principals (owners).
Management`s compensation structure is often tied to the firms` market capitalization, so the firm`s managers strive to maximize the former (their compensation) by manipulating the latter (the price of the stock.) Frequently, the only way to affect the firm`s market capitalization in the short-term is to sacrifice the firm`s interests and, therefore, its value in the medium to long-term (for instance, by doling out bonuses even as the firm is dying; by speculating on leverage; and by cooking the books).
The second open secret is that all modern financial markets are Ponzi (pyramid) schemes. The only viable exit strategy is by dumping one`s holdings on future entrants. Fresh cash flows are crucial to sustaining ever increasing prices. Once these dry up, markets collapse in a heap.
Thus, the market prices of shares and, to a lesser extent debt instruments (especially corporate ones) are determined by three cash flows:
(i) The firm`s future cash flows (incorporated into valuation models, such as the CAPM or FAR)
(ii) Future cash flows in securities markets (i.e., the ebb and flow of new entrants)
(iii) The present cash flows of current market participants
The confluence of these three cash streams translates into what we call "volatility" and reflects the risks inherent in the security itself (the firm`s idiosyncratic risk) and the hazards of the market (known as alpha and beta coefficients).
In sum, stocks and share certificates do not represent ownership of the company that issues and sells them to the public. This is a myth, a convenient piece of fiction intended to pacify losers and lure "new blood" into the arena. Shareholders` claims on the firm`s assets in cases of insolvency, bankruptcy, or liquidation are of inferior, or subordinate nature. They rarely see a dime in receivership proceedings.
Stocks are shares are merely gambles on the three cash flows enumerated above. Their prices wax and wane in accordance with expectations regarding the future net present values of these flows. Once the music stops, they are worth little.
