Maybe we always wondered, why do we have to hear what the stock market is doing every night? When the market’s booming, we’re made to believe the economy is booming. And in America, the stock market has been mostly booming for almost 40 years. As the stock market goes, so goes the wealth and the health of the American economy.
But if you add up all the goods and services bought and sold in the US, the actual economy, that number isn’t growing as quickly as it used to. Wages have hardly budged in decades and the average American family’s net worth still hasn’t recovered from the Great Recession. So what exactly is the stock market measuring?
To understand what stock markets are measuring, it helps to imagine a very simple business like a lemonade stand. In this analogy let’s name her Jill. When Jill tried to get a loan, the bank said it was too risky, and the rich investors weren’t buying it.
But Jill has another option. She can go public, giving anyone who wants to, the chance to invest in her business through something called an initial public offering or IPO. Investors pay a certain amount, say a dollar, to own a small part or share of Jill’s business.
Jill sells a bunch of shares and growing her lemonade empire! Jill can put that money towards opening new lemonade stands, which means more profits. Jill can put some of those profits towards developing new products. She can also give some of that money back to her investors. These are called dividends.
She doesn’t have to do this, but it does help get people excited about her company and more likely to buy her stock, like Sam. He was sick on IPO day, but he thinks he knows this lemonade stand thing is gonna be huge.
So he offers to buy some shares from one of the original investors for twice what she paid for them. He’s thinking if Jill keeps this up, he can sell these shares for even more later on.
That’s the stock market. It’s people buying and selling tiny pieces of companies, based on how much they think those pieces will be worth in the future. Except in real life, it’s happening thousands of times a second, all over the world.
There are stock markets everywhere, but the New York Stock Exchange is the big kahuna. It’s been around since 1792 when 24 stockbrokers put on their finest short pants and top hats and got together under a buttonwood tree on Wall Street in New York City.
Today, it’s where shares in big traditional companies like IBM and GE are traded. The NASDAQ is the cooler younger brother. It was born in 1971 and doesn’t have a physical location. All the trading happens electronically. That’s where you find tech companies like Apple and Facebook.
So, in America, if you want to know how the stock market is doing, you want to know how both these exchanges are doing. That’s where indexes come in. They take a whole bunch of share prices and transform them into one clean number. The S&P 500 tracks 500 of the largest companies on both exchanges.
While the Dow Jones is a lot more exclusive. It only follows the 30 companies it considers the most important. In 2015, it booted out AT&T and replaced it with Apple.
The Dow Jones and S&P are big American indexes, but other countries have their own indexes to measure their stock markets, like London’s FTSE 100 index, Nikkei index, Shanghai index, etc. Today, many of the world’s biggest companies are publicly traded, but that wasn’t always the case.
One guy, and it was almost always a guy, used to call all the shots. Big corporations of the 1900s, most of them at that time had a single shareholder like Andrew Carnegie, Vanderbilt, Rockefeller.
They really exercised very tight control over these businesses. But this all began to change at the beginning of the 20th century. We start to see the rise of companies like General Motors and General Electric and RCA.
Back to Jill story. Now companies discovered that Jill discovered, that if you allow the public to buy shares, you can grow a lot faster. Shareholders want to make money. So if the CEO makes a really bad decision, they’ll start selling their shares, which will drive the price down.
The opposite is also true. The possibility of a future payout encourages people to invest in risky new ideas. That’s the whole idea of the stock market as a force for good. It drives companies to make good decisions, so they have more money to give back to shareholders and more money to grow and create jobs, and that’s good for everybody.
By the middle of the 20th century, the American public corporation was proving itself one of the most effective and powerful and beneficial organizations in the world.
Decades after World War II, the stock market helped create the heyday of shared American prosperity. A new era begins, make the system more democratic, increase the flow of capital for the financing of business.
The corporation really was supposed to be a vehicle for providing investment opportunities, not just to the very very wealthy, but to average Americans. It’s generating superior returns for investors.
Millions of secure, well-paid jobs. It’s producing innovative products that are bought around the globe. Executives and directors viewed themselves as stewards or trustees of great public institutions that were supposed to serve, not just shareholders, but also bondholders, suppliers, employees, and the community.
These public corporations helped build the American middle class, and for people who knew how to play it right, trading their stocks could build a fortune. Just like Warren Buffet. Folk music is just his hobby, but mostly he’s the billionaire investor. The biggest Wall Street titan of them all and America’s most famous investor.
Investor Warren Buffett is worth 84 billion. Buffett is famous for a particular investment style. Value investing, careful analysis of a company, looking at their balance sheet, and looking at their business.
Here’s a tip from the man himself “Buy an S&P 500 low-cost index fund.” An index fund puts a little bit of your money in all companies in the index. Basically, you’re hitching your wagon to the stock market.
The other option is to give your money to professional investors, who for a fee, try to beat the stock market. Buffett once bet a hedge fund a million dollars that over ten years, an index fund would make more money, and he won.
Picking stocks is a hard game but there’s one popular strategy. John Maynard Keynes. Maybe you can remember him by his epic mustache. He came up with it. Keynes was a Nobel Prize winner and one of the most influential economists of the 20th century, and he noticed that newspapers would do this thing.
They would have a full page of the newspaper dedicated to photos of pretty faces, and you were supposed to pick the six prettiest faces and mark them down in rank order and mail them in to the newspaper. Then the newspaper would rank faces based on how many votes they got, and the winner was the person whose choices matched the crowd’s.
Let’s think about that contest. Do you really pick what seems to be the prettiest faces? No, you should pick what other people think are the prettiest faces. That’s kind of what happens in the stock market.
It’s not the real value of companies that drive their stock prices. It’s the most popular story people believe about those companies. Sometimes those stories are backed up by facts. But sometimes those stories are all hype.
The narrative in the 1990s was internet companies are going to dominate. These companies shouldn’t be trying to make profits. That’s a good story, which is partly right. We do have companies like Amazon, Google. The problem is that nobody had any way to calibrate this story. How high should the market be? Is it a boom without end?
You know something’s wrong when everyone’s talking about something like this. “It’s a bubble, it’s like a snowballing effect. It keeps getting higher and higher. But it can’t go on forever.”
When stock market bubbles burst, it doesn’t just hurt investors, it wreaks havoc on the whole economy. Millions of people can lose their jobs, companies go under, and pensions get pummeled. But even when the stock market is up and investors are making money, that can hurt the economy, too.
There was a general sense of concern that something had gone wrong in the American economy. And eventually, the finger got pointed at the way our large public corporations were operating and being run.
Meet the chief finger pointer, Milton Friedman. An economist so famous, he was invited onto popular talk shows to help explain his philosophy. He thought it should have exactly one spoke, shareholders.
In 1970, he published a blockbuster op-ed. The famous editorial that ran in The New York Times, in which he said that because corporations were owned by their shareholders, the only obligation of business was to make profits and corporations took his advice.
They start tying the top executives’ pay to share price performance. Well, if 80% of the CEO’s pay is based on what the share price is going to do next year, he or she is going to do their best to make sure that share price goes up. Even if the consequences might be harmful to employees, to customers, to society, to the environment or even to the corporation itself in the long-term.
CEOs put more money towards things that would increase stock prices in the short-term, like cutting costs or buying back a bunch of their own shares to decrease the supply and artificially bump up the price.
Between 2007 and 2016, that’s how companies in the S&P 500 spent 55% of their earnings. Another 39% went to their shareholders as dividends, which didn’t leave much left (only 6%) to raise wages or expand or develop new products, things that are good for the economy in the long-term.
If you have a long-term view that 100 years from now, and still want to be a company, maybe you should making something different. So the choices that you make in terms of investments and people and in capital are different than if you want to make an investment and generate a return within 24 months.
In 2012, the Wausau Paper Company was making investments to switch its factories from making printing and writing paper to make tissue paper. But then a hedge fund bought up a bunch of shares and pushed the company to cut costs instead. And their argument would be “We don’t need to do that. What I’d rather see you do is to increase the dividend.”
We’ve evolved to this much shorter-term view on shareholder rights, versus a longer-term view on stakeholder responsibilities. This is a trend that’s been going on for a while and has gotten even more powerful and important. It’s seriously threatening the ability of our corporations to pursue the kinds of projects that lead to long-term corporate sustainability and economic growth.
Laying off workers, closing factories, keeping wages low. These are things that are bad for the economy overall but can be great for a company’s short-term profits and that’s what the stock market cares about.
As the stock market has grown, so have CEO paychecks. In 1973, the average CEO made about 22 times more than the average worker. By 2016, it was 271 times more. And as the stock market has grown bigger, fewer Americans have benefited.
The share of Americans invested in the stock market is at its lowest point in 20 years, as the middle class dropped out. So it’s no surprise that as stock prices have gone up in the United States, so has inequality, but it doesn’t have to be this way. Stock markets give people a chance to decide which companies deserve to succeed, which ideas are worth a gamble.
There’s something about giving people games to play. You look at successful countries and they all have stock markets, and countries that tried to shut them down are coming around and instituting them now.
Stockholders can influence how companies behave, whose interest they take into account. Most of us are thinking about our long-term futures. We care about our neighbors and our children and our grandchildren.
We have values and morals and want our companies to make money by doing things that are good for the world and not by harming people and destroying it. That’s what most shareholders really want.
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