Understanding How the Stock Market Works
The recent stock market correction has been dominating the headlines over the past few days. Words like “market volatility,” “market sell-off,” and even “recession” are now back at the top of Google searches. But let’s take a few minutes to dissect the recent events and understand what’s happening.
Before I get into this article, I want to clarify that I am NOT a professional investor, financial broker, or pretend that this article will be perceived as professional investment advice for anybody. The following article is just a collection of thoughts and opinions based on my own experience as a business owner and a retail investor.
Okay, so with that clarification out of the way, let’s now spend some time talking about some basic investment concepts that may help some of you understand what drives the market and how the investment world reacts to it.
Although I had always been intrigued by the stock market (Wall Street is one of my favorite movies of all time), I didn’t decide to start investing by myself until 2008, talk about good timing! The only reason why I decided to become an active investor is because I’ve always wanted to find new ways to make money work for me so that in the future, I wouldn’t have to constantly work for money. In other words, I wanted my investments to become a new avenue for me to supplement my ordinary income. Of course, the decision to invest was not made overnight. Prior to even buying my first share, I had read dozens of books about investing, stock trading, biographies of famous investors, studied each major online broker service, listened to dozens of financial podcasts and everything in between. And yes, I also watched a LOT of CNBC programs! After all, investing is a serious business, especially when you’re going to withdraw your hard-earned money from your risk-free savings account to invest it in the high-risk stock market.
One of the first things that I realized during my research is the great influence that the Fed has in the stock market. It seems like every time the Fed makes a statement or releases their meeting minutes, the market holds its breath while it reads between the lines what the Fed is saying or meaning to say. Although explaining the role of the Federal Reserve Board is beyond the scope of this article, I will summarize the Fed’s role into four major areas as described on the Fed’s website:
- Conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices.
- Supervising and regulating banks and other important financial institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.
- Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
- Providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and playing a major role in operating and overseeing the nation’s payments systems.
In reality, what affects you and I is not so much what the Fed’s role or functions are but HOW they go about to ensure that they fulfill their mission. And that’s what you probably hear about the most in economic news these days. Practically speaking, the Federal Reserve in the United States acts as the country’s central bank. It has a mandate to promote maximum employment, stable prices, control inflation, and moderate long-term interest rates. Let’s explore each of those briefly.
It doesn’t take a genius to realize that a country with a high unemployment rate is also going to be a country with a hurting economy. Unemployed people don’t have money to spend, they can’t go out to restaurants, or buy cars, or houses, or pay their existing bills. This hurts the economy even more since companies that do not sell goods, cannot make a profit and end up reporting losses. To offset their losses, they resort to lay off more employees, which in turn it increases unemployment even more. You see how dangerous this vicious cycle can get. So the Fed always keeps a close eye on the unemployment rate in order to decide how much “stimulus” the economy will need or not need.
Now, the tricky part is that the actual unemployment rate is just half of the story. You would normally think that if the unemployment rate is low, that’s good news, and if the unemployment rate goes up, that’s bad news. Not so fast. Consider this: if a lot of people get frustrated after not finding a job for a while and decide to stop looking for a job, the unemployment rate will go down, but that’s not necessarily a good thing. On the other hand, if the economy gets better and a lot of people who stopped looking for a job, decide to get back in the job market and search for a job again, the unemployment rate will go up, however in this case, it could be a good sign of the economy improving. So again, the Fed and the economy (and the stock market) react to these situations differently each time. As an investor, you would want to watch out for the jobs report each time it comes out but you shouldn’t overreact one way or another.
This is one of these terms that is hard to explain, yet we experience it around us every day. In basic terms, inflation relates to your buying power. If you go to the grocery store today with a $100 budget, you can buy a certain number of items based on their individual prices. If you take the same $100 budget to the same store a year from now, chances are ‘inflation’ ate part of your buying power and you will NOT be able to buy as much as you did with the same money a year ago. Everyone understands that an annual salary of $30,000 twenty years ago had much more buying power than the same exact salary today. In other words, cumulative inflation year over year, causes the value of money to decrease over time.
Just like in the case of the unemployment rate, the rate of inflation also determines the state of the economy. The natural reaction is to think that any type of inflation is bad, however, not all inflation is bad. A healthy economy needs a certain rate of inflation to remain healthy. In the US for example, the Fed’s target medium term inflation rate is around 2.0 %. More than 2% will start to hurt consumers (less buying power) and therefore, the overall economy will also weaken. Less than 2% or even negative inflation (also referred to as deflation) will also hurt the economy since companies will not be able to increase prices, which in turn will result in decreased revenues and possibly lower wages for their employees, all of this causing the economy to get into an anemic and unhealthy stage.
The Fed has the power to dictate interest rates by buying or selling government backed securities. If the Fed wants to keep interest rates low, it will buy a lot of securities and in doing so, it will be adding a lot of cash into the banking system. Lots of cash means lower interest rates. On the other hand, if the Fed wants to raise interest rates, it will sell securities. Selling securities adjusts the federal funds rate or the rate the banks charge each other for short-term loans.
All of these transactions at the Fed level will ultimately affect interest rates for the average consumer. That is, when you buy a car, or a house, or apply for a loan, etc. your loan interest rate will be directly related to the Fed rate. Lower rates, ease lending, make it easier for consumers to purchase items because they are more affordable which in turn stimulates the economy. Of course the logical question at this point would be, so why doesn’t the Fed always keep interest rates down? The answer is because keeping interest rates too low for a long time will ultimately lead to higher inflation.
Keeping interest rates very low for a long period of time will create higher demand on certain goods and every day commodities. With higher demand, the supply may start to suffer, which will drive up the prices for certain products. At this point, inflation raises too and as explained above, the economic growth will begin to suffer. To offset inflation, the Fed will act and increase interest rates. This will decrease inflation but it will also eventually make it more costly for the average consumer to buy a house, pay off a loan or their credit cards. Borrowing money becomes more expensive. You can now understand how all this madness works and how interwoven all of these factors are.
Do you still want to become an active investor? Or even a trader?
Traders prefer to see the Fed keeping the economy on steroids and pumping money into the market. Investors for the most part are less concerned about short term fluctuations since the have a much longer perspective for their investments.
If you’re retail investor like me, you should have a long term plan for the next 5, 10, or 15 years, knowing that during that time, you will face a lot of volatility in the market. You can’t just expect the market to be a smooth ride month after month. The question is how do you prepare for it when a pull-back or even a market correction or a bear market takes place. You need to create your own “margin of safety” so that when the turbulence arrives (and this a matter of “when” not “if”), you have prepared for it and you’re ready to deal with it. In other words, a market crash will not necessarily create a major catastrophe in your life. My recommendation is never to invest any amount of money that you anticipate you may need within the next five years.
An important aspect to keep in mind if you are a trader, an investor, or if you plan to become one, is that the stock market doesn’t just “crash” by itself. It is the collective action of all people and institutions actively trading in the market that cause the market to crash. A market crash is nothing more than the result of people’s loss of confidence in the market. It’s always a cyclical pattern although the frequency of the pattern is always unknown. Think about it this way: when the market is stable for a long period of time, investors’ confidence increases. Investors that are ‘on the fence’ decide to get back in the market, while long term investors continue to invest in the market because the market feels safe. When the market feels safe for the majority of investors, stock prices inevitably go up. There’s a much higher demand for stocks which in turn, drives the stocks prices up. Everyone’s investment portfolio keeps increasing in value. That will continue to happen for a certain period of time. When stock prices go up, company valuations will also go up, after all, any public company valuation is based on the value of their shares multiplied by the number of shares outstanding.
A long lasting market stability will eventually reach a point at which stocks become so expensive and companies valuations get so high that any little bit of bad news is just going to break that stability. It is at this point that investors start to fear that the market is no longer safe (stable, think of the word “bubble”) and begin to panic thinking that the market may crash anytime. And in fact, it is the collective fear that WILL cause the market to crash. So you can see that the more stable the market is, the higher the chances are that at some point it will eventually crash. Stability itself leads to instability which is why –if you’re a long term investor- you need to always factor in market downturns into your investment plan. It’s not just a possibility but a certainty that you will, over your investment life, face one or several major market crashes and the key is to be prepared when for when it happens.
Some investors like to calculate their return on investment by using the popular “Rule of 72.” In finance and investments, the Rule of 72 is just a simple way of calculating how long it will take for any invested amount to double its value. The rule number (e.g., 72) is divided by the interest percentage per period to obtain the approximate number of periods (usually years) required for doubling your money. For example:
- You invest $10,000
- The average market gain is 10%
- 72 divided by 10 = 7.2 years to double your investment
The rule works fine for a basic calculation, however the tricky part is to estimate the market return over the next few years. You can however, estimate an average return based on a historical perspective. Again, if you’re a long term investor, even if for your calculations you just estimate an average 7% market gain per year, you will be able to double your investment in approximately 10 years. With that in mind, you can decide whether investing is a good option for you or if you prefer to simply save your money and keep it in a bank account.
Either way, I’ll end this article by strongly encouraging you to always research, research and research again before you invest in the market. Even if you start investing in companies that you know very well as a consumer (i.e. Google, Apple, McDonalds, P&G, Microsoft, Starbucks, etc.) always go to financial websites to find out everything you can about those companies. And I would stay away from any speculative investment unless you’re willing to spend hours in front of your trading computer monitoring those stocks every minute of the trading day.
Again, I am not a financial advisor, and the above comments are just my opinions based on my own experience. I wish all of you a very successful financial life, and as usual, if you have any questions of comments, feel free to add them to the section below.
Thank you for reading. Until next time, this is Manuel Gil del Real (MGR)