In the thread at http://www.straightdope.com/mailbag/mstockmarket.html there was a lot of “classical” interpretation of a stock market, but no mention of what the modern stock market has become. From what I’ve seen, a great deal of stock market activity has nothing at all to do with actual capitalization of a corporation (real investment) and everything to do with the current market price of the stock (stock speculation). Thus, the modern stock market is more of a gambling venue than an investment locale.
I agree that speculation plays a large role in the market today (I don’t know whether there’s more speculation today than in the past – maybe it’s just better publicized). However, one big difference between the stock market and gambling is that gambling is zero-sum (less a spread for the house) and the stock market is not.
Oh, boy, where to begin?
Let’s get one truism out of the way: yes, there are Madnesses of Crowds. At the end of every bull market, there’s a speculative bubble, and because it’s so unrelated to economic value a lot of gullible folks get burned. But despite the attention they garner, bubbles are relatively rare. Most of the time, the market isn’t doing that much, other than providing an investment vehicle that is intertwined with determining how companies are valued for further capitalization.
So, fundamentally, your question creates a false dichotomy. One of the key tools for determining what an enterprise is worth is by comparison - what’s another group of people doing with similar assets in similar business? How does the market value that enterprise? It’s certainly as if you price an IPO by saying, “Hmmm, we have $X assets, and we want to offer Y number of shares, so we just divide X by Y.” You run the risk of substantial over- or under-valuing the IPO if that’s all you do. Only by having an active market in shares of existing comparisons companies can you get a better idea of what a company is worth.
This is crucial not only for determining the valuation of new market entrants, but further financing by longstanding companies. Remember, companies are constantly rejiggering their capitalization, both to take advantage of market conditions–interest rate fluctuations, asset availability, etc., and to finance new opportunities. You need a valuation of the current entity to figure out how much funding it can raise, and at what price. That only happens through a reasonably liquid securities market.
Oh dear, I mis-typed. That third sentence in the second full paragraph should read “It’s certainly not as if you price an IPO by saying…”
Bah. The stock market hasn’t “become” anything except a bit more regulated over the years. Silly day-traders existed in the 1920s and they exist now. Except back in the day we called them “speculators.”
Silly trading of this sort (which is rarely succesful over the long term, I might add) really makes up a very very small percentage of the volume of the market at a whole. It does impess the newspeople on CNBC, though, so they talk about it a lot more than the happenings at the latest S&P Index Fund.
S&P Index Funds, sadly, just don’t make great television.
The key to this question lies in this sentence from the original article:
There is no purely rational means to determine this value, no matter how many times someone tries to tell you that the market is rational. The market is never rational in the usual sense of the word. It is a series of more or less informed guesses, extrapolations, rumors, speculations, and wishful thinking.
Future value is also dependent on the information that the company itself provides, which is why there have been recent well-publicized cases of CEOs being arrested for falsely cooking the information so that the future value of the company would be perceived to be much higher than it really was, and why stock pricing swing so much whenever a company announces earnings that are not in keeping with the guesses that stock analysts make. (Bear in mind again that no matter how many computer models are involved, the predictions of stock analysts are guesses based on inadequate current information and no information at all about the future. These adjustments to the company’s stock are punishments for no better reason than the analysts’ inability to be rational.)
Now, in the real world, a great many people are involved in making these guesses, so they tend to average out and form a general consensus. This general consensus becomes what a stock’s current price is.
In general, therefore, no stock is ever priced “correctly” (rationally). It is always overpriced or underpriced. The entire stock market is a continual set of lurches around the general consensus of what the rational price might be as people buy and sell that stock at different prices. This also applies to the market as a whole.
There are times when all guesses are wildly wrong. These are called bubbles (or bear markets at the other end of the swing). “Everybody” knew that the prices of tech stocks were insane and irrational. But they were driven up because greater fools had somehow been convinced that the future really was as bright as the wildest projections made it out to be. When the stocks went down to pennies, these prices were also insane, because there really is a tech future ahead.
What is the right price? If I knew that I’d be rich.
So what is an individual to do? The advice of almost every expert is to buy index stocks (or mutual funds). These track the market and in the long term almost always provides a nice rate of return. Why? Simply because the economy as a whole is expanding and making money. If there is more money then companies are worth more and their stock tends to go up - at least in the market as a whole. Index funds also have the advantage of costing less than most mutual funds that track particular sectors of the economy. So why buy any other funds? Because a good fund manager can discern which segments of the economy are currently doing better than the economy as a whole and purchase a range of those stocks. (Bad fund managers will lose money faster than the market as a whole.)
To get rich though, you have to do the equivalent of betting - and knowing when to fold. If you pick the right company you can multiply your money many times over. But sooner or later that company stops multiplying and you have to get out. Those that do stay rich. Those that don’t may not become poor, but will have a worse rate of return than could be found for their money elsewhere.
That’s the real story. The market is always irrational. Getting rich is a matter of luck. But in the long run, as long as the U.S. economy is healthy you will make a better rate of return on your money from stocks than from any other general form of investment available to the public.
Of course, as every stock ad says – past performance is no guarantee of future performance.
Isn’t this:
the point of the original question, which read in part
The point is that it seems to an outsider (which I certainly am) that, due to the media coverage (like CNBC), far too much of “how the economy is doing” information is based on the stock market. Thus, lots of people speculate on tech stocks, these stocks (finally) tank, and then we are told that the economy is bad. Since we are told that the economy is bad, we believe it (it’s on TV, after all) and we stop buying stuff, which causes people to stop selling stuff, which causes the economy to actually have a downturn. So it seems (despite the response to the original question) that the stock market drives the economy, though it has nothing to do with how the economy actually is doing.
I think.
Andrius
Getting rich:
-
Invest in companies which, by reasonable standards of business models, are capable of growing rapidly. Since most are untested start-ups, this is high risk, high return investment.
-
Invest in companies which, by reading the psychology of other investors, is going to be hot and in high demand. This is speculation. This is what day-traders do. This rarely works. This ofen feeds into a bubble (since many others are doing the same thing) and makes the markets much more volatile than it needs be. This is stupid, don’t do it.
Peace.
Invest in my shorts, dude.
Incidently, you can draw a pretty fair parallel between stock market speculation and betting on the horses, or any other sporting event, as distinguished from casino gambling.
Casino gambling games, or your state lottery, involve betting on an easily modeled game with known probabilities. Given that the casino has the edge, truly a sucker bet.
On the other hand, a sporting event cannot be easily modeled, though it seems as if there is a lot of information there to make an informed decision. The rub is that many factors, like say the pyschological effects of last week’s loss on the star quarterback, are very subjective - at least nobody has thought of an accurate way to predict them to date. Good thing, too, or Monday Night Football would become very boring (maybe you think it is already). Market speculation involves many equally subjective factors.
Horse racing is probably the most mature sporting event when it comes to betting on it, and a paramutual betting system operates in a way startlingly similar to the market - bet placement drives the odds at the toteboard, much as selling and buying drives market prices (although markets don’t operate on a simple formula like the odds at the local racetrack). Much is written about various ways to handicap the outcome, some of which may have some validity, but none of which have been shown to be foolproof. “Racing Forms” are published which have “past performance” indicators on the horses and jockeys. Many of the participants are making bets using faulty and illogical decision making processes which drastically affect the odds or price setting.
The analogy isn’t perfect. For one thing, horse races have a definite start and end time when the bets are placed and paid out. And there isn’t an analog to being an “investor” rather than a “speculator”, unless you actually own a racehorse, maybe, and can collect purses and stud fees. But there are some interesting parallels.
Anyone ever hear of the South-Sea Bubble (1720)?
Yep. The tulip craze of the 1630’s is another classic example.
Suppose I run “Zapfoo Spices, Inc.” and we go public. Now, some yayhoos with schemes to implement, yayhoos who are not at all connected with Zapfoo Spices, pull some fast stuff and Zapfoo’s stock tumbles from $100.00 a share to $0.01 a share in one day.
However, our sales increase at a rate greater than our expenses, we suffer no employee difficulties, have no regulatory problems, and have guaranteed no loans on the basis of any Zapfoo stock we might actually own, ourselves. Indeed, our cash reserves are good enough that none of our pension or other compensation plans are injured, either.
How has Zapfoo been hurt?
Nevertheless, “experts” will natter on in their inane fashion about how horrible Zapfoo is doing and how Zapfoo looks like it’s about to go out of business.
If one isn’t buying an IPO, the stock market is nothing but gambling.
How would they manage that kind of stock price manipulation? They would have to sell Zapfoo short or something, I guess, but as soon as they stopped selling short, the price should come back to something representing some “rational” valuation of Zapfoo. Everyone who bought at that low price would be interested in selling higher, and if there are buyers willing to buy it at $100 (as there was before the manipulation), the price should bounce back.
Leaving aside illegal market manipulation and fraud, your example seems unlikely.
Penny stocks and very thinly traded stocks are more susceptible to manipulation, but how could you pull off a move like that for any reasonably large company with reasonably high trading volume?
Investing in the stock market is risky, but not the same as gambling. As I mention above, gambling is zero sum (including horse racing, other sports betting, and casino gambling) less a spread for the house, whereas stock investing can profit all investors.
I don’t see how buying an IPO is different from other stock market investments either. How is that more fundamental investing?
What, illegal manipulation and fraud? Why that has never happened at all, even once, in all of history!
Buying an IPO is real investing. You are capitalizing a business. Your money helps expand business. You are investing.
Other stock market activity, aka “gambling”, is mere speculation with a slight boost (the dividend). The only “business” that speculation in stocks helps is the brokers who take a commission.
Not quite true. Companies continue to be concerned about their market caps for good reason.
In the “Zapfoo Spices” example you gave, there is a very real concern that somebody will simply buy enough very cheap stock in a very profitable company to gain control of it. Unless there is a “poison pill” in place, they are likely to wind up owned by “Megalithic Foods, Inc”, whether they want to be or not. The stock price is a price tag on ownership of the company.
Also, a company may use its valuation in a manner very analogous to the way you use equity in your house - to borrow against it. A company’s debt rate and its stock price are intertwined. Either one may affect the other. If their debt rating goes down, their stock may tank, but also, if they are very highly valued, they may be able to find debt funding on more favorable terms.
Dogface, you’re using strawmen here. The example you’re giving is one that the markets as they stand would deal with in short order. Information moves extremely quickly - good and bad, reliable and unreliable, but ultimately unreliable information tends to get itself sorted out very quickly. The last case I can remember concerned some counterfeit press releases, and it was resolved a day or two with the perps winding up in very serious trouble.
In short, in the major U.S. markets (read: NASDAQ & NYSE), I don’t know of any “fast stuff” one could pull that wouldn’t correct itself even faster. Even the kind of deep, multitentacled corruption we saw with Enron, WorldCom, and co. didn’t take that long to unravel, and even those billions amounted to diddly minus squat in a $10 trillion economy.
Now, I really would like you to address my earlier points refuting a small corner of your rather ludicrous distinction between “real” and “fake investing.” But let me add another: an active market in securities of a corporation is the best way that the real world can tell management whether it’s doing well or not, because it subjects the results the company reports to many more pairs of eyes. Management may be able to convince itself that everything’s hunky-dory, but short sellers will comb financials looking for signs of future problems. That’s a discipline we need.
If the stock is going into the toilet, management may decide it’s time to make a change, or directors may finally decide to roust themselves and can the managers.
Oh, and another point: how much money would you be willing to pay for stock that you couldn’t sell? Hmmm? There are lots of companies where that’s the case - and those are the ones that tend to be subject to the most significant manipulations, as yabob pointed out earlier. Ever seen the kind of battles that erupt when a company limits its stock ownership to a small group of people, and one side wants to be bought out? It’s ugly, far uglier than our imperfect, but quite functional market.
Plus, they can use their stock directly as a currency when purchasing other companies. For acquisitions, both the buyer and the seller care very much about the stock price of their companies.
If you buy a bond that has already been issued, is that investing or gambling? The company can go belly up and not pay on the bond and not pay the interest. You’re not injecting new capital into the company. It still seems like an investment to me.
When you buy a stock, you get an ownership interest in the company (usually, a tiny amount of ownership, but ownership nonetheless). Even if the dividend yield starts out tiny, it could grow over time, and often does. As the stock price rises, a company is pressured to raise the dividend so that the dividend yield is somewhat stable. If you bought in when the stock was lower, your personal dividend yield will increase over time, even if the current dividend yield is low. In that way, you get value from your investment and ownership stake in a going concern.
From the company’s perspective, since you’re not injecting new capital, they may not see your purchase as an investment (except when you start to get large pieces of ownership), but from your perspective, it certainly seems like an investment, albeit a risky one.
<< Getting rich:
- Invest in companies which, by reasonable standards of business models, are capable of growing rapidly. Since most are untested start-ups, this is high risk, high return investment. >>
A reminder (paraphrasing) Mark Twain’s instructions on investment: Monday is a risky day for investment. Similarly, Friday, Thursday, Tuesday, Saturday, Wednesday, and Sunday.
Enron
WorldCom
Their stocks were going through the roof while the companies were going into the toilet. Why? Because the stock market is fundamentally fictional. “Adjustments” only occurred after the fact.
Buying non-IPO stock is just betting on horses. It’s not investment. There is no capitalization going on.
And both of those examples had quite a number of skeptics even before they went into the tank: WorldCom was especially a concern, because many knew that much of the company’s alleged value was simply the artifact of favorable accounting rules on acquisitions.
There are lots of reasons to be suspicious about particularly companies at particular times - but the idea that the U.S. markets are corrupt to the core is simply histrionics. There are always going to be corrupt companies out there, stock exchanges or no stock exchanges, and when they go bust they’re going to hurt lots of folks. But even at the multibillion scale, it’s barely even background noise to the rest of the economy.
Dogface, please re-read this thread - several of us have given detailed responses explaining why buying stock in the secondary market is, in fact, “capitalization,” albeit indirect. If there’s something we can clarify, please tell us. But right now it doesn’t look like you’re particularly interested in learning - just in clinging to your prejudices.