Saturday, January 25, 2014

The Stock Market Disconnect

Most people do not understand the relationship between a company and its stock. When a company first enters the stock market with an IPO (initial program offer) they usually issue a fixed amount of shares. In a simplified model, say a widget company wants to raise money. It has two paths to choose from, a loan or sell stock ownership. Usually the company has already exhausted its credit with the banks. So in an IPO the widget company decides to go public. They want to sell shares, but they also want to retain ownership. So they draw up a charter and issue two million shares. Only one million shares will be sold. The owners get the other million. At this point the widget company enlists a brokerage house to go public.

After the initial IPO sale, a new party enters the mix, called the transfer agent. This is the institution that keeps track of who owns the stock from then on. So if you were to buy 100 shares of IBM today, you are not buying them from IBM, you are now buying them from a broker on the stock market. He is selling shares owned by someone listed as an owner by the transfer agent.

Just because you initiate a sell order for stock does not mean that there is a buyer on the other end. Many brokers are “Market Makers.” They buy and hold until a buyer comes along. So if no one wants to buy Widgets at $10, the market maker will buy at $8 or $9, and you guessed it, sell at $11 the next day.

A lot of stocks pay a dividend and this to a large extent determines the price people are willing to pay for them. Since every stock listed has to put out a 10K financial statement each year (called a red herring for obvious reasons), there is a second way to determine stock value. Divide the number of shares into its stated net worth to arrive at a fair market cash value for the stock. Another way to evaluate the price of a stock, is the price to earnings ratio called P/E. During normal times a P/E ratio from 5 to 10 would be considered average. IBM selling at 179 has a P/E of 11 and pays a 2% dividend; Google selling at 1,121 has a P/E of 32 and pays no dividend. So from examining these two stocks, it isn’t hard to figure out that the buyers and sellers pretty much determine the price they are willing to pay for a stock. During the 1970's a P/E of 4 wasn't uncommon for a car company.

Notice that in the real world, 20 percent ownership of the company stock gives full control, not the 51% common sense suggests is needed. Why? -- because in most company votes, the stock owners split down the middle or don’t vote. This pretty much explains how the 10 percent lunatic fringe element gets to elect our President every 4 years.

There is one other thing to point out, and that is taking possession of your stocks or leaving them with your broker in what is called “street name.” Ordering out a certificate usually costs about $25 and takes about a month to get it. That can be a real hang up if you are a day trader. The other method is to leave it in street name with your broker. He actually holds the stock and your account with him, reflects your holdings. The thing that aggravates me is the fact, if you were to buy 100 shares of Google and keep them in street name, there is nothing to stop your broker from loaning your share to another customer (for a fee) who wants to short Google (sell without owning it). It’s kind of like during the banking crisis when I was shorting Bank of America, somebody else owned it, I borrowed it and shorted it. It’s kind of like supplying the rope for your own hanging. The neat thing about having the certificates, reminds me back to the crash of 1987, everyone was waiting in line to get into the Charles Swab brokerage to sell their street held stocks. There were no lines at many brokerage houses if you showed up with a stock certificate and wanted to negotiate a sale.

What we need to realize about the stock is that it is entirely separate from the company it represents. The transfer agent is as close as you get to the company (unless you attend a shareholder meeting). Good dividends paid by the underlying company and their earnings help support stock prices. The price to earnings ratio gives the buyer some measure of how fairly priced a stock is.

There are stock market experts everywhere today, and as long as the market goes up, who needs to pay for market advice? It’s not like stocks are going to drop in price. It hasn’t always been this way, I can remember a goofy little plaque on my broker’s desk in the early 1980’s of a cartoon character holding a sign saying “DOW 2000.” I can remember asking him, “Do you think it will ever get there,” and we’d both laugh. Back then a company could announce a cure for cancer and the stock would drop 15 points, go figure.

If we were to examine the dynamics of a future market crash, things change somewhat. Instead of rising prices and increased expectations, it is a rush for the exits. Good stocks are sold to raise cash and the dogs are held in the hopes that they will come back. The main thing to realize in a crash, is that the values of the stocks are being re-determined and almost all, invariable will be undervalued by quite a bit. In a panic, there is the creation of “air pockets,” where there are no bids for a stock offered for sale. The market makers have closed up shop because of the volatility. You could conceivable bid a dollar a share for Google and get it if it was offered “at market,” and you were the only bidder.

What one needs to realize about the stock market crash in 1929, is that it was a financial liquidation disaster. It was the investors who held the stocks that were taken out and shot, not the companies themselves. We could be approaching another such event. The stock market reminds me of the Real Estate market of 2006. That million dollar house is still there, but it sells for a lot less now. Our government was able to keep that bubble pumped up with government financing. Will there be another stock market crash? Of course, and the effects will be invisible. Google and IBM will still be there; only the price per slice will be different. Of course after eating steak all of these years, you might gag on the switch to hot dogs.

Effectively, the stock market is the only game in town not under government control. Many different companies produce marvelous products and have stocks you can invest in. Don’t get wrapped up in what they make, and buy the stock for that reason. If they don’t know how to run their business, they could become the next General Motors.

So now you know the difference between the stock, the company it represents and the stock market. The one thing we haven’t discussed is the fact that a person can make just as much money in a market going down as well as one going up. I asked my broker once how come he didn’t recommend shorting stocks and he replied, “Being negative about the market is bad for business.”

The easy way to make a million dollars in the stock market, start out with several million--it works every time.


Anonymous said...

I started out with nothing . . .and still have most of it left.

Jim in San Marcos said...

Hi Anon

Great line, made me laugh.

I've heard it said that a Republican is just a Democrat with money.

I'm not far behind you.