To market, to market: How the stock market really works

I’ve had a few people express some incredulity at the resilience of the stock markets lately. At the time of writing, the Dow has increased by more than 45 percent off its bottom of 18,592 on March 23.  

The CEO of a major mutual fund company, one whom I respect greatly, recently said he felt that the “market is overbought”. With a contrary point of view, a fund manager whom I respect just as much said the stock market is right where it should be. The fact of the matter is that neither knows. In the short run the market is unknowable, but we do have a basis of understanding for the long haul. 

Stock markets are not the dens of random gambling that some make them out to be. Indeed, some markets can be like that and some speculators treat the markets that way, but stock markets are nothing more than a place for buyers and sellers to agree on a price and make an exchange. Just like you do at the grocery store. Also, just like the grocery store, sometimes there are great discounts and sometimes products seem a bit pricey.

In 1949, Benjamin Graham wrote a very valuable book called The Intelligent Investor. In it he has an allegory that is just as valuable today as it was then, and one that helps explain the vagaries of the stock market. It’s my very favourite analogy of the market: 

 “Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.

Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm, or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.

But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination… Basically, price fluctuations have only one significant meaning for the true investor.

They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention… to the operating results of his companies.”

The true value of a company is ultimately derived from what its future earnings will be. Not what they were in the past quarter. Not even what they will be next quarter. But rather what they will be for the foreseeable future. And while we can never know that with certainty, we can in many cases reasonably determine a range in which they are likely to be. We may (in fact, do) err in our estimates at times, but on balance (as has been demonstrated time and time again) we can have a fairly good idea of at least the direction and a general idea of future earnings, especially when averaged out over many, many companies.

Consider any one of the major banks. Do you believe that you will pay more, or less, for your banking fees 5 years from today? Do you believe that when they issue a mortgage next year it will be at a rate greater than they pay you for money on deposit? Isn’t it likely that they will be earning more, not less, in the next decade? Isn’t it likely that they will figure out how to make that happen, even with challenges such as global pandemics? Whether it’s through raising prices or cost reductions or technological advancements or any combination of the three, they are likely to figure out a way to earn more. That’s good by the way, because whether it’s through a mutual fund or a pension, the odds are high that you are a significant owner of several major banks.

What about toothpaste? Are you likely to use less next year? How likely are you, really, even to switch brands? Will the manufacturer of your brand likely sell less because of Covid-19? Granted, perhaps they will face some additional costs. Who do you think will pay for that? In an effort to continue to earn more money each and every year (because that is what they are mandated to do) they are likely to first attempt to reduce costs and then pass on any extra to the consumer by charging a bit more money.

I’m not saying that any particular company or sector is ripe for investing in – just that while no-one can predict the future, it is possible to come to some highly likely conclusions in many situations. With some more complicated math, it’s possible to come up with reasonable future estimates of a company’s earnings and from that, an estimate of its value. And even better, you don’t need to be the one to do that. That’s what the specialists are for.  

Ultimately, I really don’t know whether markets will go up or will go down the day after you read this –and neither do you, but don’t let that short term noise stop you from making the wise decision to take advantage of Mr. Market, when it makes sense to do so, and to ignore him when that is more prudent.  

Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area where he attends Gracepoint Community Church.  He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services.  Questions and comments can be directed to him at dr.rrsp@visionvest.ca or through his website at www.visionvest.ca.  Please note that all comments are of a general nature and should not be relied upon as individual advice.  The views and opinions expressed in this commentary are those of Arnold Machel and may not necessarily reflect those of IPC Investment Corporation.   While every attempt is made to ensure accuracy, facts and figures are not guaranteed.