Beware the Trump and Dump

Morning all and welcome to another thrilling week at Blue Lake Invest! We extend our condolences to those of you joining from the Southern-ish states that just celebrated a long weekend, its always hard to face reality again after the three days off. Unfortunately for all of us facing reality is further complicated by the fact that we still seem to be living in some kind of bizarre parallel universe where Donald Trump could conceivably become president of the USA. We’ve been talking through some of the potential ASX implications of a Trump presidency for a few weeks now (check out the last few posts here) and have established that should ‘The Donald’ become leader of the free world we’d likely see greatly increased market volatility and a rush to safer assets such as land and gold. However, we’re yet to cover the fact that even if Trump fails to become president, he’s still offering up market opportunities on a silver plate for those who know how to game the system. Enter ‘The Trump and Dump’.

‘The Trump and Dump’ is not a new market phenomenon, you’ve probably already noticed that I’m referring to a slight variation of the classic ‘Pump and Dump’ favoured by market visionaries including (for example) Jordan Belfort. In a nutshell, ‘The Pump (Trump) and Dump’ involves a three step process where an influential investor (or group of investors, including investment banks) acquire a holding in the shares of a company before engaging in activities designed to artificially raise the price of the shares they’ve just purchased, then selling at the height of the newly created demand peak (and ideally taking home a tidy profit). This method works best on infrequently traded small-cap shares, this article from The Age gives a more detailed run down using ASX examples.

So how does a ‘Pump and Dump’ (P&D) become a ‘Trump and Dump’ (T&D) ? I’m going to define the T&D as a specific type of P&D directly facilitated by the market unrest caused by Donald Trump’s presidential campaign. Sadly, P&D activity is difficult to identify due to a number of incredibly complex mechanisms that determine market outcomes. I am a massive fan of using thought experiments to understand how markets work so I’m going to step through a hypothetical example that demonstrates how the actions of Donald Trump can affect the choices of individual investors and enable the T&D strategy to be used by malicious 3rd parties. Please note that this is only one possible T&D scenario, rest assured (or not) that people more creative than me have probably figured out even better ways to ‘Trump and Dump’ without ever being tracked down by the bad boys at ASIC.

“The Trump and Dump” (Classic Version)

  • Donald Trump decides to enter the 2016 US presidential race as a candidate representing the Republican Party (GOP). Political experts assure the public that this is an absurd publicity stunt.
  • Donald Trump starts campaigning and promises (amongst other things) to deport Muslims and build a wall between the USA and Mexico. His aggressive rhetoric is extremely popular with right wing voters who have long felt betrayed by the American political system. He wins a few delegates in early Republican primaries. Political experts assure the public that this is an absurd publicity stunt.
  • Donald Trump gradually builds a viable support base by targeting all voters who have long felt betrayed by the American political system. He currently leads the race to win the GOP nomination by a considerable margin. Political experts warn the public that Trump is a legitimate presidential candidate brilliantly executing on his strategy to target voters who have long felt betrayed by the American political system.
  • Global leaders begin to renounce Trump and warn of the potential global market chaos that could be triggered by his presidency. Some capital managers begin to move funds from heavily exposed assets, ‘just in case’. These include investments in companies heavily reliant on trade deals that could be at risk if Trump is president. Profits fall at investment banks exposed to positions in these companies.
  • Small investors become concerned about their own holdings (or exposure through superannuation) and begin to research alternative assets. An investment bank (or firm or hedge fund etc.) acquires a large position in a speculative company and releases a “research” paper assuring the public of the company’s potential during current market conditions. Small investors find this report and some begin to trade in the company with the hope of making a small profit in the turbulent market, trusting the content of the research report due to the prestige associated with the investment bank (or firm or hedge fund etc.) name.
  • As the stock in this speculative company often trades with extremely low volumes this new activity is detected and discussed on stock forums such as Hot Copper. More investors research the stock, find the report and begin to invest. Demand exceeds supply and the price begins to rise, creating the return that investors were seeking.
  • The investment bank behind the initial report sells its own holding once the price has risen sufficiently. This secures a profit for the bank.
  • Meanwhile, investors (and the market at large) gradually determine that the price rise was unwarranted, and that the speculative company has been trading over true value. This leads to a reversion to the original price over the following days and months. Investors who bought in after the initial ‘Pump’ lose money.
  • This process repeats indefinitely during times of market volatility as investment banks are free to say whatever they like assuming they include the appropriate disclaimers. If you think this sounds like a massive scam you’d be right, except that it’s totally legal assuming the investment bank in question uses a “proprietary trading” arrangement. For more on this read the excellent book “Flash Boys” by Michael Lewis.

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