In a traditional Ponzi scheme, early investors are paid out with later investors investment flows. As the number of investors grows, it requires more new investors to pay out earlier investors when they liquidate their holdings to realize their (unknowingly fraudulent) gains.
In this way, the flows into the investment are critical to keep the Ponzi going.
In the stock market, the flow dynamics are the same as in a traditional Ponzi scheme. For the sage advice of “buy low, sell high” to work, later investors have to stand ready to take out early investors who are selling.
The difference is that in a true Ponzi scheme, there is nothing real behind it. The Ponzi promoter is a fraud and the so-called investments are a fraud. In the stock market, there are real companies with real assets and cash flows behind the investments.
A “normal” stock market is what I would call a participant market and not a Ponzi. It is still subject to the same flow dynamics of a Ponzi scheme, but if it has discriminating buyers, freely fluctuating prices, viable alternatives, and no supply constraints, it will police itself because participants won’t trust it. They can, and will, go elsewhere if better opportunities arise.
Because of these constraints, a “normal” participant market fails periodically, and investors are reminded that it is not to be trusted.
I want to keep these flow dynamics in mind as I introduce the idea of a “Participant Ponzi”. However, before I explain what a Participant Ponzi is, we must first make a short detour to examine the greatest Ponzi scheme of all time.
The Genius of Bernard L. Madoff
The most famous Ponzi scheme was run by the eponymous Charles Ponzi. In it, he was promising 50 percent returns in 45 days. To pull off such remarkable “returns” requires exponentially larger flows into the scheme in order to redeem earlier investors.
This is the pattern of most Ponzi schemes and the reason they all ultimately blow up, usually in short order. Once the inflows become overwhelmed by the outflows, it’s over.
However, Bernie Madoff invented a better Ponzi scheme. Instead of promising 50 percent returns in 45 days, he promised 80 to 100 basis points per month. It worked. Not only did it reduce the amount he had to pay out to investors redeeming their investments, it discouraged them from redeeming at all. This was the secret sauce of the Madof Ponzi scheme, and what allowed it to continue for so long.
The steady returns were seductive and could be justified as in-line with historic returns, even if their consistent nature was a 100 standard deviation event (i.e. like getting hit by lighting 20 years in a row, each time on your birthday).
The steady “returns” made the Madoff fund the last investment anyone would sell, and it worked until the Global Financial Crisis hit and Madoff investors redeemed en masse to meet their own cash flow needs when their other, non-Ponzi, investments were down 50+ percent.
I highlight the Madoff Ponzi because the stock market has taken on many of the same characteristics.
The Participant Ponzi Scheme and Conditions
In a Participant Ponzi, the participants play the role of the “fraudster”. They redeem earlier participants with their own money and this keeps prices high, which encourages more people to become participants and reduces the number of sellers. This is the exact dynamic of the Madoff Ponzi.
In any environment, if the market declines, it is because earlier participants are exiting and current buyers are not able to absorb those negative flows. If there were no new inflows, the market would decline further and more people would exit, in a negative feedback loop.
However, in a Participant Ponzi, the participants stand ready to buy stocks whenever the market falls. (The buy-the-dip philosophy.) Over time, this discourages outflows because sellers become accustomed to the dip being bought and know it is a losing trade. If participants sell, they know they will just have to come back in at higher prices later.
Investors participate in a Participant Ponzi because they believe prices will continue to rise. This thinking is rational because, like all Ponzi’s, it has worked up until that point. What the participants don’t realize is that they are the reason the prices have continued to rise. In this way, they are the unwitting “fraudsters”.
As long as early investors can continue to get out at higher prices, it works. However, in order for a Participant Ponzi to work, a few conditions have to be met:
- One or more sources of consistent, indiscriminate buyers (i.e. valuation indifferent);
- Steadily rising prices with no sustained or extreme drawdowns;
- Supply constraints, and;
When these conditions above are met, the Participant Ponzi becomes self-fulfilling and all the forces align to propel the market higher.
The Sports Franchise Participant Ponzi
There have been other Participant Ponzi’s, most notably in sports franchises. In these investments, owners are often willing to suffer a negative carry (in the form of ongoing operating losses) in order to realize capital appreciation. Since sports franchises are the ultimate trophy property, there are indiscriminate buyers, there have not been sustained or extreme drawdowns in price, there are hard supply constraints (which the existing owners control), and there is rationalization in that prices have always risen.
However, there has never been a Participant Ponzi as big as the one we are currently witnessing in the U.S. stock market.
In my next post, I will explore
the current Participant Ponzi and how it has developed.
 A basis point is 1/100th of one percent. Thus 50 basis points is one-half of one percent.
 I am not here saying that investors are doing anything fraudulent or illegal, only that from a flow perspective, they play the role of the fraudster.
 See Aswath Damodaran, The Sporting Business: Value and Price; Available at: http://people.stern.nyu.edu/adamodar/pdfiles/country/MITSportsPresentation.pdf; Accessed May 13, 2019. The percent of sports teams with negative EBITDA was 37, 3, 13, 37, and 20 for MLB, NFL, NBA, NHL, and European soccer, respectively.