Saturday, August 11, 2007
Clap ‘Em In Stocks!
At the most excellent Bookworm Room blog, co-host Don Quixote utters what must be a fairly common plaint:
Our trade deficit is out of control. Our national debt is out of control. The dollar is dropping against most currencies. Oil is at an all-time high. The housing market is weak. The mortgage market is in disarray.And, until two weeks ago, the stock market was hitting record highs.
In the last two weeks, it appears the market finally noticed the economy really isn’t doing that well. A rather sudden ”correction” is well under way.
Does anyone have a clue what “forces” actually influence the market?
Glad you asked, DQ. Your Curmudgeon assumes that you intended to limit your question to the stock market, rather than all markets of every time, place, and substance, but as it happens, the answer is the same for all.
No "forces" act upon "the market."
"The market" cannot be "forced." Winston Churchill had this in mind when he said "If you destroy a free market, you create a black market." "The market" cannot even be influenced by anything smaller than itself -- and everything is smaller than "the market." The reason is astoundingly simple:
"The market" is you.
Strap yourselves in securely, Gentle Readers. This ride could get bumpy.
What follows below might seem digressive and pointlessly didactic. It isn't; it's utterly critical. Please read with attention.
Why do you buy? Money's tight, right? So why do you spend it? What imaginable reason would you have to part with it, given that your supply is so limited and you have to sweat blood for every single shekel?
All right, all right, it's a silly question. You buy because you want things. Some of those wants -- food, clothing, shelter, warmth in the winter and coolth in the summer -- are more urgent than others. But in all cases, you buy because you want...and what you want is worth more than what you've paid for it.
Worth more to whom? Why, to you, of course. Who else's valuations matter? Certainly not the merchant from whom you bought. He surrendered his wares to you with a smile at the sight of the baksheesh in your upturned palm, didn't he? He hummed as he ran your credit card through his mill, pushed a signature receipt and a pen at you, and called a cheery "come again soon!" at your back as you departed his emporium. No, his opinion doesn't count. You valued his wares more highly than the valuta you exchanged for them. You wouldn't have it any other way. In point of fact, you couldn't.
Now let's talk about investment securities -- in common parlance, stocks. Your Curmudgeon has been an active investor since 1974. He's experienced some losses, but overall he's made a substantial amount of money. Does he own a crystal ball? No. Does he have access to some prescient investment guru? No. Is he a Certified Galactic Intellect whose millennial power of penetration grants him insight into all the grand secrets of the ages? Well, yes, but quite a lot of very bright persons have lost their shirts, pants, shoes and undies in the stock market; intellectual prowess simply isn't enough to prosper at it.
An investor simply has to remember to invest, and eschew all other activity. To invest is to buy something for its productive power -- in other words, its value as capital. For the source of all gain is production, the making of greater goods from lesser ones. Without production, there can be no gain for anyone. Accordingly, the surest route to gain is to produce. The second surest is to seek out other producers and back them with whatever you can prudently spare.
Persons who do this and only this are called venture capitalists. Sometimes they're wrong, and lose what they've invested; they're no more omniscient than your Curmudgeon. But the typical venture capitalist makes money consistently enough -- gains outweighing losses over reasonably short stretches of time -- to do that and nothing else. On average, they do much better than the small investor who dabbles in securities as a side interest.
The behavior of the venture capitalist is the key to understanding the stock market. It's essentially the same behavior you evince, Gentle Reader, when you pull into your local Quik-Stop for a loaf of bread. And it's the exact inverse of the behavior of the typical "investor," who, if the truth be known, is really nothing of the sort.
Persons and institutions active in the securities market all seek to gain, of course, but their approaches to the quest vary widely. The most important breeds, which outnumber all others, are those who give little or no thought to productivity. They simply seek monetary increase, and will pursue it by any means that appears promising.
First we have the relatively honest ones: the "historical" and "technical" investors. Historicals purchase the stocks of companies that have done well in the past; they're betting that a historical winner is likely to be a future winner. Technicals study price movements and seek to exploit patterns they deem to have predictive power; they're betting that the movement of securities prices follows laws that are independent of what the company is selling or to whom. Neither group, as an aggregate, makes money over the long term.
Then we have the dishonest ones: the promoters and the shills. Anyone with a listing in the phone book and a bank balance over $1.25 has received a solicitation from one of these. What these folks promote is, broadly speaking, the "greater fool" theory of investment. "XYZ Corp is going up! Get in before it gets too hot to touch!" Some persons buy into a shill's statements on the basis of nothing but his assurances; others check the financial section of the Sunday paper and see that, yes indeed, XYZ Corp is going up, and rather rapidly at that. Nothing can be done for the former group. The latter group should be made aware that XYZ Corp is going up because of the foolish confidence of the former group, and that joining them in their folly is a self-nomination as a "greater fool." If XYZ Corp has no inherent value -- no power to produce something others will buy at a profit -- the consequences are as predictable as any other Ponzi scheme.
One, and only one, species of investor truly invests: the value investor. His target is a company that has a demonstrable ability to produce something that appears desirable to a large market. As he understands the importance of patience, he buys that company's stock and holds it until and unless his convictions are reversed by developments.
The best known value investor is the Sage of Omaha, Warren Buffett. Mr. Buffett has always sought, and bought, value, and then waited for it to demonstrate itself. He doesn't seek a killing on any individual stock; he seeks a reasonable prospect of a profit. Some of his choices haven't panned out -- anyone can misjudge an investment -- but more of them have. His fortune is the third largest in the world at this time.
Despite the superior record of value investors, the other breeds are far more numerous, and therefore have far more influence on the stock market. Their confidence in their foresight appears unshakable, despite all reverses. It's their peregrinations and precipitous shifts of direction that wield the most near-term influence over stock price movements. But over the long term, it's the decisions of consumers, each of whom must also be a producer, that determine which companies will prosper and which will fail. And as producers can be relied upon, in the fullness of time, to produce, the patient, conservative value investor can rely upon their performance.
One of the most significant financial developments in recent decades has been the gradual eclipse of direct investment in individual companies in favor of the purchase of mutual funds. The typical small investor holds almost nothing else. Even institutional investors rely heavily on funds; they're easier to track, and due to the applicable regulations, display more transparency of operation than individual securities. Though they, too, have their good and bad periods, as a class small investors in mutual funds have had a smoother and more comfortable ride than small investors in individual stocks, for at least the past thirty years.
Your Curmudgeon trusts that he doesn't need to explain how a mutual fund is organized. Suffice it to say that, because it's forbidden by law to put more than 5% of its total assets into a single security, it possesses an intrinsic tendency toward diversified and moderate investing. Also, the managers of mutual funds are morally obligated to put their own money into the funds they manage, which gives them an incentive toward prudence. It's an obligation few of them shirk; no sane mutual-fund investor would have it any other way.
One of the most interesting aspects of mutual funds is how few of them have appreciable holdings in the Dow-Jones stocks: the thirty companies that make up the Dow-Jones Industrial Average (DJIA), which is easily the most talked about financial metric in the world. Orders of magnitude more people could tell you semi-knowledgeably about what the DJIA's been doing than could discourse on the Gross Domestic Product. But the Dow stocks are a tiny fraction of American enterprise: far, far less than one percent. If the DJIA means anything at all, it's as a bellwether for the non-value investors: they who are moved by trends and patterns, rather than by the substance of the companies they follow.
Mutual funds eschew the Dow stocks for a number of reasons, but most of all because of their role in trend-setting. Trend-followers are essentially a superstitious community, whose convictions are largely unaffected by objective developments; try discussing value investing with an Elliot Wave enthusiast and see for yourself. But trends are of no interest to the sane mutual fund manager whose own assets are at stake; he's interested in profit for his shareholders, and by extension, profit for himself.
Note that, in contrast to stockbrokers, mutual fund managers are not paid on commission. A typical fund takes a tiny management fee, about one percent of assets per year, as its profit and for the salaries of its managers and researchers. (There are some funds that charge large sales commissions, but these are relatively unimportant in the galaxy of mutual-fund investment. Among other things, investment counseling services are usually able to negotiate those commissions down to near zero.) So a fund has no direct incentive to encourage what's become known as "churning," the practice whereby unscrupulous brokers have profited by goosing their clients into frequent and counterproductive trades.
Small investors who purchase mutual funds are doing well as a class, and have done well for a long time now. Their profits aren't glamorous; no one will make the cover of Fortune on a 3% per year return. But prudence, patience, and compound interest ("the eighth wonder of the world" -- Baron Philippe de Rothschild) grant them a degree of security that eludes most investors in individual stocks.
News organs have to have news to report, or they quickly lose their audiences. This is as true for financial news organs as for any other sort. When there's little of objective significance to report, their tendency is to fabricate it out of whatever scraps might be lying around. At such times, we get synthetic alarmism about such mirages as the "credit crunch," the "trade deficit," fluctuations in the price of oil, the mortgage market, and the relative valuations of the dollar, the euro, the yen, and the piaster. But none of these things can have a truly significant impact on American productivity. Even the much discussed recent increases in the price of oil are quite minor in the grand scheme of the market, for a simple reason: Three-quarters of the cost of producing anything is the cost of the labor involved.
That statistic has varied very little since the end of World War II. What it suggests is that there's a fundamental stability -- a stability of Americans' earning power in relation to the prices of goods and services -- that external forces are hard pressed to affect. It's possible to disturb that stability; read about Weimar Germany or the Ford-Carter inflations for examples. This suggests that one frequently reported on metric, the annual federal deficit, should be followed with some attention, for deficits are an incentive to the government to devalue the dollar. But in the absence of government currency mangling or the erection of radical trade barriers such as the disastrous Smoot-Hawley Tariff Act of 1930, we produce and consume what we produce at a steady, and steadily expanding rate.
The market is you. It's all of us, really: the American people. We're a diverse and cantankerous bunch, to be sure, but we're united on this, at least: Every one of us wants to live better tomorrow than he does today, or at least no worse. Every one of us puts forth his powers to the extent required to get him what he wants. Ultimately, that isn't money, and it isn't an uptick in the DJIA. It's more and better goods and services of the sort that will conduce to our health, security, and happiness.
So the compressed answer to Don Quixote's question "What forces actually influence the market?" is "Pay no attention to the man in front of the curtain!" What you're being shown is, as with all "journalism," chosen to draw your attention and sell advertising space. The man behind the curtain, whom financial reporters and promoters seldom deign to notice, is far more important. He's you: your decisions, your choices, and above all your productivity.
Seek value, always.
