Political Economics Prof

Tag: Stock Market

  • Introduction to the Stock Market Crash of 1929 and the Start of the Great Depression

    Introduction to the Stock Market Crash of 1929 and the Start of the Great Depression

    INTRODUCTION

    Before reading this essay, I strongly recommend you see the PBS video on YouTube. Type in Stock Market Crash 1929.

    Look for US – The Crash of 1929 (PBS), ALLHISTORIES – PLAYLIST.  Documentary broken into 6 parts to show commercials. Or purchase video on Amazon. Great documentary with wonderful photos, videos, and scenes from movies of the 1920s and the crash. Shows what a crazy time this was. 

    I also recommend you read Frederick Lewis Allen, Only Yesterday; An Informal History of the 1920’s. This a wonderful popular history on the 1920s and the crash. It shows how the economic, social, and psychological changes in the 1920s contributed to the speculative frenzy in the stock market. The author lived through it all. You can skip some of the chapters the first time through; for example, skip Chapters III, VI, IX, And X.

    DEFINITIONS

    The Stock Market. In the 1920s, this meant the New York Stock Exchange. This is where most stocks (shares of part ownership of companies) were bought and sold. 

    Most of America’s largest companies were traded on the New York Stock Exchange. They accounted for much of the economic growth in the 1920s.

    Dividends. Some stocks pay dividends but they don’t have to. Not fixed like bond interest. Management can raise or lower or eliminate dividends.

    Bonds. When companies borrow money, they often issue bonds. Bonds pay a stated amount of interest. They also say when they mature (due date, when the lender gets paid back).

    Economic Growth. When total output of the economy goes up, as it did between 1921 and late 1929. Total output is now measured by a statistic called the Gross Domestic Product (GDP).

    Recession and Depression. A recession happens when an economy’s total output goes down. Usually, unemployment goes up. A depression is a really, really, bad recession.

    OUTLINE

    This essay of the stock market crash of 1929 comes in three parts – the 1920s economy leading up to the crash, the crash itself (1928 – 29), and the immediate aftermath of the crash in 1930 (the beginning of the Great Depression).

    Part 1 – 1920s. EXTERNAL FACTORS – THE ECONOMIC BACKGROUND OF THE 1920s.

    American industrialization, urbanization and mass consumption goes into high gear. Agriculture stagnates.

    Part 2 – 1928-29. INTERNAL FACTORS – SPECULATIVE CLIMAX OF THE 1920S

           Speculative stock buying frenzy leading to the crash.

    .

           Trending enthusiasm leading to mass speculation.

                  FOMO – Fear of missing out.

    “Irrational exuberance” of ignorant speculators buying on margin (mostly with borrowed money).

                         Trend and herd mentality.

    Part 3 – 1929-30. THE BEGINNING OF THE GREAT DEPRESSION

           Continuous, deep recession of the real economy (total output).

           Conclusion – interaction of the real economy and the stock market.

    Part 1. ECONOMIC OVERVIEW OF THE 1920s

    From the bottom of the post-World War I recession in 1921 to the top of the stock market in September 1929, the stock market rose almost 500%.

    The external factors in the real economy had a strong influence on why the stock market had such a spectacular rise in the 1920s.

    There was a spectacular increase in industrial production starting in the 1870s and continuing into the 1920s. The 1920s were a decade of economic growth and development. The large increase in output in this decade was driven by innovation in new and greatly expanding industries.

    Some examples were steel, electricity, electrical appliances, chemicals, autos, processed foods, radio, movies, telephone, oil and gasoline, cosmetics, toiletries, cigarettes, and cameras.           

    This growth created large industrial corporations.

    They had a need for large amounts of investment and expansion capital.

    Advantages of companies issuing stocks over bonds. Companies did not have to pay fixed dividends, or no dividend at all. Did not have to buy back stock.

    Many of the companies on the NYSE dominated their industries and markets. They had exhibited large increases in sales and profits over time, which led to high expectations for future growth in company sales and profits.

    This strong past performance by industrial companies was the basis for expectations that the industrial sector of the U.S. economy would continue to grow at a rapid pace.

    Auto production was an important part of the industrial economy. The auto industry produced approximately 4 million cars in 1926, fell to 3.1 million in 1927 because of the Ford shutdown, recovered in 1928, and reached a record 5.4 million in 1929. Auto ownership went from 7 million in the early 1920s to 27 million in 1929. By 1929, there was an average of almost one car per family.

    The structure of the economy changed in the 1920s, with consequences for the stock market and financial markets in general. Industrial production, especially of large corporations, were a larger and more important part of the total economy. In contrast, agriculture stagnated. In 1920, agriculture accounted for 18% of Gross Domestic Product (GDP); by 1929, agriculture’s share had fallen to 12%. 

    Much of this industrial growth was financed with debt (bonds) and new stock sales. Debt helped financed the large capital requirements of new manufacturing equipment and electric power plants and distribution, added to the large issuance of railroad bonds. Demand for homes and consumer durables were largely financed with mortgages and consumer borrowing. New financial institutions such as saving banks and building societies (now called savings and loans) and new forms of debt were created or were expanded. Financial institutions and markets became a larger part of the economy.

    1929 was an outstanding year for real economic growth. The economy grew at a rate of 6%. Industrial output grew faster. Auto production skyrocketed to new highs. Total profits, corporate investment, and dividends were up, raising expectations about future growth. Stock prices rose faster than corporate earnings. But toward the end of summer, part of the industrial economy stalled out and probably started contracting. Auto inventories grew as sales lagged production. Scattered data suggested a possible recession. But this negative economic news had to compete with a constant drumbeat of optimistic forecasts and stock market hype. The stock market had taken on a speculative life of its own, divorced from the underlying economic reality.

    Part 2.  THE STOCK MARKET BUBBLE AND CRASH OF 1929 AND 1930

    What caused the speculative frenzy? The PBS video shows part of the answer.

    Internal factors had a strong influence on why the stock market crashed so hard in late 1929.

    The Dow Jones Index was up six-fold from bottom in 1921 to top in September 1929, including almost doubling from the beginning of 1928 to the top in September 1929, going from 2000 to 3900.

    Every market “correction” (downturn) since 1921 was quickly followed by a return to upward price movement.

    The story of the stock market crash of 1929 starts in 1928. After a lull in 1927, stock market prices started going up again in March 1928. Between then and September 1929 prices rose on average about 50% a year. Millions of small investors piled into the market because all their friends and relatives were getting rich. FOMO psychology (fear of missing out). In August 1929, John J. Raskob (financial executive at General Motors) published a widely-read article in the Ladies Home Journal titled “Everybody Ought To Be Rich.”

    Daily volume rose during this period. New speculators came in at higher and higher prices.

    About 10% of American families owned stock by 1929. Many new individual (retail) investors got into the market in 1928 and 1929. About half bought on margin (with borrowed money). Margin loans rose from $4.4 billion to $8.5 billion.

    In addition, there were big leveraged pools of money and new types of leveraged investments. New investment trusts increased the leveraged demand for stocks.

    EXPECTATIONS

    New investors in 1928 and 1929 had high expectations of a rapid increase in stock prices over a short period of time. There was a big increase in volume – more investors, and maybe indicating more speculative short-term investing. Investors perceived the market as having a low risk of going down. As the market fulfilled these expectations, it strengthened expectations of a continued rise in stock prices and a lower risk of a “correction.”

    Investors who came into the market since the beginning of 1928 probably had minimum expectations of stocks going up 50%/year. Investors who bought on margin (borrowed money to pay for most of their speculating) or bought leveraged investment products had higherexpectations. If they bought stock with 20% down and borrowed the rest, they might expect to make 200% a year on their original investment.

    Families that invested in the stock market felt wealthy. They saved a smaller percent of wage income. They took out mortgages to buy homes. They borrowed more to buy more new cars, new furniture, new electrical appliances, and radios. (Believe it or not, a top-of-the-line radio cost as much as a new car.) Consumer credit doubled.

    Another problem was that over 90% of all banks were investing some of their capital in the stock market. When the stock market crashed, many banks, like individual investors, didn’t have the cash to meet obligations and expenses. This contributed to the bank failures in the Great Depression. (Also, some bank managers and owners embezzled bank funds to personally speculate in the stock market.)

    Who were the sellers? One source were the large pools of money from rich people. These pools routinely manipulated stock prices, as did insiders and professional speculators. They would buy into a stock, partly with borrowed money, start rumors about how great the stock was, and bribe journalists and analysts to recommend the company’s stock. Then, as more and more small speculators bought the stock at higher and higher prices, the pool began to sell. After they finished, the stock’s price often fell. The pool then moved on to a different stock. Or in the example of RCA, the hi-tech, high-growth company of the 1920s, the stock was manipulated more than once by the same group.

    Companies, seeing the increased demand for stock, issued a great amount of new stock to raise money for future expansion.

    SPECULATORS BUYING ON MARGIN

    The large increase in small investors borrowing to finance buying stocks contributed to the buying frenzy. Called buying on margin, this introduced an increased source of leverage (buying with borrowed funds) and financial risk into the economy.

    If the new investors had just converted cash, bank deposits and bonds into stock, there probably would not have been as great an impact when the market crashed. Stocks are a form of wealth that generates income from dividends and realized capital gains (the prices of stocks go up). About half of the new investors had bought stock on margin, that is, partly with borrowed funds. Typically, an investor put up cash for 10-20% of the cost of stock and borrowed the rest from the broker. The amount of borrowing (margin) doubled between the start of 1928 and October 1929.

    If on margin, as the value of their stocks went up, speculators could borrow more money to buy more stock. They would still be wiped out when the market crashed.

    THE STOCK MARKET CRASHES

    The stock market, according to the Dow Jones Industrial index (a weighted average of 30 stock prices), peaked on September 3, 1929. The market drifted lower for almost two months. Then, suddenly, it fell 30% in one week in October! There are some dramatic photos and other footage of the week of the crash in the video.

    When the market broke in 1929, margined investors were asked to put up more cash. If they didn’t immediately, the broker sold their stock, contributing to the selling pressure. So, for these accounts, the investors were wiped out. All others had lost about 50% of their stocks value in October 1929. They were to lose even more later. 

    After hitting new lows in November, the market partly recovered. By April 1, 1930, the market was back to levels reach in mid-1929. With a renewed retreat, the market in early June had fallen to levels in mid-1928. But by then it was obvious the U.S. economy was in a recession that was getting worse. The market continued to turn down. By the end of 1930, all the gains from 1928 and 1929 were wiped out; the market index was below the low reached in November 1929.

    Part 3.  THE RECESSION IN 1930

    After the 1929 crash, negative feedback began between the destruction of wealth (savings) from the fall in stock prices and the failure of banks (depositors lost their savings) on the one hand and the rapid and deep recession in the real economy on the other.

    Households’ balance sheets were leveraged by installment loans (buy now, pay later) to buy consumer durables. The immediate negative wealth effect hit households as savings were wiped out but consumer loan payments and mortgages still existed.  Total income fell because of a rise in unemployment. More and more families couldn’t meet the installment payments; their cars, radios, electric appliances, and furniture were repossessed.

    The recession in 1930 was severe. Real GDP – total output – fell about 8.5%. This was the second worst year in the entire Great Depression. Also, this was after the fall in output from late summer to December in 1929. Industrial production fell a greater percent, possibly as much as 25-30% from the highs of the middle of 1929. The price level fell about 6.4%. The unemployment rate went up from 3.2% to about 8.7%, tripling from about 1.5 million employees out of work to about 4.5 million by the end of the year.

    In 1930, auto production fell 40% to 3.3 million. A glut of repossessed and used cars sold by owners probably contributed to this large decrease.

    In 1930, farmers were hit with lower prices, the Dust Bowl (huge dust clouds), loss of deposits in local failed banks, and inability to make loan payments on equipment. Farmers started to lose their farms; banks foreclosed on about 100,000 farms in 1930. (See the movie and/or read the book about this – The Grapes of Wrath.) The Dust Bowl continued until 1940, helping to wipe out many more farmers (see PBS video on the Dust Bowl; the dust clouds are unbelievable).

    The number of bank failures were rising. Most were small, rural banks. When banks went under, their depositors (farmers and local businesses) lost most or all their savings in the bank; deposit insurance came later. 

    Total income fell somewhat more than 10%. Total consumer debt fell 10%, reflecting the fall in income and widespread defaults on consumer loans. Total mortgage debt stayed stable, implying no widespread mortgage defaults and loss of home ownership (that came later).

    For speculators who held onto their stock hoping for a recovery, the losses were on paper (unrealized). But their total losses got worse; by the end of 1932, the market was down 80-90% from the September 1929 high. 

    The severe recession of 1930 took the floor out of the stock market. The big runup of the market in the first eight months of 1929 was partly based on expectations of continued high economic growth, and high growth rates in profits. But the economy stalled out in late 1929 and started its contraction that continued even when the stock market rallied in the first quarter of 1930. Profits plunged. Expected dividend increases failed to materialize. Decreasing expectations led to lower price/earnings per share (P/E) ratios on falling earnings per share. The stock market was not driving the economy; the economy was driving the stock market. But there were feedback effects.

    Just as expectations of rising sales, earnings, and dividends in 1928 and 1929 helped create the bubble, the worsening economic news in 1930 stopped the stock market recovery and drove the market even lower than during the 1929 crash.

    The number of bank failures increased. During the 1920s, up to 1928, an average of about 700 banks failed every year, in total about 20% of the 27,000 banks in the U.S. Most were small, local banks in rural areas and small towns and cities. But the total number of banks increased as new banks, and new types of banks, were established. In 1929, the number of failed banks rose to 1,250; in 1930, the number was 1,350. While the total for the two years was about 10% of the total number of banks, they were mostly small, local banks. The loss in total deposits because of bank failures was substantially less than 10%. Total deposits for the entire banking system showed no decrease in 1930 compared to 1929. The big increase in bank failures and depositor losses would come later as the economy deteriorated further.

    The Federal Reserve System (the Fed) could have reduced the financial damage to the economy by providing liquidity (reserves) to banks. This would have limited bank failures and depositors loss of savings. With one exception, the Fed refused to do this.

    AFTER 1930

    As the Great Depression got worse, stock prices kept going down, about 5,000 more banks went under wiping out depositors, unemployment rose to catastrophic heights, families couldn’t meet loan payments and lost their houses and cars. Eventually, almost half of all mortgages were in default.

    The highest rate of U.S. unemployment was 24.7% in 1933. An unemployment rate of 25% meant that at any one time one-fourth of all workers were unemployed. There were no unemployment benefits.

    Unemployment remained above 14% from 1931 to 1940.

    Now the good news – booze was legalized. Two other industries that did well in the Great Depression of the 1930s – tobacco (cigarettes) and movies. By 1930, most movies had sound; by the end of the 1930s, some movies were in color. They were a cheap way to forget the grim reality of the Great Depression.

    CONCLUSIONS

    Overall, there was little evidence in 1930 of the severe weakening and collapse of the financial sector that later played a major role in turning the severe recession into the Great Depression. None of the other financial sector institutions exhibited the collapse of the stock market. This is not surprising; none were as directly connected to the sales and earnings of large public companies. Or based on such optimistic near-term expectations of these companies’ continued growth in sales and earnings.

    But the dynamics of the Great Depression had begun. Unemployment rose rapidly, meaning millions of families lost their incomes. Families with savings lost some or all of it in the stock market or as depositors in banks that went under. Although many families lost their income and savings, they still had to make mortgage payments and pay off consumer loans used to buy cars and other goods.

    Economic historians concentrate on financial reasons for the Great Depression. This is understandable because of the dramatic stock market crash of 1929. But the early and swift decrease in the real economy in late 1929 and during 1930 was internally generated; real economic factors mostly caused the early recession. Financial factors – the stock market crash, bank failures where depositors lost their savings, speculating on margin, families unable to pay on loans and mortgages – would help deepen and lengthen the early recession into the Great Depression.

    Sources and References

    If you would like to read a fuller discussion of this complicated topic, see my

    The Stock Market Crash of 1929 and the Beginning of the Great Depression

    For a (hopefully humorous) explanation of the 2007-09 financial crisis, see

    Explaining Derivatives – An Analogy

    AMERICAN ECONOMIC HISTORY

    The Beginning of the Industrial Revolution in America

    How America Industrialized and Became Wealthy

    Introduction to the Stock Market Crash of 1929 and the Start of t

    he Great Depression

    The Stock Market Crash of 1929 and the Beginning of the Great Depression

    Alice in Wonderland and the Origins of Silicon Valley
    AMERICAN HISTORY
    Why Study History? Lessons for Americans

    American Colonial History, 1607-1775

    Revolution and the New Country:  American History, 1775-1790

    A New Nation, America from 1789 to 1860

    The American Civil War

    Berkeley in the 60s:  A Personal Reminiscence

    Alice in Wonderland and the Origins of Silicon Valley

    Religion and American Politics: A Historical Perspective

    What Now?  The Crisis of America’s Middle Class

    For all posts on this blog, with links, see 

    List of Posts by Topic

  • The Economics of Financial Markets

    The Economics of Financial Markets

    THE ECONOMICS OF FINANCIAL MARKETS

    MARKET-MAKERS, BIASED INFORMATION, AND FORECASTS

    This tutorial will look at financial markets and how they actually function. 

    There are two general theories about how financial markets work. The first is the Efficient Market Theory, which assumes all decision-makers are rational – they have access to information, can analyze it, and make investment decisions. Strangely, a major conclusion is that investors cannot predict stock price movements, which are random. The second is Behavioral Finance, which assumes that investors are irrational – they have a number of biases and are influenced by the markets’ past behavior.

    Both theories based on this supposed distinction that “explain” financial price behavior are irrelevant.

    What is left out of theoretical models of financial markets is how financial markets actually operate. Between buyers (investors) and sellers (including issuers of new securities), there are market makers like brokerage firms, managed funds, hedge funds and investment banks. It is in their interest to get investors to invest in financial assets rather than other types of assets, to trade often, to buy riskier securities and derivatives. All these strategies generate more revenue for them. 

    It is also in their interest to convince investors to pay large fees for supposedly superior information or analytical skill, that is, to ignore the Efficient Market Hypothesis. And investors, including large pension funds, often do.

    The primary selling tools are financial information, analysis of the information, and forecasts. It is the self-interest of all market-makers to present biased information and optimistic forecasts. For market-makers, financial information and forecasts are marketing data.

    What is financial information? First, the current earnings of companies. The problem is politely phrased “quality of earnings.” Earnings, and earnings per share (EPS), are routinely managed by corporate accountants to show steady or exponential earnings growth. This increases the share price as EPS goes up and, if earnings rise by a high or increasing percent every quarter, by increasing the price/earnings (P/E) ratio of the stock. 

    Since top management now receives much of its compensation from stock options and bonuses based on earnings growth, they have a personal reason to see that earnings are managed.

    Even a casual reading of the financial press or case studies on corporate finance reveal the numerous ways reported earnings per share can be increased when there is no increase in operating earnings or even a decrease. The simplest way is to increase financial leverage. The current version is to borrow money to finance share buybacks. This increases earnings per share since there are fewer shares outstanding.  

    For a sample of corporate accounting frauds, see http://www.accounting-degree.org/scandals/. Also see the entertaining film The Smartest Guys in the Room for the massive accounting fraud that bankrupted Enron.

    Then analysts who work for market-makers spin the earnings. They invent plausible reasons for the steady or accelerating increase in EPS and P/E ratios. Assuming these reasons will continue if not accelerate, they make optimistic forecasts of future earnings. Since the stock market is “forward-looking,” these biased forecasts are important pieces of “information” that investors use to make decisions. Analysts (and CNBC) become cheerleaders for the industries and companies they study, especially if they work for a financial institution that competes for investment banking business. Often analysts will hype a company that they privately know is a dog.

    Analysts overwhelming issue buy or hold recommendations and very seldom issue sell recommendations.

    The worse scenario for an investor is an industry with new technology. Analysts are free to make whatever predictions they want, no matter how improbable. A good story sells. In the decades I’ve followed the stock market, I’ve never heard an analyst tell the simple truth:  Almost all the companies trying to develop a new technology will go bankrupt and it is impossible to tell which few will be big winners (if any). Think about the biotech, dotcom and “clean energy” booms. I think it is fair to include the clever innovations that made the subprime mortgage and derivative boom possible.

    Investors are buying the future. Even stock index funds, which are weighted averages of the market value of the underlying stocks, go up mostly because of the more rapid than average increase in the hot stocks and hot industries. 

    This game comes to a temporary reversal when there is an “external shock” such as a recession. The phrase indicates important events than cannot be forecasted. Then there are the inevitable losses, “restatement of earnings,” “extraordinary losses” and “write-down of assets.” Hyped new technology companies go bankrupt. Hot stocks and industries driving the market get clobbered and indexes go down. Often a lot. 

    Besides reducing past earnings, companies will also take a “big bath” write-off of assets and anticipated future expenses. It is common practice to overestimate future expenses and losses. Then when actual expenses are incurred, they are smaller than announced and earnings are higher. This is one reason for the apparent paradox that a company’s stock price often goes up when the company announces a large loss and a large write-off of assets. 

    But memories are short, hope springs eternal and there is always a new story to tell – a new hot industry, new hot companies, especially if in a new technology. And the game moves to a different location.

    The main point here is that even if investors “rationally” analyze the biased information and forecasts, their subsequent behavior will not be any different than “irrational” investors who follow trends created by the biases and asymmetries of the financial information.

    UNDERPRICING RISK AND FAULTY MARKETS

    An important part of the information used to make investment decisions is forecasts. Yet the analytical tools used to forecast, and also price financial instruments, are defective. They are mostly based on a normal distribution of price movements and related linear regression models. Normal distribution models underestimate the probability of a large downward movement in stock prices. The market has much more risk (volatility) than the models indicate. Some of the studies and statistics are summarized in Benoit Mandelbrot, The (Mis)Behavior of Markets. This conclusion has been popularized in the best-seller, Nassim Taleb’s Fooled by Randomness.

    A recent example was the credit default swap market. The pricing of credit default swaps in the 2000s was based on a correlation model that assumed away the possibility of defaults! Since AIG thought there was no risk of actually paying off for defaults, it underpriced the credit swaps and could not afford to hedge its positions. The resulting defaults of derivatives and investment companies led to the bankruptcy of the largest insurance company in the world.

    There are some markets that cannot be forecasted. The bond market is bigger than the stock market. Yet economists cannot forecast interest rates and thus the movement of bond prices. The mortgage market cannot be forecasted. The future cash flows of variable rate mortgages are highly uncertain and fixed rate mortgages can be refinanced. Thus the future cash flows of mortgage-backed securities cannot be forecasted. Uncertainty is compounded by leverage in buying mortgage-backed securities  (MBSs), the creation of derivatives based on MBSs, and default risk.

    INDEX FUNDS VERSUS MANAGED FUNDS AND PICKING STOCKS:  INFORMATION AND IGNORANCE

    Financial markets are information rich. According to economic theory, prices should reflect this information. The pricing mechanism should be very efficient, summarizing the analysis of the large amount of data. But most individual investors and many institutional investors such as pension fund trustees are totally ignorant of financial markets and incapable of interpreting and analyzing financial data. What to do?

    1) Pay someone else to analyze data and pick stocks. (Managed funds)

    2) Buy index funds and index ETFs.

    An index fund like the S&P 500 ignores the problem of picking good stocks and buys the entire stock market. Stocks in the index are weighted by their total market value (in the jargon, called “market cap,” short for market capitalization). So the index buys 10 times as much of a stock with a market cap of $100 billion than another stock with a market cap of $10 billion. The index has to adjust the weights as the relative market caps change.

    Indexes tend to be dominated by very large companies and rapidly growing technology companies with high and rising P/E ratios. Before the 2008-2009 crash, indexes were dominated by financial companies. Six of the top ten market cap companies in the S&P 500 are tech companies. Currently (2018), the eight companies in the world with the highest market cap are all information technology companies.

    “Buying the market” (index funds) rather than individual stocks is a strategy for totally ignorant investors. Much of the increase in money going into the stock market after the 2008-2009 crash has gone into index funds and index ETFs. All that investors have to assume (believe) is that the real economy will grow, total profits and earnings per share (EPS) will thus increase, and that most if not all stock prices will rise as a consequence. Investors can ignore the competitive strategies and financial performance of individual companies, industry analysis, monetary and fiscal policies, and global and macroeconomic trends.

    And total ignorance works. A great deal of statistical evidence indicates that index funds outperform over 90% of managed funds over long periods of time. They also have lower costs – no expensive analysis costs. Managed fund managers also tend to take greater risks and create leverage (invest with borrowed funds in additional to investors’ money) to offset higher costs and achieve higher rates of return than index funds. Because of greater leverage, greater risk, and high costs, managed funds tend to do poorly in stock market downturns. Many “blow up” (go out of business).

    Index funds work because in the long run the economy does grow, total profits of public companies rise, and most stock prices go up. As more money goes into index funds, the funds must buy more of all of the stocks in the fund. The whole market goes up and the index funds prosper. 

    All of this also benefits managed funds. Experienced fund managers with access to all past and current financial and economic data, data and trend analysis programs, and proprietary models should be able to outperform the market in such an environment. But they do not. Why?

    They are making decisions based on biased and misleading information.

    There is a problem of too much information that is hard to analyze. For example, many companies no longer release an annual report. Instead, they send their stockholders (and analysts) their 10-k, which is the annual report they have to file with the government’s Securities and Exchange Commission (the SEC). These are incredibly detailed reports with small type that go on typically for 100-150 pages. Most of the content is unimportant or irrelevant. (This is the mushroom effect. How do you raise mushrooms?  Keep them in the dark and pile manure on them.) 

    They tend to buy companies with rapidly rising sales and profits. These companies also have high and rising P/E ratios during the innovative, rapid growth phase, increasing the rise in the stock price. As these innovative companies mature, their growth slows down. Profit growth also slows down or stops. P/E ratios fall. The result is a drop in their stock price, often large, followed by mediocre stock performance. Many of these companies are attacked by smaller companies developing or using newer technology.

    Companies like IBM, Microsoft, Intel, and Oracle were innovative growth companies, are now large and profitable, but have been lousy stock investments for a long time. The large percentage increase in their stock prices in 2017 and early 2018 looks similar to the large runup in their prices in 1999, just before the dotcom market crash of 2000-2002.

    Professional investors cannot predict “phase transitions” in industry technology or organization, or in the underlying economy. Just as it is difficult to predict the winners developing a new technology, it is difficult to predict the losers they will replace. It is the winners, not the losers, that make it into the indexes.

    Managed funds do a lot of trading – buying and selling stocks in their portfolio. They try to time their trades with major moves in the stock market. This is difficult to do. Very few investment professionals ever predict market downturns.

    Some managed funds buy a subset of large, mature companies. A diversified portfolio of about 30 stocks reduces risk almost as much as a total market index. Their economic performance as a group will be about the same as the large, mature companies in the index funds. With about the same sales and profit growth over time, the subsets in the managed funds should have long-term stock price increases about the same as the market. But at a higher cost.

    On average, about 60-70% of an individual stock’s price movement will be correlated to the price movement of the whole market. So, much of the movement of stocks in a managed funds will move with the market, especially a managed fund dominated by large companies with large market capitalization.

    Some large cap companies are so diversified that they are a diversified portfolio in themselves. Johnson & Johnson could represent much of the pharmaceutical and health care industry. Parker Hannifin could be a proxy for investing in cyclical industrial companies. Companies like Google and Celgene buy or invest in new and small technology companies in their industries, almost like a venture capital company. Many large companies not only have a diversified business but are also multinational corporations, a proxy for investing outside the United States.

    Some managed funds concentrate on innovative companies. The problem is that many new tech and startup companies fail; their stock prices will go to zero. Many did in the 2000-2002 dotcom market downturn. They took a lot of managed funds down with them.

    As discussed throughout these tutorials, an important factor for the success of a startup is the drive, determination, focus, and strategy of the founders/entrepreneurs. It is hard for an outsider like an investment manager to evaluate the intelligence, dedication, and personality of the founders.

    Outside analysts and investors do not have the key information they need to evaluate a company – the internal detailed proprietary knowledge responsible for the competitive advantage causing sales and profit growth.

    Most stocks, including those of the large, mature companies that tend to dominate index funds tend to go up and down (are correlated) with the overall market. There may be individual exceptions because of company-specific events but as a group they heavily influence (account for) overall stock market changes. There is no need to try to pick individual stocks among this group. 

    Often, one sector drives the market – IT and Internet stocks in the 1990s, finance in the 2000s, and technology in the 2010s. It is hard to pick winners early and the timing of the downturn is also unpredictable. Index funds ride through the downturn and are there for the next upturn fueled by innovative companies in new sectors and industries.

    There are internal dynamics of the stock market. Companies increase dividends, buy back their stock, and do mergers and acquisitions. All these moves can increase the price of an individual stock; collectively, they increase the value of the entire stock market. Index funds automatically benefit. Managed funds often do not.

    Picking stocks to outperform the market critically depends on predicting growth rates in expected EPS for years into the future. Any forecast will be highly uncertain and subject to large errors.

    In conclusion, the stock market is not a random walk (impossible to forecast) or the result of irrational, emotional behavior by investors and money managers. Professional money managers seldom “beat the market” because of uncertain forecasts, the domination of mature companies, the difficulty of outsiders to pick innovative winners, and incomplete and misleading data. 

    I recommend reading Burton Malkiel, A Random Walk Down Wall Street. Revised and Updated Edition, 2007. Professor Malkiel was associated with Vanguard for a long time. Earlier editions of this book were an argument for the index fund approach to investing made popular by Vanguard. This edition gives a more balanced approach than earlier editions.


    INSIDER INFORMATION:  PROFITING FROM ASYMMETRIC INFORMATION

    Financial markets are rife with insider information. Inside information is a classic example of asymmetrical information, where insiders can profit at the benefit of investors not yet knowing the information. Sometimes insiders use their information and position to manipulate prices, such as the massive LIBOR price-fixing scandal. 

    Many foreign markets are insider markets, where locals can conspire to manipulate and fix prices, especially at the expense of foreign investors. This is similar to what U.S. markets were like before the reforms of the 1930s.

    FINANCIAL MARKETS AND MORAL HAZARD

    Conservatives argue that deregulation of financial markets leads to innovation and more efficient markets. The first part is true; many new financial instruments and new types of financial companies have been created. The implication of the second part is that because of more competition prices in financial markets quickly adjust to something approaching “fundamental value” or, in economic jargon, equilibrium. The basic problem is that the first effect works against the second effect.

    The problem is moral hazard, an idea that says that individuals like managers and owners of financial institutions will take more risk if someone else (the U.S. government and taxpayers) pays the price of failure. 

    This happened in the savings and loan crisis of the late 1980s. The industry was deregulated so that S&L managers could make riskier loans at higher interest rates but deposits were still federally insured. So the more aggressive banks offered higher interest rates on deposits, took in a lot of money, and made a lot of high-risk bets, including illegal loans to insiders. They lost. Half of the S&Ls went bankrupt and it cost U.S. taxpayers over $130 billion in losses on bad loans.

    Deposit insurance is one source of moral hazard. Another is that the two largest players in the mortgage market, Fannie Mae and Freddie Mac, had the implicit guarantee of the government. A third source is the “too big to fail” doctrine, already invoked in a big bank rescue in the 1980s. Combined with that is the idea of “systemic risk,” which implies that if a financial institution failed, even if it wasn’t a bank or “too big to fail,” it might set off a chain reaction that would threaten the collapse of the entire financial system. This is what happened with the failure of Long-Term Capital Management in 1998. 

    EXTREME RISK AND TOO BIG TO FAIL:  LONG-TERM CAPITAL MANAGEMENT (LTCM)

    In the 1990s, the company with the most sophisticated models and trading strategies was Long-Term Capital Management. Its partners included the former head of bond trading at Solomon and two Nobel Prize winners for their work in financial models (Myron Scholes and Robert Merton). Its strategy was based on reversion to the mean of the difference in the prices of a large number of supposedly unrelated financial instruments, another correlation model. But in the global financial crisis environment of 1998, the difference in prices moved in the opposite direction of historical behavior partly because of a “run to safety” in buying U.S. Treasuries. Spreads between Treasuries and other instruments increased instead of the expected decrease. This, plus enormous leverage based on underestimating risk, led to a massive bankruptcy. Only a huge infusion of capital from other firms, made under pressure from the Fed, averted a financial crisis.

    LTCM was a hedge fund so the government had no legal obligation to intervene. It also wasn’t that large in terms of capital invested. But it was very highly leveraged, meaning it had borrowed a huge amount of money (about 30 times its invested capital) and had over $100 billion of assets and liabilities on its balance sheet. If it failed, its lenders and counterparties to financial contracts would take a huge hit; it was believed that some credit markets might even freeze up (become illiquid). The Fed decided that this was too big a risk to take and forced nine major banks to chip in over $3 billion to carry the assets. LTCM was liquidated and its positions were eventually sold. But it established a precedent that a threat to financial markets, not necessarily the size of the company or the legal obligation of the government, might be a reason for the government to bailout a company. And the threat to financial markets was rapidly increasing as all large financial institutions increased their leverage in the 1990s and 2000s, many to the 30-1 ratio of LTCM. They were using borrowed funds to buy and trade inherently risky mortgage-based bonds and derivatives.

    BIASED INFORMATION, FRAUD, EXTREME RISK, AND TOO BIG TO FAIL:  THE SUBPRIME MORTGAGE MARKET CRASH OF 2007-2009

    After the Dotcom market bust of 2000-2002, the market continued upward, fueled by tremendous gains in the financial markets. Financial firms had found a great new business – securitizing mortgages and other debt instruments and selling bonds and other derivatives based on the cash flow of the underlying assets. At the foundation of this was a huge increase in subprime mortgages and mortgage refinancing. Many of the subprime mortgages were blatantly fraudulent or certain to go into default. But banks and other financial institutions were able to sell pyramids of derivatives many times greater, and more profitable, than the original issuance of mortgages. These markets were totally unregulated. (To understand how all this happened, see the movie The Big Short and read Explaining Derivatives – An Analogy after this essay.)

    The subprime mortgage business was a con game from the start. Mortgage brokers and loan officers at sketchy banks used deceptive and often fraudulent methods to originate subprime loans. Mortgage and mortgage-baked securities (MBSs) risk analysts at some banks and investment banks, the credit rating agencies, and Fannie Mae knew that there would be a high rate of default after the low “teaser” rates ran out. In loftier language, Alan Greenspan warned in 1994 that there was a good possibility of a housing bubble and massive defaults of mortgages.

    The problem was how to sell these “junk” mortgages. In a rational market, investors in subprime mortgages and their MBSs should have received high rates of return to balance the high risks of default. Not to be. If banks kept the mortgages, they could be financed by low-cost short-term borrowing. Why low cost? Because throughout most of the 2000s, the Fed kept short-term interest rates low. The prime rate was below 2% for three years.

    But banks sold most of subprime mortgages to other financial institutions that would securitize the mortgages into bonds backed by the monthly payments of the mortgage holders. The bonds should have paid a high rate of return. But they didn’t. The reason was that these mortgages and their derivatives were laundered. The financial industry, with the connivance of credit rating agencies that were paid by the banks, turned bundles of high-risk mortgages into bundles of investment-grade (low-risk) bonds. Then the riskier parts of these bundles were turned into new derivatives that were also rated as investment grade. By labeling these securities as investment grade, this greatly increased the pool of potential institutional buyers such as pension funds. Mortgage origination fees, underwriting fees, selling fees and trading commissions were enormous.

    But who bought these instruments? At the height of the subprime boom, large purchasers were Fannie Mae and Freddie Mac. In the past, both companies would have automatically rejected subprime mortgages. They didn’t even have models to evaluate these types of mortgages. As companies with de facto government guarantees, they were obligated to only buy and securitize high quality, low-risk mortgages. But under political and industry pressure, and loss of market share, they became major buyers of subprimes and sold mortgage-backed bonds at rates slightly higher than U.S. government bonds. Massive defaults led to the bankruptcy of both companies, which were taken over by the federal government. For political reasons, most of the losses were not borne by the bondholders such as the Chinese government but by U.S. taxpayers.

    So the consequence of deregulation was not diversifying risk and self-equilibrating financial markets but accelerating systemic risk underwritten by moral hazard. How could it be otherwise? Selling greater volumes of increasingly riskier assets meant huge increases in salaries and bonuses. What did mortgage originators and managers of banks, investment banks and hedge funds care if they were creating higher levels of risk that could bring down their companies or the entire financial system? Increased leverage meant increased profits and increased bonuses. Fraud was rampant. Regulators were either clueless (SEC) or ignored their feelings that a crash was coming (Greenspan). Most deals were private so that even the hope of “free market discipline” was missing. Best of all, there were huge pools of funds run by unsophisticated trustees (asymmetric information) to finance the whole thing. Wall Street’s attitude was nicely summarized in a line from the movie The Magnificent Seven, “If God didn’t want them sheared, He wouldn’t have made them sheep.”

    Will it happen again? Of course. The financial reform bill is a joke, nothing more than a political CYA crafted by the same politicians that helped create the mess. But the Congressional hearings were good theater as every member of Congress repeated a variation of the cynical line from the movie Casablanca, “I am shocked, shocked, to find out that gambling is going on in here!”

    As part of its attempt to save the financial industry from imploding, the government brokered a number of “shotgun” mergers between large financial institutions. A small number of banks are now much larger than before the bailouts. They really are “too big to fail.” They are more dominant, gaining market share. They are also closely tied to the large hedge funds and private equity firms, which gives these private, unregulated companies some government protection. And, in a delicious irony, Goldman Sachs, a major private derivatives and trading investment bank, has applied to become a commercial bank so that FDIC can protect some of their creditors. The idea that American taxpayers are providing insurance to Goldman Sachs’ creditors, which include hedge funds, is moral hazard with a vengeance.

    Government bailouts went way beyond the usual targets, to include insurance companies, General Motors’ and Chrysler’s financial arms, and GE Capital. There is delicious irony in the bailout of GE Capital. GE Capital is part of General Electric (GE), one of the largest corporations in the world. For many years, GE has paid no U.S. corporate income tax.

    A last, major example of moral hazard. Public and private pension funds have made risky investments and lost. So what? The public pension funds must have a certain level of assets in the future. So future taxpayers will pay more in taxes and receive fewer services. And $60 billion of unfunded liabilities in private pension funds are guaranteed by the government.

    Large financial firms can expect public bailouts and subsidies when they “blow-up” but investors cannot. So financial firms can take excessive risks with investors’ money to earn large fees. It is only when they start to believe their own propaganda that the financial instruments they sell are really not as risky as they are, and begin holding the securities in their own portfolios, that financial institutions risk bankruptcy.

    What this means is that in the future just about any company remotely related to finance can expect a bailout. There are no market restraints on risk left. The U.S. government is now underwriting the entire financial industry, no matter how reckless. And every risk-taking gunslinger in the future knows it.

    CONCLUSIONS

    Analytical tools and analysts are biased producing biased information and forecasts.

    Statistical models underestimate risk. Risk is underpriced and uncertainty cannot be modeled. Combined with the upward bias in public information, this creates higher percent growth of financial prices in “normal” times followed by periodic “blow-ups” in financial markets.

    Moral hazard allows investment managers to take great risks since they know that the government or taxpayers will underwrite large losses.
    The information and knowledge that most professionals possess does not give them an advantage over the total ignorance of investing in passive index funds. They cannot “beat the market.”

    ===============================================

    EXPLAINING DERIVATIVES – AN ANALOGY

    You go around to farmers with cows. You buy all the cows and pay the farmers a small fee to milk the cows and sell the milk. You pay for the cows with ass(et)-backed securities called MBSs (Milked Bovine Securities) that you tell investors are udderly safe. But some of the cows don’t give enough milk (cow flow problem) or give no milk at all. You take some of the asset-backed securities, say they’re backed by the subprime cows, and use them as collateral to sell another set of securities called CMOs (Cow Milk Obligations). Then you buy CDSs (Cow Dried-up Swaps) from AIG (Angus Insurance Company) to insure the CMOs when the cows stopped giving milk. If you work it right, you collect more on the CDSs than you pay out to retire the CMOs. The money you get from selling the dead cows go to pay the CLOs (cow leather obligations).

    You could also sell CDOs (cow dung obligations) that depend on how much cow dung is produced. This is a typical Wall Street product – turning shit into gold. 

  • Introduction to the Stock Market and Investing

     

     

    WHY STOCK PRICES GO UP

     

    The movement of a stock index such as the S&P 500 or an individual stock depends on two things:

     

    Earnings per share (EPS) and changes in EPS.

    Stock price/earnings per share ratio (PE ratio) and changes in the PE ratio.

     

    If the PE ratio stays the same, an increase in EPS leads to an increase in the stock price. The same is true of a stock index. Rising EPS combined with a rising PE ratio is often the reason why a stock goes up more than the average stock.

     

    Well, that was easy. Well, not really.

     

    The stock market is “forward-looking,” that is, it tries to anticipate changes, especially changes in EPS and the PE ratio. There is a great amount of forecasting. But since the forecasted changes are in the future, they are inherently uncertain. The forecasts of some companies’ EPS are more uncertain than others. Some are very uncertain. For example, the future sales and earnings of a small biotech company may depend on the success of a clinical trial and FDA approval. If one or both fail, the company could go bankrupt. As is true of companies trying to develop any new technology.

     

    The EPS of a stock can go up for a number of reasons:

     

    The economy is expanding. This has been the usual situation in the United States and also for the global economy for decades. An upward trend in the economy leads to an upward trend in total income and total spending. Most companies can usually expect expanding sales, usually rising faster than total expenses, and thus increasing profits (earnings). This is the main reason why you can expect to make money in the long run; it is also one of the reasons why you should buy a stock index fund, either as a mutual fund or an ETF. You are betting the U.S. economy, and the global economy, will continue to expand and public companies will become larger and more profitable.

     

    Corporate earnings and EPS are more volatile (bigger percent changes) than the economy’s GDP changes or a company’s changes in sales. So, for example, a 5% increase in nominal GDP might lead to a 10% increase in a company’s sales and a 20% rise in earnings. The same relationship works in reverse when an economy goes into recession.

     

    A company’s stock price does not entirely depend on economic expansion or other influences external to the company. Some factors are internal to the company or its industry. It may have a successful new technology, successful new products or become more efficient (lower unit costs).

     

    If you find yourself buying new products or services, you might want to look at the company as a potential investment. The first time you or your tax accountant used Turbo Tax, when you had your teeth fixed with Invisalign, when you bought your first iPhone, when you started looking for “organic” foods, when you go on your first space flight, you might investigate the company behind these new products or services as potential investments.

     

    A company’s PE ratio depends on the market’s consensus on the rate of increase in the company’s EPS. A company with a higher-than-average expected EPS growth rate will generally have a higher-than-average PE ratio. Both the market’s PE ratio and a stock’s PE ratio can change if there is a change in expectations of the future growth rate. A company’s PE ratio and stock price may go down even if its EPS grows but at a slower rate than expected. This is one reason why higher potential reward (percent gain) comes with higher risk.

     

    Generally, PE ratios rise over a business cycle. Earnings have been growing for a long time and investors expect earnings to continue growing at least as fast as over the cycle. But a large and sudden increase in the market’s PE ratio may indicate that the market has developed a speculative bubble. This increases the chances of a large downturn in stock prices.   

     

    OTHER REASONS STOCK PRICES GO UP

     

    If you are a long-term investor, you might consider investments based on a long-term

    demographic or social change. The very low birth rates seem to indicate that many couples and singles are substituting pets for children (they’re cheaper unless they need an operation). The aging of the national and global population presents opportunities for certain categories of companies, the most obvious being health care. Some leisure activities beloved of senior citizens, such as cruise lines, were doing well before Covid. 

     

    Another trend is that most of the increases in income and wealth are going to high-income households. Companies that sell services and luxury products to this income group have done well. When you buy your first Ferrari with your stock market winnings, you might think about buying stock in the company.

      

    Whether or not a company pays a dividend and changes in the dividend influence the price of a stock. Not all companies pay dividends. On the other hand, some companies have a history of increasing dividends over time. A good strategy if you own such a company is to reinvest the dividend. The company will then pay rising compound interest, which over time can be an important part of the total return of owning the stock. Check to see if the company has rising earnings to cover the rising dividend.

     

    Another way you can make money in the long run is corporate acquisitions. The acquiring company has to pay a premium over the acquired company’s stock price to obtain all the shares. Premiums are usually between 30% and 50% above current market price. Certain types of companies tend to get bought out – specialty food producers, local and regional banks, small biotechs with an FDA approved drug or good clinical results. Small tech companies tend to get bought out while still private. If the venture capital companies then take the company public through an IPO (Initial Public Offering) or a SPAC (IPO light), you should probably stay away. Usually, the early investors are cashing in. The stock price may rise quickly, often followed by a major fall in the stock price. If you like the company as a long-term investment, this is probably the time to buy.

     

    Companies can influence their stock price through financial planning (aka “financial engineering”). One strategy, noted above, is to increase the dividend. A company can also buy back some of its outstanding stock, raising EPS by lowering the number of shares. Or a company can fund its expansion through taking on more debt. This is called leverage. Interest rate expense on the debt is fixed. Imagine two companies both making $1,000,000 a year from operations and do not pay income taxes. One has 1,000,000 shares, so its EPS is $1.00/share. The other company has debt and only 500,000 shares. Its EPS is $2.00/share. Well, not quite. It pays interest on the debt, which is subtracted from the $1 million in operating earnings. But typically its EPS is still higher than $1.00/share. And its share price is probably higher. Also, its EPS growth rate will be higher for a given amount of increase in total earnings.

     

    In a period of low interest rates, corporations will tend to take on more debt and buy back shares. Both have been happening at record levels for years. This increases EPS. If done over time, this combination of financial strategies might increase the growth rate of EPS and the PE ratio, even if there is little change in the underlying business.

     

    Your long-term rate of return on buying a stock or an index will depend on when you buy the stock or the index. It you bought the stock at the end of a business cycle or bull market and then the stock price went down, your rate of return for years might be low or even zero. At the extreme, if you bought a group of stocks like the Dow Jones Industry 30 in 1929 you would have waited until 1953 to get even. The same thing happened in the 1970s. On the other hand, if you buy stock at or near the bottom of a market downturn, it is likely that your rate of return for the next 3-7 years will be substantially higher than the long-run average rate of return.

     

    A word about market downturns. There are two general types – with and without recession. A market downturn not followed by a recession tends to reverse quickly. A market downturn followed by a recession tends to be deeper and takes longer to recover.

     

    This is not very helpful since a market downturn occurs before a recession as investors anticipate a coming recession. Sometimes a market downturn anticipates a recession that does not happen or is milder or shorter than expected. 

     

    WHAT SHOULD YOU BUY?

     

    Should you buy an index fund or an ETF based on some index, an actively managed fund or individual stocks? The three are not mutually exclusive. You might start with an index fund; the most popular is an index fund or ETF that mirrors the S&P 500 (the 500 stocks with the largest total market value). Then you might like a particular industry, maybe an industry you work in, or a set of similar stocks (gene editing, for example). It may be difficult for an outside investor to pick potential winners and avoid hyped probable losers. Choose a managed fund. You are paying for their research and their keeping up with changes. But be careful; many managed funds are very similar to index funds. Also, do not chase funds with outstanding recent results. Research indicates that the funds with the best results over three years are likely to exhibit below average returns over the next three years. One reason is that the fund may have an unusual and risky investment strategy. This is your introduction to the concept of risk.

     

    Index funds and index-based ETFs are good for ignorant investors. The stock market is one of the few places where being totally ignorant in the Information Economy is an advantage. Index funds beat most managed funds over the long run, partly because their costs are lower. If you buy a lot of individual stocks or a lot of specialized funds, you may have a disguised index fund. At a higher cost.

     

    A few words about index funds. An index fund contains many stocks but they are not equal. The greater the total market value of a stock – “market cap” (capitalization) – the greater the weight of the stock in the index. So right now monster tech companies have a disproportionate influence on the price movement of an index. To some extent, these and other really big corporations have become very large and very profitable because of innovation and high growth in the past. You are betting they will have higher than average growth in the future. This is a poor bet. If you look at the tech companies that dominated the indexes 20 years ago, most have been poor investments since then, although a few tech companies have made a recent comeback by getting into new businesses. 

     

    The indexes contain companies that are losing money and many companies whose sales and earnings growth depend mostly on overall economic growth. If you believe that the U.S. economy is in for a period of low growth, then the rate of return on an index fund will probably be below the historic rate of return.

     

    The index fund becomes “the market.” You would not buy a managed fund or an individual stock unless you expected your total return (capital gains plus dividends) was going to be greater than the total return of the index fund. This tends to rule out older, mature companies whose sales and earnings depend mostly on the total income growth of the entire economy; the change in their stock prices tend to closely follow the change in the market index.

     

    Which gets us to the idea of risk. Research indicates that on average 60-70% of a stock price’s movement is correlated with the movement of the overall market. When you buy an individual stock, you are buying the other 30-40%. The question is:  Why do you think this stock will have higher EPS growth than the market? Or in the words of Dirty Harry, “Do you feel lucky?”

     

    What kinds of stocks have a chance to outperform the market? One group is sometimes called “disruptor” companies. These are innovative companies that are creating new demand or disrupting existing industries or markets. For example, my beloved local electric utility, whose main service seems to be service interruptions and blackouts, is installing “smart” meters. Who makes the meters? My dentist raves about this new digital imaging system that replaced fuzzy X-rays and gummy impressions. Who makes the digital imaging system? You might also avoid the stock of companies that are getting hurt (losing sales and market share) by new competitors with new technology.

     

    It is natural that beginning investors look at companies they are familiar with, usually companies that sell branded consumer goods and services. But many companies sell inputs (parts, components, IT, capital goods, software services) to other companies. They make their products and services available to all other companies, so their success is not tied to any one company. These are sometimes called “picks and shovels” companies. Who got rich during the California gold rush of 1849? A few gold miners. Most went bust. But companies that sold “picks and shovels” (and blue jeans) to the miners made money. 

     

    What to look for in a small, high-tech, innovative, “disruptor” company? First of all, it is probably losing money (burning cash). It may need further rounds of financing in the future. This means more debt or more shares sold, which dilutes future EPS. You need patience. What you look for are indications the company might be a winner. Are its sales growing rapidly? Is its loss per share (negative EPS) getting smaller? How long before it has positive cash flow? Is it putting most of its money into a critical growth function, such as R&D or customer acquisition and retention?

     

    If you are thinking of buying individual stocks, the warning here is that a good company – a company that you admire – may not be a good stock. I once worked for a very well-run company. But it produced a commodity in a competitive, price-sensitive market. Its earnings rose over time but varied widely and were unpredictable. Investors discounted the uncertainty and volatility. Its stock underperformed the market. It’s financial performance that counts.

    Generally avoid “inside information”, tips, and recommendations of hot stocks from your brother-in-law. By the time you hear about them, it’s probably too late.  

     

    GLOBAL INVESTING

     

    If you are thinking of buying a foreign company or country ETF, you must consider political risk. In many “emerging” economies, equity markets are thin and manipulated by locals. There are hidden costs such as extortion and bribery. The Japanese stock market and economy never recovered from the early 1990s meltdown. Japanese governments have resisted any structural reforms. With price-fixing cartels controlling much of the economy, restrictions on imports, an aging and declining population, and limited immigration, the Japanese seem content to quietly commit demographic and economic suicide. 

     

    China is a special case. To me, the political risks were always too high. I’ve never owned any Chinese stocks (with one exception, which I quickly sold). Political risk increased after Obama “pivoted” American foreign policy and military assets to confront China, Trump imposed tariffs, and Xi established political control on the Chinese economy, especially the large corporations, destroy $2 trillion in market value.

     

    One of the ways American corporations have grown is to go international. Some expanded sales to other countries, others outsourced production. American companies have become multinational companies with much of their growth in sales and earnings outside the U.S. When looking at a company, especially notice what percent of their sales and sales growth is in China. Do they depend on a critical input from Chinese companies? Can production be easily moved to other countries?

     

    There are many attractive foreign companies, particularly in Europe. One of my favorite companies started in Rumania. These companies are mostly large consumer product multinationals or smaller technology companies that sell globally to other technology companies.

     

    WHEN TO SELL

     

    You might have different strategies for different types of holdings. 

     

    For an index ETF, you might expect to hold it for a long time. This might be part of your retirement fund (or your kids college tuition fund). Which brings me to a digression on retirement planning. Think about the assets you may have when you retire. Maybe equity in a house. Maybe a 401(k) and/or a rollover IRA. Maybe other income or assets. Also, you will have one or two Social Security income streams. Medicare (an insurance policy). So, the question is:  How much consumption are you willing to give up now to have some expected amount of additional income later? Or, to paraphrase the White Queen, more jam today or more jam tomorrow?

     

    A managed fund often is a bet on some industry or sub-sector of the economy that you believe will do well (better than the overall market) in the future. Current examples – homebuilders, cybersecurity, renewable energy, large or small biotech. There are approximately 8,000 mutual funds and ETFs. Many of these funds mirror an industry index. Some don’t. You might sell the fund if something bad changes in the industry, you lose faith in the expertise of the fund managers, or the market turns down (many managed funds, being specialized, will fall a larger percent than the overall market).

     

    If you have the time, like to play games, and are not seriously risk-averse (hate to lose money, even if only temporarily), you might want to look for and buy some individual stocks. Build you own portfolio.

     

    A FEW STATISTICAL TRENDS THAT MIGHT HELP YOU WITH INVESTMENT/PORTFOLIO DECISIONS

     

    In the long run, the more investors trade, the lower their rate of return.

     

    Men trade more than women. 

     

    Your chances of finding that one stock that will make you rich are very low. And you have to buy it at or near when it goes public and hold onto it for a long time. Of all the U.S. stocks that have existed since 1926, 4% (1,000 out of 25,000) accounted for all of the market’s gain over time. The other 96% percent – some with lower gains and a lot with losses – averaged out to no gain. Even tougher, only 83 stocks out of the 1,000 fabulous winners accounted for half of the long-term gain. And you can’t buy and hold forever – some of the monster winners got that way selling fossil fuels; they have done poorly over the last few decades and will probably join the losers group in the future.

    A recent similar study of the period 1980-2020 by J. P. Morgan came to a similar conclusion.

     

    A MODEST INVESTING PROPOSAL

     

    You might want to have a portfolio something like:

     

    60% index funds/ETFs. Information and time requirement – casually following general economic and political news. Avoid watching CNBC.

     

    25% narrow index funds/ETFs or managed funds specialized by industry, country, or region. Information and time requirement – occasionally checking industry news, studies, or websites. Avoid watching CNBC.

     

    10% individual stocks of companies that you think will beat the averages, with moderate risk. Information and time requirement – time and effort finding stocks. Maybe a watchlist on your phone from Yahoo Finance or some similar source of information.

     

    5% high risk/high potential gain stocks, such as small biotechs. Information and time requirement – time and effort finding and following stocks. Suggest stop loss orders.

     

    You could change the percents depending on your investment goals, your time horizon, risk aversion, and time spent managing your portfolio. If your time has high “opportunity cost” (making a lot of money working or doing something that is important to you), you might want to pay a financial planner to watch your portfolio for you.

    Probably the best first book to read about the stock market and investment is the classic Burton G. Malkiel A Random Walk Down Wall Street. Make sure you buy the latest edition. Helped to start Vanguard; argues that investing in index funds/ETFs is the best long-term strategy. But presents alternative points of view.

     

     

  • The Stock Market: Party Like It’s 1929!

     


     

    INTRODUCTION:  SIMILARITIES AND DIFFERENCES BETWEEN 1929 AND 2020

     

    Gamestop! Short squeeze! Bitcoin! Options! IPOs! SPACs! Hydrogen trucks! Tesla up 800%! Market valuations in bubble territory. And my favorite “blue sky” stock – Virgin Galactic.    

     

    At first sight, there was nothing in 1928-1929 similar to the impact of Covid-19 on the economy. Actually, there was. In 1927, Ford closed down his entire company to retool for a new line of cars. 70,000 Ford employees were thrown out of work; many more at suppliers also lost their jobs. But everyone knew that Ford would start up production again.  

     

    Ford began production in 1928; 1929 was a record year for auto production. But in late summer and early fall, inventories began to build up.

     

    Both periods were preceded by speculation in real estate. Both ended badly, closing off an alternative area of speculation.

     

    Both periods (1920s and 2010s) saw an increase in income inequality. Large parts of the labor force, particularly farmers in the 1920s, saw stagnant or falling real income. 

     

    The assumption of endless growth based on new products, new forms of energy and mass production provided the foundation for the speculation in 1928 and 1929. Over the last 10 years, investors have believed there will be endless growth based on the development of new information technologies combined with the commercialization of an explosion of new knowledge, in biotechnology for example.

     

    The long bull market starting in 2009 was accelerating in late 2019 and early 2020, similar to the long bull market of the 1920s. Then the virus hit, sending the economy into a deep recession. But unlike the Great Depression, the federal government stepped in with massive income maintenance programs. Despite high unemployment in 2020, real disposable income and consumer spending rose. Savings also rose, some of which found its way into stocks. As vaccines became available, it was assumed that economic growth, fueled by innovation and low interest rates, would continue.

     

    One similarity was a part of the Fed, the New York office, reacted quickly to the 1929 crash. It lowered interest rates and made substantial sums available to the banking system to support the stock market. But it was a one-off; other regional Feds refused to provide liquidity to the system and the Fed governing board in Washington seemed willing to let the entire financial system go to hell.

     

    In 1929, high-tech companies like RCA and growth companies with new products and services such as the electric utilities, were especially hard hit. Unlike the beginning of the Great Depression in 1929, the impact of Covid-19 led to massive changes in behavior that benefitted information-based companies. A handful of very large companies already dominated the market indexes; they would drive the indexes higher. Other companies such as Zoom and Teledoc saw a huge increase in demand. Media concentration on the race to develop a vaccine focused attention on small biotech companies developing new drugs and health care systems. All of this drove the stock market higher in the face of a sharp recession.

     

    The economic decline stage of the Great Depression lasted for almost four years. The Covid recession was sudden and sharp. With the development and production of vaccines, it has an endpoint in the middle of 2021. And, learning from the “malign neglect” of the Hoover administration, the federal government, as in 2008, reacted quickly with massive income maintenance and aggressive monetary programs to limit the economic damage. 

     

    The rapid development of vaccines convinced investors that the economy would return to normal growth during 2021. Investors also believed that the subset of high-growth technology companies would continue their superior performance into the foreseeable future. All this sustained high stock market growth rates into early 2021 and beyond.

     

    Most of the stocks with the highest percent gains in 2020, gains of 3-10 times for the year, are equities of companies that were losing money. Most have innovative, even disruptive, technology that would make them attractive parts of a long-term growth stock portfolio. But because of large R&D expenses, long and expensive drug trials, upfront capacity growth expenses, they would lose money for the foreseeable future. But large stock price increases in 2020 have already priced in spectacular long-run success. The best-case scenario is that their stock prices will not continue to rise. Many of the companies will fail. But the market as a whole will probably not collapse as in 1929-30. 

     

    PSYCHOLOGY OF 1928-29 AND 2020-2021 ARE SIMILAR (SO FAR)

     

    In both periods, negative economic data and bear market sentiment were ignored. There were scattered indications in the late summer and early fall of 1929 that the economy might be entering a recession or at least had stopped growing. But almost no one paid attention. Anyone expressing bearish sentiments in 1929 was roundly denounced as a party pooper. Even un-American. 

     

    While there are now a few bearish voices, they are drowned out by the steady optimistic drumbeat of media commentators, brokerage and investment bank projections, and social-media driven popular culture. New investors believe the title of the most famous article written about the stock market in 1929 – Everyone Ought to Be Rich.   

     

    A few large investors were getting nervous or paying attention to the economic news in 1929. Jesse Livermore, maybe the most famous big-time speculator on Wall Street. J. P. Morgan partners; while they were putting out optimistic press releases and interviews, many were personally selling stock.

     

    In both periods, there was a big increase in small individual (“retail”) investors (speculators). Estimates of new investors during 2020-early 2021 are as high as 10 million. As in 1928-29, these new investors expect big gains in a short period of time. In both periods, there was a large increase in trading volume, compounded in 2020-2021 by a huge increase in options trading. Risk was ignored. Speculations were leveraged; options in the current period played a similar role as margin accounts (put up 10%, borrow the rest to buy stocks) did in the earlier period.

     

    In both periods, stock market speculation became a part of the popular culture. It seemed everyone was talking about the stock market, in private conversations and mass media. Investment decisions were based on rumor and gossip that went viral on the Internet.

     

    But it wasn’t just the extreme examples. The whole market was in bubble territory. In early 2021, market indexes were at historically high levels compared to earnings (P/E and other ratios), even assuming a complete recovery of total sales and earnings over the next 12 months.

     

    In 2020, a small number of companies benefitted from the changes caused by the virus. They dominated the indexes and accounted for much of the market rise. For example, about ten huge technology companies accounted for about 25% of the S&P 500 and most of the increase. Large parts of the economy, like farming in the 1920s, were hurt. 

     

     

    PSYCHOLOGY OF SPECULATORS

     

    Why did the stock market “crash” in October and November of 1929?

     

    The stock market peaked on September 3, 1929. It then drifted slightly lower for seven weeks. But speculators were expecting large gains in a short period of time. Many had margined accounts, paying interest on broker loans. Their patience ran out and some began selling in late October. Volume, already at record levels, rose even higher. Sellers overwhelmed buyers, including professional attempts to “support the market.”

     

    Many middle-class families, the source of much of the new money in stocks, were also leveraged in their finances. The 1920s saw large increases in mortgages and consumer credit to buy new products such as cars and radios (which could cost as much as a new car). Farmers, collectively experiencing declining income in the 1920s, were saddled with long-term debt used to buy land and equipment before and during World War I. Middle-class families with assets in 2021 held most of them in the form of illiquid assets such as home ownership (with mortgages) and retirement accounts. 

     

    Many investors were sitting on unrealized (paper) gains in October, 1929. But the market has stopped going up. This may have indicated that the supply of new investors (greater fools) was not increasing. I expect something similar to happen later in 2021. 

     

    WHAT HAPPENS NEXT? 

             

    In early 1930, the stock market had a partial recovery. But the economy was in a  recession. The recession got worse every month. In April, the stock market turned down; it would not start to recover until 1932.

     

    Stock market investors are assuming that the economy will grow in 2021 and 2022. Even if true, real economic growth could be low. Lowered expectations of corporate sales and earnings growth, especially of large growth stocks and beneficiaries of the forced change in behavior in 2020 – 2021, could lead to a market correction.

     

    The massive federal “stimulus” programs have done nothing to stimulate (increase) long-term economic growth. No increase in public infrastructure investment. No increase in government-funded R&D outside of Covid-19 vaccine development. No increase in government programs to reduce and reverse climate change. Because so much was borrowed during this crisis (over $4 trillion), it may be difficult for the federal government to borrow to adequately fund these programs in the future.

     

    Even without any new government programs, the federal government will be running annual deficits of $1-$2 trillion a year. Unlike Japan, where large annual deficits are necessary to counter deflationary and recession tendencies, large deficits in the U.S. could lead to higher inflation rates. That would lead to higher nominal interest rates. The Fed would find it very difficult to keep short-term rates near zero. Every one percent increase in interest rates would add over $200 billion a year to the deficit.

     

    Market indexes are already higher than the prior all-time high in February, 2020. Valuations (market P/E ratios) then were already at historically high levels. Even if corporate earnings and earnings per share reach 2019 levels over the next 12 months, they are being valued at higher, near-record historical levels.

     

    The forecast here is that sometime in the first half of 2021, there will be a market correction. The proposed “stimulus” program will get the economy through the next 4-6 months as the adult population become immunized. It will be the last large such program, although the federal government will still have a large structural annual deficit. After adjustments in the service sectors of the economy, countered by much slower growth in the sectors and companies that benefitted from the adjustments during the epidemic, the economy will experience slower than historical growth. Growth will be concentrated in high tech, innovative sectors and companies. Interest rates outside of the short-term, low-risk debt will rise. 

     

    AN ALTERNATIVE SCENARIO

     

    The main similarity between the two speculative periods is the increasingly speculative behavior of investors, especially the large number of new investors. Investors expect larger returns in shorter periods of time, ignoring the underlying fundamentals. Both periods became “momentum” markets.

     

    A market correction in this environment, like in 1929, could happen for no apparent reason, no large “external” shock or internal surprise like a fall in earnings. Most likely, it might occur because of a fall in expectations.

     

    Imagine, for example, that most adults who want the vaccine have received it by early summer. The economy returns to its economic growth path. Earnings of public corporations in 2021 accelerate and quickly return to 2019 levels; projections of 2022 earnings reflect historical growth. The bull market that began in 2009 continues.

     

    But the market has already “baked in” high earnings growth in 2021 and 2022. Imagine a different scenario. Most of the proposed “stimulus” spending other than unemployment benefits is spent. The tremendous support for total disposable income and consumer spending stops. Despite widespread vaccine use, the virus continues at a lower level. The economy does not revive at expected high levels as there is still some hesitation to return to prior levels of demand for recreation, entertainment, leisure and travel. Many companies that benefitted from the “lockdown” find their sales and earnings stop growing, or even fall. Their stock prices fall. Other companies build on their experience during the virus to continue to reorganize their companies to cut costs and increase productivity by reducing overhead costs of offices and travel, and reducing employment by accelerating the substitution of software and automation for employees.

     

    The increase in disposable income and consumer spending from increased employment does not make up for the loss of “stimulus” income. Projections become more uncertain.

     

    I have no idea exactly when a market correction will occur, just as no one had any idea the market would fall in October, 1929. But I think it is most likely to happen sometime in the period of late May to mid-July. By late May, it may seem more probable the economy is not going to recover as vigorously as expected. Mid-July is when the first of the second quarter earnings are reported. Since the market anticipates change, especially short-run change in this environment, I would guess the correction would be more likely in the beginning of this period.

     

    HOW LARGE A CORRECTION?

     

    It is possible that the stock market could fall at the same time the economy is expanding, assuming the expansion and earnings growth are less than currently forecasted. 

     

    So, assume it is a typical market correction of a bull market. Maybe around 20%. If the S&P 500 had reached 4,000 or somewhat above, a 20% correction would bring the index back to its previous high of around 3,400 reached in February, 2020. Market valuations would still be at historical highs; the market could fall further.

     

    What does this mean for individual stocks? Since the indexes are dominated by the large growth companies, this implies that as a group their stock prices will fall an average of 20%. But much of the rest of the last year’s tremendous stock market growth was caused by large percent increases in the prices of smaller growth companies. Many are technology companies that are losing money, especially small biotech companies. Many have doubled or tripled (or much more) since last March. There are no earnings or dividend floors under these stock prices. They could, on average, fall by two or three times more than the market – 40%-60%.

     

    To the extent that travel and leisure stock prices had already recovered in anticipation of a return to pre-Covid behavior, these stock prices will also probably fall.

     

    CONCLUSION

     

    Current market multiples assume historically high economic growth rates in sales and earnings. It is more likely that for a variety of reasons, intermediate and long-term growth rates may be historically low. A reduction in growth rate expectations could lead to a market correction.

     

    As in 1929, a change in expectations, even if not caused by any major expected change in the economy, could precipitate a market correction. It is a change in the expectations of some investors, in both cases expecting large returns in short period of time, that cause market corrections.

     

    It is a cliché of investing that stock prices, and the market as a whole, are determined by the conflict between greed and fear. In a long bull market that has entered bubble levels of valuation, the conflict is between momentum based on optimistic assumptions and projections, and doubt (increased uncertainty about the projections). A market correction occurs when doubt increases and more investors decide to reduce risk or realize paper gains by selling growth stocks, hedging, or moving to a more conservative portfolio (so-called value investing).


     

     

    For a detailed look at the events leading up to the Crash of 1929 and what happened, see my The Crash of 1929 and the Start of the Great Depression.

  • The Stock Market is Up and the Economy is Down: What’s Going On?

    The Stock Market is Up and the Economy is Down: What’s Going On?

    It is a puzzlement why the stock market can go up while the economy is in a virus-caused depression. Much of the economy is in lockdown or closed because of decreased consumer demand. As many of one-third of workers and many small businesses are on federal life-support programs. Profits have disappeared. Large numbers of bankruptcies loom. Given the uncertainty, including recent record numbers of new virus cases, the usual stock evaluation metrics are worthless.

    With the economy tanking, how come the stock market has gone up dramatically?

    And continues to go up.

    THE STOCK MARKET

    Let’s decompose the stock market. When people talk about the stock market going up or down, they usually refer to an index such as the S&P 500 as the measurement. The S&P 500 is a market-value (cap, short for capitalization) weighted index. The ten most valuable companies account for over 20% of the total value of the index.

    There are over 3,000 actively traded stocks. But the 500 companies account for over 80% of the total value of all stocks. They also account for a minuscule percent of the 10-20 million companies in the United States.

    Public companies account for about one-fifth of U.S. employment. Small companies account for about half of private sector employment. Government accounts for about 10% of total employment.

    So, the dominant public companies are not representative of the economy. They are not even a representative sample. They are publicly owned. Even the smallest is much larger than almost all other U.S. companies. They are usually multinationals. And the largest, most dominant companies in market value are technology companies. The six companies with the highest market value are Facebook, Apple, Amazon, and Alphabet (the parent company of Google. Counted twice. Don’t ask.), collectively known as the FANG companies, joined by Microsoft.

    Technology companies account for over 30% of the total value of the S&P 500. Digital or online companies are 13 of the 20 most valuable corporations in America. Nine of them did not exist or were small companies 25 years ago.

    THE VIRUS ECONOMY

    The economy has gone into a depression, the worse since the Great Depression of the 1930s. Damage has been limited because of massive federal income maintenance programs for workers and small business owners.

    The severe downturn, caused by the virus and attempts to control the spread of the virus, has made visible that the economy is divided into two parts. (Yes, I know this is a huge simplification but not as simple-minded as most economic theory.) There is the service sector, the largest employer. Most of the companies are small. Many of the employees are low wage. They work in buildings and meet customers. Services and their employees have been very hard hit by the virus and the depression. At the other end are the technology companies that dominate the digital economy. As a group, they have done well during the depression as consumers and business have used their digital platforms and services as substitutes for physical interaction (aka store shopping, visiting doctors’ offices, online entertainment and commuting to work).

    This split is reflected in the stock market and the indexes. Of the 500 largest companies, 44, mostly tech companies, are up 20 percent or more since the market low of March 23. The big six are up over 60% since the bottom of the market, accounting for more than 40% of the increase in the value of the S&P 500. Tech companies like Nvidia and biotech companies account for much of the rest of the increase.

    Less known is that approximately 160 companies of the 500 are down more than 20%. Although the market average is almost the same as at the beginning of the year, the stock prices of about 350 of the 500 companies are down. They are large and important parts of the older economy.

    TIMING

    The timing of the market moves is surprising. The market hit its high on February 19, a month before the president admitted there might be a problem and weeks before the more aggressive governors announced lockdown rules. While the president was telling the country there wasn’t a problem, investors began unloading stocks.

    In the last week of March, as the president began hinting there might be a problem, the stock market hit bottom. As the number of new virus cases and deaths rapidly increased, and lockdown and quarantine rules were extended, the economy tanked. But the stock market began a rapid recovery, one of the strongest and quickest in history. Even as the virus situation worsened in most of the country, the stock market continued to go up.

    During the strong advance no one, not even corporate management, had any firm idea what corporate sales and profits would be in the future. No one could do the usual financial analysis. Every wealth fund manager, financial analyst and investor I’ve talked to said the market was crazy, irrational, unpredictable (usually preceding by a colorful adjective).

    But the main reason is obvious. The dominant companies in the stock market were part of the digital sector of the economy. Besides the monster tech companies, they were into telemedicine, video conferencing for fun, family and business, video streaming and other online entertainment, e-commerce, cybersecurity, and many other online services. Behind them was a large increase in cloud computing services.  

    The accelerated shift to these companies’ services and products indicated accelerated increases in sales and profits. The macroeconomic averages and totals for the economy looked dismal. But not for these companies.

    The stock market looks ahead. Investors forecast. They anticipate. Today’s news and events have little influence, even short run influence, on stock price movements. Investors have placed bets on their best estimate (known among statisticians as SWAG – statistical wild-ass guesses) of what will happen to corporate sales and profits in the future. As my old econ prof used to say, “You puts down yer money and takes yer chances.” Transitory and political events, no matter how dramatic and urgent, usually have very short run or no influence on stock market prices.

    But not the virus. By mid-March, it was obvious it would have a large and lasting impact on the economy. It was the powerful “exogenous shock” of economics (also known as the “black-swan” or “fat-tail” or “big tsunami” event). 

    The unknown was how big and especially how long. Politicians, especially the president and some Republican governors, argued the virus’ effect would be short-lived and not too deadly or disruptive. They dismissed the proposed attempts to limit economic activity to slow down the spread of the virus. The famous “V-shaped” recovery. It seemed that many investors agreed. As the market rose rapidly, new investors flocked to the market. Average daily volume so far this year is up over 60% compared to average daily volume in 2019. Much of the internet chatter sounded awfully familiar to me – it was the same as in histories of the 1929 stock market crash.

    But the market hasn’t collapse (yet). The big difference is the massive income maintenance federal aid programs, along with the Fed’s massive money creation and its underwriting of virtually the entire debt market. Already about 40 million  American workers (25% of the labor force) have received some form of federal aid. The main program has been unemployment benefits. The maximum benefit has been raised by $600/per week and eligibility standards have been loosened. About two-thirds of the workers who have been on unemployment received benefits as high or higher than their pre-virus income.

    Investors are betting that worsening virus news will have little effect on the economic recovery, that federal income maintenance programs will go on as long as needed (or at least to the November elections), that the Fed will keep the Fed funds rate near zero and finance the massive government deficits, and that demand for online and digital services will continue to increase.

    Result? Sometime in late 2020 or early 2021, total earnings would be expected to return to 2019 levels. The S&P 500’s price/earnings ratio (P/E ratio) of this forecast has already returned to the high 2019 levels. 

    New medical protocols are reducing the death rate. Sometime in the near future an effective vaccine will be announced. All of the stock market will go up. Given how crazy this market has been, I suggest waiting a week and then start cashing in some of your winnings.

    THE STOCK MARKET IN 1933

    Something similar happened in 1933. At the depths of the Great Depression, with the entire banking system near total collapse, the stock market started to recover. The main reason seems to have been that investors were encouraged by the optimism and vigorous pursuit of new laws and policies by the incoming president, Franklin Roosevelt. In that year, the stock market went up an amazing 66.7%.

    SUMMARY

    Investors, as investors, are not directly concerned about Covid-19. They are concerned about the economic consequences of the virus, both short term and long term, especially to public companies. 

    The dominant dynamic is that most of the economy’s industries and companies are experiencing accelerated movement to the digital economy. Face-to-face transactions are expensive. Check-out personnel and cashiers are disappearing in supermarkets, Target and McDonald’s. Retail stores will function more like local distribution warehouses. Think about classrooms and doctors’ offices. And, in the future, a shrinking labor force will probably push up the low wage part of the labor market. Digital interaction will continue to be less expensive and more effective.

    The stock market – don’t look at the averages. Look at the winners and the losers. The stock market is up because it is dominated by digital and technology companies. Changes in relative stock prices indicate which economic sectors and companies will innovate and and grow their sales and profits faster than the overall economy.

    One way to think about the stock market (big public companies) is that it is made up of past winners (past innovators), current innovators, and potentially successful (profitable and growing) future innovators. The market mostly invests in future growth based on innovation. It punishes “legacy” companies, in old industries with growth determined by the growth in total income, that stop innovating.

    In short, investors are buying companies that are benefiting from the economic consequences of the virus and attempts to limit its spread. These same companies will continue to benefit after the virus is contained. Since these companies dominate the market and the averages, the market is going up. And, increasingly, these are the companies that will drive economic growth and will dominate the economy in the future.

    For a discussion of some of the economic and governmental budgetary changes caused by the virus, see my After the Virus.   

  • Stock Market Investment Primer

    Stock Market Investment Primer

    This primer is aimed at the long-term investor. But this does not mean that you should necessarily hold all of the stocks and funds in your portfolio for a long time.

    WHY STOCK PRICES GO UP

    The movement of a stock index such as the S&P 500 or an individual stock depends on two things:

    Earning per share (EPS) and changes in EPS.

    Stock price/earnings per share ratio (PE ratio) and changes in the PE ratio.

    If the PE ratio stays the same, an increase in EPS often leads to an increase in the stock price. The same is true of a stock index. Rising EPS combined with a rising PE ratio is often the reason why a stock goes up more than the average stock.

    Since 2009, the beginning of the stock market recovery from the last recession, most of the increase in stock prices has been due to the increase in earnings per share (EPS).

    Well, that was easy. Well, not really.

    The stock market is “forward-looking,” that is, it tries to anticipate change, especially change in EPS and the PE ratio. There is a great amount of forecasting. But since the forecasted changes are in the future, they are inherently uncertain. The forecasts of some companies’ EPS are more uncertain than others. Some are very uncertain. For example, the future sales and earnings of a small biotech company may depend on the success of a clinial trial and FDA approval. If one or both fail, the company could go bankrupt. 

    The EPS of a stock can go up for a number of reasons:

    The economy is expanding. This has been the usual situation in the United States and also for the global economy for decades. So there is an upward trend in the economy leading to an upward trend in income and spending. Most companies can usually expect expanding sales and profits (earnings). This is the main reason why you can expect to make money in the long run; it is also one of the reasons why you should buy a stock index fund, either as a mutual fund or an ETF.

    Corporate earnings and EPS are more volatile (bigger percent changes) than the economy’s GDP changes or a company’s changes in sales. Part of the reason is that for most companies, their EPS is leveraged by debt (see below). So, for example, a 5% increase in nominal GDP might lead to a 10% increase in a company’s sales and a 20% rise in earnings per share. The same relationship works in reverse when an economy goes into recession.

    A company’s stock price does not entirely depend on economic expansion or other influences external to the company. Some factors are internal. It may have a successful new technology, successful new products or become more efficient. 

    If you find yourself buying new products or services, you might want to look at the company as a potential investment. The first time you or your tax accountant used Turbo Tax, when you had your teeth fixed with Invisalign, when you bought your first iPhone, when you started looking for “organic” foods, when you go on your first space flight, you might investigate the company behind these new products or services as potential investments.

    A company’s PE ratio depends on the market’s consensus on the rate of increase in the company’s EPS. A company with a higher than average expected EPS growth rate will generally have a higher than average PE ratio. Both the market’s PE ratio and a stock’s PE ratio can change if there is a change in expectations of the future growth rate. A company’s PE ratio and stock price may go down even if its EPS grows but at a slower rate than expected. This is one reason why higher potential reward (percent gain) comes with higher risk.

    Generally, PE ratios rise over a business cycle. Earnings have been growing for a long time and investors expect earnings to continue growing at least as fast as over the cycle. But a large and sudden increase in the market’s PE ratio may indicate that the market has developed a speculative bubble. This increaes the chances of large downturn.   

    OTHER REASONS STOCK PRICES GO UP

    If you are a long-term investor, you might consider investments based on a long-term

    demographic or social change. The aging of the national and global population presents opportunities for certain categories of companies, the most obvious being health care. Some leisure activities, such as cruise lines, should do well. Another trend is that most of the increases in income and wealth is going to high-income households. Companies that sell luxury products to this income group have done well.

      

    Whether or not a company pays a dividend and changes in the dividend influence the price of a stock. Not all companies pay dividends. On the other hand, some companies have a history of increasing dividends over time. A good strategy if you own such a company is to reinvest the dividend. The company will then pay rising compound interest, which over time can be an important part of the total return of owning the stock. Check to see if the company has rising earnings to cover the rising dividend. There are also ETFs and funds that only contain these types of companies.

    Another way you can make money in the long run is corporate acquisitions. The acquiring company has to pay a premium over the acquired company’s stock price to obtain all the shares. Premiums are usually between 30% and 50%. Certain types of companies tend to get bought out – specialty food producers, local and regional banks, small biotechs with a FDA approved drug or good clinical results. Small tech companies tend to get bought out while still private.

    Companies can influence their stock price through financial planning. One strategy, noted above, is to increase the dividend. A company can also buy back some of its outstanding stock, raising EPS by reducing the number of shares outstanding. Or a company can fund its expansion through taking on more debt. The two can be combined; much of the cost of share buybacks over the last 10 years has been financed by new debt.

    Earning per share is leveraged by debt. Interest rate expense on the debt is fixed. Imagine two companies both making $1,000,000 a year from operations and do not pay income taxes. One has 1,000,000 shares, so its EPS is $1.00/share. The other company has more debt and only 500,000 shares. Its EPS is $2.00/share. Well, not quite. It has to pay interest on the debt, which is subtracted from the $1 million in operating earnings. But typically its EPS is still higher than $1.00/share. And its share price is probably higher. Also, its EPS growth rate will be higher for a given amount of increase in earnings.

    In a period of low interest rates, corporations will tend to take on more debt and buy back shares. This increases EPS. If done over time, this combination of financial strategies might increase the growth rate of EPS and the PE ratio.

    Your long-term rate of return on buying a stock or an index will depend on when you buy the stock or the index. It you bought the stock at the end of a business cycle or bull market and then the stock’s price went down, your rate of return for years might be low or even zero. At the extreme, if you bought a group of stocks like the Dow Jones Industry 30 in 1929 you would have waited until 1953 to get even. On the other hand, if you buy stock at or near the bottom of a market downturn, it is likely that your rate of return for the next 3-7 years will be substantially higher than the long-run average rate of return.

    A word about market downturns. There are two general types – with and without recession. A market downturn not caused by a recession tends to reverse quickly. A market downturn caused by a recession tends to be deeper and takes longer to recover. 

    WHAT SHOULD YOU BUY? AND WHY.

    Should you buy an index fund or ETF, a managed fund or ETF, or individual stocks? The three are not mutually exclusive. You might start with an index fund or ETF; the most popular is an index fund that mirrors the S&P 500 (the 500 stocks with the largest market value). Then you might like a particular industry or a set of similar stocks. It may be difficult for an outside investor to pick potential winners and avoid hyped probable losers. Choose a managed fund. You are paying for their research and their keeping up with changes. But be careful; many managed funds are very similar to index funds. Also, do not chase funds with outstanding recent results. Research indicates that the funds with the best results over three years are likely to exhibit below average returns over the next three years. 

    Index funds and managed funds are good for ignorant investors. Index funds beat most managed funds over the long run, mostly because their costs are lower. If you buy a lot of individual stocks or a lot of specialized funds, you may have a disguised index fund. At a higher cost.

    A few words about index funds. An index fund contains many stocks but they are not equal. The greater the total market value of a stock – “market cap” (capitalization) – the greater the weight of the stock in the index. So right now monster tech companies are the five largest companies in the S&P 500; the ten largest companies account for about 23% of the total market value of the index. To some extent, these and other really big corporations have become very large and very profitable because of innovation and high growth in the past. You are betting they will have higher than average growth in the future. This is a poor bet. If you look at the tech companies that dominated the indexes 20 years ago (or 10 years ago, or 30 years ago), they have been poor investments since then, although a few tech companies have made a recent comeback by getting into new businesses. 

    The indexes contain companies that are losing money and many companies whose sales and earnings growth depend mostly on overall economic growth. If you believe that the U.S. economy is in for a period of low growth, then the rate of return on an index fund will probably be below the historic rate of return. In addition, many of the companies in a market index will be hurt or destroyed by technological change and innovation from new companies.

    The index fund becomes “the market.” You would not buy a managed fund or an individual stock unless you expected your total return (capital gains plus dividends) was going to be greater than the total return of the index fund. This tends to rule out older, mature companies whose sales and earnings depend mostly on the total income growth of the entire economy; the change in their stock prices tend to closely followed the change in the market index.

    Which gets us to the idea of risk. Research indicates that on average 60-70% of a stock price’s movement is correlated with the movement of the market. When you buy an individual stock, you are buying the other 30-40%. The question is:  Why do you think this stock will have higher EPS growth than the market? Or in the words of Dirty Harry, “Do you feel lucky?”

    What kinds of stocks have a chance to outperform the market? One group is sometimes called “disruptor” companies. These are innovative companies that are creating new demand or disrupting existing industries or markets. For example, my beloved local electric utility, whose main service seems to be service interruptions and blackouts, is installing “smart” meters. Who makes the meters? My dentist raves about this new digital imaging system that replaced X-rays and gummy impressions. Who makes the digital imaging system? Again, avoid the stock of companies that are getting hurt (losing sales and market share) by new competitors with new technology or new products and services.

    If you are thinking of buying individual stocks, the warning here is that a good company – a company that you admire – may not be a good stock. I once worked for a very well-run company. But it produces a commodity in a competitive, price-sensitive market. Its earnings vary widely and are unpredictable. Its stock has underperformed the market for decades. It is financial performance that counts.

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    But first, you have to learn how to make enough income to start saving and investing. See my The 10 Minute MBA – Almost Everything You Need to Know to Manage Organizations, People and Yourself.

    A good place to learn the basics and mechanics of investing in the stock market and other financial markets is the Investopedia website.

    For an analysis of the stock market crash of 1929 and the start of the Great Depression, see my The Stock Market Crash of 1929 and the Beginning of the Great Depression. This essay questions the conventional wisdom that the stock market crash of 1929 “caused” or “triggered” the Great Depression.

    Go back to the Guide for Pages and Posts.