What is the Stock Market?

Published by Matthew Tae at March 30, 2021

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What is the Stock Market?

Imagine you found one billion dollars in cash all the sudden! What would you do with it? After the obligatory travel and fun that wealth affords, then what? Barring giving it all away, you’re officially “wealthy / rich” and will be for the rest of your life, and so will your kids (if you have them) who you can now call heirs like the fancy rich person you are now. Money is no longer a concern as long as you can outpace inflation and your billion dollars can generate enough income to cover the cost of your chosen lifestyle. Generating that income is the primary purpose of “assets”, including assets in the stock market, real estate, bonds, and any other asset new or old. The income generation from those assets exist within our society as an unwritten social contract, and the “markets” are a place where we unspokely…guarantee that over the very long term. As the meme’s of 2020 & 2021 go… “Stonks only go up!” Not 100% true, but anecdotally true if you play by the rules for a long enough time.

“Markets” Are Capital Markets! Not A Place to Store Wealth.

I can already hear some critics saying, “markets are for companies to raise money so they can grow and advance civilization!” Maybe once they were, but not so much anymore. When you consider that new companies are a tiny percentage of the overall “Market”, the vast MAJORITY of the market exists to deliver money back to shareholders. Markets exist to satisfy your lifestyle because that billion dollars you found should keep you and your family comfortable for generations upon generations. That is the current purpose for most “mature” markets.

CAN SKIP THIS SECTION IF YOU AREN’T INTERESTED IN THE MECHANICS OF CAPITAL RAISING… i.e. Capitalism: Companies nowadays raise capital from Private Equity (i.e. private wealth funds that will invest in companies very early in exchange for ownership in the company) many times before they ever reach the “public” via the stock / public bond market. When a company goes through the IPO or SPAC process (i.e. becomes a publicly traded company that non wealthy individuals can “invest” in), they’ve already raised a lot of money. Here’s how that process works:

FAST company goes to Private Equity Fund A and trades 5% of the company for 10 million dollars! Private Equity Fund A says, “Ok, now you have our money and we’re part owners, we want you to GROW FAST! That’ll make the company more valuable and allow us to raise more capital to grow faster.”
FAST company executes by burning through 8 million dollars very quickly, but the revenue growth looks amazing! Losses have increased and the company is still very far from being profitable. So Private Equity Fund A goes to their friends at Private Equity Fund B & Private Equity Fund C and sings the praises of the FAST company. Look at that revenue growth!
FAST company trades another 10% of the company (5% to PE Fund B and 5% to PE Fund C), but this time for $50 million! The company is worth more now because each 1% of the company generated 5 million dollars whereas before 1% of the company could only be traded for 1.5 million dollars. Private Equity Fund A feels very smart as their initial $10 million investment is now valued at $50 million! Remember, Private Equity Fund A paid $10 million for 5% of the company and now 5% of the company is worth $50 million based on what Fund B & Fund C paid.
FAST company executes again by burning through 45 million dollars very quickly, but the revenue growth explodes! All the advertising has paid off and revenue is 3 times greater than the previous year!
At the encouragement of Private Equity Fund A, B, & C… FAST company goes “public”. The general public should enjoy the amazing growth. So, the investment bankers do the paperwork and the company goes public at a valuation 10 times greater than what Private Equity Fund B & C paid! Each 1% of the company is now worth $50 million dollars!
Private Equity Fund A can sell their 5% ownership for a very nice profit of $240 million. Not too shabby based on their initial investment of 10 million! Private Equity Fund B & C also make a nice profit. The company founders, early employees, and insiders also can sell their ownership stake and make a nice profit. They DESERVE this windfall as they risked CAPITAL and allocated that capital efficiently, and therefore should be rewarded as the job creators they are.
FAST company hasn’t generated a profit yet, they’ve been really good at convincing “investors” to give them money to spend on marketing & product development to grow revenue in order to convince new investors to give them more money to spend on marketing to grow revenue in order to do more of the same. Eventually, the company will have to make a “profit”. IF AND WHEN the company finally makes a profit, FAST company will return those profits to investors. But this process isn’t really a concern for anyone who invested in FAST company before the IPO / SPAC. The “public” is making the bet. At this point, who knows what the returns will be. It’s a casino with brand new companies. The story might play out wonderfully, or it may crash and burn.
This can be seen with Beyond Meat: will plant based meat overtake traditional meat consumption? Electric Vehicles: will the world accept long wait times for vehicles to charge and swapping batteries rather than stopping for a few minutes at a gas pump? Online Real Estate: will people be more comfortable shopping for houses themselves and not paying the 6% realtor fee to be shown around the “right neighborhoods”? There was pets.com in the 90’s before chewy.com today.
Maybe some companies make it to the finish line and become “mature” companies that generate massive profits. Most do not. But the decision to start generating profits can be done well before the IPO / SPAC event. The IPO / SPAC event is to reward and enrich the company founders, early employees, and early-stage Private Equity investors. They can get out before the hard work of making the company profitable. They’ve sold the story of the future and FAST growth and the possibility of massive investment gains… if there’s someone willing to pay more for that story then the previous person.
The thesis that “markets” exist to fund new companies is only partly true… it really functions to transfer RISK to the public and serves as a liquidity event EXIT plan for private equity and founders. One that is perfectly fair in many cases. The public can make bets in this market… this market is a casino.

DISCLAIMER: Before a flood of hate mail comes in, I’m simplifying this for an educational narrative… not all Private Equity is evil and greedy. 80% of the companies Private Equity invests in don’t succeed and their investments are gone. The few winning bets must pay for all the losing bets. There are good Private Equity firms and bad ones. But “being early” is crucial for this entire system. During March of 2021, investors of new companies that went public recently have gotten annihilated. Their investments have been crushed. The early investors before the companies went public are fine… the people / public that bought into the “SPAC” craze of 2020 and 2021, have been hurt investing in many of these new companies that don’t generate a profit. Generally, the market exists to produce income… the process of funding new companies is a transfer of risk to the public who want to play markets for HUGE upside gains… like a casino.

I Didn’t Find a Billion Dollars Though, I Just Want to Retire One Day

Retirees and Billionaires have the same concern: they require a rate of return on “assets” so they can maintain a certain lifestyle. The stock market is great place to easily access pieces of paper (i.e. stock certificates) that represent different kinds of assets. Maybe the “asset” can generate “income” because you can sell it later for more then what you bought it for, or the asset will produce a monthly income stream like rental payments to a landlord. But there is a social contract underneath of it all. These assets and the salespeople who sell them to you, real estate, stocks, bonds, etc… will provide you a reasonable rate of return on those assets to maintain your lifestyle.

When your money manager tells you “diversification” in a “broad basket of stocks” will do well over the “long run” even in “volatile markets”, what they are saying is that the Plunge Protection Team created in 1988 will prevent extreme falls in asset prices that’ll break this social contract. Namely, we’ll bail ourselves out with created money.

Conversely INFLATION is a concern and one that’s currently in the financial media. This is a worry for retirees and billionaires as they require a higher rate of return on assets IF inflation is high. A rate of return that might not be possible, and is definitely more uncomfortable as the previous bond yields offer no protection. Inflation is the opposite of market crashes and our social contracts will prevent that from happening as well. The majority of our “society” and the relationship between the political ruling class (i.e. lawmakers), business class (i.e. wealthy), and employees are built around upholding this social contract… we are a Capitalist country after all!

I won’t get into the inflation debate here, but I don’t think inflation is the pinnacle of all evil. In fact, most economists aren’t really sure how inflation works! The prevailing wisdom at the moment is that inflation occurs because there’s too much demand chasing too little supply (i.e. 10 bidders on the same house) and people expecting inflation creates a self-fulfilling prophecy that causes inflation (i.e. I have to sell my products for more money because inflation is around the corner and I’ll need more money to pay for higher gas prices). The pundits saying the USA will experience hyper inflation and turn into Venezuela or Weimar Germany… is interesting. I wonder what masters they serve. I’m not there and I’m not prepared to use that inflation story as the boogie man to scare people yet.

The Voting Machine vs the Weighing Machine

In the long run… if you purchase a target date retirement index fund and don’t look at it, you will be fine! If you are not fine, our society (as we know it) has crumbled and you’ll of course see this coming. But we are an ESG platform after all so here’s the obligatory pitch! There’s a saying, “in the short term the stock market is a voting machine, but in the long term it is a weighing machine.” What people mean when they say this is that, “eventually high quality companies that make a lot of money will be rewarded in their stock share price”. It is a projection of virtue similar to saying, “if you work really hard and have things that people want, you will succeed”.

There’s a debate occurring right now about the merits of that statement. Some people say that is not true. The “weighing” machine doesn’t really exist! Look at the private equity process of taking companies public I wrote above… it is completely based on the narrative being told and that there are NEW investors willing to pay more than previous investors. We all just lived through GameStop! The stock price does not reflect reality. This has actually been true for a long time. Amazon would NEVER have become the institution it currently is without being able to raise capital like I described above. The argument goes, “By being able to raise capital, Amazon was able to grow into the behemoth it is now. And Amazon is SO far ahead that no competitor will ever challenge it. The winner takes all economy isn’t good and leads to wealth inequality of all kinds, so we vote for a better more equal future! The voting machine greatly effects the weighing machine, or dare we say even more important than the weighing machine.”

There’s a “rotation” by some investors into stocks that don’t prescribe to that method of investing. Today it is the anti-Cathy Wood ARK fund trade. The blue chip dividend paying stocks which have underperformed are suddenly in favor in the Wall Street fashion show! Which is right? Who knows, and you don’t have to pick a side. The stock market is a social contract and if you do what money managers say and invest in a broad basket of diversified stocks… you’ll be OK. And you will be. It’s up to you how much you’d like to dip your toe into the casino of the voting machine vs the weighing machine.