For anyone who owns a security, whether it is a stock, bond, mutual fund, or ETF, it is important to understand a little bit about how the market works. The media and the investment community make this a little harder because we’re often told that the “market” is doing things that aren’t always its fault. So let’s dig in.
Stock Indices
The S&P 500, The Dow, The NASDAQ…these are stock indices. The Dow (The Dow Jones Industrial Average) is an index which is an aggregated price-weighted index of 30 companies that are chosen to represent the US industrial sector. More on the Dow here. Simply put, it is a basket of stocks chosen to represent our economy.
And there are lots and lots of indices. Whether you’re buying a US bond or an emerging market bond, there is likely an index that represents that demographic.
The Exchanges
There are lots of exchanges too. The most well known are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ). But you told me NASDAQ was an index!!…we’ll go back to that in a sec.
And there are other exchanges for bonds and foreign stocks and commodities and futures…
Think of an exchange as a designated spot where buyers and sellers can come together to trade. Think of a farmers market. Lots of farmers load up their produce and take it to the farmer’s market to sell. Lots of customers who want fresh produce go to the farmer’s market to buy. The market area itself is a plot of land, which may have some stalls. The farmers likely pay to reserve a stall, but other than that, the market really doesn’t participate.
I’m looking to buy some corn. I go to the market, find a stand that is selling fresh corn, I talk with the farmer and if I agree to the price, I buy. I have a friend who negotiates everything. I’ve never seen her pay listed price at a farmer’s market.
The securities exchanges work the same way. The NYSE, the NASDAQ or other exchanges provide the technology platform on which the trades are made. In the old days, trading was done on the stock exchange floor. You’ve seen this in movies. Actual people standing on the NYSE floor yelling bid and ask prices.
The exchange provides a place for the trading to happen, but the market participants, buyers and sellers set the price and do the actual trading.
Market Makers
There are large investment firms that play the role of market makers. Sometimes this is a formal designation, sometimes less formal. The market makers are responsible for creating liquidity. That’s a confusing sentence that basically says that the market maker needs to have inventory of a particular security and they need to buy when no one is buying and sell when no one is selling. They make lots of money on the bid/ask spread, but that’s a story for another day…
But while the market makers trade huge volumes and are compelled to trade when buyers can’t find sellers or vice versa, market makers trade just like other market participants.
Market Participants
That’s us. And mutual funds, and pension plans and corporations and anyone else who is buying and selling securities. And brokers.
Brokers are market participants that do buying and selling on behalf of customers. I trade through a broker. Fidelity is my broker. Many people use the Robinhood app. Robinhood does the trading, so Robinhood is the broker.
Brokers sometimes charge a commission, but thanks to Robinhood, who was the first to go commission-free, commissions have mostly gone the way of the dinosaur for us retail investors.
Wrap-Up
So why is all of this important? Often, and especially over the last 2 days, we’ve heard that the market is rigged. Or that the market favors the big players. Small players don’t have a chance.
But the market itself, has no intentions. Whether it’s the NYSE, the NASDAQ, or another market, the market itself provides a platform. The NYSE charges IBM and other companies a fee to list. It also has rules for how a company needs to behave in order to remain on the platform, but other than that, the market isn’t involved.
Prices are determined solely by buyers and sellers. The market participants set the price through their bids and asks.
Why Does the Market Go Down?
Again, to be precise, the market doesn’t really go down. The prices of the companies that trade on an exchange go down. Some days, Boeing (Ticker: BA) may have some bad news. Based on the news, market participants are less optimistic about the future earnings that Boeing will produce.
Because of this, potential buyers will reevaluate the price they’d like to pay and will bid less for shares of Boeing. Sellers will recognize that the shares they hold are worth less today than they were worth yesterday. The’ll have to drop their ask price.
You’ll often hear people say the market is efficient. This is because millions of investors are constantly analyzing information about companies. When a company even hints at a possible earnings surprise, analysts and investors pull up their spreadsheets and recalculate their price target for the company. A positive surprise and the price goes up, negative surprise, it goes down. This all happens in seconds.
Tariffs
The US tariff announcement sent the price of many companies down. It wasn’t just one company that got bad news, it was (almost) all of them.
Not a lot of stuff is produced entirely in the US, most companies import parts or entire finished goods from other countries. Apple is a great American company. Open up your iPhone. The computer chips likely came from Taiwan Semiconductor Manufacturing in Taiwan and the phone itself was probably manufactured at the Foxconn factory in China.
So this means the price of an iPhone is probably going up. Apple may absorb some of the cost, but some of the increase will get passed to consumers.
Uncertainty
Even in the example above with Apple. It’s not entirely clear what the impact will be. Taiwan and China are both involved. But we’ve heard that semiconductors will be excluded from tariffs. It’s hard for analysts to fully assess the impact on the price of an iPhone, and thus the impact on the earnings of Apple, so they’re extra conservative in reevaluating price targets. And many investors who may have been thinking about buying shares decide to hold off a bit to see how this plays out. This uncertainty means buyers are bidding less and sellers need to ask for a lower price.
Uncertainty (2)
And there is uncertainty with the companies as well. Let’s look at Nike. They make a lot of their sneakers in Viet Nam. Viet Nam now has a 46% tariff. Nike, as well as analysts and most investors were not prepared for this.
What will Nike do? Should they shut down factories in Viet Nam and start building them in a country with lower tariffs? Do they move manufacturing to the US? Costs are higher, but no tariffs. But then we hear that Viet Nam wants to negotiate their 46% tariff down to zero. Maybe Nike should just stay put. More uncertainty, which as we know is bad for stock prices.
Company Valuation
As it stands right now, any US company (which is almost all) that imports from outside the US will pay more for the stuff they import. Paying more will hurt earnings. And they’ll probably have to pass some of the cost on to consumers, who will buy less. Lower sales will also adversely impact earnings.
With this double edged sword of higher cost and lower demand, future earnings start to look dismal. The result is investors are willing to pay less for those lower earnings.
Add in the uncertainty, and prices across the board drop.
Indices
The indices, whether it is the Dow, The NASDAQ, or any other is based on the price of the securities that make up the index. So if all the securities are down, the index will be down.
Is The Market Rigged?
This is a question I hear often and the reason that I think it is important to understand how markets work. The belief that the market is rigged and the small guys like us can’t win against the big guys, causes many potential investors to stay away. This is a problem.
So, is the market rigged?
No and Yes.
But it is very important to understand why. As we said, the market itself – the exchange – is the platform where securities are bought and sold. It has no influence. Prices are set based on the buyer’s bids, and the seller’s asks. So no, it is not rigged.
However, if you expect to make money trading rather than investing, this is much more difficult to do today than it was 30 years ago. 30 years ago, we waited for the afternoon paper to see the closing price of our companies. Very little happened during the day. It’s not like today where dozens of financial news channels spew information at us constantly.
To make money trading, we need to find some piece of information that no one else has discovered and exploit it. With a slower news cycle, this was a little easier to do. We could read through a company’s report (that was mailed to us) and find a nugget of information and then call our broker in the morning to place a trade in hopes that we got ahead of everyone else.
Today, huge trading firms that put their computers in New Jersey to be close to the exchange’s computers (and exploit sub-second trading advantages) analyze every piece of data on every single security, in real time. These computers can recognize a potential nugget and place a trade before we can bring up Yahoo Finance.
So, if you’re trying to make money trading, the tools and the proximity of the big firms put us at a distinct disadvantage.
But buy and hold still works. If we’re holding for 20 years, a small fraction of a percent price difference on our purchase (v. the trading firms) isn’t going to matter. We expect our investment to double many times over.
Wrap-Up (Again)
Apparently I wasn’t ready to wrap-up just yet. Now I’m ready. Promise.
How’s the market today? We’re really asking what the indices are doing. The S&P 500 is down 4%. The market is down.
The market is made up of participants – individuals and firms that trade securities. These individuals set the prices with their bids and asks. The market doesn’t play a role.
And the indices are groups of companies that represent a perspective or demographic. The S&P 500 is made up of the 500 largest publicly traded US companies. The Dow is made up of 30 companies chosen by Dow Jones to represent the US industrial economy.
And the NASDAQ…remember…is an exchange. Amazon and Alphabet trade on the NASDAQ. The NASDAQ is also an index. See what wikipedia has to say
So see – it’s both an exchange and an index…
Understanding the markets, market participants and indices, as well as understanding that price movements are based on investor’s expectations of earnings, all help us make better investing decisions.
These things aren’t a mystery, but sometimes it feels that way when many of our favorite companies, or mutual funds, drop 10% or more in just a few days.