FinanceFinancial Education

Understanding Equities (Stocks)

When it comes to equity markets, success is a function of knowing how to operate within the new rules of engagement. From a simplified perspective, a stock certificate represents fractional ownership of the issuing company, but that is where the simplicity ends. There is much more to the markets than simply buying and selling individual shares of stock.

Once a company decides to go public, the initial public offering (IPO) process often detaches the offering price from the underlying value, allowing market sentiment and the IPO managers to drive the stock value and, by default, the perceived value of the underlying company. In short, the real value of the underlying company no longer matters. All that matters is the perception of value. Facebook may be an exaggerated example, but it illustrates the point.

Once the IPO is complete and a company is publicly traded, pricing is driven by market influences, predominantly at the hands of market makers and institutional investors. As a result, individual investors and their brokers are left with little more than an illusion rather than true market realities.

The reason? Automated algorithmic high frequency trading (HFT)… Depending on the report you read, HFT is estimated to exceed 70% of all trades. These trades include individual stock issues, options, and futures.

Without going too far down the rabbit hole, options are financial instruments that allow an investor to leverage their market sentiment, purchasing (or selling) the option (right) to execute the purchase or sale of an underlying investment, without risking the actual capital for the transaction – unless it makes financial sense to trigger the option. If the option is never executed, the investor only loses the cost of the option. Futures are somewhat similar, in that the investor purchases a contract that speculates against the future value of the underlying investment.

These are the areas where the market makers can use their deep asset pools for leverage to manipulate the market. To make matters worse, instead of depending on core analytics and investment fundamentals, market manipulation becomes a game of follow the leader. Even the IMF recently warned against the herd mentality, or procyclical behavior, of institutional investors.

Not buying the analysis? Just watch the market after the next jobs report or Fed announcement. The market movement you witness will not be the result of individual independent thinkers. It will be the result of institutional groupthink.

In our current environment of low interest rates and easy money, the markets have experienced abnormal growth due to investors of all stripes seeking profit and higher income, but there is a very strong possibility the tide is about to turn even if the Fed does not increase interest rates or taper its monetary accommodation. The driving force, in my opinion, will be the contraction of investment contributions due to baby boomers nearing and entering retirement.

Think of a Ponzi scheme. The scheme “works” when new funds are flowing, but as soon as the funds slow or start to depart, the scheme begins to unravel. The same will happen with our equity markets as the inflow of new investment contributions decrease. In addition, equity markets will experience rapid capital flight once interest rates start to rise, because investors will seek the income and relative safety of bonds.

How soon will this happen? Many analysts project a window extending no further than the first quarter of 2014. Watch the herd…but get out of its way before the stampede!

Why is this information important for the little guy? Tremendous gains are possible if you know how to play the game.

Stay tuned for our next installment, as we explore the world of debt instruments…

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