There are a lot of conspiracy theories about the stock market. Some suggest that the market is “rigged”. These theories are largely untrue, but some have merit. In this article we share common reasons some people believe the stock market is unfair and evaluate the evidence to determine if these concerns are justified. We begin with a brief history on the rights of minority shareholders…because like most everything with investing…our views are shaped by the past.
Minority shareholder rights…a history
The stock market is arguably the most valuable financial innovation of the past three hundred years. The Dutch East India Company was the first company to offer shares of its business to the public. It held the world’s first initial public offering (IPO) in 1602 and paid a regular dividend that yielded from 12% to 63%.
What made stock such a powerful innovation was that it provided, for the first time, a way to own part of a company that you did not manage. Prior to the Dutch East India Company you could only own part of a a company that you created or bought outright from someone else. It is hard to overstate just how transformative this innovation was…but it took a while to really take root.
Two major challenges prevented widespread of adoption of stocks as an asset class until after WWII. The first was the legal innovation of limited liability. The second was a series of minority shareholder rights and protections which were largely created during the Great Depression.
Limited liability protects company owners from losing their private property not associated with their company in the event that their business fails or they lose a lawsuit. English law began establishing limited liability protection for some trade guilds by the 15th century. Limited Liability was granted to the Dutch East India Company so that it could more easily allow transferable shares and separation of ownership and management. Limited liability was given to both shareholders and managers allowing both parties to engage without fear of losing all their life savings.
Widespread adoption of limited liability protection picked up steam with t he world’s first modern limited liability law enacted by the state of New York in 1811. The Joint Stock Companies Act 1844 make incorporation into “joint stock” companies, meaning they could sell shares to those not running the company, far easier in England. But it took the Limited Liability Act 1855 to give minority shareholders in the USA, although investors in such companies unlimited liability.
Without fear ruin from partial ownership in a company…investors could still easily lose whatever they invested. Railroad companies were an early adopters of the joint stock model. Railroads often made up more than 80% of the total US stock market capitalization in the 1800s. This concentration made diversification extremely challenging. Accurate estimates of losses from events like the Great Railroad Strike of 1877 are hard to find but its safe to say that many investors lost everything.
Investing in stocks was still considered highly speculative if not outright gambling in the 1920s. True “investors” extended credit in the form of loans and bonds. Skepticism of stocks as a true investing asset classes appeared to be well founded when the Great Depression hit. Rampant speculation in stocks was a major cause of the Great Depression. But the reason for speculation was at least in part due to a lack of protections for minority shareholders such as transparent accounting of publicly traded companies.
The lack of information available on public companies was evident to Benjamin Graham, Warren Buffet’s prophetic teacher and arguably the world’s first value investor. Graham made a famous investment in Northern Pipeline Company in 1926. Graham was 32 years old at the time and had taken a train from New York to Washington DC for the sole purpose of getting information on a variety of railroads and pipeline companies that wasn’t available anywhere else. What he discovered is that Northern Pipeline had $95 a share in bonds just sitting on its balance sheet for no apparent reason.
The stock was trading at $65 a share and had a consistent dividend of $6 giving it a dividend yield of about 1%. Without any debt Graham concluded that $90 per share could be given to shareholders would the company suffering any shortage of cash. After purchasing 2,000 shares he wrote the company and explained his reasoning…making Graham one of the first activist investors as we wrote about here.
What the story illustrates is how hard it was for investors to get material information about company fundamentals. Without much else to go on investors largely traded around technical signals … meaning they watched the price. But the Great Depression changed that with the creation of the SEC on June 6, 1934 when President Franklin D. Roosevelt signed the Securities Exchange Act.
The SEC pushed though a series of regulations that required public companies to publish facts about their financial position. Over time these became more standardized and independent accounting firms were employed to verify their accuracy. The SEC also formally banned insider trading in 1934 by making it illegal for insiders to both buy and sell corporate stock within the same six-month period.
Over the years there have been many cases of false or misleading statements by CEOs, fraudulent activities, and accounting scandals. Companies like Enron stand out in investors minds as a reminder that accounting rules, regulations, and third party auditors can’t prevent fraud. But how serious should investors take these concerns and to what degree should they influence investing decisions?
Stock market conspiracy theories
A conspiracy theory is a belief that groups of people are secretly coordinating to do bad things…like manipulate the stock market. Conspiracy theories are particularly contagious in areas that cause stress and uncertainly…and apply to things that have big consequences. One famous conspiracy theory is that the assassination of JFK was orchestrated by a group of people such as a foreign government, or even the US government itself.
The reason people fall victim to conspiracy theories is that it is simply very hard to accept that something as consequential as an assassination, financial crisis, pandemic, or huge drop in the stock market that wipes out part of our retirement account could be the result of many complex factors, mundane circumstances or random events. Humans want someone to be responsible when bad things happen.
But bad and good things happen that influence the stock market all the time. So as we evaluate conspiracy theories and arguments for why the market is “rigged” we should check for the prevalence of these human biases…
- Attributes something bad to a small group of bad actors
- Explains something big like a Financial Crisis or market correction
- Ignores complexity, mundane circumstances, and random events
You will find that these human biases are evident in the three common conspiracy theories we will discuss below…
- The Fed is manipulating the stock market!
- Rich people cause market corrections when they all sell.
We address each in turn.
1. The Fed is manipulating the stock market!
This is just one of many conspiracy theories about the Fed…others include that the Fed is responsible for inequality, that they only want to help rich people, and that they bail out companies and ruin capitalism. The Fed really does have more than their fare share of conspiracy theories and none of them are true…at least not exactly.
The Federal Reserve was created in on December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law. This was the second time the USA created a central bank and this time it stuck…for good reason.
We have written a lot about the nature of money. Its one of those mystical parts of the economy that no one totally understands. But one thing will always be true about money…it is only valuable if people believe it has value, and people stop believing if money is not scarce.
Politicians have always had an incentive to spend more money then they take in with taxes. The reason is that debts can pile up for years before they become a problem, but deficit spending provides immediate benefits (that help with elections). That is why most every major economy in the world today attempts to give control over printing money to an independent central bank.
The Fed controls the money supply by creating physical money like coins and bills, quantitative easing which is done by creating money for purchasing financial assets, and setting capital rules and interest rates which impacts credit extension and contraction. They have been given these rights along with the responsibility to maintain stable prices and maximize employment…the Fed’s “Duel Mandate”.
Fed actions have a direct impact on the stock market and the economy. The classic example is through the setting of interest rates which drive the discount rate used to value stocks and corporate bonds. When the Fed “prints” money and buys financial assets (quantitative easing) they are increasing the amount of money available while also decreasing the amount of financial assets. This typically leads to an increase in the price of financial assets as a result of simple supply demand.
So does the Fed “manipulate the stock market”?
The Fed does not “manipulate the stock market” any more than you “manipulate” what you eat for breakfast. What you eat for breakfast is your responsibility and you make decisions in this regard to the best of your ability…satisfying your duel mandate to both stay healthy and enjoy your meal.
Fed actions often have other consequences. Lowering interest rates generally increases the price of financial assets. Financial assets are generally held by people with more money. As a result inequality has risen in part because of lower interest rates. But when the Fed lowers interest rates they are not trying to help rich people get richer at the expense of everyone else.
While this may appear to be entirely within the Fed’s control…the reality is that the Fed is very “data dependent” meaning that they are reacting to realities in the economy. For example, we have been experiencing a period of tremendous innovation which has helped lower prices. This has led to downward pressure on interest rates. Despite the Fed holding the Fed Funds rate near zero from late 2008 to 2015 inflation never really got over their 2% inflation target. The Fed has since changed their policies to accommodate the impact of technology (and to some degree demographics) by having a more dovish policy (keeping rates lower for longer).
Some may say that this new policy is “only helping rich people” or “driving up wild speculation in the stock market”…but the reality is that many investors around the world are willing to accept very low interest rates because of low inflation driven by technology and an aging population. Realities on the ground are driving the Fed for the most part…not the other way round. A big exception to this was the pandemic response which arguably helped the world avoid a global depression.
So next time someone starts blaming the Fed for everything…from inequality, bailouts, bubbles to market manipulation…just remember that the Fed is run by mostly well meaning people whose job it is to help keep unemployment low while keeping prices predictable. Its a hard job … determining when the economy needs help, when it’s getting overheated, and how often blunt policy tools should be used to prevent unnecessary harm during a pandemic or after a Financial Crisis while also trying to avoid assets bubbles and leveraged speculation. Government bond and currency markets are some of the most complex markets in the world…driven by everything from population growth and government actions to trade agreements and shifts in consumer behavior. Anyone claiming that the Fed “manipulates” these things and “should be held responsible” may save themselves a lot of energy by blaming humans for being human.
2. Rich people cause market corrections when they all sell.
Rich people make easy targets so its not surprising that some blame the rich when markets tank. But how much impact can rich people really have on markets?
Some markets are more liquid than others…meaning that some have more buyers and sellers making it harder for any one person to influence the price. There have been many high profile cases of market manipulation. One of these is the story of Nelson Bunker Hunt whose fortune collapsed after he and his brothers presumably tried to “corner” the silver market.
The Hunt brothers’ accumulated futures contracts totaling 55 million ounces, or about 9 percent of all the silver then in the world in 1974. Silver bullion rose during the decade before exploding from $11 an ounce in September 1979 to $50 an ounce in January 1980. At the peak, the Hunt brothers owned $6.6 Billion in silver. Two months later the price crashed and the Hunt brothers were charged “with manipulating and attempting to manipulate the prices of silver futures contracts and silver bullion during 1979 and 1980” by the regulators.
But the silver market is very small compared to the stock market. The S&P 500 makes up about 80% of the US stock market and is currently worth about $25 Trillion. In comparison, only one silver ETF in the USA is worth more than a billion and its only $12 billion. That’s a drop in the bucket…
So do rich investors “manipulate” stock prices, cause markets to crash when they sell, or have an edge over retail investors because they are so big?
No…its actually quite the opposite.
Warren Buffett and Charlier Munger run one of the largest companies in the world called Berkshire Hathaway. Early on when they were small they would often invest in smaller companies. He bought half of the original Berkshire Hathaway for just $8.3 million … a small cap company even after adjusting for inflation since the purchase in 1962. But over time Buffett and Munger have acknowledged that had to move into larger stocks because of liquidity.
Rich investors can impact the price of illiquid individual securities of they buy or sell enough quickly…but this is a bad thing for them not a good one. As they sell they could potentially push down the price making subsequent sales less profitable. The same is true in reverse when buying stocks.
In contrast, typical retail investors don’t have to worry about impacting prices…which is an advantage!
But what about the whole stock market?
SPY is the most liquid S&P 500 stock ETF in the world with an average trading volume this year of around 100 million shares. SPY currently has a price of $333 so that total value of traded shares is $33,300,000,000 or just over $33 Billion. In comparison…Berkshire Hathaway is worth about $500 Billion with about half of that being in liquid securities like Apple.
Now suppose Buffett decides to start day trading and buys or sells 10% of his $250 Billion in liquid securities each day. Suppose further that he opts to do this with SPY to reduce the impact on the market. Trading $25 billion in one direction in a security that has a daily volume of $33 billion volume would likely move the price.
So…Yes it is theoretically plausible for a huge investor to move even a liquid security like SPY.
But should retail investors worry about large investors manipulating market prices?
For one thing…the stock market is very efficient. What that means is that market prices are largely going to reflect available information. Even if Buffett became a day trading and started pushing prices these prices would likely revert back in short order as investors seeing the mis-pricing ruched to take the other side of Buffett’s trades.
The other reason not to worry is that for the most part wealthier people would never want to impact market prices. When they do they only hurt themselves. For example, if Buffett did become a day trader buying and selling each day and impacted the price he would lose money over time even if the overall market didn’t move over a longer period.
Conclusion
In conclusion, retail investors generally don’t need to worry about stock market manipulation. There are a lot of conspiracy theories out there, but these are driven more by a desire to explain the unexplainable and to hold someone accountable when bad things inevitably happen. Stocks have come a long way since the first IPO in 1602…gaining widespread adoption after minority shareholder rights got a boost after the Great Depression. Today, stocks remain a core part of long term investor retirement plans for a reason…they tend to go up over long periods of time…and no conspiracy is going to change that.
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