Chapter 4

The Workings of Stock and Bond Markets

In This Chapter

Going from a private to public company

Looking at the workings of the stock and bond markets and the economy

Deciphering interest rates, inflation, and the Federal Reserve

To buy and enjoy using a computer or cellphone, you don’t need to know the intricacies of how it’s put together and how it works. The same holds true for investing in stocks and bonds. However, spending some time understanding how and why the financial markets function may make you more comfortable with investing and make you a better investor.

In this chapter, I explain the ways that companies raise capital, and I give you a brief primer on financial markets and economics so you can understand and be comfortable with investing in the financial markets.

How Companies Raise Money through the Financial Markets

All businesses start small — whether they begin in a garage, a spare bedroom, or a rented office. As companies begin to grow, they often need more money (known as capital in the financial world) to expand and afford their growing needs, such as hiring more employees, buying computer systems, and purchasing other equipment. Many smaller companies rely on banks to lend them money, but growing and successful firms have other options, too, in the financial markets. Companies can choose between two major money-raising options when they go into the financial markets: issuing stocks and issuing bonds.

Deciding whether to issue stocks or bonds

A world of difference exists between the two major types of securities, both from the perspective of the investor and from that of the issuing company:

• Bonds are loans that a company must pay back. Instead of borrowing money from a bank, many companies elect to sell bonds, which are IOUs to investors. The primary disadvantage of issuing bonds compared with issuing stock, from a company’s perspective, is that the company must repay this money with interest. On the other hand, the business doesn’t have to relinquish ownership when it borrows money. Companies are also more likely to issue bonds if the stock market is depressed, meaning that companies can’t fetch as much for their stock.
• Stocks are shares of ownership in a company. Some companies choose to issue stock to raise money. Unlike bonds, the money that the company raises through a stock offering isn’t paid back, because it’s not a loan. When the investing public buys stock, these outside investors continue to hold and trade it. (Although companies occasionally buy their own stock back, usually because they think it’s a good investment, they’re under no obligation to do so.)

  Issuing stock allows a company’s founders and owners to sell some of their relatively illiquid private stock and reap the rewards of their successful company. Many growing companies also favor stock offerings because they don’t want the cash drain that comes from paying loans (bonds) back.

  Although many company owners like to take their companies public (issuing stock) to cash in on their stake of the company, not all owners want to go public, and not all who do go public are happy that they did. One of the numerous drawbacks of establishing your company as public includes the burdensome financial reporting requirements, such as publishing quarterly earnings statements and annual reports. Not only do these documents take lots of time and money to produce, but they can also reveal competitive secrets. Some companies also harm their long-term planning ability because of the pressure and focus on short-term corporate performance that comes with being a public company.

Ultimately, companies seek to raise capital in the lowest-cost way they can, so they elect to sell stocks or bonds based on what the finance folks tell them is the best option. For example, if the stock market is booming and new stock can sell at a premium price, companies opt to sell more stock. Also, some companies prefer to avoid debt because they don’t like carrying it.

From your perspective as a potential investor, you can usually make more money in stocks than bonds, but stocks are generally more volatile in the short term (see Chapter 2).

Taking a company public: Understanding IPOs

Suppose that The Capitalist Company (TCC) wants to issue stock for the first time, which is called an initial public offering (IPO). If TCC decides to go public, the company’s management team works with investment bankers, who help companies decide when and at what price to sell stock and then help actually sell (distribute) the new shares to investors willing to purchase them.

Now suppose that based upon their analysis of the value of TCC, the investment bankers believe that TCC can raise $20 million by issuing stock that represents a particular portion of the company. When a company issues stock, the price per share that the stock is sold for is somewhat arbitrary. The amount that a prospective investor will pay for a particular portion of the company’s stock should depend on the company’s profits and future growth prospects. Companies that produce higher levels of profits and grow faster can generally command a higher sales price for a given portion of the company.

Consider the following ways that investment bankers can structure the IPO for TCC:

In fact, TCC can raise $20 million in an infinite number of ways, thanks to varying stock prices. If the company wants to issue the stock at a higher price, the company sells fewer shares.

A stock’s price per share by itself is meaningless in evaluating whether to buy a stock. Ultimately, the amount that investors will pay for a company’s stock should depend greatly on the company’s growth and profitability prospects. To determine the price-earnings ratio of a particular company’s stock, you take the price per share of the company’s stock and divide it by the company’s earnings per share.

In the case of TCC, suppose that its stock is currently valued in the marketplace at $30 per share and that it earned $2 per share in the past year, which produces a price-earnings ratio of 15. Here are the numbers:

In Chapter 5, I talk more about price-earnings ratios and the factors that influence stock prices.

Understanding Financial Markets and Economics

Tens of thousands of books, millions of articles, and enough PhD dissertations to pack a major landfill explore the topics of how the financial markets and economy will perform in the years ahead. You can spend the rest of your life reading all this stuff, and you still won’t get through it. In the following sections, I explain what you need to know about how the factors that influence the financial markets and economy work so you can make informed investing decisions.

Driving stock prices through earnings

The goal of most companies is to make money, or earnings (also called profits). Earnings result from the difference between what a company takes in (revenue) and what it spends (costs). I say most companies because some organizations’ primary purpose is not to maximize profits. Nonprofit organizations, such as colleges and universities, are a good example. But even nonprofits can’t thrive without a steady money flow.

Companies that trade publicly on the stock exchanges seek to maximize their profit — that’s what their shareholders want. Higher profits generally make stock prices rise. Most private companies seek to maximize their profits as well, but they retain much more latitude to pursue other goals.

Among the major ways that successful companies increase profits are by doing the following:

• Building better mousetraps: Some companies develop or promote an invention or innovation that better meets customer needs. For example, many consumers welcomed the invention of the digital camera, which eliminated the need for costly and time-consuming development of film. The digital camera also made transferring and working with pictures much easier.
• Opening new markets to your products: Many successful U.S.-based companies, for example, have been stampeding into foreign countries to sell their products. Although some product adaptation is usually required to sell overseas, selling an already proven and developed product or service to new markets generally increases a company’s chances for success.
• Being in related businesses: Consider the hugely successful Walt Disney Company, which was started in the 1920s as a small studio that made cartoons. Over the years, it expanded into many new but related businesses, such as theme parks and resorts, movie studios, radio and television programs, toys and children’s books, and video games.
• Building a brand name: In blind taste tests, popular sodas and many well-known beers rate comparably to many generic colas and beers that are far cheaper. Yet some consumers fork over more of their hard-earned loot because of the name and packaging. Companies build brand names largely through advertising and other promotions. (For Dummies is a brand name, but For Dummies books cost about the same as lower-quality and smaller books on similar subjects!)
• Managing costs and prices: Smart companies control costs. Lowering the cost of manufacturing their products or providing their services allows companies to offer their products and services more cheaply. Managing costs may help fatten the bottom line (profit). Sometimes, though, companies try to cut too many corners, and their cost-cutting ways come back to haunt them in the form of dissatisfied customers — or even lawsuits based on a faulty or dangerous product.
• Watching the competition: Successful companies don’t follow the herd, but they do keep an eye on what the competition is up to. If lots of competitors target one part of the market, some companies target a less-pursued segment that, if they can capture it, may produce higher profits thanks to reduced competition.

Weighing whether markets are efficient

Companies generally seek to maximize profits and maintain a healthy financial condition. Ultimately, the financial markets judge the worth of a company’s stock or bond. Trying to predict what happens to the stock and bond markets and to individual securities consumes many a market prognosticator.

In the 1960s, to the chagrin of some market soothsayers, academic scholars developed a theory called the efficient market hypothesis. This theory basically maintains the following logic: Lots of investors collect and analyze all sorts of information about companies and their securities. If investors think that a security, such as a stock, is overpriced, they sell it or don’t buy it. Conversely, if many investors believe that a security is underpriced, they buy it or hold what they already own. Because of the competition among all these investors, the price that a security trades at generally reflects what many (supposedly informed) people think it’s worth.

Therefore, the efficient market theory implies that trading in and out of securities and the overall market in an attempt to be in the right stocks at the right time is a futile endeavor. Buying or selling a security because of “new” news is also fruitless because the stock price adjusts so quickly to this news that investors can’t profit by acting on it. As Burton Malkiel so eloquently said in his classic book A Random Walk Down Wall Street, this theory, “Taken to its logical extreme … means that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts.” Malkiel added, “Financial analysts in pin-striped suits don’t like being compared with bare-assed apes.”

Some money managers have beaten the market averages. In fact, beating the market over a year or three years isn’t difficult, but few can beat the market over a decade or more. Efficient market supporters argue that some of those who beat the markets, even over a ten-year period, do so because of luck. Consider that if you flip a coin five times, on some occasions you get five consecutive heads. This coincidence actually happens, on average, once every 32 times you do five coin-flip sequences because of random luck, not skill. Consistently identifying in advance which coin flipper will get five consecutive heads isn’t possible.

Strict believers in the efficient market hypothesis say that it’s equally impossible to identify the best money managers in advance. Some money managers, such as those who manage mutual funds, possess publicly available track records. Inspecting those track records (and understanding the level of risk taken for the achieved returns) and doing other common-sense things, such as investing in funds that have lower expenses, improve your odds of performing a bit better than the market.

Various investment markets differ in how efficient they are. Efficiency means that the current price of an investment accurately reflects its true value. Although the stock market is reasonably efficient, many consider the bond market to be even more efficient. The real estate market is less efficient because properties are unique, and sometimes less competition and access to information exist. If you can locate a seller who really needs to sell, you may be able to buy property at a sizeable discount from what it’s really worth. Small business is also less efficient. Entrepreneurs with innovative ideas and approaches can sometimes earn enormous returns.

Moving the market: Interest rates, inflation, and the Federal Reserve

For decades, economists, investment managers, and other (often self-anointed) gurus have attempted to understand the course of interest rates, inflation, and the monetary policies set forth by the Federal Reserve. Millions of investors follow these economic factors. Why? Because interest rates, inflation, and the Federal Reserve’s monetary policies seem to move the financial markets and the economy.

Realizing that high interest rates are generally bad

Many businesses borrow money to expand. People like you and me, who are affectionately referred to as consumers, also borrow money to finance home and auto purchases and education.

Interest rate increases tend to slow the economy. Businesses scale back on expansion plans, and some debt-laden businesses can’t afford high interest rates and go under. Most individuals possess limited budgets as well and have to scale back some purchases because of higher interest rates. For example, higher interest rates translate into higher mortgage payments for home buyers.

If high interest rates choke business expansion and consumer spending, economic growth slows or the economy shrinks — and possibly ends up in a recession. The most common definition of a recession is two consecutive quarters (six months) of contracting economic activity.

The stock market usually develops a case of the queasies as corporate profits shrink. High interest rates may depress investors’ appetites for stocks as the yields increase on certificates of deposit (CDs), Treasury bills, and other bonds.

Higher interest rates actually make some people happy. If you locked in a fixed-rate mortgage on your home or on a business loan, your loan looks much better than if you had a variable-rate mortgage. Some retirees and others who live off the interest income on their investments are happy with interest rate increases as well. Consider back in the early 1980s, for example, when a retiree received $10,000 per year in interest for each $100,000 that he invested in certificates of deposit that paid 10 percent.

Fast-forward to the early 2000s: A retiree purchasing the same CDs saw interest income slashed by about 70 percent, because rates on the CDs were just 3 percent. So for every $100,000 invested, only $3,000 in interest income was paid.

If you try to live off the income that your investments produce, a 70 percent drop in that income is likely to cramp your lifestyle. So higher interest rates are better if you’re living off your investment income, right? Not necessarily.

Discovering the inflation and interest rate connection

Consider what happened to interest rates in the late 1970s and early 1980s. After the United States successfully emerged from a terrible recession in the mid-1970s, the economy seemed to be on the right track. But within just a few years, the economy was in turmoil again. The annual increase in the cost of living (known as the rate of inflation) burst through 10 percent on its way to 14 percent. Interest rates, which are what bondholders receive when they lend their money to corporations and governments, followed inflation skyward.

Inflation and interest rates usually move in tandem. The primary driver of interest rates is the rate of inflation. Interest rates were much higher in the 1980s because the United States had double-digit inflation. If the cost of living increases at the rate of 10 percent per year, why would you, as an investor, lend your money (which is what you do when you purchase a bond or CD) at 5 percent? Interest rates were so much higher in the early 1980s because you or I would never do such a thing.

In recent years, interest rates have been low. Therefore, the rate of interest that investors can earn lending their money has dropped accordingly. Although low interest rates reduce the interest income that comes in, the corresponding low rate of inflation doesn’t devour the purchasing power of your principal balance. That’s why lower interest rates aren’t necessarily worse and higher interest rates aren’t necessarily better as you try to live off your investment income.

So what’s an investor to do when he’s living off the income he receives from his investments but doesn’t receive enough because of low interest rates? Some retirees have woken up to the risk of keeping all or too much of their money in short-term CD and bond investments. (Review the sections in Chapter 3 dealing with asset allocation and investment mix.) A simple but psychologically difficult solution is to use up some of your principal to supplement your interest and dividend income. Using up your principal to supplement your income is what effectively happens anyway when inflation is higher — the purchasing power of your principal erodes more quickly. You may also find that you haven’t saved enough money to meet your desired standard of living — that’s why you should consider your retirement goals well before retiring (see Chapter 3).

Exploring the role of the Federal Reserve

When the chairman of the Federal Reserve Board speaks (currently it’s Janet Yellen; before her, it was Ben Bernanke), an extraordinary number of people listen. Most financial market watchers and the media want to know what the Federal Reserve has decided to do about monetary policy. The Federal Reserve is the central bank of the United States. The Federal Reserve Board comprises the 12 presidents from the respective Federal Reserve district banks and the 7 Federal Reserve governors, including the chairman who conducts the Federal Open Market Committee meetings behind closed doors eight times a year.

What exactly is the Fed (as it’s known), and what does it do? The Federal Reserve sets monetary policy. In other words, the Fed influences interest-rate levels and the amount of money or currency in circulation, known as the money supply, in an attempt to maintain a stable rate of inflation and growth in the U.S. economy.

Buying money is no different from buying lettuce, computers, or sneakers. All these products and goods cost you dollars when you buy them. The cost of money is the interest rate that you must pay to borrow it. And the cost or interest rate of money is determined by many factors that ultimately influence the supply of and demand for money.

The Fed, from time to time and in different ways, attempts to influence the supply of and demand for money and the cost of money. To this end, the Fed raises or lowers short-term interest rates, primarily by buying and selling U.S. Treasury bills on the open market. Through this trading activity, known as open market operations, the Fed is able to target the Federal funds rate — the rate at which banks borrow from one another overnight.

The senior officials at the Fed readily admit that the economy is quite complex and affected by many things, so it’s difficult to predict where the economy is heading. If forecasting and influencing markets are such difficult undertakings, why does the Fed exist? Well, the Fed officials believe that they can have a positive influence in creating a healthy overall economic environment — one in which inflation is low and growth proceeds at a modest pace.

Over the years, the Fed has come under attack for various reasons. Various pundits have accused former Fed Chairman Alan Greenspan of causing speculative bubbles (see Chapter 5), such as the boom in technology stock prices in the late 1990s or in housing in the early 2000s. Some economists have argued that the Federal Reserve has, at times, goosed the economy by loosening up on the money supply, which leads to a growth spurt in the economy and a booming stock market, just in time to make El Presidente look good prior to an election. Conveniently, the consequences of inflation take longer to show up — they’re not evident until after the election. In recent years, others have questioned the Fed’s ability to largely do what it wants without accountability.

Many factors influence the course of stock prices. Never, ever make a trade or investment based on what someone at the Federal Reserve says or what someone in the media or some market pundit reads into the Fed chairman’s comments. You need to make your investment plans based on your needs and goals, not what the Fed does or doesn’t do.

What the heck is “quantitative easing”?

During and after the 2008 financial crisis, many pundits interviewed on financial cable television programs and website pontificators used the Federal Reserve as a punching bag, blaming the Fed for various economic problems, including the 2008 financial crisis. Despite the rebounding economy and stock market, some of the critics got even more vocal in blasting the Fed’s quantitative easing program begun late in 2010.

More often than not, these critics, who typically and erroneously claim to have predicted the 2008 crisis, have an agenda to appear smarter than everyone else, including the Fed. Some of these pseudo-experts are precious metals hucksters and thus like to claim that the Fed is going to cause hyperinflation that will impoverish you unless you buy gold, silver, and the like.

In one popular video that has millions of YouTube views, the author claims the following using goofy cartoonish characters:

• The Fed is printing a ton of money to implement quantitative easing (QE).
• QE is being done to stop deflation (falling prices), but the Fed is too dumb to realize that consumer prices are rising, not falling.
• The Fed has been wrong about everything the past 20 years.
• Fed Chairman Ben Bernanke is unqualified for his job because he has no business experience, has no policy experience, and has never held an elected office. He is a fool who’s been wrong about everything during his tenure in office and has already blown up the American economy and is now working on blowing up the world economy.
• The government is stupidly buying Treasuries from Goldman Sachs at grossly inflated prices (rather than buying Treasuries from the Treasury department). Goldman Sachs is ripping off the American people.

Although it’s stunning in and of itself that this video has been watched millions of times in a short time period, even more amazing and disturbing is how many mainstream media and other websites and outlets have promoted and recommended the video, making little if any effort to fact-check and reality-check its contents. I do so to set the record straight and to advance your understanding of what quantitative easing really is and why the Fed is doing it. Let’s go through the video’s main assertions point by point:

• The Fed is not printing a ton of money (expanding the money supply) to implement QE. Retail money market assets and bank deposits could increase, for example, if individuals decided to hold more cash. Demand for these highly liquid assets can come from folks around the world, so increased demand for the U.S. dollar during times of stress can lead to the growth of M2 (the leading measure of the money supply). Changes in money supply are complicated.
• The Fed is well aware that there’s inflation right now but has been concerned that the rate has been quite low by historic standards and that there were signs of accelerating deflation during the severe recession.
• If the Fed had been wrong about everything the past 20 years, our economy would be in a shambles and our stock market wouldn’t have appreciated more than 500 percent over that period. Yes, the U.S. has a somewhat elevated unemployment rate, but that’s due to various factors, notably current tax policy.
• Bernanke was well-qualified for his job.
• The Fed is buying Treasuries from banks at competitive prices and is doing so to encourage more bank lending. Saying that the Fed is directing this buying solely to Goldman Sachs is absurd. The Fed conducts such Treasury open market operations through an approved list of 18 primary dealers, and Goldman is one of the 18 dealers operating in a highly competitive environment. Goldman-bashing has been going on for a long time.

Interestingly, I haven’t seen much questioning of the background and agenda of the person behind this fact-challenged YouTube video, who in some articles is referred to as a “30-year-old real estate manager.” He has no discernible background or expertise in the subject matter discussed in the video, which helps explain why nearly every statement in the video is wrong.

In various speeches and selected interviews, Fed Chairman Bernanke has explained QE. Here’s one fairly plain English explanation that Bernanke gave during the height of the credit crisis (Note: “Central bank” means the Federal Reserve):

• Quantitative easing can be thought of as an expansion of the central bank’s balance sheet with no intentional change in its composition. That is, the central bank undertakes more open market operations with the objective of expanding bank reserve balances, which the banking system should then use to make new loans and buy additional securities. However, when credit spreads are very wide, as they are at present, and the credit markets are quite dysfunctional, it becomes less likely that new loans and additional securities purchases will result from increasing bank reserve balances.
• In contrast, credit easing focuses on the mix of loans and securities that the central bank holds as assets on its balance sheet as a means to reduce credit spreads and improve the functioning of private credit markets. The ultimate objective is improvement in the credit conditions faced by households and businesses. In this respect, the Federal Reserve has focused on improving functioning in the credit markets that are severely disrupted and that are key sources of funding for financial firms, nonfinancial firms, and households.