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Traders on the floor of the New York Stock Exchange. Picture: REUTERS/BRENDAN MCDERMID
Traders on the floor of the New York Stock Exchange. Picture: REUTERS/BRENDAN MCDERMID

The management of private savings is central to ensuring the stability of society and the improvement in living standards.

These savings, made by individuals, are generally accumulated through collective schemes such as pension and retirement funds. Those entrusted with the management of these savings have a critically responsible role. They are accorded high status and are well remunerated in rough proportion to the value of the assets they manage. By far the largest proportion of private savings entrusted to these wealth managers is invested in stock markets, both domestically and internationally.

So the performance of the stock market is of considerable interest to a wide sector of the public. Yet the financial jargon used to describe the day-to-day performance of the stock market is in many cases opaque, somewhat illogical and sometimes even misleading. 

Outlined below are some common explanations that seem designed to exclude the wider public from the market’s inner sanctum.

Share price movements and what they reveal

Share prices are the perceived present value of the future rewards, mainly dividends, expected to flow from ownership of a company’s shares. These rewards depend on the company’s profits or earnings. Investors and professional traders constantly assess the effect on earnings of information arriving on the newswires. 

These packets of almost continuously flowing information fall into two categories: those that confirm events that were generally expected, and those that come as a surprise and are often described as a “shock”.

The greater the divergence of opinion about what the future may bring, the more active trade in a share is likely to be,  and the more share prices may change from day to day

Information that is unexpected and therefore genuinely newsworthy will change perceptions of the economic future and the value of the companies that largely make up a modern economy. Market participants, with every incentive to do so, will try to work out how such news will affect listed companies and their share prices. The information might not refer directly to a particular firm but can  affect perceptions of the performance of the wider economy. 

Therefore, any unexpected, genuine news can change the perception of the value of a company in the eyes of potential buyers and sellers of its shares. Trading of a share takes place at an agreed price between a buyer — who must think the price will rise on the basis of current and past information — and a seller, who believes the opposite. Thus trading only takes place when there is a divergence of opinion between buyer and seller.

What’s more, on any one day only a small fraction of shares in circulation will ever change hands; in fact, most shareholders do not trade their shares at all — they simply buy and hold.

The greater the divergence of opinion about what the future may bring, the more active trade in a share is likely to be, and the more share prices may change from day to day or even minute to minute. Heightened uncertainty will be reflected in temporarily volatile markets. The price of an individual share, or some index of a group of shares, can exhibit volatility when the news is truly surprising or shocking and market participants are taking some time to assess its implications.

In the light of the above, let’s look at the clichés offered by commentators that do little justice to this complicated reality.

Commentator: The stock market fell sharply today as sellers flooded the market

In fact, the only prices that are recorded are those of actual trades. So precisely as much share value is bought as is sold. Of course, negative news might indeed have flooded the market, causing a general downward assessment of most stock prices and recorded (last-traded) prices may fall pretty much across the board. But the maxim holds. Each buyer expects the share bought to go up. Each seller expects the share price to fall and as many shares are bought as are sold.

Commentator: The stock market fell steadily today as traders took profits after yesterday’s sharp rise

If a trader bought yesterday, thinking the price would go up according to the available information at the time, they might sell today on the basis of their expectation being realised in some part. But the person they sell to also presumably thinks that, according to today’s information and their analysis, the current price is attractive and will rise.

One will be right and one will be wrong, and the factor that makes one a winner and the other a loser is  generally unpredictable. But the notion of “taking profits” tends to imply that in the short run there is a split between clever people in the market who make money and dumb people in the market who lose money. The clever group (described by the commentator as “traders”) assessed that prices were too high relative to value, and therefore took profits by selling to the dumb group, who have failed to appreciate this and now sit with a (book) loss.

Commentator: We are clearly in the middle of a bull run. Almost all shares are trending upwards, and it looks as if one can’t go wrong putting money into this market.

Or, a variation on this theme:

The trend is your friend. The share price of X has moved up 50% in the past two months and I think another 50% rise is in sight.

One of the most extraordinary fictions is that a share price exhibits animal-like behaviour. That is, if you look at the performance of a stock you might be tempted to conclude that it follows a predictable path in the same way that an animal would. So if a stock price has moved in one direction and established, say, an upward trend, then it is likely to continue to do so; thus mimicking the instincts of an animal,  which is more likely to continue moving in the same direction than suddenly change course.

One of the most extraordinary fictions is that a share price exhibits animal-like behaviour

The identification of patterns of future movements finds its nadir in the dark art known as technical analysis. In this world, share prices are assumed to move along predictable future paths when the past prices have formed some pattern. For example, in the jargon of technical analysis, share prices can be expected to break down after they have formed a “triple top” or break out when prices have formed a “flag” formation. It could be regarded as extraordinary that such analysis has gained currency, invoking the notion that the movement of a share price is akin to a living creature that habitually walks along a designated path.

Of course, once such analysis is accepted by market participants as actually indicating future behaviour, then market players will act accordingly and  the share price prediction can become self-fulfilling. In other words, if technical analysts see a “triple top”, knowing that in their world this heralds a break down they may sell the share — which will lead to a price plunge  exactly as they had predicted.

It must be made clear that though some stock market analysis may push the limits of logic, this does not detract from the fact that the stock market is a central investment vehicle for society.

It allows investors to plug into the extraordinary growth of modern economies, which are supported and driven by the explosive rise in technological innovation. Stock market analysts and portfolio managers have a pivotal role to play in ensuring the delivery of these returns to the savers in society who wish to secure their future.

The colourful, but often obtuse, commentary made by pundits should not detract from this fact.

Barr is emeritus professor of statistical sciences at the University of Cape Town (UCT); Kantor chairs the Investec Wealth & Investment Research Institute and is emeritus professor of economics at UCT 

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