Economics part 2

In this part I'll pause my tirade on the government's role in the economy and look at the stock market. I'll start with a short overview of what the stock market does.

Mr Ambitious sees an opportunity to make money by making and selling Throgs. H doesn't have enough money to set up a business so he has three choices. He could borrow the money from the bank. He could borrow from a friend. Or he could float a company on the Stock Market.

The first option is tricky because the bank will want repayments of capital and interest. Ambitious doesn't have any money so can't repay capital until the business is well under way. The bank will also require security in the form of the right to take possession of Ambitious' house and nice car if he fails to make the repayments in time.

The second looks good, if there is a friend (e.g. Mr Den Dragon) with a wodge of cash burning a hole in his pocket. Ambitious will have to convince Den that his business is viable and hand over some control and future profits. Den is taking a big risk - if Ambitious' project is a flop Den is left with nothing.

The third option is pretty good all round in theory. The stock market allows many people to invest a small amount in Ambitious' company and all they want in return is an expectation that they will make money in the long run. Those people can invest in many businesses so one failure won't lose all their money. (In practice floating on the market is a second step, used either to pay off the initial investors be they a bank or a friend, or to enrich the dotcom founders, but for the purposes of illustration I'll forget about that).

Once Ambitious has floated his business he gets on with running it and pays his shareholders a dividend out of the company's profits. (The shareholders own the business so are entitled to the profits, but they don't run it). Ambitious can also pay himself a huge salary if there's enough money around. Once a year Ambitious calls an AGM at which the shareholders, it sufficiently interested and organised, could vote him out of the company and put someone else in charge, but if Throgs are selling well and profits are strong they have no reason to do that.

Later, Ambitious decides to start making another product, New Chags. He needs more capital so creates more shares in his company and offers them for sale. Technically these are shares in a business already owned by the existing shareholders so Mr A offers the shares first to those people, then places whatever is left on the open market. Chags do well and a wider group of people benefit from the dividend payments. The amount of money Mr A gets for the shares he issues depends on the market value of the existing shares and the perceived value if the enlarged business, so it is in his interest to maintain the value of the company he has created. This might be done by paying good dividends, or it might be done by good salesmanship promising future dividends even though the company is losing money right now. The investors in the business can retrieve their capital at any time by selling their shares to someone else. If the company is thought to be doing well there will be a strong demand for shares so the investor gets a good price and walks away smiling. Otherwise the investor might have to sell at a low pricer and end up losing money. If investors are perceived to be losing money there are two consequences. First, they could get together and find a replacement for Mr Ambitious, someone who can run the business more profitably. Second, they can decline to buy more shares when Mr A needs to raise more capital.

Anyhow, that is the basis of the stock market. It is a place where one can raise capital to start or expand a business without having a wealthy friend, and where investors can trade those investments to get what they think will be the best return for them.

Now, what REALLY happens? Pretty much every employed person in the UK pays up to 10% of their income into a pension plan. (if they don't pay it all, their employer pays the rest). That money has to go somewhere and make more money to pay out all those current and future pensions. A lot of it ends up buying shares on the stock market. Lets assume Mr A's business is valued at £1M on the basis of some clever sums, such as the resale value of all A's assets or his £50,000 annual profits (i.e. a return of 5% on the nominal amount invested). Along comes a pension fund and decides to invest in the business. A doesn't want any more capital so doesn't issue any more shares. The pension fund just offers some investors 10% over the odds for their shares. The value of A's company is now £1.1M, not because A has done anything to make the business worth more, just because a buyer has thrown money at the stock. As in part 1 of this post, when demand exceeds supply the price goes up - inflation.

I postulate that much of the stock market growth over the past 20 years is down to stock price inflation. This is supported by looking at a common indicator of stock values, the price to earnings ratio (P/E). This is simply the effective interest the investor receives on his capital. As the market rises, P/E goes down. The rise is a bubble. If people need to get their capital out of the market, because they need the money or to invest elsewhere, the price may come down sharply as the incoming investors demand more earnings for their capital. Also, in a recession earnings go down and so price follows. There is of course a floor price where the asset value of the business is covered by the stock value and asset strippers move in. Somehow, asset stripping hasn't been an issue lately, perhaps because nearly every stock is overvalued against assets.

tbc...