A reader writes:
I’ve asked brokers, finance wizards and total strangers to explain what the stock market does. Yes, I understand that when a business issues new shares, it gets capitalized. And when a business folds, shareholders get the (ha ha) liquidation dividend. I also acknowledge that there needs to be some sort of vehicle for buying and selling stocks. OK so far.
But once the stock is out in the market, why do people pay more or less for it? The universal answer is something like “If the company does well the stock is worth more.” But why? For every buyer there is a seller, and one of them is making a gain while the other is taking a loss. The company doesn’t participate. Isn’t the trading of shares just a variant on the greater fool theory? Someone will pay me more than I paid. Once again, why? As long as the company’s in business, not buying back shares and not merging, seems that all an investor can do is hope there’s a greater fool.
The ongoing purpose of the stock market is to set the price at which companies are valued when they do decide to buy back shares, or issue new ones to make acquisitions or pay employees, or when they merge with other companies. And I think the reality (and even just the possibility) of buybacks and share issuance does place some bounds on the prices prevailing on the market.
To illustrate: In the early 1980s stocks were extremely cheap relative to earnings, so leveraged-buyout artists arose to take shares off the market using borrowed money. In the late 1990s stocks were extremely expensive relative to earnings, so lots of new companies went public and companies already on the market issued tons of new shares.
So those are the bounds. But there’s an awful lot of greater-fool speculating–a.k.a. noise–going on between them. As finance guru Fischer Black put in his famous “Noise” speech in 1985:
[W]e might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value. The factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value. By this definition, I think almost all markets are efficient almost all of the time. ‘Almost all’ means at least 90%.