Saturday, August 20, 2011

The Stock Market Explained in One Simple Chart

The Short Term Cycle – Not the Trend

Barry Ritholtz has this nice chart on the stock market, and asks the question, where are we.

Where Are We?  Well We Know Where We Ain't

Unfortunately we know where we are, and it’s somewhere on the down part of the cycle.  What we do not know is how far down, and how long until we reach the bottom.

The Dismal Political Economist is a strong believer in what Finance has come to call the “Random Walk Theory”.  This theory holds that all of the known information about stocks is already incorporated into the price of stocks, and that any future information is a random event, and so cannot be forecast or determined.

Stock professionals hate the Random Walk Theory because it says that any individual using a random process to assemble a portfolio can do as well as an expert, and on average better than the expert after the expert is paid his or her expert advising fees.  Unfortunately for stock professionals, studies have shown this to be true.

As for the long term prospects of the market as a whole, the future is also uncertain.  Factors which will tend to reduce the market in the long term are these.

    Why are these people happy?  Because they are not in  stocks
  1. Demographics:  As the U. S. and Europe’s population ages, individuals will be selling stocks to finance retirements.  Life insurance companies will be selling stocks to pay settlements.

  1. Weak European and U. S. economies are now at the new norm.  It is clear that other than a few exceptions like Canada and Germany, western economies are in a downward trend.  This trend is being driven in part by economic policy to reduce budget deficits.

  1. Corporate profits surged in the last two years after major cost cutting by many companies.  Cost cutting is a one time event, it can increase profits one time, but the cost cutting cannot be repeated year after year.  At some point in time higher revenues will be needed to boost profits, and as for them, see point 2.

  1. Interest rates are at the lowest point possible.  Low interest rates drive money into stocks.  If at some time in the future interest rates return to historical norms, this will draw money out of the market.

On the plus side are the rapidly growing areas of Asia and Latin America.  These regions are producing growth and wealth that could be invested in western stock markets, and this will support higher prices. 

The Dismal Political Economist's View of the Market

So what does The Dismal Political Economist think will be the long term prospects for stocks?  He just told you, he believes in this Random Walk thing.  In plain English that means “he doesn’t know”.


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