The US Stock Market is Neither a Ponzi Scheme, nor a Bible Psalm
“Markets are never wrong — opinions often are.” — Jesse Livermore
Lately, I couldn’t help but notice the misconceptions and bad arguments from the public space about the stock market during the current crisis. The common leitmotif is that the US stock market is a scheme driven by “evil” institutions and supported by the government, which helps the rich get richer, and the poor get poorer and which will wreck the entire economy. No matter if this is true or not, one should first fully understand the mechanism behind how capital markets before drawing such radical conclusions. One should acknowledge, as well, that the equity market represents both a by-product and a component of capitalism and, therefore, it can’t be judged independently.
In this article, I won’t criticize nor defend the stock market concept, but instead, I will try to remain objective and provide you with some insights on how the stock markets (especially in the US) truly function and why trading stocks might seem so devious.
The stock markets are not directly inflated by central banks, but with the help of central banks
In my previous article, I explained how the central banks are juggling with asset-backed securities (mostly government treasuries) to ease or contract the money supply (i.e., to “print” or to “unprint” money). Lately, amid the still-ongoing pandemic, the central banks have been injecting huge amounts of credit into member banks, to provide enough liquidity and prevent the financial system from collapse. As I like to explain it, they basically replaced debt (money that has to be received at some point in the future) with credit (money that can be used right away), by buying the debt securities with created (yes, “printed”) money. That simply means that banks have more money to operate with (i.e., lend or provide different types of assets to the clients) and thus aid the economy and the financial system to keep running. The Fed has injected money into banks, and the banks are using that money to conduct financial operations for their clients, which implies buying stocks as well as other securities (gold certificates, bonds, etc) to provide asset liquidity to them.
It is true that the Federal Reserve, for instance, has bought corporate assets as well (through intermediary index fund companies), but the amount is still almost negligible compared to the size of the US stock market overall.
Central banks have, however, cheapened the money, making the investors more willing to buy stocks
What the central banks did, though, is that they distorted the interest rates and government bond yields along their monetary easing process, which has indirect effects on the markets. When money is cheap (interest rates near zero) and bond yields not rewarding anymore, financial institutions and private investors will look to rebalance their portfolios, looking for higher risk-reward assets. Stocks are attractive, because the upside profit is theoretically unconstrained (there is theoretically no upper limit for stock prices), while the downside can be contained by hedging using stock options. Another reason is that stocks are artificially protected against inflation and also benefit from economic growth.
The stock market reflects the future cash flows, not the present economic situation
Another misconception being circulated is that the stock market is currently misleading, because the economic situation is worse than the market shows. This argument is wrong, simply because the markets aren’t supposed in the first place to describe the current economic health, but rather the future outlook regarding the cash flows (i.e. revenues and earnings) of the companies in question. Investors are buying stocks as they are expecting positive returns in the form of dividends or a price increase of those stocks. A company that is doing bad now, but has good chances to recover sometime in the future, is generally an attractive investment. In other words, the stock market is a bet on the future and not on the present.
Stock markets recovered on the strength of successful companies
We are already passing through the third round of earnings calls since the pandemic started and we can see that many large companies actually thrived compared to pre-pandemic (even though Q3 was not so bright), especially the tech sector. As major indexes comprise successful companies mostly, they have been lifted up by companies with strong earnings reports. For example, Tesla, Amazon, Apple, or Facebook stock prices have seen a substantial increase since March, simply because these companies have been overperforming during this time, showing strong revenues and earnings and suggesting a promising outlook.
On the other hand, underperforming companies, like airlines, banks, and oil companies, have seen a decline in market capitalization, leading to a discrepancy between major indexes based on the comprised underlying sectors.
The stock market doesn’t comprise small and medium-sized business
The companies listed on stock exchange markets are usually big companies with strong capital and cash flow (especially those included in the major indexes), which tend to withstand a financial crisis or economic downturn better than small or medium-sized companies can. That’s why Wall Street (the financial institutions, stock exchanges, and big corporations) might look financially better than Main Street (small businesses and individuals) during a crisis. An exception would be, however, the financial crisis from 2008, when both Wall Street and Main Street were severely affected by a housing bubble triggered by both of those “factions”.
The stock market is not entirely efficient
Some economists elaborated the Efficient Markets Hypothesis, which states that the stock prices reflect all the available or known information, and therefore they are always “right” or “fair”, and that investors can’t systematically beat the market in the long run (legally) by picking individual stocks and, thus, achieving a better performance than the major indexes.
The assumption relies on the random walk hypothesis and the mathematical interpretation of the stock price movement as a Brownian motion consisting of two components: the fixed drift rate (the certainty, or the signal) and a random stochastic variable (the uncertainty, or the noise). The first component could be seen as the expected return of the stock based on all the information provided, and thus strictly dependent on the performance of the company in question, while the second component could be seen as the effect of the market participants randomly buying and selling the stock over time.
If the investors and traders would really elaborate thesis and strategies based solely on all the available information for the general public and randomly throughout the day (independent of market movements), then and only then we could say that the markets are really efficient.
However, this is mostly not the case, as financial institutions and sophisticated traders use certain technical indicators, as MACD (Moving Average Convergence/Divergence), VWAP (Volume Weighted Average Price), or candlestick patterns to establish the right moment to buy or sell, along with big financial events, such as earnings calls and Fed announcements. When the big news (e.g. outstanding earnings or interest rates decision) and technical indicators (e.g. financial institutions rotating assets and, thus, creating momentum) have a greater weight than the fundamental analysis (i.e. the future outlook of the company) in a certain period, the volatility of the stock will spike over that period, giving the invisible hand of markets a hard time to “correctly” adjust the stock to the “right and fair price” (quotes here because this is an illusory concept), as investors and traders might step in and ride.
For example, let’s say that Company X, trading at $100, has earnings call in a few hours. Traders are optimistic and start buying before the announcement, driving the price up to $105. The call is made and earnings beat expectations, pushing the price forward to $110. Traders continue to buy as the price gets higher and higher, driven by momentum. That’s when financial institutions and experienced traders cash in the profits, as the stock has just become overpriced. They had had already priced in the better-than-expected results and had set the target price at $107-$108 before the earnings call, so every stock unit sold for more than this target price represents extra profit. When the momentum is reverting, people start selling, sinking the price at around $106-$107. After a few hours/one trading day the price stabilizes at $106 and most of the involved participants that had entered at $106 or above have probably taken a loss. This a very simple example and yet not much different from what happens regularly in the markets.
Furthermore, one core assumption of the Brownian model is that price movement and returns are normally distributed. This assumption is, however, rejected by the historical returns of markets or individual stocks. Over the last decades, the markets have seen around 2,000 times more major price fluctuations (of more than 3 standard deviations from the mean) than normal distribution implies (Fama, 1970). For this reason, N. N. Taleb claims that financial investments follow an asymmetrical, fat-tailed returns/payoff distribution, a concept which was was later called the Taleb distribution by journalist Martin Wolf and economist John Kay.
The term is meant to refer to an investment returns profile in which there is a high probability of a small gain, and a small probability of a very large loss, which more than outweighs the gains. In these situations, the expected value is very much less than zero, but this fact is camouflaged by the appearance of low risk and steady returns. It is a combination of kurtosis risk and skewness risk: overall returns are dominated by extreme events (kurtosis), which are to the downside (skew). Such kind of distributions have been studied in economic time series related to business cycles.
— from Wikipedia
In other words, financial markets provide steady returns and relatively high exposure to rare, but catastrophic events. Taleb claims that these unexpected and disastrous events, which he calls “black swans”, occur mostly due to poor or insufficient risk assessment, usually caused by extreme adverse events, unobserved events, and hard-to-compute expectations.
The stock market is all about risk management and the “big fishes” are simply better at this game
Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.
In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment, such as a moral hazard, and then takes the appropriate action (or inaction) given the fund’s investment objectives and risk tolerance.
— from Investopedia
For beginners, the stock market is mostly just a gamble, while for the professionals (either individuals or FIs) it’s pure risk management. Beginners usually try to guess the winning stocks, are tricked by trends, have high exposure to downturns, and are not consistent or profitable in the long run. On the other hand, professionals use advanced tools and metrics in their analysis, position themselves ahead of trends, seek well-established and consistent returns, and use hedging (i.e. stocks insurance via the options market) to limit their losses and adjust their portfolios according to the stakeholders’ expectations (in terms of potential losses and gains) and to the market conditions.
As a comparison to the fore-mentioned concept of “black swans”, amateur traders and investors try to profit from the steady returns of the markets as long as possible and then exit at the right time, while professionals try to earn steady returns by following specific analysis and guidelines and actively managing the risk they are exposed to.
Conclusion
The stock market can be a deceptive place for many, as some may be caught by the mirage of easy money, while others might fall victim to the relentless effects of randomness. No matter how experienced, talented, or sophisticated a trader might be, the markets can always find a way to turn against him. Under these circumstances, one should gear up with knowledge, good-quality information, patience, and responsibility before starting this journey, in order to prevent as much as possible an undesired outcome.
Legal disclaimer: I am not a financial advisor, nor do I hold any positions in the mentioned stocks or indexes. The points covered in this article are for educational purposes only and serve under no circumstances as financial advice.
