Virtually everything we buy and sell, both wholesale and retail, is auctioned to the highest bidder daily; demand for goods and services are generally satisfied by competitive auction. The foundation of Capitalism is the auction process of exchanging property. The auction is the only manner in which private property and labor can be exchanged for the highest contemporary value. Every owner desiring to sell a product will make it available to all potential buyers and strike a deal with the highest bidder.
The auction format of buying and selling surrounds us. Even our daily purchases at the supermarket or department store are an auction. Buying or not buying different goods causes prices to fluctuate in response to our demands. When we want more of certain goods or services, the asking price is raised until the competition amongst those who want to consume does not increase above the available supply. And similarly if demand falls off, prices will have to fall or potential customers will continue to leave goods on the store shelves. Our willingness to consume or not consume throughout the year is our expression of our bids for goods and services.
A stock market is an auction where representatives (called specialists) of stock brokerage companies meet to buy and sell stocks (corporate equity). Brokerages also have employees and/or self-employed stockbrokers around the country who receive buy and sell orders from their customers, and relay those orders to their exchange broker who alerts the specialist that is responsible for the particular stock that is wanted, or offered for sale. The specialist then proceeds to the area of the exchange where that stock is traded and offers to buy or sell your stock, as the case may be, by dickering with specialists from other brokerages. The buying specialists group together, facing the selling specialists, prices to sell are announced and bids to purchase are made, with each side making some adjustments until trades are made. If you the customer have offered to buy or sell at the best auction price available at that time, your order will be executed and you will receive a written record of that sale.
Originally stocks represented ownership of a company in the sense of equity, wherein the original sale of stock was insured by the collateral of manufacturing facilities and equipment, so that in the event a company went bankrupt, the stockholders would be somewhat compensated by the sale of buildings and equipment. Today, companies expand production or survive slow times by borrowing money from banks or through the sale of bonds, rather than creating and selling new stock. They use company assets as collateral for those loans or bonds, which offers some protection to banks and bondholders and none to stockholders. If the company should fail, outstanding loans and bonds may be repaid out of the sale of equipment and property, if that equipment and property still have economic value.
If a company has assets worth ten million dollars, and one million shares of stock are owned by the public, that stock is protected to a price of ten dollars per share. But if the value of that stock rises to one hundred dollars per share when speculators and investors bid up its price without regard to its equity value, then ninety-percent of that stock's value is unprotected by company assets and profits. Its price has been inflated in a careless and economically dangerous manner. If bonds are sold to raise ten million dollars for operating capital, then the company's assets will be used to guarantee those bonds and there will be no equity value in that stock. Bankruptcy for such a company would result in a total loss for stockholders.
Not all players in these markets are long-term investors, or consumers of resources and commodities; many are strictly short-term speculators, betting on price changes. Speculators are people who bid to own, or offer to sell all sorts of stocks, bonds, and commodities, without holding stocks to receive dividends, or holding bonds to maturity, or taking possession of commodities to produce consumable products. Their gains come directly from other peoples' losses and their every effort is to try and read the markets, to be able to predict the actions of investors and consumers, and buy or sell on their own most favorable terms.
Speculation does not drive or strengthen the economy; it only feeds off the wealth of the economy. Speculators do not provide services and infrastructure. They have become institutionalized in our commercial real estate, bond, stock and commodity markets. Their actions in these markets conspire to create values for the pieces of paper that they buy and sell, which are different from the real market value of the assets represented by stocks, as well as the real market value of the commodities that speculators buy and sell, but never see. Political power is manipulated to regulate these investment markets for the benefit of speculators.
Speculation in stocks and other financial papers has caused the attention of the greedy to focus on the changing values of stocks, rather than on actual corporate earnings and dividends paid to investors. These changes in stock values are brought about more by the activity of speculators than by economic activities of production and consumption. The longevity of investment toward gain, from present and future profits of a company, is giving way to short term buying and selling, based solely on stock price. Speculation often drives many stock values way above or way below real current market values and earning capacity. These variations allow speculators to unduly influence trading in the markets, by encouraging investment for short-term gain through volatility, rather than long term gain via profits from the sales of goods and services. As the markets oscillate, speculators buy and sell to siphon off a portion of the flow of investment dollars coming at the markets. Whenever uncertainty arises, speculators (and investors turned into speculators by their brokers) drive the markets toward economic anarchy.
Many corporations are now more interested in how their stock price is viewed by speculators than by investors. When stock prices get somewhat above one hundred dollars per share, a round lot of one hundred shares would cost over ten thousand dollars. These higher prices tend to discourage speculators, who want to own lower price stocks, which are usually more volatile, allowing them to skim profits off that volatility. High stock prices therefore reduce the exchange activity of a stock (volatility); such that many corporations split their stock two-for-one or three-for-one, dropping the share price to one-half or one-third of its previous price, to encourage increased speculative buying of their stock.
"The market is always right," investment brokers, referring to the value of stocks, bonds, and commodities often quote this statement to customers; hoping to impress them with a belief that the markets reflect overall attitudes of investors and speculators. But for every buyer of stocks and commodities there is a seller of the same. Therefore, the markets are actually low as far as buyers are concerned, and high as far as sellers are concerned. Neither group thinks the markets are right. The fact is, the markets are always changing. The direction of change is determined when there is a surplus of buyers over sellers (rising market) or vice versa. The market is only right when and if it stagnates with no change.
The greatest challenge to investors and speculators is the legal requirement that dealing in stocks and bonds must be a gamble. Forehand knowledge of information that will affect the value of a stock or bond is illegal, and is called insider trading. The government requires that all potential-players in these markets be equally informed of the present and equally ignorant of the future. Though there is great diversity of opinions about the meaning of corporate data, still all players must have equal access to that data.
It used to be that every stock trade was done face to face and that a particular stock would only be traded at one exchange. Today stocks are traded 24-hours a day; over the phone between customer and broker, via computer between brokerages, and on numerous stock exchanges around the world. When stock trades were made face-to-face, trading was relatively slow even at its most volatile times. Now that brokerages can buy and sell stocks via computer, orders to buy and sell can be processed with lightning speed.
Many speculators automatically offer their stocks for sale if the market should decline a certain amount, while others have standing orders to buy certain stocks if the market is rising. Standing orders to buy or sell at certain price levels tend to exaggerate the volatility of the market. They cause a rising market to rise further, or a declining market to fall further, than they would have without speculative standing orders.
Many investors and speculators buy stocks on margin (partial payment), paying only a portion of the cost. If the market drops far enough that their down-payment equals the loss on their stock, they then must immediately send more money to the brokerage firm that they bought it through. If investors do not respond to the margin call for additional money, their brokerage will sell their stock at any price, without their permission, and send them a bill if the brokerage had to pay the difference between their customers' down payment and the selling price. In such a case the investor has not only lost their stock or bonds and a chance to recoup their losses when that stock or bond regains market value, they may be saddled with additional debt to pay for losses beyond their control.
While your broker is trying to get you the best deal available, you are actually competing with your broker's company to buy and sell stocks. Brokerages invest heavily in stocks, bonds and commodities, speculating for their own profit. So if you want to sell a stock that their chief strategists believe is going to go up, they will not necessarily inform you. More likely they will buy your stock from you and be quite happy to have you contribute to their welfare. Likewise, if you want to buy stock that they believe is going down, they will tell you so if they don't own any, or they will sell you theirs and remain happily silent. The real competition between you and your brokerage firm happens when you both want to buy or sell. In that case your brokerage will sell or buy a number of stock orders through the same specialist at the same relative time, and yours will be the ones with the least gains, making the ones with the most gains their trades. Brokerage firms look out for themselves at everyone's expense, including their valued customers.
Each stock transaction determines the value of all of the stock for a company. When one trade of 100 shares, usually the minimum amount which can be bought or sold, is made at a price above or below any current price, the value of all of a company's stock is considered to have risen or fallen by that same amount. And though many investors do not buy or sell on a daily basis, they still watch their stocks and note how their perceived net worth has increased or decreased as their stocks move up or down. The greatest of fallacies is the belief that one's stocks are worth the prices quoted daily in the paper. Only a small percentage of any company's stock needs to be placed on the market and sold at any price to wreak havoc in the value of all of that particular stock. A company's stock is worthless as soon as investors are unwilling to own all of it. By this I mean, if more of its stock is offered than the market can find buyers at any price, the value of all of that company's stock falls to zero, (no demand, no value).
All stocks are in a false equilibrium day to day. Barring some catastrophe in the world in general, or some segment of our economy in particular, a stock's equilibrium is established by its previous day's activity. Each daily close of the markets establishes a new point from which gains or losses are measured. But since it is buyers and sellers who define this equilibrium, the ratio of buyers to sellers is very important to the value of a company's stock.
If there were an infinite number of buyers and sellers available to a market, it would be fairly stagnant and nearly impossible to crash. But there are only a finite number of buyers and sellers; both sides draw from the same pool of speculators and investors. Whenever the market falls, it is likely that many would-be buyers will become sellers, and many who were on the sidelines will step in to sell their stocks and avoid further losses. If sufficient pressure to sell stocks at any price occurs, even if only in one sector of the market, it can attract cash from other sectors, consume that capital and thereby reduce the cash available to support values in other markets. Pressure to sell for lower prices in one market can produce a downward momentum for all of the markets. As new prices are established at lower levels, equity is lost across the board, both for sellers and for owners who remain on the sideline hoping for stability. With any major loss of equity in one market, those needing to cover their losses may transfer or borrow capital from other areas of the economy to balance account sheets at brokerage firms. The loss of capital to investors in those other markets will cause prices to fall for them as well.
In 1987, many small investors could not get out of the stock market before being wiped out. This was not only a result of it being impossible to get through to your broker by phone, since many thousands of other investors were doing as you were. Your broker's company had two things to gain by your losses. It could sell its own stock first and consume what little demand may have existed to buy stocks, and it could keep your stock off the market to prevent prices falling even lower. When supply of anything exceeds demand, prices will fall relative to the available surplus and any demand to consume that surplus.
There is a method of selling stocks and commodities in our economy that is called selling-stock-short or short-selling. Short-selling is a way of creating a false surplus of a stock or commodity. In essence we borrow stock from some investor, through a broker, and we sell that stock to a third party because we believe that its price will fall in the future (we are selling short because we are short the amount of stock that we have borrowed and sold). At this point all we have done is sell something that does not belong to us, making neither a gain nor a loss. If our gamble is right and the price of that stock or commodity does fall, we can then buy that stock back from a fourth party at the lower price and return it to the person or brokerage we borrowed it from. Because we do not pay anything to borrow the stocks, our profit is the difference between the higher price we sold and the lower price we paid to have them returned to their original owner.
The history of selling-short is the most calamitous in all of our economic history. One hundred years ago professional stock traders were ruining each other and many sound businesses by selling large amounts of a particular stock short. Then they would put out rumors that caused other investors to also sell that stock, driving the price very low, which would allow them to make large profits by buying back that stock at a lower price and return it to the brokerage they had borrowed it from. Other traders who owned that stock on margin might go bankrupt, unable to cover a sudden and unexpected loss due to unfounded rumors. The company that issued that stock may have other shares held as collateral for expansion loans. If the price of the stock should fall, the loss of price equity would force banks to call for other collateral, or they might seize property, take over a company's management and possibly liquidate it. If a company had cash assets that would allow it to buy up these short sales as they occurred, it would not only support the price of their stock, but as less and less stock was available for investors to own, the price of a company's stock could rise. The short-sellers would eventually have to buy stocks to replace those that they had sold short. This would create demand for a reduced supply, causing the price to rise and possibly catastrophic losses for those who had sold short. The Japanese do not allow selling-short in their markets, and for good reason. There have been many stock panics in our history and all of them have been worsened by selling-short.
Consider a long time investor-A that owns stock outright and is as much concerned with dividends as stock prices. If this stock is managed by a brokerage for that investor-A; the brokerage could loan that stock to speculator-B, who would sell it on the market to speculator-C. If investor-A did not want to sell, there would be less stock available to the market and the price would remain higher; forcing speculator-C to offer a higher price to entice an investor to sell some stock. But since speculator-B is borrowing and then selling this stock, he is helping his own gamble by adding this borrowed stock for sale to the market, thereby encouraging a price decrease simply by increasing supply. If the price does fall, speculator-B has made a profit when he buys stock from investor-D (who could actually be investor-A dumping the stock to avoid further loss) and returns it to the brokerage. In essence the brokerage has aided and abetted a loss to one of its investor customers, while helping a speculator customer profit. Selling-short does not increase investor equity; however, it does reduce it by the amount of profit made by the short-seller.
So why do stockbrokers offer short selling? Simply to make money; stockbrokers earn a fee each time stock is traded. They do not like investors who purchase stocks and then hold them for years to earn dividends. They want the fees associated with trades and market volatility, and they are happy to help speculators hurt investors. If they can they will turn all investors into speculators.
There is a big difference between investors and speculators. Investors put surplus money in the stock, bond and commodity markets for the long term. They hold stocks for years to receive dividends as a return on capital investment. They buy bonds and hold them to maturity and receive interest payments. They buy commodities and use them to manufacture goods and provide foodstuffs. While the speculator is a pure gambler, buying and selling stocks, bonds and commodity contracts based on price changes, seldom holding them to receive dividends or interest. Only a speculator would sell a stock or commodity short. Only a speculator would buy or sell a stock index contract, betting that the market as a whole will go up or down. Only a speculator would take an option to buy stocks, or sell stocks, rather than commit fully.
As more money flows through the markets to speculate in price changes rather than dividend or interest returns, the volatility of price changes will increase. When earnings reports are low or below market expectations, many stocks fall in price rapidly and somewhat drastically as speculators dump those stocks knowing that with bad reports other speculators will sell such stocks and others will temporarily choose not to buy. In a non-speculative market a stock would drift lower in price, or stagnate for some time. So speculators will move out early, and even sell the markets short to accelerate a decline brought on by perceived weakness, and reap profits for themselves thereby.
Not everyone in the markets is a speculator. If this were the case we would have daily panics and weekly chaos. But the amount of activity in the markets that is strictly speculation is increasing, and we can see this in the changing relationship between dividends and prices. How can a stock, which returns a 4% quarterly dividend to a market that was expecting 5%, have its price drop 5% or more in one day? In the opposite case, the stock price might rise 5% in one day on a dividend of only 1% above market expectations. Investors would not sell or buy enough stock on this information alone to make any noticeable price changes. Only speculators can do this, because speculators are working a pure gamble, based on near term strength or weakness of companies.
Due to its length this article is being published in two parts. Part_2 is also on this site, or will be shortly.
© June 2009
Craig D. Hanks
