I constantly hear many people claim that the stock market is a scam. Is it possible for the source of the most common assets to be a scam, or are people fear mongering to sell books and “secrets” to make extra money? In this post I will address how the idea got started that the stock market is a scam and throw my two cents in whether it is or not. Although, if you read any of my previous posts you probably know I am leaning towards the concept that the stock market is not a scam.
Do Stock Market Values Actually Reflect The Value Of The Company?
Many people believe that the stock market is a scam because company revenues nor profits correlate perfectly with the prices of their stocks. Anyone who told you that stock prices correlate perfectly with company revenues and profits knows almost nothing about the stock market. Hopefully stock prices will correlate with revenues and profits. There is a phrase though, correlation is not causation. Ultimately stock prices are determined by the company value and the number of stocks. This is called the market cap. The main drivers (not the only ones) are supply and demand.
Why Do Stocks Prices Have To Rely On Supply And Demand?
Do you know anything in a free market that does not rely on supply and demand? This is not just the battle cry of free markets, it is the best way to balance out any market. For instance, if there is a shortage of a certain necessity, the supply goes down, the prices go up. Hypothetically, let’s say this happens with fuel. Now let’s say that we run a free market and raise the price of fuel during a shortage, fewer people will buy it. The fuel market will survive as there are still some who can buy fuel and their are profits while the supply is low, but still conceivably available. Eventually, either there will not be a shortage of fuel or another cheaper and better alternative will come up which will make fuel less of a necessity, either way, the fuel market will survive or adapt.
Now, let’s say the opposite happens and the government fixes the prices. Instead of a controlled market, many fuel stations will sell out of their supply since they cannot raise the price to match the supply and demand. They will close down, at least temporarily, but some will close permanently. Then the stations that are open will have car lines stretched for blocks to sell gas. You can only buy so much fuel, or they will have to shut down. Alternatives to using fuel may be sought for, but the fuel market will still be severely crippled.
Oh, sorry, I just had a talk with my wife/editor. Apparently the latter happened in the 1970s and it was a nightmare.
Basics In The Stock Market
What does this have to do with stocks? First, let me start with this. A stock is a piece of equity at a company, which means you own a percentage of the company. Who issues these stocks? The owner(s). The idea is they give up a part of their ownership and profits for cash. The cash used to buy the initial stock is used to further invest in the company (or at least this should happen).
Owners hold onto some of the stocks for reasons of ownership. Many times, they can use the cash flow from the stocks themselves to invest further in the company.
How Supply And Demand Works In The Stock Market
Let’s say that the owner(s) of a company wants to sell some shares of their company, they will start with a less expensive price. The reason for this is because the company needs cash to grow and wants to attract investors. When they have more cash the company will invest in assets that grow their value. When the value rises, the stock price rises, making the owners including the shareholders happy. More people will see the company as valuable and try to buy. But the price will be higher due to the higher value, this will be used to limit the number of shares sold. Some investors will still buy the stock, but not too many that the company will have little tangible use for the cash flow.
Cash Flow Produces Value
Ideally, the company will try to produce some additional value by a product or service, not just for shareholders, but for themselves. This additional value will make investors interested in the company. Then they may be willing to pay more for these shares and the company stock prices will rise. The cash flow once again will be used to invest in more assets to raise the value.
If not, the company value will lower, and so will the share price. More investors will be willing to buy lower priced shares to keep the cash flow going and the share price could rise in the near future. However, the cash flow after a pullback can only be justified if the company is making more products or services people will pay for. If not, they will likely close down. Some companies will close down, but many will continue growing and on occasion falling.
It is kind of like a cycle. A company starts developing some cash flow. The cash flow raises the value, but the value can only go so high with the limited cash flow. They then try to develop additional cash flow, usually from investors, but there is a cap in cash flow as fewer people will invest until the company shows value gains again. Hopefully, the company will develop assets that raise their value. The shareholders are happy, investors are eager and it starts all over again.
Supply And Demand In The Stock Market Prevents Scams
Let’s say the the price of stocks are fixed. When the stock price is low, too many will try to buy shares of companies. They can easily afford these stocks and believe it will give them more money. People love money so why wouldn’t they buy these stocks? Shares will quickly run out. Since companies now sold many or even all of their shares, they have too much cash flow.
Can too much cash flow be bad? If there is too much money coming from shareholders, the company will quickly lay out ground work to build the company to grow. More times than not, when there is too much cash flow in a company the owner(s) will be excited and there will be less focus on sales of products and services to increase the value of the company to pay back the shareholders. The company’s first investors will ask for some of the profits and sometimes even sell their shares. Since the company has lacked the incentive to develop any profits, they will seek out more investors to pay the original ones. This is the literal first step to a Ponzi Scheme, an iconic scam.
The prices of shares should change to supply and demand as it reflects the value of the company. This does not make the stock market a scam, quite the opposite, it prevents the stock market from being a scam. That being said there are some public companies that are scams, I will write a post on how to detect them in a later post.
There Is “More Money” In The Stock Market Than There Is Cash
One of the other claims that the stock market is a scam is the fact that there is more money in the stock market than printed cash. There is only $1.5 trillion in printed cash while there is $30 trillion in the stock market.
There are two problems with this statement. First, how much does the average person have in their wallet in tangible cash? Not much. Most money is digital, not paper.
However, I know exactly what the scam conspiracy theorists will say. “But the stock market still exceeds liquid cash. Printed currency is only M0. M1 is what is in checking accounts, that only adds about $1 trillion. M2 is in savings accounts and CDs, these only add up to around $10.5 trillion, that is still less than the $30 trillion in the stock market.”
This is a case where people are very knowledgeable, but have trouble applying the knowledge. While it is true that the US altogether has around $10.5 trillion in actual money but $30 trillion in stocks, one thing to keep in mind is that the value of a stock is driven by the company and what it owns, produces, and sells.
Keep in mind that even real estate, one of the most tangible and valuable things anyone can purchase, has no real dollar value and the price is speculative. There is so much real estate in the US, but not a single one adds a penny to the $10.5 trillion dollars in liquid money the US has. Just because something has no absolute dollar value does not mean it has no value, and we all own something of value to someone else (some of it will be low in value compared to the price, but it still has value).
It is completely understandable that people believe that the stock market is a scam. When my assets go down sometimes I wonder if I could be investing in scams. However, all of these are actually signs that the stock market is not a scam. At best, people will not invest in something they are confused by. At worst, they destroy their wealth. Those who understand how their investments in the stock market work will forge their wealth.