The Participant Ponzi - Endgame

The truth goes through three phases: First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as self-evident.

In my first two blog posts in this series, I introduced the idea of the Participant Ponzi and then explained how the U.S. stock markets have been in a Participant Ponzi.

In this post, I explain how theU.S. equity Participant Ponzi could end.

The End of the Participant Ponzi

Funding is the key to the ParticipantPonzi, as it is for all Ponzi schemes.  Likea traditional Ponzi, the Participant Ponzi fails when the sources of fundinghave become exhausted.  New buyers arenot available to take out earlier buyers who want to sell.

I believe we have entered thatpoint in the U.S. equity Participant Ponzi.

When the dip is finally notbought and the market continues to decline, panic will ensue.  As the realization spreads that theParticipant Ponzi is over, the previously indiscriminate buyers will become currentindiscriminate sellers and there will be a rush for the exit.  The gears will reverse, and instead of dipsbeing bought, rallies will be sold.

Unlike a traditional Ponzi, theU.S. equity Participant Ponzi will not go to zero.  There are real assets and cash flows behindthe U.S. stock market.  However, when thegears reverse, the decline is likely to be more pronounced than it would undernormal circumstances.

Gears, Reversing

In my second blog post in this series, I unpacked the necessary conditions for a Participant Ponzi to flourish, and how the Federal Reserve has played a key role in these conditions.  Here I will begin with the Federal Reserve and show how the necessary conditions have either stopped, or are primed to stop.

The Federal Reserve

After keeping the Fed Funds rateat close to zero for seven years, the Fed raised the benchmark rate to 2.5percent and has kept it there, despite much recent dovish interest ratetalk.  In the past, periods of low ratesfollowed by a long series of hikes and then a pause, have been followed by asharp decline in rates, and frequently an economic recession (marked by the redbars in Chart 1, below).

Chart 1:  Fed Funds Rate and U.S. Recessions[1]

bantam inc jack duval MFO UHNW multi-family office New York Manhattan - Fed Funds Rate and US Recessions

Perhaps more important is thefact that the Federal Reserve continues to shrink its balance sheet.

Chart 2: Federal Reserve Balance Sheet v. S&P 500 Price[2]

bantam inc jack duval MFO UHNW multi-family office New York Manhattan - Federal Reserve Balance Sheet v. S&P 500

In the chart above, it can beclearly seen that the S&P 500 (green line) ramps when the Fed is buyingmortgage-backed securities and U.S. Treasuries (white line), and struggles toadvance when the Fed is a seller.  Whilethe Fed denies any connection with a straight face, it is there for everyone tosee.  (The one exception is the 2017ramp, which was due to the Trump corporate tax cut.  A one-off event.)

Just as interest rates have notbeen lowered, the Fed’s balance sheet reduction continues.  The original $50 billion per month unwindingwas changed to $35B per month beginning in May and will continue throughSeptember.  While this will only take theFed’s balance sheet down to $3.731 trillion, it is still significant.  For psychological reasons, if nothing else.

All this amounts to tighterfinancial conditions.  (Remember, whenthe Fed sells securities, it takes money in and puts securities out,effectively removing money from circulation.)

The Necessary Conditions Will No Longer Be Fulfilled

As discussed in my second post in this series, there are four necessary conditions for a Participant Ponzi to flourish.  They include:

  • One or more sources of consistent, indiscriminate(valuation indifferent) buyers;
  • Steadily rising prices with no sustained or extremedrawdowns;
  • Supply constraints, and;
  • Rationalization.

Each of these necessaryconditions will fall when the gears reverse. It will begin with a sharp and swift decline in U.S. equity prices, thatdoes not immediately recover.  This willbreak the smooth uptrend of the market and change the market psychology.  Those who bought the dip on the way down willbe punished, instead of rewarded.  Thereflexive buying that has worked for the past 10 years will be replaced with await and see approach.

Further declines will be matchedwith additional selling as investors wake up to the paradigm shift in themarket.  Those who hold will be punished,and will be likely to sell into any rallies, further suppressing the market.

Even though systematic buying in401(k) plans and other dollar cost averaging programs will continue, existingassets will be allocated away from equities and into bonds.  Also, in the second half of the year 401(k)participants begin maxing out their contributions, which further reduces indiscriminatebuying.

Corporations that have provided astrong and consistent bid for their own shares will pull back, as their averageprice paid becomes higher than the current price.  They will want to buy at lower prices tobring the average down.  In short, theywill become more price discriminate. Additionally, the lever of using debt to buy back stock will bebroken.  Assuming the global economy is slowing,firms will have a hard time raising capital for buybacks and their own internalcash generation will be slowing, if not declining, from previous levels.

Index investors will almostcertainly see their investments underperform active managers.  This is simply due to the momentum investmentdesign of capitalization weighted indexes. The higher a stock goes, the bigger it becomes in the index.  For instance, right now the top four holdingsof the SPY index ETF are: Microsoft, Apple,, and Facebook.  They represent 12.6 percent of the ETFassets.  This is an extreme overweightfor an index with 500 names.

Supply has been increasing in thetechnology space as a stable of over 120 “unicorns” wait to go public.[3]  Those firms smart enough to IPO before theliquidity window shuts have not be rewarded. It is not clear that the other firms will make it.

Chart 3: Lyft and Uber Stock Price Since IPO[4]

bantam inc jack duval MFO UHNW multi-family office New York Manhattan - Lyft and Uber chart

Lyft and Uber have declined by 17.3and 8.33 percent, respectively, since their IPOs.

Finally, there are the rationalizations for the equity market advance and valuation.  These will die last.

Even as the market declines, CNBClickspittles will pound the table about how cheap stocks have gotten and how themarket is overreacting.  Yet in their nextbreath, they will beseech the Federal Reserve to save the market with interestrate cuts and Quantitative Easing.

However, as Schopenhauer taughtus, the truth goes through three phases: First, it is ridiculed.  Second, it is violently opposed.  Third, it is accepted as self-evident.[5]

Eventually, no one believes in the rationalizations anymore, as they are crushed under the weight of continuing market declines.  CNBC becomes populated by baleful faces, and the old roundelay “no one could have seen this coming,” rings out.   The asset flows have stopped and the narratives stop with them.

It is then, in the depths of the decline, that the new bull market is born.


[1]      Source: Bloomberg.

[2]      Source: Bloomberg.

[3]      A “unicorn” is a private firm with a $1+ billion valuation.

[4]      Source: Bloomberg.

[5]      There is some debate about the origin of this quote.  See Jeffrey Shallit;  “Science, Pseudoscience, and The Three Stages of Truth”; March 28, 2005.  Available at:;  Accessed June 4, 2019.


Jack Duval

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