The stock market isn't designed to make retail sheep rich...

I normally reserve general market commentary for Sundays, writing about the ways in which the market astounds and confounds, dazes and amazes, the fun and games that can thrill and chill retail investors.  

But every now and again I have an "Aha" moment, Christians will refer to it as an Epiphany.  However there's nothing religious about my latest "AHA".  Although it does have a similarity in that people will often come to a religious revelation, then it will drift away, they will forget about it.  But then it will come back yet again, sometimes over and over.  

The revelation that keeps coming back to this writer again and again, is how the stock market is not in any way designed to make lowly retail investors rich.  While I'm certain there are many individuals dreaming of quick riches from the stock market, I would bet proverbial dollars against donuts that only an incredibly small number will ever succeed.

Do you know someone who's made a fortune from the markets?  I don't, and I'll bet you don't either.  I'm not talking about on-line here, I mean someone in the real world.  There are always Nostradamus types in the virtual world, telling you of the fortunes they've made, and offering to help you do the same.  But you don't actually know them.  Do you?

Is it even possible to for a small retail investor to make mind blowing gains?  Can an individual take a few thousand dollars and parlay it into hundreds of thousands or millions?  I do think its possible, but I also think it is incredibly rare.  I would bet that you're more likely to have first hand knowledge of someone who had a big lottery win, as opposed to someone who bought their dream house from trading or investing in stocks.

I think it was Plato who used to say that the way to understand things was to first understand their opposite.  So in trying to understand how it might be possible to achieve great wealth from the market, I think its important to first understand why its nearly impossible to do so.

And I'm going to suggest, no make that assert.  I am going to assert that the reason why its so hard is because that's not the way the market game is designed.

First consider the players involved.  Let's start with the stocks that typically make the largest percentage gains, the companies whose share prices double, triple and sometimes go up ten fold or more in a very short period of time.  I think it will prove instructive to start at the bottom and work our way up.

I'm not talking about companies like the Apples or the FaceBooks here, or the Amazons and Googles.  I'm talking about highly speculative companies that are losing money, often bucket loads.  It is with highly speculative stocks that you'll most often see monster gains, and that includes Penny Stocks of course. 

Often with highly speculative public companies you will see that their CEO is earning a handsome salary, hundreds of thousands of dollars and sometimes even over $1 million.  This despite the fact that the business itself has an accumulated deficit in the tens of millions, sometimes hundreds of millions.  How can the CEO of a company that is losing money by the bucket full pull in a 6 or 7 figure compensation package?  

How is it managed?  Simple, its a public company.  The company is able to pay the CEO and other key executives big money because investors believe in the future and are willing to hand over cash in exchange for an ownership position.  But the CEO and other executives don't do this on their own of course.  You're not going to see someone wearing an Armani suit standing on a street corner flogging shares in his company, that wouldn't look too good.

No, retail investors aren't getting their shares directly.  Before being offered to the public there's a few steps in between.  Typically a brokerage firm that engages in investor banking services will serve as an underwriter, perhaps more than one.  We'll call our company "Money Losing Industries" or MLI for short.  Their stock is trading at we'll say $1.50 and they're soon to be broke, having just lost $5 million over the last 3 months.  

A large underwriter we'll call "We Love Crap" or WLC for short, steps in and underwrites a 20 million share offering priced at $1.00 per share, they might even bring in other firms to participate with WLC acting as the lead underwriter.  Now the company has $20 million less fees to fund operations, and to pay those big pay envelopes with.  

Am I suggesting that MLI is a scam company?  Nope, far from it.  They could have offices and production facilities for a tech innovation, perhaps even warehousing.  Its not a shell game, they have a real product and real sales, they just don't make any money at their business.  

So now the lead underwriter WLC and its team have 20 million shares to sell.  Are you ready to buy yet retail sheep?  Not so fast.  Before they make their way to the herd WLC and the other underwriters are first going to call on their book.  By book I mean their investor clients, they'll get first crack.  So now a bunch of brokers are calling their customers and they're talking up MLI as a great investment.  These customers are not basement dwelling losers trading on-line with a discount brokerage.  No sir.  These are well heeled professionals who employ the services of industry professionals to buy and sell shares.

And those that do buy in aren't going to be taking a flyer on a few hundred or even a few thousand shares.  At bare minimum they're going to be buying in blocks of 10,000....some will buy 100K or more.  Pikers don't get the benefit of using the services of a full service brokerage house.

Back in the days of the tech bubble some firms engaged in a practice that was called laddering.  Investors buying into an offering had to agree to buy a specified number of shares after their initial purchase.  First they might buy for 50,000 shares, but when doing so they had to agree to buy another 25,000 shares within say 6 months.  It was a great way to ensure a steady flow of buy side demand which would help inflate the PPS.

Okay, back to our lowly retail investors now.  Are you ready to start snapping up those $1 shares of MLI yet?  Of course they're not trading for $1 anymore, that's what the underwriters paid....and they got them at a discount of 50 cents to the market price.  But they've stirred up some activity and interest from their books and now the PPS has climbed over $2.  

But wait.  How's a retail investor to know about MLI anyway?  Down in the basement the Cell Phone reception is spotty at best, and besides....what Boo Radley type has a broker who's going to call.  I'm glad you asked. There are any number of ways it could happen, it might even be on a TV show.  It all depends on how big a profile Money Losing Industries has.  With the stock having moved from $1.50 to over $2 its very possible that there's some mainstream media attention, maybe even a CNBC.  

Now the herd moves in, and if its a perfect storm it can get exciting.  The stock price starts exploding, from $2 to $3....blowing past $4 and going over $5.  The underwrites have made a nice buck, but then they have big expenses.  Their customers who were able to get in early are happy as pigs rolling in their own excrement, providing they cashed in. Now its the retail sheep clawing all over each other, touting their genius on twitter and facebook and stock centered social media sites.

Of course it will end, and it won't end well.

Not for the retail sheep who've now bought into the idea that MLI is going to be a big winner.  Someone who pays $10 for this stock that was recently at just $1.50....he's thinking $20 is a sure thing, and that maybe even $100 is possible.  He might not have even bothered to read one single filing and might not even be aware that this company burned through $5 million in losses in the MRQ.

Man this is going to be a long entry, but what the heck, I'm enjoying myself.  For every 10 people who started reading this, I bet there's only one left now.  No matter.  

But wait wait wait I hear a smart retailer saying.  What if someone got in back before all this happened, when MLI was still trading for $1.50.....Doesn't he have a chance to make money?

Yes, yes he does.  But let me ask you....how much money did this wise individual invest?

Let's say this gutsy player bought 10,000 shares at $1.50 for a total investment of $15,000.....This retail genius bought in when things were quiet, when the PPS was treading water and volumes were very light.  He had the chance to read the financials without fear of the PPS running away while he did his research.  He knows this company lost $5 million in the MRQ but risked $15,000 in cold hard cash anyway.  

I won't say this guy doesn't exist, but he found a company that was quiet and wasn't being promoted and he got incredibly lucky.  The question now is, at what price should he sell?  We'll say that TMI's top price is $12 before it starts the long painful road back down.  So our genius early investor is going to watch it climb from $1.50 all the way to $12....but maybe he'll sell half his shares, we'll say at $6....that's 5,000 shares turned in for $30,000....he's already ahead.  

But what's he going to think when the PPS hits $10.  Is he going to congratulate himself on the $30,000 he has sitting in his account?  Or is he going to cry over the $50,000 he could have had instead if he'd waited just a little longer.  Is he going to read about predictions of the PPS going to $20 and buy back in again?

This is why its so hard for retail investors to make life changing gains in the stock market in my view.  The game is designed to lure the sheep in AFTER the big gains have been made.  And even those lucky enough to have bought in before mind blowing gains, they have to battle a psychological war geared totally toward getting them to hold on tight, and to even buy more.  

And I would further argue that this is the way it has to be.  The companies paying the big salaries, the firms underwriting the share offerings, the media outlets big and small catering to retail investors....combined we're talking about a multi billion dollar industry, and those dollars have to come from somewhere.

I'll leave it there and see if anyone cares to comment.  But anyone telling me they've made huge money on the market, they can get bent.  If they have they're not going to be reading this practically invisible little blog.

Cheers.