The Stock Market

Despite its importance, the stock market remains a bit of a mystery, even to many otherwise staunch champions of the free market. People who have no problem defending the actions of advertising executives or payday lenders, often fall short of defending the stock speculator or “corporate raider.” Yet these popular villains actually perform vital services, and government policies against “hostile takeovers” actually make us poorer.

The Stock Market: What Is It?

At the most basic level, the “stock market” simply refers to the abstract market for ownership of corporations. There are physical places, called stock exchanges, where buyers and sellers meet—the most famous, of course, being the New York Stock Exchange, located at 11 Wall Street, New York, NY. But the “stock market” itself is the intangible nexus of all such buyers and sellers, including day traders executing transactions from their laptops in Tahiti.

On the stock market, people buy and sell fractional shares of ownership in a corporation. For example, if XYZ Corporation has 10,000 shares of stock, and Joe Smith owns 1,000 shares, then, loosely speaking, Smith owns ten percent of the assets and liabilities on the balance sheet of XYZ Corporation.

People often forget that corporations aren’t on autopilot. Someone or some group of people have to decide how a corporation will conduct itself. How much should it invest in research and development (R&D)? How many factories should it close—or open? Should it issue new bonds to finance the takeover of a smaller corporation in a related industry? Should it release the new model of its signature product in order to beat the competition, even though all the bugs haven’t been worked out?

In practice, management typically makes these decisions. In the minds of the public, the “buck stops” with the Chief Executive Officer (CEO). But this is a superficial analysis because the CEO is an employee who can be fired. Ultimately, it is the shareholders who own the corporation, and they (collectively) have the final say on its operations.

In this context, we can say that the purpose of the stock market is to determine which people are the shareholders of the various corporations.

The Importance of Correct Stock Prices

Standard economics teaches that under certain conditions, the decentralized market leads to an efficient allocation of resources among various industries because it aligns the personal incentive for profit among entrepreneurs with the desires of the consumers.

The relatively high price of gold, for example, ensures that the yellow metal is channeled into jewelry and arthritis treatments. Cheaper metals, such as aluminum, are used much more liberally—such that people use it as foil to wrap their leftovers and then throw it out after a single use. Nobody throws out gold on a regular basis.

This same process holds for prices not just of various metals, but also of corporate stocks. A “penny stock” indicates a corporation that the market does not particularly value. The average Joe, arguing with his buddies around the water cooler, can afford to plunk down the occasional weekly paycheck and buy a sizable portion of the company if he so chooses.

In contrast, no matter how certain a man feels that he “could turn Microsoft around in three months,” unless the man is a billionaire, he won’t be able to alter the fate of the giant company by himself. The share price times the number of shares is ultimately the price tag of the corporation. The relatively high price of gold signals that it is a scarce commodity and should be treated with the corresponding care. Likewise, the “market cap” (short for “market capitalization”) of Microsoft is more than $200 billion, indicating that the market values it very highly.

Consequently, the people who ultimately control the fate of Microsoft (and other such companies) will have a fabulous amount of wealth hanging on their decisions. This doesn’t guarantee that they will make the right decisions, of course. But it does make it far more likely that some of the most capable experts in society are involved in the decision-making process.

The Stock Market and Corporate Investment

One popular complaint about the stock market is that it fails to channel savings into productive investment. According to this thinking, someone who takes $1,000 out of his paycheck to buy shares of Acme stock doesn’t really “invest in” Acme, but rather transfers cash to a prior holder of Acme stock. The corporation doesn’t get its hands on this $1,000; it’s not available for Acme to expand its factories or hire new talent.

This view is superficial. In the first place, corporations can, in fact, raise capital directly from new investors through a Seasoned Equity Offering (SEO), in which the corporation issues new shares. (This allows a firm to expand through issuing new equity, rather than by taking on more debt by issuing new bonds.)

But even in the more standard case of a new investor buying “used” shares of stock from a previous owner, the ability to sell used shares still allows the corporation access to more funds for investment. Nobody denies that a corporation receives an influx of capital when it first sells shares in an Initial Public Offering (IPO). The existence of a “secondhand stock market,” then, boosts the resale value of these initially-offered shares and makes investors willing to pay a higher price for them than would otherwise be the case. In other words, Acme Corporation received more capital from investors when it first went public because those investors knew that if the company were successful, newcomers would eventually want their piece of the action and would pay (say) $1,000 to buy some of the shares that had presumably risen in price since the IPO.

Finally, we should consider what the recipient of our hypothetical $1,000 does with the money. If he goes out and spends it on fancy clothes, then it’s not surprising that Acme Corporation has no new funds for investment; the investor plunking down $1,000 in savings merely offset the seller’s increase of $1,000 in consumption.

However, if the seller takes the $1,000 from his sale of Acme stock and puts it in another asset (such as the new shares of the XYZ corporation, which has just gone public), then there has been a net increase in savings. But even here there hasn’t been a net investment in Acme, but rather in XYZ Corporation. So it’s not surprising that the investor who spends $1,000 on Acme doesn’t at that moment allow Acme to spend $1,000 more on investment; all that the investor has done is allow the original owner to transfer his savings into a different place, while leaving Acme unchanged.

The Social Role of Stock Speculation

In the new Wall Street film sequel, an older Gordon Gekko—perhaps merely in an attempt to sell more copies of his book—tells a young audience that the “mother of all evils” is speculation. Other parts of the movie reinforce the common view that stock speculators don’t really produce anything, but instead simply “move money around.”

This disdain for stock speculation is part of a more general loathing of “middlemen.” For example, someone who buys oranges in Florida at 75 cents per pound and sells them in New York at $1 per pound, is condemned for just “moving fruit around.” But such a middleman is definitely performing a service to citrus lovers in New York—a juicy orange 1,000 miles away is not very useful.

Likewise, the successful stock speculator earns profits for himself while performing a useful service to others. The motto of the speculator is to “buy low, sell high” (or to “short-sell high and buy back low”). If he is successful, it means that the speculator made stock prices less volatile and actually pushed them toward their future prices more quickly than otherwise would have occurred.

A simple example will illustrate. Suppose that a speculator sees that Acme Solar Panels is currently trading at $10 per share. However, the speculator believes that war with Iran will break out within the month and that others in the market do not fully appreciate this development. The speculator predicts that when the war breaks out, oil prices will skyrocket to $200 a barrel and that the share prices of alternative energy companies will likewise zoom upward.

The speculator, therefore, rushes to buy Acme stock, which he believes is grossly undervalued at $10. His aggressive buying pushes up the price to, say, $13 per share. If and when war breaks out, the price of Acme rises to $20, at which point the speculator sells, netting anywhere from $7 to $10 per share in profit.

The average person—indeed, Gordon Gekko himself in the first Wall Street film—thinks that this is a zero-sum game and that the speculator’s profit must correspond to other people’s losses. This is true in the narrow sense, that somebody who sold to the speculator at $11 would have “lost” $9 that he could have reaped had he only postponed his selling until the price had risen to $20.

But the speculator’s actions have conferred definite services to the community. First of all, he has smoothed out the jumps in Acme’s share price. By buying the undervalued stock, he has put upward pressure on the price. (Likewise, if he short sells an overvalued stock, he puts downward pressure on the price.) Rather than Acme’s stock jumping from $10 to $20 when war breaks out, it jumps only from $13 to $20 because (in our example) the speculator’s heavy buying had already closed 30 percent of the gap.

By reducing stock-price volatility, speculators take some of the risk out of holding stocks. For example, it’s not necessarily true that the person who sold early to the speculator at $11 “lost” $9 to the wily profiteer. It’s entirely possible that the person needed to sell his holdings of Acme because he had lost his job or because his kid’s tuition went up again. Thus, the speculator has actually made this person—who had planned to sell even if Acme remained at $10—richer.

More generally, by anticipating future changes in the “fundamentals” and translating them into current stock prices, speculators reward even long-term investors, the kind whom most people praise (as opposed to the short-term quick-buck speculators). For example, if an institutional investor thinks she has found a solid company that will pay high dividends and will be around for at least twenty years, it is speculators who will help keep the day-to-day stock price from straying too far out of line with these long-term facts. If a financial panic sets in and shareholders are dumping stocks across the board, it is speculators who will staunch the bleeding and swoop in to pick up “deals” at fire-sale prices.

This shows that speculators provide liquidity to the stock market and make it more lucrative for other, long-term investors to do their homework and put some of their savings into corporations they believe have a solid future. A major risk of such an investment is illiquidity—that the investor may have to sell under duress and accept a much lower price than she could get if she only had more time—but speculators mitigate this risk. If the price gets well below “what the stock is really worth,” then that’s exactly when a speculator has an incentive to swoop in and buy.

Policy Implications

Now that we have seen the services that stock speculators provide, we can draw two conclusions regarding government policy. The first is that bailing out “too big to fail” corporations weakens the self-corrective process described above. In fact, government bailouts can perversely turn speculation into an actively harmful force.

Consider that there is nothing in our arguments to rule out the possibility of a “bubble,” in which stock prices get pushed ever higher because of speculation itself. If speculators think that XYZ Corporation will jump from $20 to $30, in the short run they can cause a self-fulfilling prophecy. Indeed, as XYZ’s price continues rising, more and more people are drawn into speculation and can accelerate the process.

Even though bubbles can occur in a free market, as one intensifies, speculators have more and more to gain by shorting the stock. This helps push the price down, making the bubble less extreme and getting the price closer to its long-run “correct” value. It’s true that speculators can make short-term gains by feeding into an unsustainable boom, but it’s also true that if they don’t get out in time, the market ultimately punishes them with losses. Their losses, moreover, are proportional to how “artificial” the bubble price had become.

This vital check is crippled by government bailouts or other interventions designed to reflate bubbles after they have popped. In such an environment, the tradeoffs are distorted. By taking some of the sting out of the downturn, the government removes the market’s only way of disciplining speculators.

A second, less obvious, implication is that regulations designed to thwart “corporate raiders” actually hurt shareholders and reduce economic efficiency. Consider the alleged worst-case scenario of a speculator using borrowed money to buy a controlling share of a corporation, laying off all the workers, and selling off its assets to the highest bidders. To see why this might be socially useful, we need to realize what type of corporation is vulnerable to the raider: one that has a lower purchase price (stock price times number of shares) than the price of its individual assets minus its liabilities.

In other words, the corporate raider profits by breaking up a company only if he can move its assets—factories, inventory, tools, and so forth—into the possession of other firms, where they will be more productive.

The boundaries of each firm are not arbitrary; there are economic reasons that Google owns a huge capacity of computing power, whereas Bayer has facilities suitable for drug research. In extreme cases, when an industry rapidly changes or management is particularly inept, the proper course is for the firm itself to be dissolved, taking its resources out of a relatively inefficient organization and putting them in different lines where they will be more useful. Although this process is particularly painful for the workers involved, in a free society, layoffs are the only way to signal when labor is being used in a very unproductive enterprise.

Once we understand the vital role played by the stock market and (successful) speculation, the case for government intervention in financial markets is considerably weakened.