ANTHONYRUGGERI.COM - Essay: Stock Prices and the Financial Markets

Stock Prices and the Financial Markets

Classical economics tells us how the price of a company�s stock is a measure of that company�s value. The price to earnings ratio tells us how the price of the stock is related to the earnings of the company. The market capitalization of a company is a measure of the total long-term value that the company can offer investors.

Unfortunately, this is a flawed view for one simple reason. Stocks themselves are commodities that are subject to supply and demand, and subject to some of the most irrational and emotionally-driven forces behind supply and demand. Stock prices are indeed related to the value of a company � but they are also related to the perceived value potential of one stock compared to another, and stocks in general compared to other investments. The various factors that influence this perceived value are numerous and cannot be easily modeled, tracked, or predicted, because of the complexity of the investment system.

When people think stocks are a good value, they want to buy them. When they don�t, they want to sell them. Assuming that the price of a stock reflects the value of the company incorrectly assumes a tremendous amount of knowledge on the part of every stock consumer, and also that they sell only when the stock is overpriced (based on company performance) and buy only when it is underpriced (again based on company performance). I would argue that it is rare for any stock to truly reflect the performance of a company. Investing in stocks means less investing in the companies and more investing in the behavior of other shareholders. Thus we find that some of the most successful investors are those who pay more attention to the other people buying stocks than the fundamentals of the company itself. If this sounds familiar, I refer you to several pending lawsuits filed by the state of New York against investment banks for disseminating fraudulent analyst information.

The bottom line is that human irrationality is the most important market force affecting investments. The Internet bubble was totally irrational from the standpoint of company valuations and real performance, but completely rational when seen as a game of chicken between investors. It was a game of one-upmanship and the longer the game went, the more people joined, and the more upward pressure on stock prices. The winners sold on the way down, realizing the game was over, and the na�ve losers bought. Stocks became more like precious metals and gem-quality diamonds, valuable only because of the excessive demand and limited supply. It was not the underlying companies that people were investing in, but the stock certificates themselves. The smart investors realized that and were only in the game long enough to see how far it would go. The dumb investors bought into all the hype about the New Economy and thought that skyrocketing stock prices were concrete evidence of a new world order and predicted spectacular performance for the underlying companies.

This is why I hate the financial markets and believe that most of what goes on within them is of no value whatsoever. I will allow that they represent the engines of capitalism, and that they serve a few different useful purposes (providing capital to companies, providing incentives to employees, providing the opportunity to get rich doing nothing, whether that is worth anything or not). Aside from a few redeeming qualities, however, the markets are largely a playground detached from the actual business of producing value for customers. I remember reading about the �bard of Wall Street� and his poetry about the excitement of the trading pits. Do you think those trading pits have anything to do with analyzing the value of companies? No. As Michael Lewis so eloquently wrote, it is about liar�s poker, and about trying to beat fellow traders at their own game.