Decoding The Wolf of Wall Street - and it's not about the movie

By A Special Correspondent

Martin Scorcese’s The Wolf of Wall Street with Leonardo DiCaprio in the role of Jordan Belfort opened recently to critical and popular acclaim. The hype around the film has been remarkably large for a Hollywood film. There are even rumours that Dhoom 3 was postponed to avoid clashes with dates, perhaps the first time a Bollywood film is accommodating a Hollywood release.

It’s all here. The greed and the excess and the sex and the booze and the Swiss bank accounts and the comical attempts to stay one step ahead of the FBI. The underlying financial market themes are - ahem, ahem - equally interesting, at least to this writer. No, really. The movie brings out issues of herding, momentum and information cascades quite well.

On the Wizard of Oz

The movie belongs to a genre that has a long history in American cinema. This is the morality play that pits Main Street against Wall Street. Main Street here is all those individuals and businesses who make their living the way most businesses do - by turning a profit making widgets and such things. It may also include the general population that invests in a financial market. Wall Street, by contrast, is the epitome of finance capital, the world of the big banks and brokerages. Some people think that Main Street’s interest – to grow their money in the capital markets - contrasts with the interest of Wall Street, which is to generate profit s by shuffling paper assets.

So Main Street and Wall Street have often shared an uneasy relationship in the US. The idea that Wall Street was crucifying mankind on a cross of gold goes all the way back to William Jennings Bryan. It always manifests itself when a full blown financial crisis fuelled by easy money, excess leverage, and an orgy of risk taking ends in tears. Its finest display is at the public hearings that usually take place at the end of such a crisis. Ferdinand Pecora’s hearings after Wall Street’s crash of 1929, or the US Senate hearings after the 2008 sub-prime debacle, are good examples. Here we have the spectacle of Main Street trying to curb Wall Street’s tendency to crucify itself on that gold cross.

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The idea that Wall Street is a place dominated by the vice of greed, one of the seven deadly sins, is also prominent in this narrative. Hence the morality play movie where the characters portray a human sin - usually greed, gluttony, excess, or lust - and where a lesson is taught. The morality play works as an allegory, taking virtues and vices and converting them into personified characters acting out the workings of good and evil.

Hollywood’s been doing this for some time. In the 1939 children’s classic The Wizard of Oz, “oz” is the way troy ounces of gold are referred to in print, and the Wicked Witch of the East represents East Coast banking interests. The genre reaches a high point in Oliver Stone’s account, Wall Street. Stone’s account involved shenanigans on the corporate finance and investment banking side, and develops the Main Street vs. Wall Street clash more profoundly than The Wolf does. The Wolf, by contrast, is about bucket shops - or their modern avatar - the boiler rooms. This is the seamier side of the business, about the pump and dump operations on penny stocks that produce herding, followed by momentum, which leads to information cascades, and feedback loops.

Buckets and Pennies

Bucket shops are, well, bucket shops. These are small brokerages, usually unregistered, where customers bet on price movement without any regard for underlying fundamentals. Some don’t even take margin, rather allowing the customer to bet just on the difference in the price movement. The term comes from a time when buckets, or cranes, would move small time speculators down into the trading pits in Chicago. The modern avatar is the boiler room, where most of the trading communication is done on the phone, rather like a BPO for trading stocks. Buckets and boilers are, surprisingly enough, still common in India. The word used is dabba trading, and it is usually common in certain trading communities. Welshing is also common, as when a customer who bets wrong doesn’t cough up the difference and runs away. Apparently, trust based networks, often with a community angle, keep this to a minimum.

Most bucket shops deal in what are called penny stocks. These are low-priced stocks or fallen angels, often companies that have gone belly up with no discernable business activity. In India, there are over 240 traded stocks between the prices of 0 and Re 1, and over 1,200 priced between Re 1 and Rs 10. The latter list includes the wonderfully named Cinderella Finance. This is a Cinderella world.

Most penny stocks have low capitalisations and typically limited assets. Often there is little reliable publicly available information about the company, and the company may have a limited track record. In fact, there may be no company at all behind the stock. In the US, pennies are defined as stocks trading below $5, not listed on a national exchange and failing to meet other specified criteria. In 2008, during the market collapse, Citi traded below a dollar but was not a penny stock, because of its NYSE listing. In India, there is no such accepted definition, and the absence of a substantial over-the-counter (OTC) market means that all pennies trade on either the BSE or NSE.

The beauty about penny stocks is that the bucket shop’s commission as a percentage of the total share price can be huge. This is how those large sums of money were generated in commissions in The Wolf. Somewhere in the fine print will be the injunction that the bucket shop charges - say - a brokerage of 0.2 percent subject to a minimum brokerage of - say - 50 cents a share. Nothing much if you’re talking IBM, but that’s 25 percent of a $2 share. Contrast this with just the commission of say 0.2 percent on a blue chip stock. The brokerage makes 125 times more in commission on the penny stock, as it did on the blue chip!

Pump and Dump

The basic insight needed to understand The Wolf comes from Edwin Lefevre’s 1923 roman clef Reminiscences of a Stock Operator, still widely regarded as the greatest book ever written on financial markets. The average conservative small town businessman, Lefevre noted, would visit five dealerships and kick scores of tyres, before he bought a car. But that same person would punt half the cost of the car on the basis of a phone call with a sharp broker he hadn’t heard of - in a stock that no one else had also heard of. Human nature, and the tendency to gamble, are at the heart of all this.

This tendency of human nature gets exploited by the bucket shop in the pump and dump. There seems to be something irresistible about small denomination penny stocks that attract human nature. The Wolf is all about a bucket shop’s pump and dump manipulation of penny stocks . This involves hyping up shares typically through spreading misleading and false statements that increase the price, and then selling the inflated stocks to the public.

The arrival of the Internet and smart phones make these easier to perpetrate. Often insiders accumulate shares, then use a host of media and “research” to hype interest in the stock. Sometimes claims of credible “inside” information, or khabar, are used. When buying pressure pushes the share price up, the rise in price itself entices more people to believe the hype and to buy shares as well. Sometimes a reductio ad absurdum is reached when the hype masters actually end up believing their own hype. Eventually the insiders doing the pumping, sell or dump their holdings, and the stock crashes.

The technique can be highly effective. The late 80s and early 90s - the period The Wolf is set in - were not noted for being one of history’s great bull markets. Yet Stratton Oakmont, Belfort’s firm, did well, despite that fact that it was not a bulge bracket firm. In fact, The Wolf of Wall Street wasn’t even on, or near, Wall Street. He operated from a shopping mall in suburban Long Island.

Herding, Momentum, and Cascades

More technically what is going on here is an information cascade that has feedback loops. Investors practice herding behaviour, which leads to momentum, and an information cascade with positive feedback loops.

Most of us participate in an information cascade at one time or another. Walking down a road of empty restaurants, people naturally gravitate towards the one that is half full. The half full status itself arose because an initial agent went in, followed by others. Absent other information, they assume the food has to be a little better at the half full restaurant as opposed to the empty ones. Information cascades in this sense can help as they can reduce search and transaction costs.

In an information cascade in a stock market, agents, - in this case Belfort’s clients - make sequential decisions rationally based on the information they have - which is purely price action - and without access to information of others.

Problems arise, however, when cascades form based on improper beliefs or valuation models. Most people in The Wolf either were led on, or more fascinatingly, deliberately ignored their personal beliefs regarding the valuation of their shares.As the share price climbed, subsequent investors assumed that the original investors were acting on valid information which assigned a higher value to the company, and on this basis bought the shares as well. People anxious to make a quick profit mistook the signals from earlier buyers, seeing them as an indication that the market was better informed than they were.

Even when agents are rational and valuation beliefs sound, people might be practicing greater fool investing. Everybody’s buying assuming that a greater fool is out there whom they can offload to.

The result of all this is a positive feedback loop. An initial action leads to a continuation of the same action, higher prices resulting in higher prices, with these new higher prices resulting in even higher prices, and so on.

Valuation bubbles can form quite easily when this happens. They can burst equally soon. This can happen when, an insider usually The Wolf himself or company promoters, starts to sell their stake and reduce shareholdings in the firm. Sometimes it can happen when the herd itself realizes it’s caught in a cascade, and comes to sell at the same time.

That leads to the denouement as the herd heads for the exits at the same time and the share price crashes.

Uncle Quentin then holds his head in his hands and swears at everyone - including Aunt Virginia. Everyone, that is, except himself.

Then he swears off the stock market.

Till the next phone call from the next bucket shop.