The Stock Exchange Demystified

The stock market is a central institution of capitalism. Companies go public in order to raise capital for their expansion. Economic growth consists in the enlargement of business profitability. The income that firms generate is the basis of expenditure for private consumption and government. How profitable are companies determines the returns of other investment vehicles, including bonds or real estate.

There is an indissoluble link between capitalism and the stock market. Over the long run, stocks will rise when capitalism flourishes and fall when the entrepreneurial spirit wilts. Therefore, a crash is not to blame on the stock market but on the erosion of capitalism that has preceded the collapse.

Function

Exchanges are markets where supply meets demand and where price formation takes place. A specific stock market price says that at a certain point in time and space, purchases and sales took place at this definite price. The “stock market value” of a company does not represent the value of this company. As a price, the stock market valuation of an asset fluctuates with the trades at the stock exchange.

The stock market is not a predictor of the future. Nobody knows the future, and financial market operators are no exception. The fluctuations of stock market price quotations reflect current expectations about profits. Small changes of these anticipations can have profound effects on stock prices because the time horizon of investors extends over many periods.

The stock exchange has an anchor in companies’ profits. To distribute dividends, a company must generate earnings. The main determinant of the price of a company’s stock is its profit position relative to that of alternative investments. Therefore, the current price of a share depends not only on the individual company but also on the risk environment and the earnings of other companies and on the potential income and uncertainties of other investment vehicles.

As an owner of shares, an investor is at the origin of wealth creation in the capitalist economy. Other forms of income depend on the wealth that the corporate world creates. Employment income arises from and through the profits of companies. For banks to pay interest on savings, they must generate income by granting loans to companies and consumers. Earnings from bonds also derive from the wealth companies create.

For the state to pay interest on its bonds, it must collect tax receipts, which depend on profits, wages, and sales. Government expenditure depends on incomes in the private sector. When businesses fail, everything else in the economy also falls to pieces. Those investors who fear stock market crashes and panics and seek refuge in other investment vehicles cannot avoid losses when the political and social environment falls into chaos.

Trading

A stock market is a trading place. There are markets for commodities, foreign exchange, bonds, stocks, and their derivatives. If supply is tight, and demand increases, prices will rise. When demand falls and supply increases, prices drop. Sometimes the market is “thin” because only light trading is going on. Under such a condition, some market participants’ urgent need for cash can cause strong price cuts. This day-to-day trading is unpredictable.

Of the total amount of existing stocks, bonds, and commodities, only a small part trades in a session. It is therefore misleading to take the daily stock market quotations at face value to determine the “value” of the entire company, as is the case, for example, when one calculates the so-called capitalization of companies. This figure is already obsolete when the results get published. According to the individual needs of stockholders for cash, the market quotations change even if nothing remarkable happens in the economy or with the company that the share represents.

Intense observation of the price quotations is useful when one wants to buy or to sell and is on the lookout for good timing. The momentary quotations are important for market professionals, yet for the investor, the short-term fluctuations are of little significance. What counts is being in the market and earning a dividend in the long run. The dividends of stocks and the interest payments of bonds are the sources of income for the capitalist, unlike the speculator who wants to profit from the price changes and the market professional who lives off the trades.

Price Determination

There is a debate in finance about the determinants of stock market prices. The dispute rages between representatives of the efficient market hypothesis and the behavioral theorists.

The adherents of the efficient market hypothesis claim that the stock price itself is the best expression of the present value as it reflects the state of obtainable information. Only new information changes the price. Therefore, stock market prices move at a random walk as information comes in. As an argument against the efficiency hypothesis, one can hold that the market is not perfect since people are not perfect and markets are no more and no less “information-efficient” than human beings. It is not the information that makes the price, but the human decision to buy or to sell according to the individual evaluation of the information.

At the other extreme, the behavioral theory of asset markets is wrong because it tries to explain human action in light of a psychology of irrationality. Yet what may seem irrational to the observer may not be irrational for the actors themselves. Extreme fluctuations in the prices are not irrational — for example, when the market is narrow and when the participants change their views about how to assess the future profitability of a company.

Bubbles and Crashes

Long periods of a bull market (rising prices) or a bear market (falling prices) result from the flow of funds — whether more money flows into the stock market or out of the market. These inflows and outflows reflect the amount of money that circulates in the economy and the returns and risks of investment alternatives. While the relative prices of stocks reflect the profit expectations for individual stocks, the overall financial liquidity in the economy determines the level of stock prices.

Stock market booms tend to become bubbles when central banks flood the economy with fresh money when the real economy offers few attractive alternative investments. A bear market happens when financial liquidity shrinks. Then there is a general lack of money or money remains outside of the stock exchange to finance business transactions by other means. If securities owners want to sell with urgency in such a situation, they can do so only at lower prices.

Since the 1980s, there has been a strong expansion of the financial sector. The growth of finance, or what some call casino capitalism, has its cause in the growth of the public debt and in monetary inflation. When the growth of government debt and of the money supply reach their limits, the share of the financial sector will decline and the price levels of securities will normalize.

Conclusion

The price of an individual share and the status of the securities market represented in its index result from the prices of all potential investments in the financial markets and their embeddedness in the national and global environment. Therefore, it is impossible to systematically predict the movements of individual shares or the stock market index. Yet such forecasts are also unnecessary because the main advantage of investing in stocks is to participate in the growth of the economy and to maintain at the same time high liquidity.

Unlike real estate, for example, stocks can be converted into cash quickly and in small or large quantities on the stock exchange. In this respect, stock market investment is unique and provides advantages over other kinds of investment.

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