Why Do Stocks Go Up?

[califdreamer]

If I understand correctly what you are saying, it is very similar to Tobin's Q, introduced into the literature by James Tobin in 1969. Q is defined as the market value of a diversified set of securities divided by the net worth of these same companies, with assets stated at replacement value.

The effect of this is to cancel "goodwill". The theory behind this is that while their can be goodwill for an individual company, in a competitive capitalist economy the concept is nonsensical for all companies since whatever economic advantage that lay behind the goodwill would be competed away.

High Q, as pertains at present, suggests an overvalued market, low Q OTOH suggests undervaluation.

Q has been high for so long that many feel it is no longer relevant. I disagree. Things can stay odd for a long time. Remember going around looking like polyester idiots in the 70s? For 10 years!

To me it seems evident that investments will be made until at equilibrium the marginal investment commands a return equal to the marginal cost of capital. At that point, the value of firms taken in the aggregate should approach the net worth of the replacement value of their assets.

Ha

Yes, it sounds like the Q factor is essentially supply and demand or investor opinion or whatever you'd like to call it.  Investors will pay more or less than the replacement value of the assets of the company. 

I'm unclear on your last paragraph.  Can you translate please? 

 

[haha]

I am referring to investments in physical capital at the level of the firm, not to stock investments by outside inverstors.

I agree with your synopsis of "Q"

Ha

 

[Nords]

I'm just trying to get an intuitive handle on the primary drivers of equity growth.   Obviously, increasing market share and increasing productivity are drivers, but it's not clear to me why the US should be able to consistently outperform other countries in that regard, and it's not clear how to predict future growth due to those factors.

Maybe we're just not thinking about this clearly enough.

Maybe you need to transfer this debate over to M*'s Vanguard Diehards board, where those indexing zealots and Hokus can help straighten out our valuation thinking...

 

[ladelfina]

I probably came across like I wanted to start a shooting match

no hard feelings, califdreamer.. I may've been feeling frustrated since I am trying to see the forest rather than the trees. (Not "why does stock X go up?" or "why should American stocks go up?" or "why do bank stocks go up?" )

Ha said:

Q is defined as the market value of a diversified set of securities divided by the net worth of these same companies, with assets stated at replacement value.

Gotcha. But that seems to be completely indifferent to the real potential of these assets (in certain hands, with certain history, distribution channels, R&D in the works, etc.).   All that has value that may have a subjective element but to me is still quite real indeed, not just chalked up to goodwill..  In terms of "Q", obviously a negative number, which could occur, shows someone isn't paying attention    But once you've got your positive Q, how it is determined what is 'too high'?

To me it seems evident that investments will be made until at equilibrium the marginal investment commands a return equal to the marginal cost of capital. At that point, the value of firms taken in the aggregate should approach the net worth of the replacement value of their assets.

I understand how the first part of that refers to capital investment, but doesn't the second sentence refer to stocks? If so, that is really pessimistic!

wab.. is the US 'outperforming' important to this discussion? Starting from "Why Do Stocks Go Up?" are we talking only US stocks w/r/t the rest of the world? [Are there markets where stocks in the long run always go down? That would be strange indeed.]  If US productivity drops (that's all relative anyway) or its market share diminishes, that means that, somewhere, someone else is picking up the pace. I take "stocks" to mean all stocks, in the aggregate, everywhere.

Some stocks may go up more or less than they "should", but to me it is a given that 'stocks go up'. Otherwise are we saying that all the world's combined raw materials, labor, and ingenuity are worth a net of zero, or less than zero? 

 

[haha]

Gotcha. But that seems to be completely indifferent to the real potential of these assets (in certain hands, with certain history, distribution channels, R&D in the works, etc.).   All that has value that may have a subjective element but to me is still quite real indeed, not just chalked up to goodwill..  In terms of "Q", obviously a negative number, which could occur, shows someone isn't paying attention    But once you've got your positive Q, how it is determined what is 'too high'?

Although I suppose it is mathematically possible for Q to be negative, in reality I can't imagine the conditions wherein this would occur.

As far as intangible drivers of corporate profitability being ignored, the theory is that while intangibles can be important to individual firms, it is fallacious to try to scale this up to a large diversified set of firms which include most participants in an industry, and most industries. This makes sense to me; it is part of basic finance theory in a capitalist competitive economy. Still, IMO whatever weakness there might be in this approach lies in this area.

As to how do you know when Q is high, you can look at history, and of course you have to make judgments.

Remember, it isn’t my theory-I am not well enough informed to be a very good defender of it.

Ha

 

[wabmester]

wab.. is the US 'outperforming' important to this discussion? Starting from "Why Do Stocks Go Up?" are we talking only US stocks w/r/t the rest of the world? [Are there markets where stocks in the long run always go down? That would be strange indeed.]  If US productivity drops (that's all relative anyway) or its market share diminishes, that means that, somewhere, someone else is picking up the pace. I take "stocks" to mean all stocks, in the aggregate, everywhere.

I believe a lot of people get their "feel" of stock markets from US stocks, and both our market and our economy have been pretty unique in terms of performance.

Are there markets where stocks don't go up in the long run?   Interesting question.  I haven't found much long-term international stock data.   Obviously, Japan's market has had net-zero growth over almost 20 years now, and they have one of the world's strongest economies.

When Bernstein looked at this, he found that stock market capital growth always lagged GDP growth.   In the US, the lag was around 2%.   He accounted for this as dilution due to options and secondary offerings.   He found that in some international markets, the dilution factor was as high as 30%!

But I'm not totally satisfied with the GDP relationship.  Since companies are contributors to GDP, it makes more sense to consider the fundamentals that produced company growth rather than capital growth as a function of GDP growth.

Anyway, as I said in the original post, I'm still baffled.   The stock market is incredibly complex.   The US market is one of the most liquid, most transparent, and most highly regulated markets in the world.   And the US economy probably has the highest developed infrastructure in the world.   I'm not ready to give up on the US by any means.

But I am getting less enamored by the "total market" approach in the US due to the potential drags on the economy going forward.   And I'm getting less enamored by international markets due to the general lack of transparency and high incidence of dilution and outright theft in some of those markets.

 

[brewer12345]

Wab, this is pretty basic so I suspect the answer is yes, but did bernstein factor in dividends?

The lack of transparency and opportunities for outright theft are some of the major reasons I am squeamish about emerging markets securities. That sort of thing is exactly why I have zero interest in owning any Chinese equity whatsoever. I even have to hold my nose a bit to own Greek shipping company stocks, although being listed on a US exchange helps a bit.

As far as the US equity market, well, that is an exercise for the reader. It is hard to ignore the historical returns generated by a passive holding of US indexes, and I think the same can be said for other developed countries. That said, I find it a lot easier to fully analyze and get comfy with individual securities simply because I can pull them apart and look at the guts. Hard to do that with a total market fund.

 

[ladelfina]

Obviously, Japan's market has had net-zero growth over almost 20 years now, and they have one of the world's strongest economies.

That is bizarre!! Maybe if bpp sees this thread he can help explain this phenomenon.. and also why he keeps his investments in Japan! Something to look in to.

I also agree that the US will tend to be stronger overall due to what you and brewer have already mentioned: more transparency, generally speaking less corruption, and less government interference in business. (Haven't paid much attention the Yukos story, for example, but things like that are likely to turn off foreign investors to say the very least.)

 

[haha]

IMO the only even moderately safe way to play emerging markets is to wait for the periodic crashes, and then buy a basket of funds from the affected region. They may still stink, but historically it tends to work.

Probably a truly rational investing class would never touch this crap, but since when has there been a truly rational investing class?

We can always count on the media to help us to sell this junk if we buy it cheaply enough.

Ha

 

[haha]

Referring to the long period of poor returns in the Nikkei, La Delfina said:

That is bizarre!! Maybe if bpp sees this thread he can help explain this phenomenon.. and also why he keeps his investments in Japan! Something to look in to.

I think it is easily explained by an incredibly overvalued market, first crashing and then making a small snap-back. As I remember, the high in 1989 was around 39,000. The low in spring of 2003 below 8000. It is currently trading around 15,600.

Ha

 

[wabmester]

Wab, this is pretty basic so I suspect the answer is yes, but did bernstein factor in dividends?

No, he was just looking at market cap growth.   Dividends seem to be the only reliable return from stocks, and of course you generally have to pay a lot more for those dividends than you used to.

In the long-run, stocks will give you something like inflation + economic growth + dividend yield - dilution.    But as Japan shows us, that dog can stray waaay off the path and take a lonnnng time to get back on.

I find it a lot easier to fully analyze and get comfy with individual securities simply because I can pull them apart and look at the guts.  Hard to do that with a total market fund.

Did you see MOVI today!?   Whoo boy.   Talk about a stock where analysis will make you comfy!   While the US market is pretty transparent, it's still way too easy for individual companies to hide their skeletons.   That's why I prefer to look at the sector level or higher.

 

[brewer12345]

I think the calculus you offered is missing one item: stock buybacks (as a deduction).

i guess you pick your shots and take the risks you are comfy with. Sometimes, you get it wrong. Hopefully the good decisions outweigh the bad ones. They have for me.

 

[Scrooge]

I also agree that the US will tend to be stronger overall due to what you and brewer have already mentioned: more transparency, generally speaking less corruption, and less government interference in business. (Haven't paid much attention the Yukos story, for example, but things like that are likely to turn off foreign investors to say the very least.)

Investing in opaque economies can be incredibly lucrative if you know the right people. For example, I am about to close an incredible deal in Nigeria next week!  8)

 

[ladelfina]

Is it with a relative of a deposed member of a military junta whose assets have been unjustly frozen?

These sites are a riot!
http://www.potifos.com/fraud/
http://www.svbizlaw.com/nigerian.419.letters.htm

Now I know why my mother is "afraid of the Internet".. probably a good thing (tho' she'd be unlikely to fall for something like this, thank goodness).

 

[Nords]

Investing in opaque economies can be incredibly lucrative if you know the right people. For example, I am about to close an incredible deal in Nigeria next week!

Is it with a relative of a deposed member of a military junta whose assets have been unjustly frozen?

Last week my FIL, my MIL, and my BIL all won the Spanish lottery. They're contacting their Nigerian bankers for a loan to pay the shipping fees on the Spanish winnings.

I'm pretty sure that I'm next. I'll win millions and be able to quit my job.

I'm halfway there-- I've already quit my job!!

 

[free4now]

Externalized costs

I'll give a cynical but I think true answer to why stocks go up over time: externalized costs.

Corporations rape the environment and the population, by not paying the true costs for the damage they cause in the course of their operations. Go see the movie "The Corporation" if you want to understand how this is so.

Phillip Morris stock goes up because they are convincing new people around the world to smoke their product. But MO doesn't pay the health care costs for all the lung damage that is caused by those changes they wrought, that is shifted onto future generations, and paid by various governments and private individuals. So in effect this is a transfer of wealth from future generations to current MO stockholders.

This effect happens more often with environmental damage. 3M produces toxic chemicals as a part of their manufacturing process, and figures out ways of shifting the burden for cleanup of those toxics onto governments and private individuals, often members of future generations. So in effect those future generations are subsidizing current 3M shareholders.

I believe this effect of externalizing costs onto future generations is the biggest reason why stocks on average go up over time. It will end whenever governments and individuals figure out ways to make corporations accountable for their externalized costs. I don't see that happening until the world has been so seriously poisonned and depleted that there is no other way. That will likely be way after my lifetime, so I'm betting on index funds keeping on going up for my lifetime.

 

[Gone4Good]

Re: Externalized costs

Corporations rape the environment and the population, by not paying the true costs for the damage they cause in the course of their operations. 

I believe this effect of externalizing costs onto future generations is the biggest reason why stocks on average go up over time. 

Hogwash.

Notwithstanding substantial economic growth over the past several decades, many man-made sources of pollution have declined. Air quality is a case in point:

In 1995, the first year of implementation, SO2 emissions decreased by 24 percent—nearly 4 million tons—from 1990 levels. During the past decade, SO2 emissions dropped an additional 13 percent from 1995 levels despite a 20 percent increase in utilization (based on heat input). In 2004, SO2 emissions from all Acid Rain Program units totaled 10.3 million tons, a 34 percent decrease from 1990 levels (15.7 million tons).

Over the same time frame that air quality was improving the S&P 500 tripled - hardly the correlation your theory would suggest. The reality is that the wealth created by economic progress allows us to spend more to improve the environment. For developing countries like China, environmental protection takes a back seat to feeding the population - not so in the US where we can afford to feed ourselves while simultaneously spending billions to retrofit power plants with environmental controls.

 

[Gone4Good]

I find this the most compelling argument so far.   For companies producing commodity widgets, their growth is limited by demand, regardless of how much of their earnings they reinvest.  But for companies that leverage their human capital smartly, by continuously creating new products and new demand, their growth is basically limitless.

So, the spoils should go to the country with the most innovation, and there should be a high correlation between equity growth and an educated populace, right?   I'll have to dig into this some more.

Interestingly, I compared the price growth of Phillip Morris (Altria) -- a commodity maker of tobacco products with the growth of 3M, who's stated mission is basically "to make things that didn't exist before."

And that's just price growth without dividends!

BTW, MO is supposedly the only stock that Bernanke owns.

But the description also includes selling existing products to new customers in new markets. There is a lot of growth to be had selling addictive consumables with low price elasticity to a growing world population.

 

[wabmester]

But the description also includes selling existing products to new customers in new markets.  There is a lot of growth to be had selling addictive consumables with low price elasticity to a growing world population. 

I compared MO to MCD and PEP, and they all have similar long-term growth (and they all grew much faster than the S&P 500). So market penetration into growing world-wide populations seems to be a bigger factor than "addictive" or "low price elasticity."

That seems like a pretty compelling argument for buying stock in companies with strong world-wide brands: your investment should grow at the rate of global population growth + inflation.

 

[Gone4Good]

That seems like a pretty compelling argument for buying stock in companies with strong world-wide brands: your investment should grow at the rate of global population growth + inflation.

Well, the historic performance of the companies you reference is more likely the result of expansion into new global markets than global population growth. We forget that although McDonald's is ubiquitous here, there are still areas of the world where a Big Mac is a new (and perhaps a luxury) product. To the extent a company can expand into these new markets it can grow faster than the economy, or the market, as a whole.

But picking these companies ahead of time is a tricky business. Solid brand name products, tastes, and business models do not always translate effectively overseas. For existing global brands, the rate of growth may easily slow from past trends due to market saturation - you can only grab so much world market share.

 

[Gone4Good]

Productivity (the be all and end all of wealth creation) has been accelerating in recent decades, not slowing down.

I've heard that, but I don't really understand it.   There has to be a limit to how much work we can squeeze out of one person, right?   Are we approaching that limit?   No idea.  But a lot of people here probably felt burned out by work.

I don't think we are approaching a productivity limit. Information technology continues to revolutionize the way we do things.

1) ATMs reduced the number of bank tellers
2) Word processors and copy machines eliminated scores of typists
3) Gone are the days when legions of accountants would toil away over hand written ledger books
4) Call trees with voice recognition software are reducing the number of call-center operators (i.e. don't worry so much about call-center outsourcing to India - its a dieing business)
5) E-mail and distributed networks greatly reduced the time it takes for geographically disperse workers to collaborate on projects
6) Electric utilities are installing automatic meter readers
7) Improvements in robotics continue to reduce the need for manual labor

Who knows what will come next.

 

[free4now]

Re: Externalized costs

The reality is that the wealth created by economic progress allows us to spend more to improve the environment.  For developing countries like China, environmental protection takes a back seat to feeding the population - not so in the US where we can afford to feed ourselves while simultaneously spending billions to retrofit power plants with environmental controls.

Agreed. The USA does a much better job of protecting the environment because it has the wealth to do so. China does a much worse job of protecting the environment because it doesn't have the cash flow to do so.

This comparison of USA and China supports my thesis that growth comes largely at the expense of the future generations. The USA would be growing much faster if it didn't have to divert profits into environmental protection. China is growing fast in large part because it isn't spending money on environmental protection.

 

[d]

China does a much worse job of protecting the environment because it

... chooses to; just as the US is doing a better job, because it chooses to.

 

[spideyrdpd]

Although many corporations will go outside the us to avoid the rules.....

What I never understood is that companies stock seem to go up on the rumor that there will be good news. When the news pops everyone sells.. and the shares go down .

 

[kcowan]

...
What I never understood is that companies stock seem to go up on the rumor that there will be good news. When the news pops everyone sells.. and the shares go down .

Market timers and day traders. They create most of the short-term volatility: Buy on rumour and sell on news.