Why Do Stocks Go Up?

[wabmester]

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

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

The only problem I have with the Gordon Equation is that it looks backwards to predict forward growth. We have leading indicators that predict forward GDP growth, so why not use those?

For example, economists have predicted that the housing bubble will knock 2 points off GDP growth.

And other economists have predicted that the demographic bubble will knock another 2 points off.

We're usually growing GDP around 4%, right? What's 4 - 2 - 2?

 

[sgeeeee]

Why Do Stocks Go Up? . . .

I gotta stick with, "for the same reason the chicken crosses the road." When you've got an answer that can't be proven wrong, I say, "stick with it."

 

[eridanus]

Two words: Pyramid scheme.

 

[wabmester]

Bummer.   Ha deleted his post about Triumph of the Optimists, but I think I'll have to find that book.

Anyway, it led me to this interesting quote from Steve Wisdom:

My son loves history books, and today I read to him about Elizabethan theater. What caught my eye: In those times, a ticket to see a Shakespeare play at the Globe cost 1 or 2 pence, and a 'pint of good ale' cost 2 pence. Whereas now a Broadway ticket is 10 or 20 times as expensive as a taproom beer. So the play/beer ratio has risen about 20-fold.

Beer is a capital-intensive commodity; theatre loads heavily on human capital -- ingenuity, creativity, etc. Shows in a nutshell why stocks, which are essentially a securitization of human capital, always go up in the long term relative to physical goods.

That's an interesting take.   Stocks = an investment in human capital, and humans will always give you a better ROI than capital assets.   I'm not sure I buy it, but I'll have to ponder it.

 

[saluki9]

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

Absolutely

That's why I have a lot of admiration for successful traders, and yet ALL of my long term stock market investments are into index funds.

In the short term prices are less a function of economic value and much more influenced (almost 100% IMHO) by supply and demand. I have been witness to the success of many short term traders who have a tremendous ability to understand and act on short term supply / demand inequalities and use that to their advantage

On the same breath the data shows that in the long term "expert" stock pickers prove to be nothing more that what could be expected from a random sampling of all active managers. Which is why I do not believe in active mangagement


As for why stock prices go up in the long run, how much time do we have?

 

[ladelfina]

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.

I am not at the level of financial/math understanding as some of you seem to be, but I found this phrase startling.. I'm surprised it got any traction!

I think you guys are over-analysing it... Thankfully, 3 Yrs to Go stepped in with exactly my thoughts: 

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

Stocks go up, generally, because companies build and invent things that people want that didn't exist before.  In other words, they create value and that value accrues to the owners of the organizations doing the building and inventing.

Companies aren't in business in order to remain static; the majority make a profit of some kind. Investors want to buy into the future profit stream, just like bond buyers want to buy into an income stream.

I must say I don't get the point of looking that much at 'assets'. With most things of any value, the whole is greater than the sum of the parts. When you buy a pair of pants, you're not buying 10,000m of cotton thread, a plastic button, and a metal zipper, you're buying valuable body-covering "pants-ness" into the future. You can take .02 of flour, a .10 egg and make it into fresh pasta "worth" a few dollars...

It's about the positive power of transformation. Also, sustainability, contacts, distribution. If you buy Coke you are buying all that intangible stuff.. all part of the likely power of Coke to continue making products that people will buy.

The desire to make and transform 'stuff' and the profitability of doing so may experience a lull here and a Kim Jong Il there but it can never be completely extinguished as long as the world survives. Human nature will keep stoking the fire.

-------------------
I like the quote posted by wab.. I sorta buy it, but in most parts of the world, I'm sure beer is expensive compared to indigenous local entertainment. A Broadway show is a ridiculously over-produced anomaly; there are plenty of free poetry slams and jam sessions around these days, and an off-off B'way ticket can be had for $10 (which I dare say at this point might be the same as the price of a Heineken some places in NY).

More important, who knows if in the Westernized world there will come a time again when talent is cheaper than basic resources like food..??  ..we ignore that this is currently still the case in many places.

 

[brewer12345]

I have been exposed to various theories as to why equity markets as a whole go up over time, but I can't say that I have a satisfying explanation except that the individual equities that make up the indexes go up over time.

So why do indvidual stocks go up? In the short term, sentiment, random influeces, space aliens, and Gawd knows what moves stocks around. Over the long term (years) stocks go up because the present value of the discounted cash flows they produce increases. So what does that phrase mean? Over time, companies tend to grow their businesses and figure out how to operate them more efficiently. This increases the amount of cash they generate, which can be used to reinvest in the company, buy back stock, pay dividends, pay off debt, or pile up a warchest of cash. All of the above enhance shareholder value, some more than others.

 

[slepyhed]

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.

In the olden days, you hired a high-school drop-out to run a press and stamp out frying pans all day (and this was considered a good job). You increased productivity by making the machine run faster, or maybe building a machine that stamps out four frying pans per cycle, etc.

Then some smart guy figured out that the press operator is doing repetitive things all day long, so more machines were built to feed the material, remove the product, package it, etc. Now you need just someone with mechanics skills to maintain all these robots. Even so, that one skilled mechanic and all the robots make more frying pans than a whole room full of high-school dropouts ever could.

But manufacturing in this country has been on the decline for my whole life (born in 1972). Have we reached the limit of just how many frying pans the world needs? Not yet, they're just being made elsewhere. Maybe there will come a day when one person floats around in a pan-manufacturing satellite producing enough pans to satisfy the entire human population's demand for frying pans. This guy's job will be to turn a dial to regulate the pan production rate, and worry about when someone is going to wise up and hook up the knob to the internet so it can be adjusted remotely.

 

[ladelfina]

naah.. we'll just be cooking our food in nuclear-powered ovens, then we'll paying someone to figure out new disposal methods for transuranic waste.

 

[wabmester]

Stocks go up, generally, because companies build and invent things that people want that didn't exist before.  In other words, they create value and that value accrues to the owners of the organizations doing the building and inventing.

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.

 

[ladelfina]

mm yeah.. too bad the heroin/cocaine/marijuana industries aren't figured into to national economic figures
Can you say "28,000% markup"?

Really, you can paint any kind of scenario, and there will be someone who wants something -- anything -- a little more fervently than the next guy. And someone will profit off of that differential by providing it.

 

[kcowan]

Why did my AAPL go from $13 to $78? Because they invented iPod and iTunes and everyone wanted it. A mania set in and soon everyone wanted their shares too. Then we sold most of our holdings (1100/1400) because it was just too big in size for our portfolio. Obviously others did too because the stock retraced down to $50.67 on July 14th.

Then they posted another record quarter and showed that they were still gaining iPod share (in spite of competitive threats) and that they were now gaining market share in PCs (+12% shipments) when the traditional PC business was flat (and market leader Dell was declining). They bounced back to $69.59 on Aug 3rd. Then portfolio balancing started again with more selling. Of in the case of traders, profit-taking.

What is AAPL worth? Whatever the market will pay for it!

 

[brewer12345]

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.

So companies that don't innovate on something should never show any growth?  Doesn't compute.  How do you explain the banking and insurance industries, then?

 

[wabmester]

So companies that don't innovate on something should never show any growth?  Doesn't compute.  How do you explain the banking and insurance industries, then?

Well, banks don't usually grow much, do they? They have a high dividend payout ratio, and I'd be surprised if they grow much faster than the money supply.

Insurance companies make most of their money by investing their float, right? So, they should grow as fast as inflation + the growth of their investments.

 

[haha]

Bummer.   Ha deleted his post about Triumph of the Optimists, but I think I'll have to find that book.

I went to Amazon to consider buying it, as I liked the book a  lot. There are a few typos that IMO shouldn't be in a $100 book, but excellent charts and a great deal of data.

While at Amazon I started reading the reviews- and I thought that they must have been talking about a different book! So I have it on hold at my library to read again, in case I was in a superbear frame of mind when I read it and totally misinterpreted the data.

If so, I shudder to think what else I might have filed in the wrong cabinet over the years. 

Ha

 

[brewer12345]

Well, banks don't usually grow much, do they?   They have a high dividend payout ratio, and I'd be surprised if they grow much faster than the money supply.

Insurance companies make most of their money by investing their float, right?   So, they should grow as fast as inflation + the growth of their investments.

Go look at the charts of a few banks, insurers, etc. for example, chart CBH and AF over the last 10 years. For insurers, try PGR and CGI. All four are in mundane businesses that haven't significantly changed in decades.

And I would suggest you pick up a finance textbook ior two if you really want to know about the theoretical underpinnings of this stuff. Brealey & Meyers' book is a good one.

 

[wabmester]

Go look at the charts of a few banks, insurers, etc.  for example, chart CBH and AF over the last 10 years.  For insurers, try PGR and CGI.  All four are in mundane businesses that haven't significantly changed in decades.

But have the banking/insurance sectors (as opposed to individual companies) grown faster than the economy over time?

And I would suggest you pick up a finance textbook ior two if you really want to know about the theoretical underpinnings of this stuff.  Brealey & Meyers' book is a good one.

Can you give me a one-liner summary? How do banks grow faster than the difference between the interest they get from loans and the interest they pay on deposits?

 

[brewer12345]

But have the banking/insurance sectors (as opposed to individual companies) grown faster than the economy over time?


Can you give me a one-liner summary?   How do banks grow faster than the difference between the interest they get from loans and the interest they pay on deposits?

The financial sector has become one of the most competitive if not THE most competitive part of the US economy over a period of decades.

My mention of a corporate finance text was in regards to stocks in general, not necessarily banks. I could bore you for hours on the subject of depository institutions. Suffice to say there are many, many levers these entities can use to increase shareholder value.

 

[HnE]

Stocks go up because corporations grow their earnings and create wealth. Simple enough?

 

[califdreamer]

"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."

I am not at the level of financial/math understanding as some of you seem to be, but I found this phrase startling.. I'm surprised it got any traction!

I

I think you're missing the point.  I wasn't saying stocks should be priced according to the corresponding company's liquidation value.  I'm saying something else is in play if the value is something other than that.  What is the additional value of a company (and its stock) if its something other than the stuff it owns?  Investor sentiment will make that determination.  When a stock buyer is willing to pay 15 times earnings for Stock x, that becomes the value of the stock.  That's a decision reached by the buyer and the seller.  Both are investors and their sentiment determined the selling price.  

Even if the population grows, international markets open up more, the GDP grows, productivity increases, dividend yields rise, expectations of future cash flows grow more optimistic and alternative investments become less attractive it will be up to investors to determine how much they are willing to pay for stocks.  

 

[ladelfina]

Even if the population grows, international markets open up more, the GDP grows, productivity increases, dividend yields rise, expectations of future cash flows grow more optimistic and alternative investments become less attractive it will be up to investors to determine how much they are willing to pay for stocks.

ok.. but if all this happens, will a stock really "go down"? Not in the short term but beneath levels before the scenario you describe? Hard for me to conceive. The "something else in play" is everything in the long run, and little to nothing in the short term, I guess is what I'm saying. Though it can have an effect, emotional sentiment only goes so far in denying fiscal reality.

 

[wabmester]

The financial sector has become one of the most competitive if not THE most competitive part of the US economy over a period of decades.

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.

If innovation is a factor (and I'm sure it is for banking and insurance), it seems like that should correlate strongly with growth in better educated countries.

Let's look at it this way: buying the total US market is attractive to people because it requires no analysis.   You're simply investing in GDP growth of the US.  So, you only need to convince yourself of one thing: that GDP growth will continue at something like the historical rate.

I can't convince myself of that.   So, I'm looking for countries and sectors that should grow faster than US GDP.

Do you think insurance and banking will grow faster than the economy?    If innovation is really an important factor, then GOOG is a value stock, right?  

 

[brewer12345]

Do you think insurance and banking will grow faster than the economy?    If innovation is really an important factor, then GOOG is a value stock, right?  

I think you are completely barking up the wrong tree (heck, wrong forest). Be that as it may, I will disclose that I am heavily invested in banking and insurance (and reinsurance) at the moment and I expect these sectors to do very well in the next 12 to 18 months.

 

[califdreamer]

ok.. but if all this happens, will a stock really "go down"? Not in the short term but beneath levels before the scenario you describe? Hard for me to conceive. The "something else in play" is everything in the long run, and little to nothing in the short term, I guess is what I'm saying. Though it can have an effect, emotional sentiment only goes so far in denying fiscal reality.

Hi delfina,

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

I agree in the long run stocks will continue to go up because, IMHO, all of the good trends will continue (GDP up, productivity up, etc.).  As long as investors are valuing investments as they have in the past, the good news will increase stock values.  Whether or not investor sentiment is rational, emotional or some combination of the two is for someone far smarter than me to figure out.

 

[haha]

I agree in the long run stocks will continue to go up because, IMHO, all of the good trends will continue (GDP up, productivity up, etc.).  As long as investors are valuing investments as they have in the past, the good news will increase stock values.  Whether or not investor sentiment is rational, emotional or some combination of the two is for someone far smarter than me to figure out.

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