Stock Market Volatility

                                 STOCK MARKET VOLATILITY

ABSTRACT:  Reasons for recent stock market volatility are outlined, with implications for the future.

KEY WORDS:  stock market, investing, busts, booms

[The following are my observations and opinions as a stock market observer and investor of many years, and not the statements of an economist or expert.]

In the last three years, at several points in time the overall U.S. stock market has varied quite significantly (even “wildly”) in price.  Many investors lost large amounts of wealth (averaging forty percent in one downturn!), some or all of which was recovered in the next upswing by those who did not sell or trade at the time but simply kept their holdings.  A few prescient souls avoided the debacle by getting out of the market when the housing bubble of 2008 appeared to be about to burst, but they were few in number.  Many investors are delaying plans for retirement due to their losses, and losses for the elderly made life more difficult for those with small incomes.  Clearly, if these large swings in value become frequent, many small and retirement investors will have to leave the market permanently, thus reducing the capital pool of the overall economy.

Complicating responses to recent downturns is the fact that Treasury bond and money market alternatives were paying very little.  Gold has risen spectacularly with the flight from stocks, but from history we know that it can fall just as spectacularly.

There are several reasons why big downturns may be becoming more frequent, many of which relate to the fact that by far the majority of investors know very little about economics or the stock market and have invested only to take advantage of what seemed to be a money machine.  Those who know little and do their own investing have suffered the most, but those who use agents have suffered also, suggesting that those agents by and large have little predictive ability and few alternatives for investors in big downturns.

NO DEPENDABLE VALUE AND INVESTOR IGNORANCE

It is difficult for most investors to fully grasp that their holdings have no dependable or trustable value, but are valued at any point in time by what someone would pay to buy them.  This fact makes large market swings possible, since when investors attempt to minimize losses in a downturn, their selling of stock always reduces the stock price which induces more people to wish to sell, further reducing the price, and so on, until a full market rout is under way.  Very few investors investigate the value of their potential stocks with data (to base their purchases on the capital, production abilities, and management expertise of the company under consideration).  They are therefore not able later to consider selling or holding based on underlying value.  The important point is that ignorance and having no stable stock price promote buying and selling on instinct and emotion, which makes large swings in the market much more possible, as people race to buy into an upswing (thus pushing prices up and enhancing the upswing) or sell in a downturn.

GLOBALIZATION

The U.S. market’s involvement in foreign markets and companies has made the picture more complicated for investors.  At first this was seen as an important hedge, since if the U.S. market declined, investors could count on their foreign holdings to remain stable.  What we are seeing now is that there is so much intertwining of markets that it is becoming more like one huge worldwide market, thus creating even more potential for even larger market swings.  (The more interconnected the markets are and the more different items are included in securitization packages, the fewer safe havens there are, and if everything swings together, the swings will probably be even larger.)

INVESTING SOLELY FOR INFLATION GAIN RATHER THAN FOR DIVIDENDS

A significant part of the capital in the markets now is from people hoping to use market growth or inflation (rather than dividends or actual results of companies invested in) as a means of building retirement savings.  These people are looking only at the “bottom line,” with no concern for the reasonableness or appropriateness (from an economic point of view) of their investment.  Most use mutual funds as their vehicle and thus have no knowledge of most of the companies invested in.  These small investors do not realize that they are not benefiting from production or positioning of the companies in which they are invested but that most of the benefit that they see and hope for is from economic growth and resultant market inflation.  This inflation is dependent on the belief by large numbers of investors that growth will continue, which induces ever more people to invest, which drives up prices again, etc., etc., leading to another boom and bust cycle.  Once again we see that the ups and downs of the market are in large part psychological, based in what people expect or hope for and not on any hard facts or actual production or achievement.

The markets have developed many investment vehicles that do not relate directly to the production of products.  “Hedging” and similar arrangements allow one essentially to bet on whether an index or other value will go up or down, so that these “investments” are more like gambling than they are like true investments (lending money hoping for business achievement).  This is usually leveraged, so that both gains and losses are magnified.  This betting feeds into the urge of many people to gamble, thus making “the markets” even more irrational and more subject to large swings.

DEPENDENCE ON ECONOMIC GROWTH

The fact that most stock gains in recent years have been economic inflation gains (based largely on expectations of more growth, rather than on actual production, sales, etc.) means that most investors don’t realize just how small returns on stocks (dividends) are.  If judged only by dividends, the stock market is not a particularly good investment and would not be used for retirement savings by nearly as many people.  Thus, most investment decisions are driven by the attempt to pick stocks that will benefit most from market growth/inflation, rather than picking companies with good prospects in terms of what they produce.  One result of this is that the financial community or system is single-minded and vociferous in advocating for national policies that promote economic growth, because they know that without that, the capital pool for them to channel in various ways would not be nearly as big.

CURRENT MARKET STAGNATION

There seem to be two basic reasons for the current market stagnation in most parts of the world.  One is that the burden of debt has become large enough that many fewer people have any new money to invest and more people are defaulting on their loans (thus decreasing the capital pool and the cash reserves of the lenders).  Borrowers (companies) are also in debt sufficiently to reduce demand for borrowing.  The capital pool of the economy for lending depends on demand for borrowing.  (Borrowing is basically paying for money that is used to consume or spend now rather than later.  Buying a stock is in effect lending money to the company, increasing its capital pool (and it gives the buyer a tiny per share ownership in the company as well).  The company can use the money to build or improve, and it hopes to earn enough in the meantime to be able to reward the buyer of the stock with a dividend, as well as looking good enough to prevent degradation of its reputation and therefore its stock price.)  Since there is less demand for borrowing, rewards for lending go down.  With less investing, stock prices go down.  With less buying by consumers, company profits (and reputations) go down.  With a smaller capital pool, interest tends to go up.

Another important reason for the current stagnation may be that there has been no new area of investing for a number of years that inspires greater interest in possible big gains, as when the technology bubble grew.  These new markets inspire considerable investment, from which the market in general benefits to some degree (but which may also lead to a bubble and a downturn).  For a number of years, it has been apparent that much effort was going into squeezing more profit from the same business (by greater efficiencies, cuts in wages, cuts in retirement plans), instead of into expansion through development of new products or markets.  (The negative effects on workers of this squeezing have been justified by the need for greater “global competitiveness,” but in the process businesses have lost the loyalty and faith of workers.)  There is at the moment no new natural resource or new type of product to exploit (at little or no investment cost), so “the market” has no real inspiration or energy.  For example, if someone should discover a new way to use water as a source of power or a manufacturing component, it would create a huge investment run, because a very cheap (at the moment) resource can be used to make money.

GREATER STABILITY?

The basic stability of the stock market is a serious concern, since without “faith” in the market’s stability, many investors will leave the market, and presumably the economy overall will suffer somewhat from the reduction in the capital pool.  The government apparently has little it can do to control the market or ease market swings beyond influencing interest rates through the Treasuries market.  Most Americans seem to want the government to have more control (to prevent them from losing money in the market), but the economic system is still free enough that that is not the case. 

There are three factors that might bring more stability to the market, the first being less speculation.  By speculation I mean the current way that most investors invest in things that they have not evaluated and do not understand, essentially making emotion-based bets rather than reasoned, long-term lending.  Most investors these days are in the market for large returns and will run after any area that appears to “promise” large returns, without adequate risk assessment, which is the definition of speculation.  (Financial advisors seem almost as bad as small investors in this respect.)  If enough investors engage in this type of speculation, then market swings are inevitable.  Less speculation and more investing on the basis of company value and prospects could reduce current market swings.  This would require, though, that more (most?) investors accept the assumption that they are not going to “get rich” through the market, even though they may benefit significantly from investing in the market. 

The second factor that might reduce market swings would be to separate into two separate markets investment in companies versus making bets on whether a stock or index will go up or down.  The latter is another form of speculation, essentially equivalent to betting on sports events.  Some forms of this behavior are justified as “hedging one’s bets,” but in the end it is simply betting, and it does nothing to help the economy.  Putting all of these activities in a separate market would make it more clear to investors where they were putting their money.  Investing in potential production helps the economy, while the other does not.

The third factor that might reduce market swings is more saving and less borrowing—a change from having everything now, at the cost of paying interest, to more saving until the desired item can be purchased outright, without a loan or with smaller loans.  Individuals, companies, and governments could operate more in this way.  Once again, we see major economic consequences (the creation of a huge lending industry and the siphoning off of consumer purchasing power into interest payments) resulting from a psychological issue or decision (the desire to have what we want now instead of later).  More saving before purchasing (and less borrowing) would slow down economic “progress” (if progress means having more or better things), and it would reduce the earnings from lending, which could have other effects on the economy that are not apparent to me, but it might prevent rounds of over-indebtedness and resultant downturns, such as the one we are experiencing now.  It would also move us back to a more realistic, long-term view of the realities of life, since most acquisitions and achievements require preparation and investment in materials or labor before success can be achieved.  The human distaste for delay of gratification (putting off or waiting for something desired) has been rejected in favor of immediate gratification and delayed (though larger) payments.  (There are a few purchases for which, at current prices, saving the entire price before purchasing is unrealistic, such as homes, but paying larger “down payments” and less overall interest would result in more reasonably priced homes being built, since we don’t really need homes as big or as “nice” as those currently offered.)

The biggest change needed in “the market” is a reduction of expectations on the part of investors, so that “get rich quick” motivation is reduced, and investment can focus somewhat more on what has value to the economy.  It is fortunate for some investors if they can benefit from growth inflation of market values, but that is true only for those who are at the right place at the right time (and who also sell at the right time).  We may well be in a period when growth will not be adding much to our wealth.

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