I’ll be taking a break for the next several weeks to enjoy the many holiday season festivities, and catch up on some long neglected projects. I shall return in the new year with new (and hopefully interesting posts) – thank you for reading, and enjoy the season!
Archive for November, 2008
What Will Drive Markets Higher (or Lower)?
November 9, 2008What drives the price of stocks on a day-to-day (or year-to-year) basis? What causes the price to go up or down? A lot of people talk about “cash flow”, and money flowing in and out of the market. For example, it’s not uncommon to hear snippets on the news like:
“Liquid capital could come back and fuel a rally.”
“There is a lot of money waiting on the sidelines.”
“I think there’s enough cash on the sideline that any pullback is being greeted with buying.“
But does cash really drive markets? Let’s see…
1) Say Bob has a comic book that he bought for $5, and $15 cash for buying other comic books. Jim has $20 cash for buying comic books.
| Cash | Comics | Total | |
| Bob | $15 | $5 | $20 |
| Jim | $20 | $0 | $20 |
| Total | $35 | $5 | $40 |
2) Jim offers to buy Bob’s comic book for $10 because he thinks that it’s going to be more valuable in the future. Bob agrees to the price. The comic is now worth $10, and Bob makes $5 on the deal.
| Cash | Comics | Total | |
| Bob | $25 | $0 | $25 |
| Jim | $10 | $10 | $20 |
| Total | $35 | $10 | $45 |
3) A few days later, Bob regrets selling the comic and really wants it back, so he begs Jim to sell it back to him. Jim reluctantly agrees, and sells it back to him for $25. The comic is now worth $25, and Jim made $15 between the two transactions.
| Cash | Comics | Total | |
| Bob | $0 | $25 | $25 |
| Jim | $35 | $0 | $35 |
| Total | $35 | $25 | $60 |
4) The next day, the comic publisher announces that it will run another printing of Bob’s comic because it’s so popular. Now anyone can buy that comic for $5.
| Cash | Comics | Total | |
| Bob | $0 | $5 | $5 |
| Jim | $35 | $0 | $35 |
| Total | $35 | $5 | $40 |
Notice two things:
- The total “cash on the sideline” doesn’t change. Every time a transaction takes place, cash moves, but the total cash available doesn’t change.
- The system is not a zero-sum game – it’s possible for everyone to win (or lose) at least for some period of time.
This is exactly what happens in the stock market every day. There are a fixed number of shares in the stock market (except when there’s a secondary offering, or an IPO). A rally doesn’t actually “use up” (nor require) cash sitting on sideline. Cash moves around from person to person, but doesn’t “enter” or “leave” the market except when its owner decides to reallocate that cash for some other purpose. Hmm…
So what happens when a bunch of people want to move a bunch of cash from other asset classes into the stock market? Back to the above example: if Ted has $1,000 and wants to get into the comic business, he might buy Bob’s comic for $50 (or not). His decision isn’t based on the fact he has money burning a hole in his pocket. His decision is based on whether he can buy the comic at a lower price than that at which he can later sell it – i.e. it’s all about sentiment. If Ted doesn’t believe that he can make money buying the comic at $50, regardless of how much cash he has, he’d be an idiot to pay that much for it…
The same thing happens in the stock market. The only reason to buy something is if you believe you can make money in whatever timeframe you’re looking at – it doesn’t matter how much cash you have. Prices rise when greed and optimism are prevalent. Prices fall when fear and pessimism rule the day. All cash does is provide liquidity for this to happen efficiently (“sideline” cash has actually been rising for years by the way). Don’t worry – there will always be more than enough sideline cash looking for opportunities regardless of the state of the market. The thing that changes on a day to day basis is sentiment.
So when some talking head says, “the markets will rally when cash comes into the market”, what he really means to say “the markets will rally when optimism comes into the market”.
[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]
Who’s Better For The Economy, Obama or McCain?
November 2, 2008Leading up to this U.S. election, there’s been lots of talk about how to fix the economy, and which Presidential candidate would be best for the country. Sometimes, someone will come up with reasonable, unbiased analysis like Andy on the Saving to Invest blog. But more often than not, the debate will degenerate into partisan bickering.
For example, a common tactic is to compare stock market returns under Republican Presidents and Democratic presidents – as was discussed on the Carpe Diem blog. The claim there was that if you had invested money since 1929 under one party or the other, the outcome would have been:
- Democratic Presidents: $10,000 became $360,000
- Republican Presidents: $10,000 became $11,000 (or $51,000 skipping the Hoover years)
Hmm… This merits a little investigation. The first thing to wonder is why they would start the comparison in 1929, just before the great crash? It would have been nice to at least go right back to the turn of the century. Too bad. I’m starting in 1929 because Yahoo only provides data back that far.
The next thing to do is to make sure we’re comparing apples to apples. Were Republican’s Presidents in power as much as Democratic Presidents? Yes, 40 years each. Good.
How consistent were the returns? I’m not sure which markets they were analyzing, but I’ll use the Dow Jones Industrial Average.
| President | Party | Years | Average % Return Per Year |
| Hoover | Republican | 4 | -35.6% |
| Roosevelt | Democrat | 12.2 | 9.3% |
| Truman | Democrat | 7.8 | 8.0% |
| Eisenhower | Republican | 8 | 10.4% |
| Kennedy | Democrat | 2.8 | 4.1% |
| Johnson | Democrat | 5.2 | 5.3% |
| Nixon | Republican | 5.5 | -3.2% |
| Ford | Republican | 2.5 | 8.9% |
| Carter | Democrat | 4 | -0.2% |
| Reagan | Republican | 8 | 11.3% |
| Bush (H.W.) | Republican | 4 | 9.7% |
| Clinton | Democrat | 8 | 15.9% |
| Bush (W.) | Republican | 8 | -1.6% |
When looking at these numbers, 2 outliers stand out – Hoover and Clinton. What if we compare the average % return per year without these outliers?
| Party | 1929 – now | 1933 – now | 1933 – 1993 |
| Republican | 0.4% | 5.5% | 7.6% |
| Democrat | 8.4% | 8.4% | 6.6% |
Hmm… Was Hoover (or the Republican presidents before him), directly responsible for the 1929 crash? I don’t know enough history to know. But I wouldn’t be surprised if it was just lack of economic knowledge at the time, where anyone would have made the same mistakes.
Was Clinton directly responsible for the historic bull market during his term? Not really. The bull market started back in 1980, and continued through the end of the century. Was Bush responsible for tech crash in 2001? No. If anything, we can blame Clinton for creating the tech bubble, which led to the outsized returns during his term… Can we blame Bush for the current credit crisis? Sure…
But overall, looking at the chart, there are obvious bull periods, and obvious bear periods.
| Presidential Terms | Annual % Return Per Year | Years Republican | Years Democrat |
| 1933-1937, 1945-1961, 1981-2001 |
13.7% | 20 | 20 |
| The rest | -4.1% | 20 | 20 |
You can slice and dice the numbers however you want, and come up with just about whatever result you want…
Bottom line, the economy has larger business cycles, that I think have little to do with the Presidents of the day. Besides, how much policy does the President implement? He can’t pass laws, he can only veto them….
So back to the original question, who’s the best person to help the stock market? Neither, I fear.
Everyone’s trying to figure out how to avoid a recession. The problem is, recessions are a natural and necessary part of the business cycle. “Creative destruction” cleans out the deadwood and inefficiencies in the economy, and leads to prosperous periods in the future.
The 2003-2007 bull market was based on false growth created by spending money we didn’t have, in order to avoid having a mild recession. Now we’ve created an even bigger mess, and presumably an even bigger recession. Eventually we need to pay the piper.
There is no quick fix to our problems because our problem is not lack of available credit or lack of confidence – our problem is lack of reasonable expectations. Until we, as a society, change our mind set about what is reasonable and normal, we can’t move on. We had a 20-year bull market, we had 25 years of housing price appreciation compressed into 5, and we had commodity prices triple this decade. These things are not normal. Artificially pushing up prices faster than is warranted just leads to a bubble, not sustainable growth…
[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]
