The stock market has had a remarkable ride in 2009. Presently, it has substantially recovered from its low point of March, 2009. Many of us are wondering where it is now heading, given that so many people have their retirement savings tied up in the market.
In fact, I am often asked to prognosticate about the direction of the stock market. Though tempted, I simply repeat the famous quotation attributed to J.P. Morgan when he was asked about the direction of the market: “It will fluctuate.”
That said, it is still important to take a look at recent stock market activity and to be aware of the dynamics that cause such wide fluctuations in stock values.
Where Have We Come From in the Last Year?
To understand our recent market history, we have to examine two well-known indices that reflect the daily changes in stock values. One is the Dow Jones Industrial Average (DJIA). Some economists feel that the DJIA can be a prognosticator of where the overall economy is going. Another leading indicator is the Standard & Poor (S&P) 500 Index, and there are economists who feel that the S&P is also a good indicator and predictor of our economic future.
As this column went to press, the DJIA stood at 10,574, and the S&P is over 1,137. To give some perspective, the DJIA dropped to an annual low of around 6,500 in March 2009 with the S&P bottoming out around 700 at that time. This means that the DJIA experienced an increase of well over 50 percent from March 2009 to present, and the S&P had roughly the same percentage increase. Obviously we have come a long way since the dark days of March.
What Is the Significance of Such Large Rebound in Stock Prices?
This is a difficult question to answer. There are those who feel that the stock market and its major indices are good predictors of where the economy is heading, and there are those who feel that major indices do little but foretell short-term market conditions. The fact is that there are so many dynamics that affect stock prices that it really is quite difficult to extrapolate from the ebb and flow of market prices to some future economic date and to make a prediction as to where we will be on that future date.
Before I explain the stock market dynamics as I see them, I want to recommend a book that was written in 1967 under the pseudonym Adam Smith. It is called The Money Game. The actual name of the author is George Jerome Waldo Goodman, a brilliant Harvard-educated Rhodes Scholar. After reading that book, I was fascinated by how the author thought that one might be better off reading tea leaves than in following stock market gurus — my words not his — because there are so many behind-the-scene dynamics that affect stock prices.
Goodman gives examples of how traders really control a great deal of what is happening in the stock market. I got the feeling after reading his book that the stock market is controlled by a sort of “old boys” club whose members usually are the real winners in the trading game. For this reason, I switched most of my stock holdings to large, tested mutual funds — not very interesting or sexy, but a sure way to sleep well at night.
Therefore, I would say that it is extremely difficult to look at the large rebound in stock prices over the last year and make any sound economic predictions. There are just too many dynamics that play into stock prices, thus making it maddeningly difficult to use the stock market as a true predictor of where we’re going.
What Makes the Stock Market Tick?
Most of us with some basic knowledge of the market realize that many trades are made by computers. That’s correct. There are large computers that are constantly digesting and spitting out data as to where the market is going. Based on these data, the computers, in effect, execute trades. Of course, the software parameters in the computers are put there by so-called market experts. But as we all know, the experts are not always right.
Additionally, we have day traders who are constantly watching the market, looking for fluctuations in a stock’s price that can be taken advantage of by buying and selling a stock during a 24-hour period. This type of trading is quite harrowing for anyone but the market-savvy person who has a good deal of money and an equal amount of guts. It is not for the faint-hearted.
If being a day trader is not exciting enough for you, how about the micro trader? The micro trader watches charts that cover a miniscule amount of time, say from five to fifteen minutes. This trader could be in and out of a given stock several times during the course of a 24-hour period. Some micro traders believe that the best deals can be had by quickly “flipping” a stock when trading begins in the morning. Other micro traders wait until the end of the day, then they do their flipping. In my opinion, the micro trader must be even more stock-savvy then the day trader.
Putting a little sanity into the situation, we have the institutional investors. These investors are major buyers and sellers of stock. They usually hold their positions over a longer period of time in order to maximize value for their owners. An institutional investor could be an insurance company, a bank, even an endowment fund of a university. My experience is that institutional investors take a much more wise approach to the market than does the day trader, the micro investor, or a hedge fund that is using a “sophisticated computer” to execute trades.
We also have individual investors who may or may not rely on outside advisers. Some of them do well and others do poorly. In fact, when the market hit an annual low last March, a friend of mine advised me that he was selling all of his holdings and converting them to mainly cash instruments like certificates of deposit and money market funds. He not only sold at the low point of the market, but he also realized substantial losses in his portfolio — the worst of both worlds.
The dynamics listed above give you some idea of what makes the stock market tick. Though they don’t include the total array of investors influencing market prices, I do believe that they give one a good idea of some of the dynamics going on behind the scenes.
So, if someone asks you where the stock market is heading, it doesn’t hurt to say, “I don’t know.” I usually do.
Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.