Why Do Stocks Go Up?

[wabmester]

I think we beat bonds to death in another thread, but how about stocks? I don't like investing in things I don't understand. And towards the end of 1999, I decided that I really didn't understand the way stocks were behaving, so I pulled out and vowed that I wouldn't get back into the stock market until I better understood what stocks were all about.

I've got to admit, I'm still baffled, but I've got a slightly better handle than I used to. I think.

Anyway, let's talk basics. Forget about three factors (or is it four with momentum?), P/E, and all that. We all know that stocks go up most of the time (2/3?), and that the long-term trend is up (in most places). So, here's a simple question that you may or may not have pondered:

Why do stocks go up?

[califdreamer]

Originally Posted by wab

Why do stocks go up?

Investor sentiment.* The prices of stocks reflect the price the "market", that is investors collectively, is willing to pay for a piece of ownership of a publicly traded company.* It's interesting to think about why a company would be valued at something other than the value of its assets.* The only answer I can see is investors are guessing what other investors are thinking about the company and its stock value.* Once sentiment turns, the herd instinct kicks in and magnifies the trend.

[Coach]

Wab, it seems to me that stock prcies are at least indirectly affected by inflation. Also, most companies reinvest a good part of their earnings. Both of these should increase the market value of the assets the company holds, and help stock price trend upward.

Coach

[Marshac]

Originally Posted by califdreamer

Investor sentiment.* The prices of stocks reflect the price the "market", that is investors collectively, is willing to pay for a piece of ownership of a publicly traded company.* It's interesting to think about why a company would be valued at something other than the value of its assets.* The only answer I can see is investors are guessing what other investors are thinking about the company and its stock value.* Once sentiment turns, the herd instinct kicks in and magnifies the trend.

I have always wondered about the 'dumb' investor. These would be funds which have cash coming in on a monthly basis (ie: retirement funds) that MUST be invested into the S&P500 (or whatever), regardless of sentiment or market conditions. Wouldn't this provide upward pressure on the market? Conversely, once 401k money starts leaving the market, and these funds become net sellers of assets, wouldn't this cause downward pressure on stocks, regardless of sentiment?

Anyone how know market volatility since the inception of the 401k compares to pre-401k days?

[wabmester]

So, in the short term price changes are basically a popularity contest.

And, in the long term price changes reflect inflation and earnings growth.

Excellent!

And why do earnings grow?

[Nords]

Originally Posted by wab

Why do stocks go up?

Originally Posted by wab

And why do earnings grow?

Because the dollar goes down.

Oh, do you mean American stocks?

Hmmm... good question...

[wabmester]

Originally Posted by Marshac

I have always wondered about the 'dumb' investor. These would be funds which have cash coming in on a monthly basis (ie: retirement funds) that MUST be invested into the S&P500 (or whatever), regardless of sentiment or market conditions. Wouldn't this provide upward pressure on the market? Conversely, once 401k money starts leaving the market, and these funds become net sellers of assets, wouldn't this cause downward pressure on stocks, regardless of sentiment?

I think this is key. * Basically, long-term price changes are driven by available investment capital vs available "homes" for that capital (stock).

I've often argued that P/E's went permanently higher in the early 80's due to those new-fangled IRAs and 401(k)'s. * *Of course, we'd need a brand new source of capital to see that happen again, right?

Let say a stock like Coca-Cola was paying a dividend of 50%. Would you be interested in buying it? Would other people?

[IHateCNBC]

Bigger sucker theory.

[califdreamer]

Let's say a company has assets worth x. *Over the course of several years, the company sheds some assets and grows or acquires others. *So several years later, let's say the company has assets of 1.3 times x. *It's interesting to ponder why the stock value would be anything other than 1.3 times higher than it was originally. *

You could cite change in earnings. *But who determines that the company is intrinsically worth eight times earnings or thiry times earnings? *It's really just investors guessing where other investors are going to value the stock.

You could cite dividend yeild. *But, once again, who determines that the stock is worth fifty times the dividend (2% yield) or one hundred times the dividend (1% yield)?

It seems to me the only intrinsic value is the inflation adjusted value of the assets. *Other than that, it's a bunch of people guessing what other people will value the security at. *

[macdaddy]

REITs may be a good way to look at this issue. Three things affect the price of a REIT - inflation and the ability of management to compete versus others in the industry and to a lesser extent the strength of the rental market. So if management peddles along and the markets stay relatively balanced then you are left with growth due to inflation, which shouldn't be underestimated.

[wabmester]

Originally Posted by califdreamer

You could cite change in earnings. *But who determines that the company is intrinsically worth eight times earnings or thiry times earnings? *It's really just investors guessing where other investors are going to value the stock.

You could cite dividend yeild. *But, once again, who determines that the stock is worth fifty times the dividend (2% yield) or one hundred times the dividend (1% yield)?

It seems to me the only intrinsic value is the inflation adjusted value of the assets. *Other than that, it's a bunch of people guessing what other people will value the security at. *

Right, I think you've nailed the problem with trying to value individual securities.* *You need to guess about asset value, then you need to guess about earnings/dividend growth, then you need to guess how others will interpret the data and what they'll do about it.* *Tough work for sure.

Which is why indexing is so popular.* *All you need to do is guess that stocks will continue to go up.* *But why should they?

I think the drivers for the stock market as a whole are inflation, GDP growth, and increases in available investment capital.

We've had great GDP growth recently, and perhaps a large influx of global investment capital.* * But those influxes tend to be one-time events, and they can reverse as quickly as they came.

So, we're basically left with GDP growth.

Bernstein wrote a little paper once that almost everybody ignored, and I don't really understand why this isn't more important to people. * He basically said that historically, stock market growth = GDP growth - 2%. * *The 2% discount is for dilution. * Every time a company grants options or has a secondary offering, they dilute the market.

Now, GDP growth is dependent on lots of factors.* * You basically need an increasing worker population, increasing productivity, and increasing global market share to sustain the kind of growth we've had historically.

I'm not sure those things will increase at nearly the rate they have in the past, which makes me a bear, I guess.

[Mwsinron]

I will be honest. Im betting they will follow what has happened in the past. I guess that makes me a sucker. So I will index and see what happens. When im old and gray living on cat food I guess I will find out what the end result is.

[. . . Yrs to Go]

Originally Posted by califdreamer

Let's say a company has assets worth x. . *. *. So several years later, let's say the company has assets of 1.3 times x. *It's interesting to ponder why the stock value would be anything other than 1.3 times higher than it was originally. *

Leverage.

If your original assets were financed with 50% debt & 50% equity your original equity value would be .5x. *If your assets grow to 1.3x, your equity interest grows by 60% [1.3x - .5x = .8x] or twice as much as the asset growth.

Originally Posted by califdreamer

You could cite change in earnings. *But who determines that the company is intrinsically worth eight times earnings or thiry times earnings? *It's really just investors guessing where other investors are going to value the stock.

Not quite. *An earnings multiple is simply the inverse of an earnings yield. *A 30x PE equates to a 3.3% earnings yield and an 8x multiple equates to 12.5% yield. *If accounting reflects economic reality (suspension of disbelief required here) then earnings reflect the cash that is available to shareholders, either for reinvestment or for dividends. *After adjusting for expected growth in earnings, a stock's yield can be compared against the "risk free rate" to determine the level of risk premium being paid to investors for owning the "risky" equity security versus the "risk free" bond. *PEs are therefore a function of both the level of interest rates (higher PEs make sense in today's low interest rate environment) and the risk premium demanded by the market. *

Originally Posted by califdreamer

It seems to me the only intrinsic value is the inflation adjusted value of the assets. *Other than that, it's a bunch of people guessing what other people will value the security at. *

But how do you value an asset? *Pretty much the same way you value a stock, by discounting expected future cash flows.

[. . . Yrs to Go]

Originally Posted by wab

Now, GDP growth is dependent on lots of factors.* * You basically need an increasing worker population, increasing productivity, and increasing global market share to sustain the kind of growth we've had historically.

I'm not sure those things will increase at nearly the rate they have in the past, which makes me a bear, I guess.

But the U.S. stock market and U.S. GDP is not a closed system. Increasingly earnings & growth are being driven by investments made internationally. People fear the rise of the Chinese and Indian economies but their burgoning middle class is going to fuel world economic growth for the next 100 years.

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

[califdreamer]

Good point on GDP. *I think in the long run, real GDP growth underlies the values of businesses and their stocks. *It's interesting to think about why expected returns in the stock market are so much higher than expected growth in real GDP. *Not to belabor the "investor sentiment" perspective on all of this, but big increases in cash inflows must be the cause *of stock prices growing faster than real GDP. *And it's investor sentiment that puts the new capital into the stock market.

Originally Posted by 3 Yrs to Go

Leverage.

If your original assets were financed with 50% debt & 50% equity your original equity value would be .5x.* If your assets grow to 1.3x, your equity interest grows by 60% [1.3x - .5x = .8x] or twice as much as the asset growth.



Not quite.* An earnings multiple is simply the inverse of an earnings yield.* A 30x PE equates to a 3.3% earnings yield and an 8x multiple equates to 12.5% yield.* If accounting reflects economic reality (suspension of disbelief required here) then earnings reflect the cash that is available to shareholders, either for reinvestment or for dividends.* After adjusting for expected growth in earnings, a stock's yield can be compared against the "risk free rate" to determine the level of risk premium being paid to investors for owning the "risky" equity security versus the "risk free" bond.* PEs are therefore a function of both the level of interest rates (higher PEs make sense in today's low interest rate environment) and the risk premium demanded by the market.*


But how do you value an asset?* Pretty much the same way you value a stock, by discounting expected future cash flows.

Good points 3 Yrs to Go.* Sounds like CAPM at work.* Hope I'm not just being ridiculously circular here, but even CAPM evaluations are based on .... oh, I won't even say it.

For instance, someone has to determine a "risk premium".* Someone has to develop a forecast of future cash flows.* It's kinda high-falutin' investor sentiment I suppose*

As for leverage, I understand how, if a fixed multiplier is used, growth in equity translates into a higher rate of return.* That's how the real estate game works too.* But we always come back to "who determines what the asset value is multiplied by?"

[JPatrick]

Supply/Demand
Really, that's all there is to it.* (Day trader perspective)

I know, I know, *the question is---what creates the imbalance in supply/demand that creates the up, and or down movement?

[unclemick]

Hmmm

The population goes up, the GDP goes up, thus stocks go up - er ah sometimes. Bernstein has visited the issue more than once over the years - as to how much the shareholder gets as his cut. The August issue of Efficient Frontier looks at B.R.I.C. - Brazil,Russia,India,China.

I usually stick with Bogle - being a Boglehead(mostly):

Div + economic growth(including Inflation) *+ P/E( Mr Market's valuation).

The last term is the bugger as one who invested thru 1996-1981 flat period can attest.

Ala De Gaul - investing in stocks can be a matter of faith - or sour grapes in De Gaul's rueful remark.

60/40 and soldier on!!

heh heh heh heh

[grumpy]

Thanks Unclemick! I was reading thru this thread and wondering why nobody had mentioned population growth. It seems to me that this is a major driver of long term growth of stock valuations. With population growth comes increased demand for goods and services - just the things that publicly traded companies are in business to supply. Of course not all companies are equally adept at capturing their share of the increased demand so some share prices fall even though the overall trend is up. If you doubt this effect, just imagine the impact on stock prices of a sudden population crash (say due to a pandemic or other natural disaster) or the impact of a gradual fall in world population due to a decrease in fertility. It is hard to for me to imagine stock prices continuing to rise if world aggregate demand for goods and services falls.

Grumpy