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08/02/2018 7:06 AM AEDT | Updated 08/02/2018 11:16 AM AEDT

Everything You Should Know About The Stock Market

The market matters, for the wrong reasons.

Anyone who studies The Wealth Of Nations hoping to glean insights on the mysteries and mechanics of the stock market will be disappointed. Adam Smith didn’t discuss stock exchanges anywhere in the 1,100-plus pages of his foundational capitalist treatise. Nor did Karl Marx feel compelled to include the stock market among the damning contradictions and irrationalities of the capitalist system documented in Das Kapital.

The bestselling economics textbook ever written ― Paul Samuelson’s adventurously titled Economics ― devotes just five of its 608 pages to the stock market, drawing the unhelpful conclusion: “Anyone who can accurately predict the future course of business will prosper, but there is no such person.”

Yet nothing captivates Americans like the stock market. We gape at the great fortunes won and lost on the exchanges, and broadcast the Dow Jones’ minor movements on the nightly news. This week’s wild swings in the market have alternately thrilled and alarmed us.

The stock market is a good story ― one of the best. But it doesn’t mean what most people think it does. The stock market is not an important measure of national well-being, productive capacity or material wealth. It isn’t even a reliable gauge for the health of specific companies, and is only tangentially related to helping them raise capital. The most iconic contemporary capitalist institution is, in truth, inessential to the operation of capitalism itself. The stock market, in the words of the late British economist John Maynard Keynes, is merely “the outcome of the mass psychology of a large number of ignorant individuals.”

The basics: A stock exchange is where people go to buy and sell shares of corporations. Buying stock gives you an ownership stake in a company, but this stake itself has no inherent value. It doesn’t entitle you to proceeds from the firm’s earnings, or provide you with a stream of revenue. The stock is worth whatever you can get somebody else to pay for it.

Companies issue stock to raise money for personnel, equipment, research and everything else that goes into providing goods and services. But after the stock is issued, its price is no longer directly involved in corporate finance. A company doesn’t see any additional revenue when its stock price increases, or lose cash when it falls. Stock prices are determined by bidders in the stock market ― whatever a willing buyer and seller agree on ― and the profits and losses on stock accrue to those speculators.

Spencer Platt via Getty Images
Traders work on the floor of the New York Stock Exchange on Feb. 6 during a wild day of market swings.

We like to think that stock prices are closely connected to events in the real world, and that the values the market assigns are the concrete, reliable assessments of experts. As the market has rocketed this way and that this week, the commentariat has scrambled into action to explain the deeper meaning. Money magazine attributed Monday’s sell-off to new inflation data. MarketWatch told its readers to keep their eye on the yield curve of Treasury bonds. The Guardian, with a bit more precision, explained that investors expect higher interest rates from the Fed.

But none of this is really true. When Keynes bemoaned the ignorance of stock traders more than 80 years ago, he wasn’t insulting their education. He was pointing out that any precise value judgments about a company’s future prospects require knowledge of the future ― something nobody possesses.

A fall in oil prices might signal a profit boost for a shipping company, but not if political instability disrupts its trade route. The meaning and value of each new piece of data that traders evaluate is dependent on a flood of unknowable future data.

The point is that stock traders don’t respond to new information, they respond to each other. When they bid on stock prices, traders aren’t stating their beliefs about the “true” value of a company, but making inferences about how to play the reactions of other traders, who, in turn, are doing the same thing. When corporate earnings come in unexpectedly high, traders expect the stock to go up and bid accordingly. It has very little to do with a company’s long-term or even near-term prospects. It’s just what people do.

This means that the value of a company’s stock, while based on an enormous amount of information, is inherently unstable and essentially arbitrary.

At the moment, a lot of people believe that the stock market is “overvalued” ― although this idea itself wrongly assumes there is some “real” stock market value that the market has pulled away from. Years of low interest rates from the Federal Reserve have discouraged people from buying interest-bearing bonds and spurred purchases of stock instead. When the GOP cut corporate taxes, it created the prospect of companies paying out dividends to shareholders or buying back stock to drive up the price. The Fed is now steadily raising interest rates, and plenty of stock experts think traders have gotten a little carried away with tax-cut enthusiasm. And so, while the economic data is pretty good, there is a consensus in some quarters that the market is due for dip.

This doesn’t necessarily tell us anything about the real world, so more cautious economic analysts like Neil Irwin at The New York Times urge their readers to focus not on stock price swings, but on economic “fundamentals” ― things like employment, wages and interest rates ― in assessing the country’s economic prospects. And if the stock market were, in fact, nothing more than a lightly regulated casino, this would be the end of the story.

But over the past half-century, we have instead imbued the stock market with an almost cosmic significance. We use stock prices to evaluate the performance of corporate executives. Business schools teach aspiring young men and women that “shareholder value” is the only appropriate pursuit for corporate leaders.

Because the business world believes stock prices reflect deep metaphysical truths about the state of commerce, big movements in the stock market do, in fact, affect real-world decisions about trade. Even if its revenues are strong, a company might pull back on major investments in the face of a declining stock market, worried about pessimism over corporate prospects in general. Bankers looking at a stock slump might decide to withhold loans from perfectly responsible businesses. Even if it’s an ideal time to upgrade its equipment or expand its operations, a company might decide to be tight-fisted about expenses to prove its fiscal discipline to shareholders when the stock price is low.

Most alarming, we have made the financial security of the elderly almost completely dependent on stock market values by making 401k plans and mutual funds the flagship operations of our retirement system. The value of your nest egg is dependent not on your thrift or prudence, but on when you happen to invest, and when you need to cash out.

But even with that, only about half of all Americans own stock, either directly or indirectly through retirement accounts. And the vast majority of stocks ― over 86 percent, according to People’s Policy Project President Matt Bruenig ― are owned by the richest 10 percent of households. To the extent that the strange casino of the stock market does, in fact, create wealth, it almost exclusively circulates it among the rich.

The idea of using proceeds from business wealth to secure the well-being of society at large is, however, a good one. Instead of tying wealth to the speculative whims of the stock market, we might bind it directly to the productive activities of business. Instead of having individuals save for retirement by purchasing stock, we could have companies that are turning a profit pay a special dividend into a public fund. We could even call it a tax.

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