Confused about stock market principles

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What is the Stock Market anyway? I always thought owning a stock was part ownership of a corporation. I don't understand how investor "confidence" affects stock prices. Let's say that corp XYZ on its 3Q Balance Sheet says it has assets of $1 billion. If there are 20 million shares of stock then the price is $50/share. Period. If in 4Q, the assets are $1.1 billion, then the price becomes $55/share until the next quarter. There shouldn't be any price shifts until an official quarterly report comes out and then that is the price until the next quarter.

I know, you're saying that they have earnings and pay dividends. But that's where the whole fallacy (IMHO) comes in. The system has become so complex that no one quite understands it. There should be no dividends - if they're not paying dividends, then the corp can invest in themselves instead of their investors, but the investors would still benefit, because the stock price would go up along with assets (invested earnings). If an investor needs money, simply sell some of the stock.

I know this is beyond simplistic, but I guess my main confusion is: If the DOW drops from 10K to 5K in a week or so (a crash), I just don't understand how that is a loss of wealth. I mean the same factories, infrastructure, transportation, employees, etc., etc. are still out there. How can a loss of confidence affect material assets and wealth? (Unless the system is inherently corrupt and fake, the money's not there at all, and if you used "my" valuation model, the DOW would actually be at 1-2K). I don't know, I'm just guessing.

Also, about the DOW, S&P 500, etc. Everyone argues the merits of the "leading market indicators," but why don't they have an average of all the stocks in the market. It seems that would be the best. Oh well, I guess I'll never get it.....

-- Jim (x@x.x), October 19, 1999

Answers

"I just don't understand how that is a loss of wealth."

In the simplest of terms, as an investor if you purchase a stock for $10 and it goes to $5 in value you have just lost your ass.

-- OR (orwelliator@biosys.net), October 19, 1999.


Jim,

A stock's value is the amount a person is willing to pay for one share at a specific point in time. Period. There are many reasons stocks go up and down. Some are due to revenue shifts (sales drop), some are purely for emotional reasons (change in government, y2k, Greenspan makes a speach

-- 8 (8@8.com), October 19, 1999.


If the forum econo-weenies will forgive me...

Stocks are worth the highest amount that people will pay for them. If people will pay you $1,000,000 for a share of Mudwrestle.com (symbol KOS on NASDAQ) then it's worth that. Stocks used to be governed by the profits that the company generated, but that's not happening today. It may happen tomorrow. And if you paid $1,000,000 for that share of KOS and the next day no one will give you more than $10 for it, the economy, specifically the tiny bit of it that is you, just lost $999,990 of wealth.

Did you ever play musical chairs? Hot potato? Yes? Congradualtions. You have broker training.

And someone really ought to write a book on the effects of electronic mass media on the stock market.

Watch six and keep your...

-- eyes_open (best@wishes.not), October 19, 1999.


Like many, I've been investing for a while..

I'll try to answer your questions. With a publicly traded company, ownership of the company is shared with the public that purchases the stock. Usually this gives voting rights. (but who fills out all those proxy statements ;-)

As for dividends, companies that don't expect to grow much issue dividends to keep shareholders happy. Companies that are bent on growth reinvest the money. Some industries like software are capable of great growth, some just plunk along earning money but don't grow.

Contrary to a lot of hype mongers, in the long term, earnings drive stock growth. For companies like Amazon (that don't have earnings), investors buy it because they EXPECT earnings in the future. Some investors, however, don't look at fundamentals, and just buy on momentum though (with mixed results) ..

As for share price, it is determened millions of times a day as investors buy and sell. For that time of day, I'd argue that the price is perfectly fair, THERE IS NO SUCH THING AS AN OVERINFLATED STOCK.

To take a simple example (not insulting your intelligence..). Take a gallon of milk. If I walked up to a storekeeper and said, "I'll give you a quarter for that gallon of milk". They would probably tell me to take a hike. If, for example, I own a microsoft share (lets say I paid 90 bucks for it) I've made money on it, I expect to make more money on it, and someone offers me 50 bucks.. I'll say FORGET IT, unless I think that Microsoft is going to tank, or I notice or hear about substantially disturbing news. Unfortunately what's "substantial" tends to vary..

As a simplified example, this is how the market works. There are many types of investors that invest many ways (irrationally and rationally).

There really should be no 'mystique' about the market, as it is simply buying and selling at agreed upon prices.

As for the overinflated myth.. What is a fair price for a company? It used to be that a PE ratio of 20 was 'high'. But now, companies trade at 80 times earnings.. Why would an investor pay this? Probably because the expect the company to keep growing!

In my opinion, buying a stock is the same as buying a piece of gold or a gallon of milk. It's a commodity, nothing more, nothing less.

Bryce

-- Bryce (bryce@nomail.com), October 19, 1999.


Thanks for your answers, looks like I forgot about ol' supply & demand. But it still seems like it shouldn't have that much of an impact at the macro level.

For example, if Microsoft's stock price was around $90/share and falls in half because of whatever - a foreign market stumble, PPI/CPI figures, Greenspan speaking, Y2K, whatever. Even something "real", like an environmental disaster (Exxon) or a higher min. wage being passed, whatever, but real in the sense that it actually cuts into profits, not something perceived, but real. Even then, how would (why should) the stock price be so drastically lowered. Even in the Bhopal disaster, Eveready probably only cut into profits a max of 10-20%, probably only 1-2% (just guessing here).

Maybe what I'm trying to say is, if I had $1,000,000 in stocks and they went down by 1/2, then I lost $500,000. But where does that money go? The ASSETS are still there. Even if they TANK the assets are still there (buildings, furniture, trucks, warehouses, computers, etc. etc.) If Microsoft tanks and every stockholder loses money, where does that money go? - and where does the stuff go?

The fair price of the company is the price. It has nothing to do with earnings. If I go out and buy a chainsaw for $300 and try to sell it for $3,000 because of it's "earnings potential", then somebody's going to laugh me off the planet. If Phizer or somebody finds a cure for cancer or aids or something real huge, their stock price shouldn't jump until after they've earned it. This is the problem in a nutshell: expectations.

Now suppose you owned that Phizer stock when the news broke and it was $100/share. Then you probably wouldn't want to sell for $100. Suppose you didn't own any but really wanted to because it was expected to go to $500/share by the end of the year. I can see supply and demand fighting it out to determine the stock price during the quarter with anticipation, etc. But there's got to be a reckoning day. Suppose that it becomes $300/share when the next balance sheet is due out. When you divide the assets by # shares the figure is $252/share. It automatically becomes $252 right then and there. Or if it comes out to be $335 then it becomes $335 right then. Is this too simple?

-- Jim (x@x.x), October 19, 1999.



Jim

You asked "Maybe what I'm trying to say is, if I had $1,000,000 in stocks and they went down by 1/2, then I lost $500,000. But where does that money go? The ASSETS are still there. "

That money? There's no money going anywhere really. The plunge in value just means less money will go to you for that stock. The value of the stock is all in our collective heads. What the market will bear is what people, or fund managers, will pay for the stock. The actual money is electronic. The stock market provides liquidity. You can move your piece of paper with implied value for this many electronic dollors at this point in time.

Don't be suprised if the stock is worth far more than the actual worth of the physical assets. You said yourself, earning potential is added on top of that. That's a guess, BTW. So the market deals in guesses, paper valued far above the value of the physical assets of the company and money that you can only see on a CRT at your bank.

You know, the whole thing is starting to sound really silly.

Somebody summon up Mr. Decker or Brian and give Jim a straight answer.

And keep your...

-- eyes_open (best@wishes.not), October 19, 1999.


YIKES! Jim, when I read your comment about supply and demand I nearly fell out of my chair. Supply and demand have everything to do with equities.

Price is determined by the interaction of supply and demand. An easier way to understand this is to imagine the interaction between buyers and sellers. Our first rule: Every buyer must seller (and vice versa.) Our second rule: The buyer and seller must agree on a price to complete a transaction.

Let's say you want to buy Microsoft stock. You place an order to buy Microsoft at $90. Let's say no one wants to sell you their Microsoft stock at $90... they want $95. You offer $92 and they accept. Now, imagine this happening thousands of times a minute. The price for Microsoft rises because of fluctuations in supply and demand (or sellers and buyers.)

This is why the market "falls" when everyone wants to sell. Prices fall to the point of equilibrium. Equilibrium shifts on a moment to moment basis. Remember, events do not change prices... people's reactions to events do. (Wow, that's catchy.)

When stock prices fall, you lose money. In the crash in 1987, a trillion dollars was "erased." Ouch. Where does the money go? Here's a better question, where did the money exist in the first place. Our third rule: It is not a profit (or loss), until you sell. Just before the 1987 crash, people were sitting on great "paper" profits. Those "profits" vanished after the crash.

Let's make this easy. Let's say you buy your dream house for $500,000. A year later, you decide to sell your house, but the best offer is $250,000. Where did the money go? It's the same house. You paid $500,000 based on your assessment of the value of the house. The "market" (all people interested in buying homes) decided your house was only "worth" half of its original value.

Price is ALWAYS the interaction of supply and demand unless set by a government agency. The only "fair" price is determined by the free interaction of buyers and sellers in an open marketplace.

With stocks, the outlook for future value is often factored into the current price. Instead of a chainsaw, let's talk about a tree trimming company. What is this company worth? The sum of its assets? No. A better valuation method is its earnings. Let's our little tree trimming company owns lots of saws and trucks. To make it easy, we have $500,000 in assets. The real question here is whether our company is profitable.

Let's say we have a great business and make $200,000 in profits every year... and business is improving all the time. If we bought this company for $500,000, all things held equal, we'd make our whole investment back in under three years. Wow! That's a much better return than T Bills. The old rule of thumb for small business investing was 20% to 25% annual return on investment. If you sell me the tree trimming company for half a million, I'm looking at a 40% per year return. I'll take those numbers!

As an investor, I weigh risks against the rewards. T Bills are a sure bet. The tree trimming company is a riskier investment.

If we issue stock in our little company, what is the "fair" price? It has EVERYTHING to do with earnings... present and future. If I own this company, as it grows, so does my investment. Consider the above valuation of a business and tell me what you think it's worth at $1 million per year in profits?

A chunk of metal has no earning potential, per se. Hey, it's just a chunk of metal. A company produces goods and/or services. It makes profits... and those profits influence the "attractiveness" of its stock. As demand for stock increases... so do the stock prices.

You make a common mistake, Jim. You see "worth" of a company as the sale prices of its cumulative assets. As I point out above, a company may be "worth" far more than the sum of its physical assets. The real value is determined by the stream of profits.

One last test question. Your great grandfather dies and leaves you a note. He made two investments. As the oldest great-grandson, you get to choose first. In 1900, he bought 1,000 ounces of gold and kept it in his safe. The same year, he also opened a simple savings account for $10,000 paying 6% interest.

It's 1999... which do you choose?

-- Ken Decker (kcdecker@worldnet.att.net), October 19, 1999.


Straight answer? Maybe. I can at least share my best understanding.

First, if you buy stock at $10/share and the market price moves down to $5/share, you have not *directly* lost money. That loss occurs if you "realize" the loss by selling at $5/share. Money has moved out of your pocket, but that loss is purely personal. If the person who sold you the $10/share stock was shorting the market and then you sold the same stock back to that person, he made as much (less commissions) as you lost. It's a wash.

So, if it's all a wash, how could money be "lost" if the market crashed? The answer is leverage.

Leverage is just a fancy way of saying that the stock valuation is used as backing for a loan. As we have all learned from the incessant posting on this subject (myself included) credit can create money that didn't exist before. Banks do it all the time. Brokers do it, too, by extending margin loans, but usually a bank is lurking somewhere in the back of that deal.

Corporations own their own stock, then use that stock as collateral. Mutual fund managers may leverage their stock through credit. Hedge funds, rich folks and little-guy speculators all indulge themselves in leverage. Where the money gets destroyed in a crash is when that leverage unwinds. Roughly, the credit that was extended on the strength of the stock valuation is now "called" on its weakness. If the loan is repaid, that's great for the creditor, though bad for the debtor. If the debtor can't meet the call, that's bad for both.

The very act of calling loans shrinks the money supply by reducing the value of the loan as an asset. If the called loans are not repaid, then even more money is destroyed, as bank assets become losses.

When money is destroyed, is that a "loss of wealth"? Not exactly. As Jim pointed out, the factories and infrastructure are not destroyed. It is only a loss of liquidity. But that's bad enough. We all need liquidity in order to supply ourselves with the goods we don't make or already own. We need liquidity to replay our *own* debts.

One of the biggest weak points in a capitalist system is the same as one of its great strengths: we make contracts on fixed terms and enforce them. This provides a solid structure to build on. It also provides a very *rigid* structure that doesn't respond well to abrupt changes in either the money supply or in the supply of goods.

If the market bubble were to crash and the leveraged positions that built it up unwound very badly, the money supply would deflate rapidly and the Federal Reserve would have a *very* hard time reflating it. In personal terms, that would mean our debts would remain rigidly in place and enforced, but the wherewithall to pay them back would be greatly reduced. A lot of bankruptcies. A contraction instead of an expansion in commercial activity. Job losses. Factories and businesses closed. At that point, *wealth* would be reduced, too. Not just the money supply.

Now, as for Jim's questions about how stock valuations are set... Classic economics describes this as a process of discounting all the known risks. It envisions a knowledgable investor who understands the market, analyzes all the strengths and weaknesses of a company and its competitors, sets realistic goals about future conditions, and arrives at a price he is willing to pay. The difference between the various conclusions of these investors and their different goals and needs provides room in which a deal can be made, where both the seller and buyer are satisfied that a fair price has been struck.

Classical economics presumes a lot of knowledge on the part of buyers and sellers. Jim's remarks show he is sympathetic to that point of view. ["... corp XYZ on its 3Q Balance Sheet says it has assets of $1 billion. If there are 20 million shares of stock then the price is $50/share. Period. ..."] All I can say is that reality is a lot messier.

The idea, put forward by someone else, that there is no such thing as an overpriced stock is, um, the kind of thing people say who are committed to an ideology to the extent that it completely controls their definition of reality. It is logically consistant, I'll say that for it. But it requires the holder of that opinion to postulate that "value" is of such an effervescent nature that it jumps around as rapidly (and as randomly) as subatomic particles.

-- Brian McLaughlin (brianm@ims.com), October 19, 1999.


Thanks, everyone, for your replies. I kinda knew some of it already - I guess the thread (for me) was more of a rant on the complexity of things.

-- Jim (x@x.x), October 19, 1999.

I'm going to print this thread for my teens, who have asked a few questions of late about basic economics, supply and demand, and the stock market. Thanks to all, especially Mr. Decker and Brian, for the succinct and clear contributions.

-- Mac (sneak@lurk.hid), October 19, 1999.


Very well stated Mr. Decker, good example.

I buy stock in companies that I expect to grow. Earnings are stricly correlated with growth. Projected earnings with projected growth.

As soon as you ignore that, you are a momentum investor.. That's fine if that's your method, but at least it should be recognized.

Bryce

-- Bryce (bryce@nonet.com), October 19, 1999.


JIM: Regarding your last question in the original post ,there IS a market index that tries to track most of the publicly issued stocks in the USA. It's called the WILSHIRE 5000, and you will see it mentioned briefly each night by Paul Kangas on the PBS NIGHTLY BUSINESS REPORT. No one index can tell you EVERYTHING that's happening, so that's why there are so many. I do know that almost every other stock index is CAPITALIZATION-weighted, but I'm not sure about the WILSHIRE 5000.

-- profit_of_doom (doom@helltopay.ca), October 19, 1999.

Understanding the stock market: (1) Fear. (2) Greed.

-- J Henry Lyons (shotgun12@att.net), October 20, 1999.

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