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Confusions About Stock Prices

Most investors' beliefs about how stock prices are determined are wrong Why do stock prices rise? Why do they fall? Most people, including the vast majority of investment professionals, think that they know the right answers to these two basic questions. They are usually quite wrong. Consider: Economic Times Reports "The bombshell dropped by the Congress president by withdrawing the party's support to the ruling United Front government left the stockmarkets completely devastated. Share prices fell like nine pins today, as traders and speculators sold feverishly amid looming worries over the fate of the pro-market Union Budget. The Bombay Stock Exchange 30-share Sensex crashed 302.64 points, or 8.26 per cent . . . Share prices crashed on the Delhi Stock Exchange on Monday following all round selling by operators due to prevailing political crisis . . ." The above quote has been taken from a report covering the stockmarket trading on 31 March 1997. The report was published by the Economic Times on 1 April 1997. The italics are mine. The words which are italicised emphasise the misunderstanding in the mind of the person who wrote that report. My Own Report I now restate the above report in my own words: "The bombshell dropped by the Congress president by withdrawing the party's support to the ruling United Front government left the stockmarkets completely devastated. Share prices fell like nine pins today, as traders and speculators bought feverishly amid looming worries over the fate of the pro-market Union Budget. The Bombay Stock Exchange 30-share Sensex crashed 302.64 points, or 8.26 per cent . . . Share prices crashed on the Delhi Stock Exchange on Monday following all round buying by operators due to prevailing political crisis . . ." If the facts stated in the Economic Times report are correct, then the facts stated in my report must also be correct. Why? Because, every share that is sold by someone in the market is bought by someone else. For every seller there must be a buyer and for every buyer there must be a seller. For instance, if the total volume of shares sold on 31 March 1997 was one crore twenty lacs eleven thousand three hundred and fifty, the total volume of shares bought on the same day can also be calculated. On this particular day it was 1,20,11,350 shares. Therefore, whenever you read, words like "the market crashed today in a great wave of selling," it will be equally correct to state that "the market crashed today in a great wave of buying." This very simple point is lost on millions of market participants. A Confusion of Stocks and Flows When a stockmarket crashes it is easy to think that money is "flowing out" of shares and into somewhere else. Frequently newspaper reports claim that the markets crashed because, "hundreds of crores of rupees
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poured out of equities and moved into the relative safety of bonds and cash." There is a fundamental flaw in the above argument and that is this: For every investor who converts his shares into cash, there must be an investor who converts his cash into shares. Therefore, even though an individual investors can withdraw money from the market, money cannot flow out of the market as a whole. If 1 crore shares of Reliance Industries are sold on any given day at an average price of, say, Rs 275 per share, then it is true that Rs 275 crores have been withdrawn from the market by sellers if the sale proceeds are not immediately reinvested by those sellers. But, at the same time, it is also true that someone who bought 1 crore shares of Reliance on that day, injected exactly Rs 275 crores back in the market. Taking the equity market as a whole, money cannot pour out of a stock market because for every rupee that "pours out" in search of a bond has to be provided by someone else willing to buy shares. Money cannot flow into or out of equities unless new shares are being issued, or being retired by a company buying its own shares or winding itself up. With those two exceptions, money always flows through a market, being neither created nor destroyed in the process. The Confusion About the Weight of Money A reason often cited for a stockmarket rise is that excess liquidity is driving prices up. But "weight-ofmoney" is neither a sufficient, nor even a necessary, condition for rising stock prices: it just happens when the time is otherwise ripe. The movement of share prices does not have much to do with the volume of money flowing towards shares. The Sensex can rise sharply on a day of thin trading, or slide gently on a day of heavy trading. In the first instance, a meagre inflow of money has done wonders for prices; in the second, heavy buying has not. The volume of share-sales waiting to be triggered by a movement in share-prices is just as important as the volume of money available to buy them. . . Weight of money, per-se, does no more for share prices than a big ship does for level of the Arabian sea. The real determinants of share prices are fashion, market sentiment and comparative analysis of different forms of investment - in other words opinions of the financial community about the true worth of shares. Institutions are not bound to invest cash merely because they have it. Even a negative real rate of return on a short-term deposit is preferable to riding down with a bear market. If investors move cash into shares, it is because they think shares offer a better return than the alternatives. So, is the weight of money irrelevant? Of course not. If the sentiment among a particular class of investors is in favour of a certain type of investment, it has more impact on prices if they have money to spend. A tramp who is convinced that Old Masters are undervalued relative to Impressionists will move the art market less than a billionaire with a similar hunch. A Confusion About Demand and Supply It is generally believed that stock prices are set by a relationship between supply and demand and that management of a company can and should, market it's shares in much the same fashion as any other consumer product. After all, if the number of shares is fixed, would not proper advertising create a new demand for shares and thereby increase the share price? Well the correct answer to that question is that while managements can succeed in fooling investors once in a while by through advertising, the market price of the company's shares will eventually fall back to their true value. Any primary market investor would know this fact by now. Remember how MS Shoes raised its stock price to Rs 500 per share through advertising and market manipulation? Remember how
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Essar Oil, Gadgil Western and many others did the same? In fact, if you conduct a study of company advertising campaigns which talk about their investment appeal, you will find that the more vigorous the ad campaign the more the price will fall eventually. The reverse is also true. Usually a great company need not advertise its investment appeal to raise its stock price. The fact is that stocks are not like potatoes whose prices are set by the forces of demand and supply. Rather, stocks represent claims on future cash flows of businesses and it is only investors' opinions about those cash flows and the risk associated with those cash flows which determines stock prices. When those opinions are wrong, which is frequently the case, the prices diverge far from their value. And when the opinions are right, prices hover around intrinsic value. One way to understand this is to think of stock prices as continuous. In India stockmarkets are closed on Saturdays and Sundays, and trading normally takes place on the other five days of the week. Now suppose, Reliance closes at 275 per share at the end of the last trading day of the next week, that is next Friday. Now assume, a war is declared between Indian and Pakistan after the market closes on next Friday. What do you think Reliance's opening quote will be when the market opens on the next trading day, that is, on Monday next? I think it will be far below Rs 275. Why? Because of selling pressure on Monday morning? No. Reliance will open at far less than Rs 275, not because of any selling pressure since, for every Reliance share sold, one must be bought. The real reason is that, as soon as the information about the war is known, people will revise their opinion about the value of the stock of Reliance Industries. This change of opinion may or may not be rational, but it is this change in opinion and not the forces of demand and supply which will result in the fall in the price of the shares. Another example. Suppose, you buy shares in Colgate Palmolive at Rs 280 per share. You like the industry, you like the management and you like the price you are paying for those shares. You want to be a long-term owner of this wonderful business. Now suppose, after your shares have been registered in your name, there are no further quotations for the next ten years. After ten years, however, Colgate shares are quoted. What do you think will be the price at which Colgate shares are quoted after 10 years? I think the price of those shares will be a lot more than Rs 280, provided Colgate continues to perform well. Even though the trading volume in Colgate shares was zero in these ten years, that will not prevent rational investors from forming an opinion about the value of those shares based on how the business has been performing. That opinion will be revised whenever new information about the company became known. The absence of market quotations will not mean that people do not hold opinions about the value of Colgate shares. It is simply not necessary for quotations to exist for values to exist. Proponents of the demand-supply theory, however, will be horrified to find that Colgate shares command a much higher price than Rs 280 per share after ten years from your purchase. The above confusions about stock prices exist in the minds of people because they do not really understand how prices are set in the market. Two investment authors have given the correct explanation: John Burr Williams gave the his explanation in his book, "The Theory of Investment Value" published in 1937 and Philip Fisher gave his explanation in his book, "Conservative Investors Sleep Well" published in 1975. Here are a few extracts from the works of both these authors which explain, as clearly as I have found anywhere, exactly how prices are set in the market: The Truth About Prices - J.B. Williams "Let us assume for the moment that the market contains only a single stock. Concerning its true worth, every man will cherish his own opinion; as to what price is really right, time only will tell. Time will not give its answer all at once, though, but only slowly, word by word, as the years go by; nor will the last
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word be spoken till the corporation shall have closed its books for ever and ever. Those who bought their stock long ago will know their answer in the main by now, but those who buy now will hear theirs only in the future. But right now, when all investors can merely estimate, and none can surely know, what their stock will prove to be worth in the end - the market can only be an expression of opinion, not a statement of fact. Today's opinion will make today's price; tomorrow's opinion, tomorrow's price; and seldom if ever will any price be exactly right as proved by the event. Both wise men and foolish will trade in the market, but no one group by itself will set the price. Nor will it matter what the majority, however overwhelming, may think; for the last owner, and he alone, will set the price. Thus marginal opinion will determine market price. Always some would-be buyers will be excluded from ownership because to them the price would seem more than the stock is worth to them. These buyers will stand with cash in hand, waiting for some present owner to change his mind and sell out to them at their price. If this happens, then the quotation will fall to their figure, but if they change their own minds, then the price will rise to whatever they must bid to dislodge stock from the least optimistic present owner. The bid and asked quotations will reflect the opinions of the most optimistic non-owner and the least optimistic owner. The margin will fall between owners and non-owners, the ins and the outs, the ayes and the nays; and, at this margin, opinion, mere opinion, will determine actual price, even to the extent of values running into billions of dollars. The marginal opinion concerning, and hence the market price of, any given stock is affected by opinion regarding other stocks too. If John Doe owns American Telephone, but holds an opinion concerning United States Steel as well, then he will own whichever stock he considers the cheaper - in this case American Telephone, let us say. If now some news comes out on United States Steel, such as an increase in the rate of its operations, he may decide that Steel is the cheaper, and wish to switch his investment. John Doe then sells Telephone to a marginal non-owner, Mr Wiseman, and uses the cash thus obtained to buy Steel from a marginal owner, Richard Roe. Richard Roe then becomes a marginal non-owner of Steel, replacing the original marginal non-owner of Telephone, Mr Wiseman, and invests the proceeds of his sale in the same bank assets that the other non-owner, Mr Wiseman, once held. The switching sends Telephone down and Steel up; it causes two transactions to occur, and two sales to be recorded on the ticker tape. Sometimes the switching is even more complete, for John Doe and Richard Roe may exchange Telephone and Steel with each other, and in this case neither changes from being an owner to being a non-owner. Without doubt the vast majority of the sales reported each day represent switching transactions . . . Switching operations throughout the market represent a change in places among various buyers and sellers. Heavy trading indicates widespread changing of opinion. It is wrong, therefore, to say of a market rising on heavy volume that it shows the inrush of new money seeking investment, or of a falling market that it shows capital scurrying to safety. Such statements as these, all too common, are naive in the extreme. The correct view is that rising and falling markets show changing marginal opinion, while heavy volume shows much switching. [It is incorrect to say] that excess reserves might breed excess bank deposits which would flow into the stock market and cause a rise in stock prices. That stock prices would rise merely because of an increase in the quantity of money, we should deny; for we maintain that stock prices will rise only because people think stocks are worth more. The quantity of money has nothing to do with the price of stocks. . . An increase in the quantity of money is neither a necessary nor a sufficient condition for a rise in the price of stocks. It is not necessary because stock prices can rise by sales that involve no use of money - by sales
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between traders using only bookkeeping entries on brokers' books. Thus if John Doe owns American Telephone, now quoted at 160, and Richard Roe owns Allied Chemical, now quoted at the same price, there is nothing to prevent them from exchanging these shares at 180 next month without the use of any money at all, if each buys and sells within the same trading day. If investors generally trade back and forth with each other, continually becoming more optimistic, just such a rise would occur. In fact, this is just what took place during most of the 1935-36 bull movement. Stock prices in general rose without the use of any new credit to finance the rise. Clearly an increase in the quantity of money is not a necessary condition for a rise in stock prices. Neither is it a sufficient condition. No matter if bank deposits increased, stocks would not go up if people become more pessimistic." The Truth About Prices - Philip Fisher "Most investors, including many professionals who should know better, become confused on this point because they don't have a clear understanding of what makes the price of the particular stock go up or down by a significant amount. . . . It is truly remarkable that so few have looked beneath the surface to understand exactly what causes these sharp price changes. Yet the law that governs them can be stated reasonably simply: Every significant price move of any individual stock in relation to stocks as a whole occurs because of a changed appraisal of that stock by the financial community. The phrase "significant price changes" is used rather than merely "price changes." This is to exclude the kind of minor price variation that occurs if, say, an estate has twenty thousand shares of a stock that a clumsy broker rapidly dumps on the market with the result that the stock drops a point or two and then usually recovers as the liquidation ends. Similarly, at times an institution will determine that on going into a new situation it must buy a minimum number of shares. The result is frequently a one small onetime bulge that subsides on the completion of this type of buying. Such moves, in the absence of a genuinely changed appraisal of the company by the financial community as a whole, have no importance or longterm effect on the price of the shares. Usually such small price changes disappear once the special buying or selling is over. The term "financial community" has been used to include all those able and enough interested to be potentially ready to buy or sell a particular stock at some price, keeping in mind that, with regard to impact on prices, the importance of each of these potential buyers and sellers is weighed by the amount of buying or selling power each is in a position to exercise." Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1997.

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