Understanding The Stock Market: What Is It And How Does It Work

June 26, 2020
Understanding The Stock Market: What Is It And How Does It Work

(And Why We Think It Will Continue Going Up)

Philosopher: And what kind of business is this about which I have often heard people talk but which I neither understand nor have made efforts to comprehend? And I have found no book that deals with the subject and makes apprehension easier.

Shareholder: I really must say you are an ignorant person, friend Greybeard, if you know nothing of this enigmatic business [stocks] which is at once the fairest and most deceitful in Europe, the noblest and the most infamous in the world, the finest and the most vulgar on earth. It is a quintessence of academic learning and a paragon of fraudulence; it is a touchstone for the intelligent and a tombstone for the audacious, a treasury of usefulness and a source of disaster, and finally a counterpart of Sisyphus who never rests as also of Ixion who is chained to a wheel that turns perpetually.

Confusion of Confusions, Joseph de le Vega, 1688

The stock market is hard. Really it is. There is perhaps no other institution where the cold, inhuman objectivity of all the available information speaks indiscriminately and for itself. When it does, it does so with a force that can scarcely regard our irrelevant emotions or biases. When people tell you that the stock market is easy and to ‘just listen to their easy formula!’ they usually are trying to swindle you, or at least charge you for information that won’t help you much. The reason they are trying to deceive you? The stock market was too hard for them, and now they need to get your money using an unscrupulous method. This highlights one of the risks consumers face in the market. However, the stock market has also created more opportunities and wealth than perhaps any other institution of Western Civilization. Hence, you’re quite right to be interested in it as a means to augment and protect your wealth.

The introductory passage is from the first book ever written on stock markets, The Confusion of Confusions. The title is apt.  It is incredible to hear de la Vega’s 17th-century descriptions of market dynamics still so prevalent and similar to that of contemporary markets. He describes bulls, bears, “opsies” or options, margin accounts, and even penny stocks of the day. He even describes the 17th century version of a state-sponsored bailout, “appealing to Frederick.” Yes, markets are always changing. For example, in the 1970s, the trading week was reduced because of a back-log of paper trades known as ‘the paper crunch.’ This is obviously no longer a problem. However, the underlying human behaviors and incentives remain conspicuously perennial. 

              There are two ancient Chinese ‘blessings’ that also double as a curse. The first ‘may you live in interesting times’ seems positive until you realize that consistent peace and prosperity is uninteresting from history’s perspective, then interesting takes on a more ominous tone, like the ‘interesting’ markets of March 2020. The other is, ‘may you get everything you wish for.’ How could this be bad, right? Well, when a global pandemic comes along, which causes an unprecedented and mandatory cessation in economic activity, what would you want the Federal Reserve to do? From a generalized shareholder’s perspective, you would want them to do precisely what they did; come in with bazookas blazing and necessarily remove the consequence of near-term corporate bankruptcy with unlimited liquidity. And do this, they certainly did, and in a timely and stylish manner too! Kudos to Jay Powell.

However, when the Fed does exactly what you want, and you’re used to valuing stocks solely on earnings and estimates (which are interrupted), then you start to understand the conundrum of the ancient Chinese ‘blessings’. This is especially so if you put a bunch of short positions on the most heavily affected sectors expecting an easy payoff too late in the decline. If you have no idea what we’re talking about, then that’s OK too.

Who Is FS Insight For?

You could be a relatively new investor looking to roll over some of your recent gains on Robinhood into quality companies that have an actual positive cashflow. Stocks are an excellent long-term store of value historically, and we believe they will continue to be. Maybe you’re a well-established investor who got rightfully spooked, went to cash, and missed out on the fastest rally in history, as parabolic and unexpected as it was (except not by us). Now you don’t know what to do. Maybe you simply wasted too much capital on downside protection and are looking at how to get long wisely in uncertain times. We love to help recovering bears. Nothing gets you more attentive to the stock market, like watching people you judge to be your inferiors getting rich in it. Maybe you saw Davey Day Trader lambasting Warren Buffet’s investment prowess and just needed to get grounded and back to some basics (we’re pretty sure he was joking). Maybe you want a fresh, data-driven voice in your resources to provide a contra-argument to the stale (and repeatedly wrong) investment advice that is entirely dependent on earnings guidance (which has virtually ceased to exist).

Hopefully, you saw that we have been telling investors as loud as we can to pick the top-performing sectors since the heat of the March crash when there was blood in the streets so-to-speak. Whatever your reason for visiting, we’re happy to have you, and we’d like to share some thoughts with you briefly that we hope will help you grasp some of the fundamental concepts and key terms in today’s financial discourse. While we hope you’ll consider joining our FS Insight Family, we wish all investors and their families good health and prosperity during this unprecedented time of uncertainty and tragedy. We are grateful that you look us to for counsel in your financial affairs, and we are honored and humbled to hold that trust.

 FS Insight was started to give individual investors access to the same research, albeit distilled for accessibility, that we provide to top institutional clients like hedge funds and investment banks. That is why our team put together this article; we want to explain some confusing aspects of the post-pandemic stock market that may seem counterintuitive, or even plain crazy to most people. However, when you take the time and effort to inform yourself on a deeper level than most investors are operating at, the most controversial of all bell-weathers may begin to make a lot more sense. When all is said and done, the stock market speaks in the language of price.

Get Out Of The Bear Trap

Wait, why does the Fed have a bazooka? Why and how does the Fed buying corporate bonds affect stocks? U Shaped? V-Shaped? Who Shaped? What Shaped? The financial discourse moves fast, and markets move even faster. For even the most seasoned investors, it can be a chore to keep up with all the comings and goings of international stock markets during a global pandemic. That’s why we want to describe the basics in the context of what’s happening. We believe it offers a fresh and advantageous perspective. We have written this for all skill levels, so bear with us, a refresher never hurts!

Since the beginning of the coronavirus crisis and the subsequent rapid market crash, apocalyptic prognostications about our financial future have been copious and prominently displayed. The market has been ‘just on the verge’ of retesting the lows according to some bear every single day since March 23rd. While some may misunderstand our view as being ‘blanket’ bullish, it is not. We aim to delve into the details of the data to gain insights that the broader market is missing and then turn those insights into actionable investment advice. Despite our non-consensus view, we also provide excellent tips for managing market volatility and downswings when they inevitably arrive. On June 25th, our Senior Editor is hosting a webinar on how to use Covered Calls to capitalize on volatility. Here are some of the main prevailing bearish arguments and our general responses to them.

  1. Wall Street Has Never Been So Disconnected From Main Street

This is true, and while it may seem heartless, one of the main benefits the market provides is an entirely unbiased view of the sum of millions of unrelated decisions.  This impartiality is one of the things that makes the market so powerful and compelling, although it can seem cold. The market does not have emotions. Wall Street is not Main Street. It has never been.

  If you have two bags of umbrellas, one which had been certified by someone to have all intact umbrellas with no holes, and one bag which was not certified and which may hold faulty umbrellas in it and it started raining, then what would happen to the relative value of the certified bag? It would go up, wouldn’t it? The companies that trade publicly on the US stock market are akin to the certified umbrellas.

Logically, when you have a group of better and more survivable companies than one, it is natural that their general attractiveness compared to others, as investments would go up. Some bears may say ‘the stock market dropped 50% in 2008 and only 33% now and the effect on the economy is far worse’. To this, we would point out that since the 2008 financial crisis, the US government reformed markets and mandated much higher capital at US banks. Also, the primary cause of credit losses in that crisis, OTC derivatives, are no longer permitted. Derivatives have actually mitigated risk this time around at large financial institutions. US banks recently saw the most significant influx of deposits in their history, about $2 trillion. The financial system in 2008 caused and exacerbated the situation. In this crisis, the financial system has been a source of strength and support for the rest of the economy. Loans are flowing out of US banks to main street, and the Federal Reserve will even begin lending to everyday businesses. Yeah, we’d say that’s worth about 20% on the averages, if not more.

  • The Economic Data Will Cause Market Panic

There is no question that we are seeing torrents of the worse economic data in our lifetimes, and probably 3 or 4 others as well. However, recently we’ve been seeing positive surprises in the economic data. We think this will continue. The rapid drop in the market reflected the unprecedented cessation of economic activity, and everyone has assumed the data will be worse than estimates. Since the depth of the crisis in March, we have been saying that the general level of fear and pessimism creates a higher probability that economic data will surprise to the upside more often than to the downside. We call it the ‘glass half full.’  So far, recent developments have proven us correct. Jobs numbers, retail sales, bank deposits, consumer confidence, and cash in peoples’ hands have been better than expected. This suggests that demand may be more intact than the Wall Street consensus suggests.

  • Earnings Will Be Depressed For Years, And So PE Ratios Will Have To Significantly Drop

Logically, this does make sense at one level. How can companies come back from such an enormous shock quickly? Well, not all companies will. Those that do will come back stronger. How can you be saying there will be a ‘V’ Shaped Recovery? Firstly, all the comparable stock market drops in recent history to March’s panicked selling have been followed by a ‘V’ shape recovery. So, historical trends support this conclusion. The other thing is that companies are in survival mode, and to survive, many are going to have to undergo the most aggressive cost-cutting in history. We believe that this will create a set of scrappy and robust businesses that will be able to outperform their overly negative earnings expectations. We believe the best companies amongst the hardest hit sectors will provide considerable upside, and that effected industries will come back quicker and stronger than predicted by the consensus view. If what we just experienced was a sucker’s ‘bear market rally’ then it was the largest in history. 

  • Coronavirus Cases Continue to Rise, So Another Lockdown Is Inevitable

Coronavirus cases are rising. They are increasing in The United States and elsewhere. However, let’s remember why the lockdowns were necessary in the first place because the government was trying to prevent the healthcare system from becoming overwhelmed. Despite the consistent uptick in cases (which we believe is not due to reopening), there has also been a steady downward trend in deaths and hospitalizations. Even in Germany, which has seen a recent and dramatic rise in certain areas, the authorities do not consider re-implementing a lockdown immediately. Instead, they are erring toward ‘more targeted’ measures. This is positive for the reopening thesis, and despite prevailing sentiments, we think the prospect of a new lockdown in the near term is very low.

  • We Are In A Speculative Bubble That Will Crash Soon

This is, in our opinion, one of the more ridiculous assertions. While we all witnessed how an unanticipated exogenous shock can roil markets (and one certainly could again), we believe that this line of logic is fundamentally wrong. How many past bubbles were burst when 78% of fund managers thought stocks were overvalued? It is almost oxymoronic to call the recent market gains a mania when the overwhelming sentiment on the street is bearish. This means that there is a lot of downside protection. So, when there are downside moves, the profits from those moves to those holding protection are swift. Those profits are often re-invested in long positions, which softens moves downward and helps the market hold key levels. When you have the entire market spring-loaded to benefit off a massive crash, it ironically makes it much more difficult for one to occur since people are not typically overleveraged, certainly not by macro indicators.  The general risk/reward profile of stocks has significantly improved. The Nasdaq recently outperformed the 10-year treasury bond. The positively changing alpha will continue to attract capital away from investment-grade debt and toward equities. There is trillions and trillions of investment capital on the sidelines (much of it governed by predictable covenants) that will begin seeking the rewards the stock market has been providing to those taking risk. We believe that the trillions in dry powder sitting on the sideline (much of which will be required to start moving to equities by existing covenant) has only just begun to get behind this rally. We think it will drive prices higher and generally make equities more attractive in the medium to long term.

Why The Fed Trumps All, Even Trump

The rate of interest on ordinary loan amounts, and, if a creditor receives security, to only 2 and one-half percent. Therefore even the wealthiest men are forced to buy stocks, and there are people who do not sell them when the prices have fallen in order to avoid a loss. But they do not sell at rising prices either, because they do not know a more secure investment for their capital. Moreover in this kind of investment, their funds can be recovered in the quickest way

Confusion of Confusions, Joseph de le Vega, 1688

Joseph de le Vega said it in 1688, not us. There are a lot of forces aligned, including the US status as global reserve currency that we believe puts a lot of firepower ready to purchase US stocks. We understand all the talk of ‘don’t fight the fed’ simultaneously with wild assertions that the Fed has ‘destroyed price discovery’ can be very, very confusing.  We personally think much of these discussions would be left better to philosophers (not shareholders), we want to focus on what the immediate effect of the Fed’s actions are for markets today and next week, not the generational discussion about the role of the state in the economy that will be accelerated and refined by this crisis.

The financial eco-system has entities (companies) that abide by certain rules and laws. When you are purchasing stock, you are purchasing a claim on current and future profits. So, of course, profitability and solvency are the key metrics by which any business is judged, and the same with the value of its stock. If the prospect of insolvency due to the virus is removed or substantially mitigated, the value of every publicly traded stock should go up (which it has), barring other developments. The Federal Reserve has exceeded the scope of any central bank by effectively stating that companies not failing because of poor management and solely because of a government-mandated shutdown should not lose the market’s confidence. Essentially, what the Fed is doing is the exact opposite of the Financial Repression of the 1970s that occurred in other countries. The Fed is promoting financial disinhibition, and urging investors to take more risk than the prevailing situation would typically make them inclined to take. It does this responsibly by removing the prospect of one of the virus’s main risks for business, near-term insolvency. This, coupled with Fiscal authorities’ ability and willingness to make meaningful efforts to plug the demand-hole caused by the virus, makes the US governments response the most effective and powerful state intervention in the economy in modern history.

So why does the Fed’s action trump pretty much all other news?  Because for the corporate world, it is like having death suspended. The funding runs and dash for liquidity that usually causes most of the downward price movement during panics (as investors indiscriminately liquidate) have been arrested forcefully. The Fed preventing that panic from spiraling out of control also gave informed market participants plenty of time to de-lever and get defensive. The Fed got debt markets functioning again quickly, and that is good for stocks. It prevented corporate debt from becoming the catalyst for a financial crisis on top of the health crisis. This has, for the time being, significantly mitigated downside risk in our estimation and will continue to be a positive for stocks.

The Stock Market Is Like A Beauty Contest And…

              Have you ever had to judge a beauty contest? Sounds pretty easy, right? Just pick the prettiest girl and be on your way. If stock investing were this easy, then many professionals would be out of the job, and even more would be wildly wealthy. Let’s add one more variable and see how the complexity of your task exponentially increases: now don’t pick who you think is the prettiest girl, pick who you think all the others judging the contest will pick. This is Keynes’s beauty contest, and it is a way to demonstrate the difficulty in pricing stocks. How much do you know about those judging the competition with you and their perceptions of beauty? How similar are they to you? Do they even like girls? There are quite a few factors that could influence that and make the correct answer very difficult to ascertain. It would seem then, that to correctly guess which contestant would win, you would have to know quite a lot about the other judges and their aesthetic proclivities. In fact, that information is just as important as, if not more important then, the faces of the actual contestants themselves.

 John Maynard Keynes devised this analogy to explain how investors value and pick stocks to buy. If it were as easy as simply choosing the companies with the best 10-K filings, then stock selection would be effortless indeed. The problem is, investors must evaluate the inherent value of a stock and the willingness of the investing public to purchase it at a given price. Try as we may to use pure rationality to value financial assets, human emotion and passion have been part of financial markets since their inception. Despite many efforts to purify the market of this element, it has been a perennial driver of boom and bust.

It’s not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest… We devote our intelligences to anticipating what average opinion expects the average opinion to be

-John Maynard Keynes

A Guessing Game…. and

              Let’s take the same principle to a quantitative contest to illustrate just how difficult the extra variable of competition with other rational players that have access to the same information as you can become. Rather than judging a beauty contest, let’s have you guess a number correctly. Behavioral economist Richard Thaler ran the following ‘game’ or experiment to illustrate what Keynes was talking about in the Financial Times in 1997:

Readers pick a number between zero and 100. The winner is the contestant with the number closest to 2/3 of the average of all numbers entered in the contest

Let’s put our thinking caps on. Since the number has to be 2/3 of the number selected, we can deduce that it is lower than 67 since if everyone picked 100, unlikely as it may be, any number above 67 does not meet the criteria for a winning number. Since you know the other participants in the study are rational and have the same information and task as you, you could also assume that they likely would not pick 67 since it is the highest permissible number and 2/3 of 67 (which a lot of people might choose) is about 45. Oh! Wait! Then maybe the extra smart people will pick 45, which would mean the winning number would be 30, but how smart is my competition? How smart do they think I am? This is the issue when the extra variable is added.

This is why it is so hard to determine the true value of stocks. If you follow this iterative logic, extrapolating the logic of your competition to get the perfect guess, then you would eventually come to the answer zero. However, while this iterative logic can be a useful exercise or analytical tool, it does not reflect the real answer in the experiment or the real world. The average of the numbers was 19, and the winning number was 13. In a nutshell, what we are offering at FS Insight is helping you get to 13. We know the market participants, and we have the data and analytical firepower to give you an edge. 

Yes, The Stock Market Is Like Gambling, Just Not The Kind You Think

 You may have heard people deride the stock market as nothing but a rigged casino. While there may be some superficial similarities, we think this is an unfortunate metaphor. That is not to say that the stock market is not like gambling. It is, a different kind of gambling. In horse racing, unlike casinos, there is no house with an inherent advantage.

Same with the stock market. Players play against each other, and each horse will have ‘odds’ of winning. Those horses with poorer odds will pay off better if they win. Those horses with the best odds are expected to win, so when they do, the payoff is not nearly as high as if a ‘dark horse’ who was underrated came from behind and won. This is why there is a lot of similarity between a winning strategy in horse racing and a winning strategy in stock picking. You certainly don’t want to have all ‘dark horses’ because your odds of winning anything will be severely diminished.

However, you also don’t want only the horses with the best odds, as your risk-adjusted return will not be as high as if you included a healthy mix of both! Diversification, along diverse metrics is always a good strategy in picking stocks. Oh, diversifying by narrative doesn’t hurt either. We can help you with that.

Breaking Rocks In The Hot Sun, You Fought The Fed and The Fed Won

Fed got you down? Don’t be down while the market is going up! It looks bad on you! Stocks are attractive, and we firmly believe that the end of the world is NOT at hand. Have you been margin called? Are you in the ‘dog house’ with your investors for missing the biggest rally ever? Are you an individual investor who is just starting to understand the complexities of the market? Whatever your situation give us a try. Come for the Skepticism, Stay For The Growth. Get Long With Tom! Try 1 month free!

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