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How does the stock market actually work?
CygnusZ
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Registered User regular
Today I was looking through some charts showing how the value of the DOW industrial average changed from the 1920's to the current crash. I noticed that starting from about 1990 to about 2000 the DJI had absolutely bat-shit insane growth. In 1990 it was trading for around 2,800 and by 2000 it was trading for 10,447. I do understand that the information technology and biotech revolutions are largely responsible for this, but they actually expanded the DJI by a factor of FIVE?! That seems ridiculous to me. If we started looking at the market from around 1950 (the DJi is around 200), it took until the mid 80's to reach that kind of growth (around 1,000).
The Nikkei 225 is really just as eratic. Hell, it's lower today than when they started the index.
Ok, so... how does this happen? How come the DJI is basically stable up till the 1990's and then suddenly shoots up out of control? Does this have something to do with the current crash?
The Nikkei 225 is really just as eratic. Hell, it's lower today than when they started the index.
Ok, so... how does this happen? How come the DJI is basically stable up till the 1990's and then suddenly shoots up out of control? Does this have something to do with the current crash?
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http://finance.yahoo.com/q/bc?s=^DJI&t=my&l=on&z=l&q=l&c=
If you really want to understand macroeconomic trends, pick up an econ textbook or take a class. If you don't have time for that, get a decent book. It's a vast and really interesting topic that reveals some pretty funny quirks about how people value things.
See The list of the 30 current companies, half of which were added after 1990.
Some people like to look at the NYSE or Nasdaq (or any number of other indices), but you've got crazy people who study economics that write papers on some of the wild fluctuations that you see in any one you pick.
During times like this, people think the future earnings potential of most companies drops precipitously. This means that their value drops considerably, too. But say tomorrow a company invented a way to colonize Mars costing them $100 per person. While today their earnings potential would be practically zero (say they don't have a product right now), tomorrow it would be in the billions. The value of the company would multiply by orders of magnitude overnight.
Yes, a lot of people thought they had much more money than they did, as they were all buying worthless shit that they thought was gold.
There's a great series of programs called The Ascent of Money, it was an over the air broadcast in the UK, and I think in the US? It covers a lot of the financial history of the world, telling the story behind how many financial institutions formed. It's not really academic but it's very interesting. It's out on DVD but also at various sites on the internet... Channel4 had it on their 4onDemand for a while.
Pluto was a planet and I'll never forget
If I told you that down the street, there was a fruit market, you would know exactly what I meant. Assuming a variety of background factors for the sake of illustration, you would know that: 1) should there be fruit in the area, there is a good chance it would end up at that market somewhere along the way, 2) buyers and sellers of fruit, or those who represent them, would be at that market, and 3) there a variety of support mechanisms and rules/regulations would be in place to ensure the buying and selling of fruit in a relatively secure and easy manner.
So in short, if I told you there was a fruit market down the street, and you wanted some fruit, you'd probably go to the fruit market. The same holds for the stock market. The only real distinction is that instead of dealing in fruit, you're dealing with stocks. When you hand money over to the orange seller, the orange seller hands you back an orange. Fundamentally, a stock is nothing more than ownership of some portion, or share, of a company. So when you purchase an orange at a fruit market, you're buying ownership of that orange. Similarly, when you purchase Microsoft shares at a stock market, you're buying ownership of Microsoft (e.g., "7 shares of Microsoft"). How much ownership you have is dependent upon how many shares are out there.
Now, a really great way to see the value of a company is to look at how much it earns (hence, Price/Earning ratio, a fundamental measure of stock value). Because "valuable" companies should earn a lot of money relative to their price, right? Similarly, some companies attach regular payments for ownership, in an effort to attach more "value" to the stock, because if owning it means you get $25 every month, that's a pretty good reason to own it, right? These payments are called dividends.
On another vein, to really start answering your question, let's say you have someone who wants to buy a company because he needs it as part of a larger business plan (let's say, he wants to buy a local granary because he wants to expand his bread-making factory). Because he values the stock in a different way than most everyone else who owns it, he is willing to purchase it at a higher price than most everyone else bought it at. Now, a few people sell to him, but suddenly the other owners realize that hey, Jim Smith is buying up all of the Great Granary stock. This means he must really want it. Let's hold out and see how much he's willing to pay for it. So now Jim has to negotiate with everyone to figure out what the lowest price he can get for Great Granary is, and whether or not it is worth it for him to still purchase the company, or if he's better off looking elsewhere or just starting up his own granary.
So that, in a nutshell, is supposedly, ostensibly, "fundamentally" how the stock market is supposed to work. It's a market. For stocks. Prices are established based on supply and demand. People trade it based on their perceptions of value.
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One of the key differences between fruit and companies is that when you buy an orange, it's pretty much a given that you're going to consume it in some fashion (eat it, use it as raw material for something else, dump it in the ground in a desperate attempt to grow an orange tree, etc. etc. etc.). The value of the orange is in its consumption, in its use. Part of this is because the very nature of the orange - it is a tangible thing. And hey, it's food. Another part is because it eventually biodegrades and becomes waste product (or rots away entirely), so its lifespan is limited - the expectation is that you use it or lose it. An orange is an orange. You know what you're getting.
Ownership of companies, on the other hand, can really only be exercised via limited voting on the direction of the company (if you even have that right, which is negotiated in the type of stock you purchase). Other than that, you are "buying" the company with the expectation that ownership of it has some fundamental value. You own the company because it in and of itself is valuable. In a sense, the value of a company is based on how much everyone else thinks its worth. Because, really, you can't do anything with it. So in a sense, it is very much a psychological exercise in supply and demand.
The question becomes: how do you determine the price of a stock? When all is said and done, the price of an orange is pretty easy to determine in a functioning, regulated, free market. Everyone who wants an orange can just go to the store and get one. Everyone who wants to sell an orange knows to sell it at the market. And at the end of the day, you get an intersection of supply and demand at a given price. Not everyone who wants an orange gets one, not everyone who wants to sell an orange gets to sell one, but generally, any exchange that is worth it to both the buyer and the seller gets done, and a general price is established.
When dealing with stocks, it's a little more finicky. You'd thing oranges would be tough, given all the stuff you can do with oranges, compared to the general lack of "stuff" you can do with stocks. But if anything, because of the rather dubious (I show a bias based in my philosophy training in the use of that word) nature of stocks, it is more difficult to ascertain a price on them than it is an orange. Because oranges are there. You can eat them. You can touch them. You can use them. This allows for ample evaluation on whatever requirements you set out for your method of consumption.
Stocks? Not so much. You own a stock because you think it has value (note that this is the first time I've said value and not price - two completely different things). Essentially, you own a company because you think, down the road, the price of the company will rise and eventually you will be able to sell the stock you purchased at a higher price than you bought it. Note that I am greatly simplifying things for the sake of illustration, but the basic principle is always the same. People buy stocks because they think the price will rise. People sell stocks because they think the value will not rise. There are a lot of things out there that complicate things, but at the root of it all is a market based purely on the perceived value of a given company at a given time.
In essence, trading stocks becomes a game of information and psychology. The more information you have on the "value" of a company, the better you can ascertain the accuracy of its price. The more ways you can control that information, or affect the perception of the value of that stock in the market, the easier it becomes to manipulate the price of a stock regardless of its actual value.
Because really, you can't hype fruit. Like I said, an orange is an orange. However, you can hype a company to high heaven. Great Granary is fantastic because it has an awesome location, it has a variety of suppliers, and it always puts out awesome grain. Whisperwhisper rumor has it Jim Smith is looking to buy it out because he wants to expand his bread factory, so you should get in on the ground floor and buy the stock now when it's "cheap", because the price is going to rise (because Jimmy is assigning a higher value to the company than everyone else).
These market basics already obfuscate things enough due to competing interests and incomplete information. Things only get worse when you include the sheer number of tools and tricks out there people have to essentially "play" the market. The best analogy (for this place) I can think of is trying to play Street Fighter with only punches and kicks, and no special moves. Or playing Street Fighter IV without using the Focus system at all. You think you're doing OK, but the truth is there's a whole 'nother game out there. For example, in the stock market, you can basically bet that the price of a stock is too high, and make money off of it by borrowing the stock at the given price, buying an equivalent share of the stock when the price falls at a later date, and then selling back the "borrowed" stock to the original lender at the same high price at which it was borrowed, essentially pocketing the difference as profit. This is "short selling". Suffice it to say, you can't really do this with oranges, because the people selling oranges generally just want to get rid of them, and the people buying oranges generally just want to consume them (in some fashion). If you gave the orange guy the proposition of short selling he'd be like, "WTF am I going to do with another box of oranges at a later date? Why can't I just sell you my damn oranges?"
Again, as with this entire post I am significantly oversimplifying things, but in the hopes that the general concepts and principles are coming across here. Hopefully that helped to answer your question. Unfortunately I can't really think of a simple one-phrase response, although I'm sure someone will give you one that will make my entire post a waste of time.
Random thoughts:
Confucious generally undervalued the merchant class because, at their heart, he saw no value in their labor. Unlike farmers, who grow things, or builders, who build things, or even artists, who can "inspire" people, the merchant class didn't really produce anything, as he could see it. At its heart, his critique went along the lines of, "Merchants are worthless because they don't make anything. All they do is move shit around and take money from people for doing it."
Unfortunately, he failed to see the value in precisely that act. Getting something from Point A, where someone had a lower value for it, to Point B, where someone had a higher value for it, in and of itself produces value. It produces a positive net gain for both people at both ends, because neither person at either end of the transaction would have anything to do with the merchant unless they got something out of it.
This is one of the fundamental tenets of economics. That the total aggregate of all transactions produces some value, because the perception on both ends is that they are getting something out of it. So the more trade there is, the better things are for everyone. This is a heavy assumption, but I think in general a good one. Not all transactions are good, but at the end of the day, things generally work out for everyone involved. And we all move forward, together.
But there is an opposite end of the spectrum, as well. The trouble begins when you start doing shit like chopping things up, obfuscating their true value (or lying entirely about it), leveraging something you know to have little value and pretending that it has tons of value in order to obtain more things of questionable value, and selling things of questionable value all in the name of pure, unadulterated, greed. Confucious wasn't right when he said that, "Merchants do nothing." But he wasn't all wrong, either. There is such a thing as just plain moving shit aorund. Or, in other words, creating something out of nothing.
[Holy shit I just wrote a term paper at 4:45am and I have work tomorrow at 7:00. Why am I even here? I already graduated college...]
If you ever need to talk to someone, feel free to message me. Yes, that includes you.
Food is really very similar to stocks, except in the end product. An orange may be an orange, but an orange in a year with a particularly poor harvest is worth a lot more in a year with an abundant harvest. Any number of things can rapidly effect food pricing, particularly notable with the spate of recent food riots around the world etc.
Yeah, this is how futures/hedging started.
Let's say I'm a farmer and I'm growing oranges, but I'm scared that by the time I plant, cultivate, and pick 100 acres of oranges, there won't be anyone interested in buying them. Maybe they want them now, but will they want them by the time they're ready?
People will then come to me and offer, "yo, I'll give you $0.10 per orange now in order to be able buy them later for $1, no matter how much oranges cost by then."
Why would I take that? Because I get 10% of my money upfront, and I have a seller interested in my goods. Score!
Why would someone offer that? Because they think that while oranges cost $1 each now, they'll cost $2 each by the time those oranges are grown. They're essentially paying $1.10 ($1 + the $0.10 contract) for $2 oranges. Score!
These are futures, and they can really fuck people over. Essentially, people are *speculating* on how much oranges will cost in the future, and then making bets on them. The weird part is that by the time those oranges are done growing, there are tons of people holding futures contracts that have claims on them. The value of the oranges *at the time they're ready to be sold* will actually be somewhat informed by the speculated price from before. This happened with oil, where people assumed it would just go up and up, and the price of oil actually mirrored the speculation. That's called a bubble.
Eventually, people were like "fuck this, I'm paying $8 for an orange. fuck oranges" and the market corrects itself by seeing the bubble get burst, setting the price of oranges back to $1. But I paid $2,000 to get oranges for $7.50 each! And now I don't even want to use those contracts! Well, those contracts are now completely worthless. Sucks!
Right, but he wasn't asking about all securities - he was asking specifically about stocks and the stock market. Derivatives, bonds, commodities, etc. etc. etc. are not in the Dow Jones Industrial Average.
Also, the similarity you describe between oranges and stocks is the same analogue between any objects within a market arrangement (which is why I used fruit as a basic example in the first place). Supply and demand dictate price. I agree that the main difference is in the end product being traded - it is precisely because of the difference between the two that we don't sell stocks in the grocery store.
Yeah, this is a good answer. Thanatos is basically giving you a run down on what some people call "value investing" - it's the sort of strategy that Warren Buffet uses to great effect. Value investing is predicated on doing fundamental analysis of the company in question you are looking at buying, which means you look at lots of graphs, balance sheets, and forecasts for company growth, as well as market standing, branding, and management. Then you ask yourself the question: do you think that X (the value of the stock at its current price) is less than the earning potential of the company over some period of time? There are other questions, but the basics are all similar. Will the company make more money in the future than the market currently values it at?
There's another method of stock trading that relies on more mathematical and psychological analysis of the price of stocks. It's not very popular, as far as I know, and I don't know anyone who actually does this type of analysis, but you basically look at the prices and trends of stocks themselves in isolation from the apparent "foundational" factors that a value investor would say drives them. Then you make your decisions to buy or sell based on the general trend of the stocks and the market place as a whole rather than the supposed real value that the stocks represent.
The problem with this second type of strategy is it basically exploits one of the fundamental weaknesses of modern capitalism, and can lead to bubbles (like the dotcom boom in the '90's).
Basically, I have about $2k-3k that I want to use to actually start investing in some way (right now it's just sitting with everything else I have in a savings account). But...I don't know much beyond the basics of the stock market and other forms of investment.
Seems to me that anyone who can pick out stable companies stands to profit a little as long as things don't get horribly horribly worse, but should I find a financial advisor and tell them to put my monies in low risk stocks, or is there a better way to invest it?
Edit: Startin' a new thread, don't mind me.