Jump Around! What’s With These Big Stock Market Moves?

Dear Friends,

As the global stock market has bounced up and down over the past two weeks, some clients have asked, “What causes the market to move so much in one day?”  Before we get to the answer, it’s important to understand how financial markets work.  This simplistic example should help.

At any given moment, there exists a “market price” for every one of the thousands of stocks traded on exchanges around the globe.  A company’s market price is simply the last price at which a buyer and a seller agreed and a trade took place.  Let’s assume Walmart, Inc.’s market price is $100 per share.  While the last trade took place at $100, there are currently owners of Walmart who have communicated that they wish to sell their shares at a given price, while there are others who wish to buy Walmart shares at a different, lower price.  Let’s say Joe is willing to sell his 1,000 shares at $101, while Jill has expressed that she wants to buy 1,000 shares at $99.

In many respects, this scenario is very similar to one many of us have experienced:  Buying or selling a house.  Joe is “listing” or “offering” his shares at $101 per share, and Jill has “bid” $99.  Just as with a home, no sale takes place at this point, as the buyer and seller have not agreed on a price.  Said differently, there is a “spread” between the bid price and the offer price.  For a sale to be consummated, either Joe or Jill needs to “cross the spread” (change their price) to meet the other party’s.  Just as with the sale of a home, the party that is more motivated to have the transaction take place is the one most likely to accept the other’s price.

In the case of a home, a buyer or seller might have many possible motivations to acquiesce to the other’s price.  The seller might not want to carry two mortgages or might be in a cash pinch.  The buyer might be from out of town and needs to have his family relocated before starting the school year, or a recent divorcee motivated to get started on the next phase of his/her life.  The exact same thing is true of Walmart transactions; there is a multitude of reasons that a buyer or a seller might be highly motivated to accept a less-attractive price and effect a transaction.

Let’s say Joe, for whatever reason, is desperate to sell his shares quickly and agrees to Jill’s bid of $99.  Walmart’s price now shows on every ticker around the world as $99, down 1%.  What is different about Walmart’s business now, relative to five seconds ago when it traded at $100?  Probably nothing.  It likely has the same stores, selling the same products at the same prices as it did yesterday.  Its earnings are likely not any different, and its own profit forecasts for the future presumably have not changed.  It’s a good assumption that the global economy is not any different nor have interest rates changed in the last five seconds.  In this example, the only thing that caused this move in Walmart’s price was simply that Joe was more desperate to sell than Jill was to buy.

What would drive Walmart’s stock down 10% in a short period of time when there has been no changes to its business?  The most likely cause is that the aggregate of people wishing to sell Walmart are much more desperate to do so than those willing to buy.  Transactions occur at lower and lower prices when the prospective buyers begin lowering their “bid” prices and the more-motivated sellers keep agreeing to those lower and lower prices just to get rid of their shares quickly.  Of course, this momentum eventually reverses when the price gets low enough that sellers lose some of their motivation to sell, and/or the buyers become more motivated to buy.

Back to the original question:  Why are we seeing such dramatic short-term moves in the market?  The answer is not that the economy is any different than it was two weeks ago, or that corporations are not as profitable as they were a month ago.  The answer is that, in general, last week sellers felt more urgency to get rid of their stocks than buyers felt to buy them.  But why did the sellers feel more motivated than the buyers?  Clearly, no one knows the answer to that question, as thousands of different institutions and individuals trade stocks every day, each with their own circumstances, goals and views about the future.

So when you see statements in the media like “stocks down due to inflation fears”, do you really think the reporter surveyed a relevant number of sellers and concluded that the fear of inflation was their primary motivation?  Of course not, no such survey could ever be conducted.  However, the truth–that no one can possibly know exactly why the market went up or down today–is uncomfortable to many and thus stories such as the inflation example above are often incorrectly presumed as fact.

Now that you see what drives market gyrations, you can probably see why those short-term moves are impossible to forecast with any degree of accuracy.  To successfully make such forecasts would require being able to accurately predict the collective emotions and motivations of all the market participants around the world tomorrow, next week or next month.  A daunting task indeed.  The good news is that history tells us we do not need to make these forecasts to have success as an investor.  From 1926-2017, the S&P 500 Index has produced an annualized return more than 3x that of inflation.1 Investors who don’t get spooked by the periodic, but unpredictable declines of their stock investments improve their chances of reaping similar rewards in the future.

Sincerely,

Chuck Carroll, CFA, CAIA
Chief Investment Officer
TFO Phoenix, Inc.

 

1 From 1926-2017, the S&P 500 Index produced a return of 10.2%, while the Consumer Price Index grew at 2.9%.  Source:  Dimensional Returns 3.0 software.