It’s not how they say
One of the recurring themes here at Financology is just how bad the popular financial media are. Decades ago I used to think I could learn something from them. Maybe I did, but as time has passed, I’ve had to unlearn most of it. It’s mostly marketing … it gets absurd, really, when the broadcaster takes a commercial break, as if what you’ve just seen wasn’t already an ad. Other times it ranges from misleading to outright false.
One favorite example is the buying and selling meme. Stocks went up because everybody’s buying. Or they went down because everybody’s selling.
Utter rubbish.
It’s made believable only through the fallacy of composition. You can buy stocks. You can sell stocks. It seems plausible that if you can, everybody else can too. But that’s a big fat non sequitur. If you buy stocks, who did you buy them from? Somebody sold them. The fact that an individual can buy and sell stocks does not extend to the aggregate. Every share sold is a share bought. The crowd cannot buy and sell stocks.
So then what moves markets?
In the final analysis, it comes down to two things. One is that while investors cannot in the aggregate buy or sell assets, they can in the aggregate change their asset allocations.
Suppose investors as a whole are allocated 50% to stocks. And suppose they as a whole decide to reduce their stock allocations to 40%. They cannot do this by selling. But the market will nevertheless oblige. Stock prices will decline by 20%.
Now this doesn’t mean that everyone has to participate, or even that everyone who does participates in the same way. An early bird might actually sell 20% of his stocks, while another more passive investor merely sees the market value if his holdings decline by 20%. But in no case is there any net selling. The early seller sold to a buyer, and might even later buy back the shares sold at 20% off, netting no change in the number of shares for the round trip. Every sale is a purchase and every purchase a sale.
The other way is if the net float of an asset class changes due to net issuance or net redemption. And it doesn’t have to be the asset class whose price changes. Prominent contemporary examples of this are the creation of new dollars by the Fed and the creation of new bonds by the Treasury.
Suppose for example that over the course of a hundred days the US Treasury issues a trillion dollars of new bonds. (Hardly a hypothetical.) Someone has to hold these bonds. This means that if all else remains the same, investors’ allocation to bonds increases and their allocation to everything else decreases. If they want to hold their allocations the same, there is only one way this can happen. Asset prices must change. Either bond prices must fall or other prices must rise.
If the Fed intervenes to hold bond prices steady, that eliminates option number one and other prices must rise. As the main alternative to bonds, this usually means stocks. And again contrary to media portrayal, there is however no new prosperity created as a result, only a transfer of wealth. The world is not richer because stock prices went up, nor is it poorer if the capitalization of the stock market goes down by a trillion dollars.
So this is no mere theoretical abstraction; it has practical application. It explains the outsized inflation in stock prices despite extreme valuations. The combination of large federal deficits with monetary accommodation almost requires it. It’s quite mechanical … far more so than vague and fuzzy constructs like “investor psychology” or “animal spirits” would imply.
It also explains how big deficits widen the wealth gap.
A related nugget of nonsense is that money “on the sidelines” can “go into” stocks. It doesn’t because it can’t. You may be able to put money into stocks, but everybody can’t. If you do it, somebody else did the opposite. The only way that cash can go away is if its issuer retires it.
A bear market in stocks arises in the same way. Either investors have in the aggregate decided to reduce their allocations – which they cannot do by selling – or the market cap of another market to which they allocate decreases, resulting in prices falling to maintain the allocation investors seek.
In each case, the market is accommodating investors’ allocation preferences. Prices adjust to balance these preferences with the float of each asset on the market.
perhaps i missed it, but there is always the question of the eagerness of the buyers and sellers. as in an auction, eager buyers mean higher prices. mutatis mutandis, eager sellers mean bargains. market orders vs limit orders will move prices, although there are of course equal volumes from buyers and sellers.
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buffett talks about mr market [did he crib this from graham?] who is bipolar. sometimes he’s manic and willing to buy at high prices. and sometimes he’s depressed and willing to sell at low prices. people do well to cater to mr. market’s moods.
Probably not; I just didn’t mention because it’s not relevant to the point. Which is that, contrary to media portrayal, markets do not move because of more selling than buying or vice versa, but rather to balance the float of assets with investors’ allocation preferences. How investors arrive at those allocation preferences, rationally, emotionally or whatever, is a different subject.
So the aim here is not to preach the party line but to correct it. The line that’s either useless or outright false. I appreciate it could take some effort for readers to get their arms around; ideas that challenge the orthodoxy, especially if they also challenge one’s powers of abstraction, tend to meet resistance. But the post pretty fully explains it so for most the effort to read it should be enough.
It’s also likely a new perspective for most how a change in the float of one asset can lead to a change in the price of another, as highlighted by the discussion about large Treasury issuance resulting in an increase in stock prices. And it’s a big one too … failure to appreciate this likely explains why even some brilliant market analysts have failed to understand why stock prices have continued to rise in the face of obscene valuations.
It’s not because they missed out on eagerness. Rather they missed where it’s coming from. I’ve just explained it. I showed how to dispense with fuzzy, unobservable and immeasurable intermediate variables and connect the input and output directly.
The system is a machine. Of course it has many more moving parts than just the two or three I’ve covered here, but it’s still a machine. No need to speculate about how the fulcrum feels to know what one end of the lever will do when you push the other.