The simplest and most common form of inventory fraud is “pump and dump”. It has three parts. Someone gets hold of some cheap stocks; tells lies about why they will increase; and when they do, sell them, before the lies are discovered and the stocks fall. It is against the law.
But what if we removed the middle step – the lie? Instead of lying about stocks, our attacker yells at anyone who wants to listen, “If we buy all these cheap stocks, the price will go up and we will make money.”
The reason for writing about this now, of course, is Robin Hood, Reddit and GameStop.
The third step has yet to happen, of course. When everyone sells for a profit, stocks fall and some people lose a bundle. Far from denying this fact, however, our perplexed person points out. “It’s a dangerous game,” he said, “your better timing is good.”
This form of inventory manipulation may seem unlikely to be successful, but it has been done. The most famous promoter was Jesse Livermore, considered the world’s largest stock trader during the first two decades of the 20th century. His biography, Reminiscences of a stock operator, in which it is given the paper-thin alternative identity of “Larry Livingston”, might be the best book ever written on the market.
Reminiscences describes how Livermore ran stock “pools” in the 1920s. These were groups of well-funded shareholders, often company insiders, who had large blocks of stock that they wanted to unload onto the public. They did this by trading the stocks with each other, making the stock appear liquid and rising, attracting speculators. The pool would then sell its stock in this feverish environment.
Livermore was such a good trader that the pools often hired him to execute their plans, in return for a large chunk of the profits. Surprisingly, the presence of the master manipulator made speculators more likely to join them. Newspapers reported breathlessly that Livermore was running a pool of bulls, and he would take off, without deception. “After it’s all said and done,” said Livermore, “the biggest advertising agent in the whole world is the ticker.”
This was before the Securities Exchange Act of 1934. Section 9 of the act appears to directly target Livermore. He made it illegal to “incite the purchase or sale of any security “by stating that the price of the security” is likely to rise or fall due to market operations. . . carried out with the aim of raising or lowering the price of these security“. In other words, you are not allowed to inflate stocks just to pump them up, as Livermore did (“trading in the market” is exactly how he described what he did). Deception is not required for manipulation.
In a series of articles, the FT examines the exuberant start of 2021 in global financial markets
If what the Redditors of r / WallStreetBets are saying “let’s get together and inflate GameStop’s stock”, either to oust a few big short sellers, or even just to make money, there’s a risk they’ll break the law. There is a question (a top securities lawyer tells me) about the word “inducement” – whether Redditors were in fact using their transactions to trade other people – but the spirit of the law is pretty clear . These types of games are not allowed.
But there are many well-meaning laws that go unenforced, for good reason. Should this one be? There are two arguments in favor of this.
The first is that allowing the stock market to become a stand-alone speculative game, unrelated to the value of the underlying companies, will discourage companies from wanting to list – which defeats the market’s objective of train and allocate capital. Given the long history of speculative excesses in the secondary market alongside successful deals in the primary market, this is not convincing. If savage speculation was toxic to capitalism, capitalism would have died centuries ago.
Then there is the idea that retail investors who are dragged into the frenzy will be badly hurt. They will without a doubt. GameStop action was always going to drop because the company doesn’t have enough value to back it up. The question is, what is the fairest and most effective way to discourage dangerous behavior: to make certain types of speculation illegal or to let certain speculators get squashed in the public eye? Overall, I’m in favor of the second path, as long as there are rules in place – high margin requirements, etc. – to protect the market itself from collapse.
Livermore would probably agree with me, if he was alive. But he died broke, by suicide, in 1940.
What do you want to know about the impact of Reddit on Wall Street? FT Global Financial Correspondent Robin Wigglesworth will be resumption of the @financialtimes account at 6:30 p.m. GMT / 1:30 p.m. ET to answer your questions on Instagram Live. Submit questions here.