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Stock Market Characteristics

by Roger Bourke White Jr., copyright July 2015

Introduction

Stocks are exciting. They go up and down unpredictably, and there is lots of money riding on their every move. This makes them important as well as unpredictable, and that makes them interesting to analyze.

But the future, discussed at the end of this essay, is going to be different. Thanks to computers running more and more of all kinds of business operations, there is going to be less uncertainty in conducting business. In twenty years that reduced uncertainty will dramatically change the character of stock markets.

That said, lets get back to today and talk about the basics of what we are now experiencing.

The Basics

First, the basics, these basics are the foundations for explaining why we have stocks, and why they move the way they do.

Cooperation

Stocks are a form of cooperation. Companies issue stocks because the existing owners and operators feel they can use more money to improve and grow their business. Keep in mind that stocks are a form of ownership, so stock buyers become new part-owners of the company they give money to. These new part-owners, the investors, buy into the company because they think they can make money doing so. The important part here is: Both sides of this relation are looking for gains.

But business is an activity filled with risks. This means that how much can be gained can only be guessed at by the various participants, and all the guesses come with a lot of uncertainty.

This uncertainty means there are ups and downs in this cooperative relation, but in most cases, over time, both sides prosper. Once again, keep in mind that if most of the participants did not gain most of the time, there would be no market for stocks.

Emotion

There is a lot of analytics in running a business, and in picking stocks. But there is a lot of emotion as well -- this emotion side is called things like "intuition" and "gut feeling" when it is used to make buying and selling choices.

Because investing is a heady mix of both analytics and emotion, the short-term ups and downs of the market are exciting and unpredictable... but that doesn't stop people from trying to!

Some big institutions -- hedge funds -- and some individual investors -- retail investors -- try to take advantage of short term price moves of stocks. The retailers are known as "day traders".

Those who try to gain over the long term are known as "buy and holders". As mentioned, in addition to individual investors there are many kinds of institutional investors who collect and manage large amounts of money, and put a lot of money in the stock market. These are called institutional investors and they can act as either day traders or buy and holders.

The short term stock market changes are exciting and for the most part unpredictable, but one interesting linkage they have that is a bit more predictable is they can signal emotional changes. If the market likes a stock -- as in, thinks its company's business future looks rosy -- it will go up, if the market starts worrying about a stock and the company, it will go down.

But there is analytic thinking mixed in as well. This is why stock buyers are very interested when quarterly reports and other business news about a company is released. This kind of information is music to the analytic types' ears.

Longer time scale trends -- booms and busts

A boom is when the economy of a community is experiencing positive feedback -- the more the community invests, the more and faster there is return on the investment. If, say, the market for steel is growing rapidly (booming), and a community invests in a steel mill, it will get some return. If it invests in a cluster of steel mills, it will get return from the mills, plus return from a lot of infrastructure that is also built to support the steel mills -- roads, railroads, docks and housing. This is the multiplier effect of a boom, and it is a powerful force for bringing prosperity to a community and the companies participating. In addition to the community booming, the companies in the community will grow, and grow more profitable. This expectation creates rising prices for these companies on the stock market.

In sum, positive feedback is wonderful for investing. And when it is happening a company and a community are experiencing boom times.

But positive feedback doesn't go on forever. At some point it is replaced by diminishing returns -- more is invested, but not much return comes back from the investment. When this is going to start happening is one of the exciting guesses in all business investing -- no one ever knows for sure.

When diminishing returns happen it is time to change what is being invested in. The exciting question then becomes, "Change to what?" and this is rarely an easy question to answer. Finding the answer takes painful research, painful retraining of people and rebuilding of machinery, and painful changing what is invested in. Much of the pain is due to the uncertainty: no one knows which of the many projects being attempted is going to turn into another positive feedback success.

When this is happening to a company, it is experiencing a "transition" or "reinvention". When it happens to an industry, the industry is "experiencing a decline". When it happens to a community, it is having a "bust", "downturn", "recession", "depression"... lots of euphemisms. In all of the above stock prices are going down a lot and for a fairly long time. This price decline is called a bear market.

One of the characteristics of a bear market is that when it ends, it ends because different stocks are rising than were rising in the previous boom. The business climate has changed, and which businesses are winners has changed. In one of my other essays I say that, "Recession is a time of dream changing." The dreams have changed, so what rises changes. The new boom is different than the old boom.

Even longer scale -- bubbles and panics

Bubbles and panics are different than average booms and busts. They are larger in magnitude, much more emotion driven, and happen much less frequently. They also have a lot more of the surprise element involved.

Bubbles happen when stocks (and property values) rise much faster and higher that raw analytics suggest they should. Something besides analytics is driving the rise, and that something is an exciting emotion that is spreading through the community.

Two basic sorts of bubbles are common:

o One sort happens when something comes to be considered as a "given" in the investing community and the community invents new ways of taking advantage of the given. But the given is not as rock-solid as people were thinking it was. When the given crumbles it causes a lot of scary "ouchies" -- a panic. An example of this was the steadily rising housing prices in the US during the 1990's and 2000's, and the invention of Collateralized Debt Obligations (CDO's) in response to that phenomenon. When housing prices began a many-months-long decline in 2007, this given proved to be not so given, and the panic of 2008 followed.

o Another sort happens when the investing community gets excited about a tantalizing new prospect. The rise in interest creates a rise in stocks, and that rise builds "momentum" -- even more interest and more rise. In the case of a bubble the momentum gets quite large. And then, one day, the tantalizing prospect comes face-to-face harsh reality, and the reality is that it is nowhere near as profitable or easy to accomplish as the tantalizing was telling. Crash and panic follow when this "morning after" thinking gets widespread. A famous early example of this was the South Sea Company set up in Britain in 1711. A more recent case was the Dot-com Bubble that burst in 2000, and yet more recent the China stock market bubble of the spring of 2015.

One of the big differences between a bear market and a bubble bursting is that regulations are changed a lot more after a bubble burst and the following panic is experienced.

These are the basics. Now lets talk about the ramifications of these basics.

Investing on Analytics

Investing on analytics is making choices based on: the financial statements of a company, information on the industry it is part of, other data about the company, other data about the industry, and the economy in general. In essence, all those statistical things which will influence the company's future.

This kind of information is most interesting to those who pursue various "buy and hold" strategies. Buy and Holders are people who plan on owning the stocks they purchase for a year to decades. The most famous Buy and Hold investor is Warren Buffet of Berkshire Hathaway. He has been pursuing this style for decades and has a lot of devoted followers.

Letting someone do the analyzing for you: mutual funds

If a person wants to pursue a Buy and Hold strategy, but doesn't want to do lots of research, they can invest in a mutual fund. The mutual fund manager does the research and makes the choices. This is a lot simpler way of doing Buy and Hold. The tradeoff is the fee the fund manager takes.

Investing on Emotions

Day-to-day stock moves are more influenced by the emotions of active traders than by analytics. These days the markets are also influenced by software -- many players in the markets, big and small, have computer programs that make quick choices on buying and selling.

The ultimate version of this -- lots of trades every day with just a few dollars of profit on each transaction -- is called High Frequency Trading, and getting these trading programs to work well without creating "flash crashes" and other scary volatility is still being worked on. It is a worry, but it is now pretty well ironed out.

The "retail" people (people investing for themselves, not some institution) who are in and out of the market on daily-to-monthly basis are called Day Traders or Technical Traders. These people use a different set of analytic tools than Buy and Holders -- they are more interested in charts of daily stock price moves than balance sheets. What the daily charts show is the key to their stock buying/selling decisions.

Many Styles

Because of all this uncertainty stock investing is like sports and art -- there are as many styles as there are players. Here is another example of an individual style.

The player pays attention to current events, and to what industries are growing fast. These are the analytic activities. On the emotion side the player pays attention to what people are saying about their gut feelings. On the technical side the player watches the company's stock price curve.

If the industry is hot, if the company is hot in the industry, if the stock has a steady price rise over the last three years. If its P/E is not outrageous. Then it is interesting to this player.

And over the long term this player monitors current events and industry trends for "dream changing" -- watching for when a business or industry transitions from being positive feedback to diminishing returns. When that happens that boom is over and it is time to switch to new stocks which are following a new dream.

This is an example of an individual style.

Coming soon: BIG changes: more computers, more certainty

Stock markets in twenty years are going to be very different from what we are now experiencing in the 2010's.

As computers get better at analytics and better at forecasting and helping businesses make operating decisions, the uncertainty that surrounds running a business will be declining.

In the near future, twenty years from now, this increasing certainty will make a big difference in how stock markets operate. With more predictability, the volatility of stocks should decline dramatically. Business forecasts should become lots more reliable, and as that happens stock pricing should become much less uncertain. The increased certainty, plus robo-trading taking advantage of it, should reduce the day-to-day price swings. That will take a lot of the "fun" out of playing the market, which will reduce the amount of retail technical trading activity.

Instead of playing the market the vast majority of investors will pick a fund, or two, and buy and hold them. Those who want to have fun will go back to betting on sports and entertainment activities. Even with lots of computer analysis those will remain uncertain in outcome, and exciting activities to watch and "play" in various ways.

Conclusion

Stock investing is something a lot of people are interested in. Those who are interested each use a distinctive mix of analytics and emotion to make their choices. On the analytic side there is a lot to measure, but a lot of uncertainty about the future, and even good measuring can't change that, so there is still a lot of guessing to be done. The result of the large part guessing plays is adding lots of emotion to the choosing process. Having to do a lot of guessing is all about emotion.

In sum, stock investing is exciting, in both happy and scary ways. This means: there are many ways to play the market, there is lots of advice being offered, and there will be lots of surprises... for the next two decades.

After that computers will be so deeply involved in business operations that stock prices will become much more predictable and certain. That change will change investing styles and techniques dramatically -- your son's stockmarket is not going to be anything like what your daddy's was.

 

--The End--

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