The Stock Market: Back to Basics
Yesterday, on one of the financial wrap-up shows on MSNBC, a reporter remarked that that the stock market had gone down even though there had been good earnings reports that day.
This is somehow supposed to come as a surprise, as if the market is a black-box that looks at all of the facts and then adjusts stock prices based on the true values of the companies. However, in fact, there is only one thing that determines the price of a share of stock--the price that a share for that company was last sold.
If I have two willing participants that want to trade the stock at 50 cents lower than the last transaction, then the stock price goes down 50 cents. It's that simple. Even if the company has assets that are worth more than their market cap (The price of 1 share times the total number of shares in the company), that won't necessarily mean that the price will go up. It only goes up when stock is sold for more than the last time it was sold. The reasons why someone would buy or sell stock are on the micro level (sell to pay my bills, buy because I have extra cash, hold because I'm in it for the long term, sell because I never hold stock overnight). The market as a whole is the sum of all of these mini-decisions.
Now, if all interested parties in the stock of a particular company are extremely informed about that company and have total and equal knowledge about its industry, position, assets, revenue, costs, etc, then the share price would tend to reflect the true value of the company--an earnings report would be meaningful. When you mix in irrational participants who invest based on hype, misinformation, or wild speculation, then it becomes less correlated with value. When you mix in immoral participants with more inside knowledge and more control of the sources of information, then you're in for a roller coaster ride.
Now let's consider what happens when a company releases a rosy earnings report. Three years ago, the news channels would be fawning all over them, they'd be the darlings of The Street. Everyone would know who they were and would want to invest. Those with stock would tend to want to hold it; those without would tend to want to buy it. To buy, I have to convince someone (with stock) to sell. If everyone thinks they should hold, I have to offer more money. When they accept, a transaction is made, and the price goes up (to the level of the transaction). It really isn't any more complicated than this.
A good earnings report is only worth anything if people believe that it's true. If they do, then they will hold and buy stock and the price will go up. If they don't, then it falls back to whatever reason they were holding, selling, buying the stock before. This could be anything. Right now, those reasons are tending to make prices go down and there's nothing an earnings report in this climate can do about it.
In 1999, students at The Stanford Graduate School of Business showed that Internet stocks were governed more by the laws of supply and demand rather than value of the company. This happens whenever the value is hard to determine. Here's a short overview of the research
, the full version can be found here
(it's a Microsoft Word document).