What is the Stock Market?
An accountant recently told me that a number of her clients remained nervous about the stock market. Apparently the residual fear from the great upheaval of 2008-2009 and the uncertain state of the world economy is making them extremely cautious. I am sure that for many of these people the stock market appears to be a casino—a game of chance with no apparent explanation for its movements.
This perspective may be impacted, to some extent, by the growing popularity of index funds. An article in Morningstar Advisor argues that the proliferation of index funds corresponds to "increased trading commonality among index constituents through the interactions of market participants." Huh?
In simpler terms, this suggests that the majority of stocks are rising and falling each day in the same pattern. There is less of a distinction between stocks with an attractive valuation, which should arguably go up in price, and those stocks that seem overvalued and deserve to have their share price decline. The market appears to be one of "risk on, risk off"—if we're feeling good about the world, most stocks go up; if not, most of them go down. The fundamentals of any particular stock are of less importance.
At this point, it would be good to remember the two main functions of the stock market. As the columnist Buttonwood points out in The Economist, one is to "encourage the efficient allocation of capital." An astute colleague of mine describes the stock market as a mechanism to set prices for stocks so that money flows to the most promising business opportunities.
The other function of the stock market is to allow savers to "participate in economic growth by linking their savings to business profits." If we invest in companies that succeed, we shareholders—as co-owners of the businesses—should be able to reap the rewards.
The important thing to note is that these aspects of the stock market "are long-term goals that have virtually nothing to do with the daily fluctuations of the market."
Businesses do not always succeed and the stock market does not always go up. Obviously, a downturn in the economy can limit business profits and cause them to be less valuable. But separate from these rational considerations is investor psychology. When investors have large mood swings about their desire to invest, then volatility can be exacerbated by this "risk-on, risk-off" mentality. Index funds may make these mood swings even more prominent.
Nevertheless, we should keep in mind that the stock market, over time, allows us to participate in business growth. The short-term gyrations of the market can easily make us lose sight of this concept.
We may wish to heed the reasoned words of the First Eagle Funds in their recent Annual Report. While acknowledging that we are in the midst of a challenging investment environment, they state: "On a final note, we would like to express our gratitude to our investors—most of whom share our long term perspective. If you are new to the fund and you do not share our three to five year horizon, you should consider closely the appropriateness of this investment as we will not attempt to mirror shorter term market movements... We are investing for the long haul, not the next quarter ..."
Words of Wisdom
Salesman: This deep-fat fryer can flash-fry a buffalo in under 40 seconds.
Homer Simpson: 40 seconds? But I want it now!