Thursday, June 14, 2012

There Should Be No Profit in the Stock Market

If you were like me when you were younger, you had questions or observations about economics, philosophy, finance, etc., that were so simple that you PRESUMED you were wrong.  Your logic was too simple, it made too much sense, and the real world around you (at that time) was providing evidence to the contrary of your observation.

However, I've studied economics long enough, lived long enough, and thought all my founding and consequential theories through to the point I've realized that one of my innocent observations back when I was in college was actually correct, and no, my logic was not flawed.  And that observation was:

There should be no profit in the stock market. 

I came to this observation when I was thinking about "market efficiency" - the concept that a market would price in all known data and information into the price of a stock, thereby reflecting its true value. If this is true, then prices would be bid up or down to the point the stock would have a "fair" value, leaving no room for profit or arbitrage. 

What triggered this original observation was the "investment philosophy" that over time the S&P 500 has historically provided 10-12% annualized rates of return (depending on whether you account for dividends or not).  I found that odd because 10-12% per year is a sizable premium over inflation. If markets were truly efficient, that margin of return would attract more and more money, flooding the market until the real rate of return was 0%.  This would initially result in prices being driven up (becoming a self-fulfilling prophecy as those increases in prices would result in higher returns), but inevitably stock prices would reach an "equilibrium" point where the dividends and profits of a firm would attract no more money and prices would stabilize resulting in no future capital gains. 

I originally theorized why the market kept going up for reasons similar to why we have a underfunded pension crisis - poor assumptions made on the part of actuaries.  Specifically, the market was failing to account for population growth and longevity of people.  So when Henry Ford started Ford, investors thought "we can sell these things to all 50 million Americans" failing to look into the future where the market in 100 years would NOT be 300 million Americans, but 3 billion people in 1st and 2nd world economies.  That growth was never factored into prices back then.

I also theorized that the S&P 500 index is always "fresh."  Meaning that it is a self-selecting and de-selecting index, getting rid of companies that either fail and are obsoleted through technological advancements, while bringing in the new, up-and-coming companies.  This "survival of the fittest" aspect of the S&P 500 means companies that grow the most to become the largest and most "successful" companies in the US ensure positive rates of return.  And not just positive, but these new companies and the technologies they bring into the world capitalize on larger and entirely new markets made from whole cloth (Apple for example with its electronic doo-daddery). 

However, while this explains why there has been (historically) considerably higher-than-inflation rates of return, it still doesn't debunk my theory there should be no profit.  All it shows is that the market failed to be efficient and underestimated technological advances and population growth.

There is, however, a very interesting chart that speaks to this.  Robert Shiller has created, among many other charts, this one which I find very telling:

It is the 10 year average PE ratio vs. their 20 year annualized returns for 5 separate periods or "vintages" throughout the history of the S&P 500.  What it shows is that people are actually OVERLY OPTIMISTIC when it comes to their expected rate of return.  Companies with very high PE ratios provide lower returns than companies with very low PE ratios, never delivering the profits they were promising. 

This is counter to what I thought was the case.  If people were underestimating the market, then higher PE ratio companies would result in higher returns.  But here, it shows we are overestimating the market. Admittedly, following the "survival of the fittest" aspect of the S&P 500 Index, a lot of those dots in that chart that had high PE's are no longer with us today and thus their statistical representation is moot.  The S&P 500 jettisoned them once they got too small or went bankrupt.  This, however, does not change the fact people's psychologies remain overly-optimistic.

Sadly, this is as far as my thinking and statistics have gotten me.  I know intuitively that if the stock market were TRULY efficient, it would reach an equilibrium point in terms of pricing resulting in 0% capital gains (which, consequently, would DESTROY the entire US retirement industry).  However, my best guess would be the answer lies somewhere in the market failing to account for population growth, underestimating technological advances, or just plain failing to account for increase in disposable income (though that factor will soon be going away).

Any ideas lieutenants?


Anonymous said...

So where should money be invested for retirement?

Myrmecodon said...

You should consider John T Reed's take on bonds:

"People make a faulty assumption that all securities market prices are based on hundreds of millions of investors analyzing then buying securities based on their analysis as to which offer the best value.

Double ha!

In fact, much of the market is not really a market at all. It is just human zombies like in that most famous of all TV commercials: the 1984 Apple Superbowl commercial. Like the zombies in the commercial, they buy US bonds, in spite of the S&P downgrade to AA and in spite of the rapidly deteriorating debt-to-GDP ratio because:

• they cannot find a better alternative investment for the volume of money they have and they refuse to do the moral thing: return the money to the investors

• they are required to buy U.S. bonds by company policy, law, reserve-requirement regulations, habit

• they know US bonds are insanely risky and even doomed at this point, but their Main Street investors are too ignorant to understand that so they do what the ignorant investors want rather than educate the investors

• many funds advertise “low risk,” “capital preservation,” and similar things and implicitly or explicitly promise to only put the investors’ funds in things like US bonds

In 1982, 55% of U.S. bonds were owned by individuals and institutional investors. Today, only 23% are. Most of the rest are owned by foreign governments, heavily-regulated banks and pension funds, and the U.S. Federal Reserve. Those guys are NOT the world bond market who buy US bonds because they believe the U.S. government is well runfinancially.

Zweig calls them “price-insensitive buyers.” The many books I read about the Subprime Crisis called them “ratings investors.”

A ratings investor is one who will buy any piece of garbage as long as it has a AAA bond rating. The subprime mortgage—classic garbage—had a high percentage of AAA ratings—basically because the three bond rating agencies (Moody’s, S&P, and Fitch) were corrupt and had a conflict of interest. They got paid by the bond issuers to give AAA ratings and got fired if they did not. They were never punished in any way and still are the main bond raters. The main owner of Moody’s when they were dishonestly and incompetently rating subprime moratgges AAA was Warren Buffett. He, famous for telling investors to make sure they understand the companies in which they invest, excused his involvement by saying he did not even know where the Moody’s offices were. Oh, well, then I guess you’re off the hook, Warren. Go back to singing “I’ve been working on the railroad” and playing your ukelele."

Good stuff. Oh, and in the end:

"Perhaps the main issue is there is a huge market for a passive, no-brainer, safe investment.

But that does not mean there is a passive, no-brainer, safe investment. There used to be: U.S. bonds, AAA corporate and municipal bonds, some foreign bonds. But those have generally gone away. Sorry."

Bliss was it in that dawn to be alive, as they say.

Anonymous said...

Or the government lying about inflation (by messing with the calculation method), and stock prices depending more on the next round of QE than fundamentals.
That is why there's no efficient market, your government is nearly 50% of your GDP, wake up.

How the **** can you price something when you don't know the demand?

Anonymous said...

Ideas? What the hell Captain. You forgot that the whole thing is a Ponzi!???

Anonymous said...

The problem with your zero percent capital gains is that it does not take into account the growth of the company. Assuming a company is making money, it will typically pay some money out in dividends and reinvest some money to expand the business. If Ford is not diluting his share holders equity by issuing new shares, and he takes some of his reinvested profits and builds a new factory, the asset value per share increases, and the shares become worth more.

Not all companies are like this. I have shares in a mining company that is drilling holes looking for diamonds. They will likely spend all my money before they find anything and the shares will be worthless. If however, the discover something I could be a rich man. The asset value per share either increases massively, or it evaporates. People are gambling on the outcome, and there is not really very much rational about it. - minuteman

FSK said...

Your big error is inflation.

Future inflation isn't factored into current stock prices, because that money hasn't been printed yet.

If there's 30% inflation and the stock market went up 20%, then it actually decreased 10%.

That makes capital gain taxes really evil. You owe tax on a "gain" that only exists due to inflation.

Look at a chart for "S&P 500 divided by gold" over the past 10 years.

The only people who make money off the stock market are CEOs and insiders, selling their paper to unsuspecting fools.

Anonymous said...

Speaking of simple observations. One thing I always wondered about the stock market though which no one ever answered. What intrinsic value do stocks have? I mean considering that corporations have no obligations to pay dividends and most of the time they don't then it's like the only reason people buy them is to sell them to someone else. I know next to nothing about finance but it makes no sense to me.

Anonymous said...

I do take issue with the poor assumptions made by actuaries claim. It's not actuaries who set the final assumptions used in the valuation of a pension plan's liabilities. The final decision rests with the board itself. Ever try to get a pension board to update their mortality table? It's like pulling teeth.

You have a guy trying to convince a group of people (from both the employer and employee side) who have likely no more than high-school math, that people are living longer and therefore that needs to be accounted for. All that the pension board will see is that an updated mortality table means more liability which means that they'll need to increase contributions from either the employer or the employees. Or that they can't take that contribution holiday they wanted to take.

Eventually after brow-beating them for five years, they'll agree to adjust their table, but wait even the table they updated to is now old after only a year.

As for their fund return, they listen to their fund manager instead of their actuary, who then have to use that as the discount rate in their valuation.

Pension actuaries are only glorified calculators, they have less input than you might think.

Anonymous said...

There should be no economic profit. There can still be normal profit.

Anonymous said...

There should be no economic profit. There can still be normal profit.

Captain Capitalism said...

The intellectual commentary is worth gold on this one. Thanks for everybody's insight. Don't get much intelligent conversation in South Dakota.

Aurini said...

This comment is closer to a copper piece.

While I understand the fundamentals of economics (even some of the more obscure fundamentals) I am largely ignorant of the jargon. For instance, I only have a vague concept of what a price-to-earnings ratio is, and "Fortune 500" is essentially meaningless to me.

So - if, say, you were to be a bit more kindergarteney in a future post, and explain what the nuts and bolts are - I, for one, would be very appreciative. Or if you could provide a reference

Theory I can learn from Rothbard, but I don't know where to go to figure out what that scrolling ticker-tape at the bottom of the news channel means.

Anonymous said...

You very greatly misunderstand the idea of efficient markets. In the long run, one cannot come up with EXCESS profits. Your profits will simply match the market, as nerves calm and information spreads and more people join the party.

But, the investment always gets its fair slice. A corporation basically functions like its own bank, offering stock for say 7% to fund a factory with a 12% margin, with 5% excess profits.

In the long run, those profits disappear, but the shareholders still get their 7% dividends and the corporation enjoys the gravy of their expansion.

The catch, is that aiming for excess profits involves risk. Yet, time has shown that risk DOES pay. Until it doesn't, when people get stupid, but that's preventable.

Any idiot could see the dot-com bubble in 1999 and any idiot can now see the shale bubble for what it is. These things just happen because of greed, period.

I'd pick Halliburton. Stupid speculators are going to get burned, while oil service companies who sell to those fools laugh all the way to the bank. Sort of how the whores always made the most money in gold rush towns, not the miners.

Sometimes a "market" in a strict sense has no excess profits, but the excess profits are found in those who indirectly service the market. Like, Applied Materials making money on both sides as Intel and AMD lock horns in fruitless competition. Think Yojimbo.

Anonymous said...

"I have shares in a mining company that is drilling holes looking for diamonds. They will likely spend ALL MY MONEY before they find anything and the shares will be worthless."
unless you were involved in their IPO they are not spending 'your' money. your money is in the pocket of the person from whom you bought the company's shares (at a profit to them no doubt). that is the problem with the stock market - buying and selling of shares is totally cut off from real PRODUCTION - just buyers and sellers swapping shares, bidding up prices until the next crash.

Ryan Fuller said...

FSK cranks too hard on inflation, as usual. There's more to this. Captain, I think the part where you make your mistake is here:

"I came to this observation when I was thinking about "market efficiency" - the concept that a market would price in all known data and information into the price of a stock, thereby reflecting its true value. If this is true, then prices would be bid up or down to the point the stock would have a "fair" value, leaving no room for profit or arbitrage."

Profit is the incentive that induces people to contribute their information that makes the market more efficient. If there were no profit, nobody would contribute, and whatever information they have would not be taken into account by the market. Part of the problem is that we have legions of ignorant investors whose dollars influence prices just as much as the dollars of people who actually know what's going on, resulting in a poor signal to noise ratio. It's small consolation that these know-nothing investors typically lose money on a regular basis, but I think their copycat investment strategies and tendency toward fad-chasing makes the market as a whole more volatile.

Anonymous at 8:52 also makes a worthy point. There would be no economic profit in a perfectly efficient market (for stocks, or anything else) but that is not the same thing as there being no profit at all. The marginal rate of return for the last dollar spent would simply be equal regardless of what it was spent on.

Anonymous 7:31 is just flat wrong, though. Don't claim that government spending is "nearly 50% of GDP" when it's actually quite close to 40% just because you feel like being dramatic. The problem with that approach is that people who actually know these statistics will not be impressed by your exaggerations.

Anonymous said...

@Anonymous @ 4:11 AM:
Correct, however wouldn't you agree that even a 40% share in the entire economy by an entity that is itself not regulated by market forces throws the entire thing off?

The government has the backing of the taxpayer, yet no real idea what the taxpayer actually demands. this might lead to HUGE orders of The Wrong Stuff (Tm) which nobody ends up needing. In order to buy this Wrong Stuff they cut the budget in another sector, essentially reducing it to nothing.

There are no predictors for that scenario, not for the boom in the one sector nor the bust in the other. It's simply not possible to price it in unless you have insider knowledge.

The government does not poll it's people constantly, and therefore does not know which stuff is The Right Stuff to buy, and furthermore what people are willing to pay for The Right Stuff.
Therefore these inefficient buying and selling scenarios are VERY real.

I could go on about why a non-market government will always spend it's money inefficiently, but I'll just end this post with the classical retort "One bureaucrat is never smarter than the rest of us."

Larry Sheldon said...

Why should stocks not increase in value?

That sounds really stupid.

Please note that "54" in a square is not a word. "gsonser" is not a word in any language I speak.

The Outsider said...

The efficient market hypothesis doesn't say you can't get a return greater than zero. It says you can't get a return greater than the "normal" return of the market if you invested broadly across all the economy.

In other words, a return of 10% (if that's truly the market return) does not represent an economic profit. It is simply the opportunity cost of capital. to the radio said...

When I was watching Canwest swirl down the twahlet I looked up something about their corporate structure.
The three siblings held two thirds of the stock and the public held the rest.

And then I figured out that all public companies are structured this way.
Fuck me! I said.
You can't really own them.

The only way to own something is to really own something tangible like a pizza joint or a hotel.

Clutch cargo cult said...

Buy and hold is dead and dumb. Options are the only inefficiency you can exploit. Sell premium!!

Clutch cargo cult said...

Sell option premium, its the only inefficiency that is exploitable

Anonymous said...

Cappy, where's the 'productivity' in options? Should there be 'profit' in the derivatives market? hahaha counting cards at the casino is very clever and profitable too...
"The only way to own something is to really own something tangible like a pizza joint or a hotel."

The Outsider said...

I'd like to short Clutch Cargo Cult's portfolio.

Ecclesiastes said...

First, there is no "investment" going on in the stock markets. It's deception to call those exchanges "investments."

I offer a blog post, More Smoke Than Mirrors. I strongly urge all to read it as a warning :

So, if you mean 'profit in the stock market' as I think you do, then no, there isn't any profit, only winnings.

You, however, are mistaken in a more accurate understanding of the stock market. Those exchanges are always profitable - to those who are charging the fees for making the exchange.

Never, ever, ever, EVER forget that the tout makes his money on the trade, whether the stock is going up or down. Volatility is his only hope and his primary objective.

Anonymous said...

Yes, inflation is a factor, especially in industries that depend on a depreciating dollar (banks, etc), but real profits are very possible in industries that can pass on inflative costs of their inputs to the end customer. My personal favorites are food, booze and soap companies, YMMV, but as the Good Capitain pointed out, real economies exist because people want STUFF.

The weakness of EMH is the assumption that the "market" is ALWAYS rational, when history has shown time and again, it can be very irrational in the short term (1929, 1998-2001), and quite often wildly irrational to specific companies (Coca Cola in 1985). A nimble investor can find bargain companies (and hence make a profit) if he knows what to look for, and understand irrationality drives markets far more than rationality does.

Unfortunately, irrationality causes, almost by definition, unpredictable behavior.

Incidentally, this type of behavor is found in all asset classes, sooner or later. The key is to recognize it in time to buy or sell as appropriate. (buy Coke in 1985, sell or short mortgages in 2007)

Anonymous said...

In the long run, general stock market increases are supposed to reflect the increases in productivity and total economic output + inflation. Since GDP typically grows around 3~4% per year, and real inflation (not government lies) is around 6%, you get your 10% growth/year.

Dirt Man said...

Information is what makes the market highly profitable for some, and disastrous or mildly worth it for most. If you know what's really going on you make one set of decisions (moving your money in and out before others) and if you have another set of information, you make a different set of decisions, and likely make less money or lose.

The idea of true efficiency in markets is an illusion fostered by those who make the real money. So you're right to smell the rat in markets.

Anonymous said...

Equilibrium does not exist, except for when a system has died.

Rachel & Robert said...

Could it be as simple as not being able to tell the future? If I own stock in your blog, and I think it is worthless, and sell it to someone who thinks it is, I make money if I am right, and they make money if they are right. We all had the same information, but even with all the information (and most people don't have ALL of it), it is impossible to predict the future. Hence, the risk factor (and potential profit) to investing in business ventures.

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