Stock Markets are Completely Rational? Yep!!

When watching a stock market news based television show, or reading about the stock market’s gyrations in the newspaper, you’d get the impression that the stock market was some kind of very independent, darting animal.

But nothing could be further from the truth. If you know anyone who invests in the stock market, they contribute to that wild animal’s seemingly psychotic behaviour—often without even knowing it.

The stock market’s movements are directly (and only!) related to supply and demand. When people (individuals and institutions) buy more stocks than they sell, the markets rise in value. When people do more selling than buying, the markets fall in value. It’s that simple.

Short Term—Humans are psychopathic

Short term, the stock market is fairly psychopathic, because (hold on for this) short term, humans are somewhat psychopathic.

Don’t believe me? Have you or a friend of yours ever been in an unhealthy relationship? Wrapped up in love, lust or a variety of other emotions, bizarre decisions are made that friends and family can clearly see. But ruled by emotions, it can take a long time before we can see these issues ourselves. When an ugly, unhealthy, or just plain unsuitable relationship eventually ends, the person who was in it often asks, “What was I thinking? How could I have fallen for that person at all?”

This explains most people’s relationship with the stock market. They do crazy things with their money—and often, much later, they wonder, “What was I thinking?” I’m not going to try telling you that love can be demystified. But the stock market can be.

The stock market doesn’t represent a sexy or terrifying online quotation

We have to think of the stock market as a collection of businesses because that’s what it is. It isn’t just a squiggly bunch of lines on a chart or quotes in the newspaper. When you own shares in an index fund, mutual fund or individual stock, you own something that’s as real as the land you’re standing on. You become an indirect owner of all kinds of things, via the companies you own: land, buildings, brand names, machinery, transportation systems and products. Too many people disconnect themselves from what the stock market really is—preferring not to see (or perhaps they don’t understand) that owning shares is really the same as owning businesses.

Imagine having a desire to buy the corner store down the street from your house. You’ll want to evaluate it as a business, so you can figure out what it’s worth.

The owners are motivated to sell, so they show you the store’s financial records for the past 3 years. And after paying for their products, paying their staff, paying the lease on their buildings, paying their electricity (and all other expenses) the business’ profits were as follows:

Year 1 = $50,000

Year 2 = $45,000

Year 3 = $55,000

You’re a businessperson, and most money-minded people of your ilk could come up with a reasonable price to offer for that corner store. But I’m going to use a calculation that lends itself well to understanding the stock market.

During the above 3 years, the average profits for the business were $50,000 per year. Now let’s make the assumption that a fair price to pay for that business will represent a price that’s 14X higher than the business’ profits, or $700,000 a year. ($50,000 x14 = $700,000) The current owners feel that this is a reasonable price, but they change their mind and decide to hold on to the business.

Three years later, the business owners call you up and ask if you’re still interested in buying their store.

Rising business values = Rising Stock market prices

You suggest, of course, that you’ll need to look at the business’ financial records again. And this time, you notice that the store has become more profitable, with the profits as follows:

Year 4 = $65,000

Year 5 = $60,000

Year 6 = $70,000

The average earnings for that business, over the past 3 years, now represents $65,000.

As such, the business is now 30% more profitable than it was 3 years before. And for this reason, when calculating a price based on 14X the earnings level, we get a price of $910,000 for the business ($65,000 x 14 = $910,000)

It makes perfect sense, of course. The business makes more money, so the new purchase price should represent a direct correlation between price and profits. If the profits are now consistently 30% higher, then the price offered for the business should be 30% higher.

Long term, this is exactly how the stock market works. If you own a total stock market index fund, you own a small piece of every publically traded business. From 1920 to 2010, the average American business increased its profits by about 6% a year, and it paid cash dividends to its shareholders of roughly 4% a year. This created a total increase of 10% annually (6% earnings increase + 4% dividends paid out = 10% overall increase)

Some American businesses increased their profits at a higher rate than this, some increased their profits at lower rates, and others went bankrupt. And some years were better than others. But as an average, American businesses increased profits by 6% and paid dividends of 4% annually. If you could have bought a total stock market index fund in 1920, this is what you would have made: 6% annually from price appreciation and 4% annually from dividends, for that total of 10% annually.

And this is where the “people are rational long term” argument comes in. Because those business profits increased by 6% annually, people were willing to pay 6% annually more for the rights to own shares in those businesses. As owners, they then reaped the extra 4% paid out in dividends.

Over the long term, people were willing to pay what the businesses were worth. American business earnings plus dividends increased an average of 10% annually from 1920 to 2010, and that’s why investing in the stock market from 1920 to 2010 would have produced 10% annually, with dividends reinvested.

Like the little corner store, there’s a direct relationship between the level of profits and the price that people are willing to pay.

Long term, it’s perfectly rational.

Short term, however, the markets aren’t rational. Short term, people are financially psychotic.

It’s a beautiful thing that you can take advantage of, if you keep a level head.