Why the Stock Market is so Good when the Economy is so Bad

Posted by PITHOCRATES - March 31st, 2014

Economics 101

No One is going to get Rich by Buying and Selling only one Share of Stock

It takes money to make money.  I’m sure we all heard that before.  If you want to ‘flip’ a house you need money for a down payment to get a mortgage first.  If you want to start a business you need to save up some money first.  Or borrow it from a family member.  And if you want to get rich by playing the stock market you need money.  A lot of money.  Because you only make money by selling stocks.  And before you can sell them you have to buy them.

Stock prices may go up and down a lot.  But over a period of time the average stock price may only increase a little bit.  So if you bought one share of stock at, say, $35 and sold it later at, say, $37.50 that’s a gain of 7.14%.  Which is pretty impressive.  Just try to earn that with a savings account at a bank.  Of course, you only made a whopping $2.50.  So no one is going to get rich by buying and selling only one share of stock.

However, if you bought 10,000 shares of a stock at $35/share and then sold it later at $37.50 that’s a whole other story.  Your initial stock purchase will cost you $350,000.  And that stock will sell for $375,000 at $37.50/share.  Giving you a gain of $25,000.  Let’s say you make 6 buys and sells in a year like this with the same money.  You buy some stock, hold it a month or so and then sell it.  Then you use that money to buy some more stock, hold it for a month or so and then sell it.  Assuming you replicate the same 7.14% stock gain through all of these transactions the total gain will come to $150,000.  And if you used no more than your original investment of $350,000 during that year that $350,000 will have given you a return on investment of 42.9%.  This is why the rich get richer.  Because they have the money to make money.  Of course, if stock prices move the other way investors can have losses as big as these gains.

Rich Investors benefit most from the Fed’s Quantitative Easing that gives us Near-Zero Interest Rates

Rich investors can make an even higher return on investment by borrowing from a brokerage house.  He or she can open a margin account.  Deposit something of value in it (money, stocks, option, etc.) and use that value as collateral.  This isn’t exactly how it works but it will serve as an illustration.  In our example an investor could open a margin account with a value of $175,000.  So instead of spending $350,000 the investor can borrow $175,000 from the broker and add it to his or her $175,000.  Bringing the total stock investment to $350,000.  Earning that $25,000 by risking half of the previous amount.  Bringing the return on investment to 116.7%.  But these big returns come with even bigger risks.  For if your stock loses value it can make your losses as big as those gains.

Some investors borrow money entirely to make money.  Such as carry trades.  Where an investor will borrow a currency from a low-interest rate country to invest in the currency of a higher-interest rate country.  For example, they could borrow a foreign currency at a near zero interest rate (like the Japanese yen).  Convert that money into U.S. dollars.  And then use that money to buy an American treasury bond paying, say, 2%.  So they basically borrow money for free to invest.  Making a return on investment without using any of his or her money.  However, these carry trades can be very risky.  For if the yen gains value against the U.S. dollar the investor will have to pay back more yen than they borrowed.  Wiping out any gain they made.  Perhaps even turning that gain into a loss.  And a small swing in the exchange rate can create a huge loss.

So there is big money to make in the stock market.  Making money with money.  And investors can make even more money when they borrow money.  Making money with other people’s money.  Something rich investors like doing.  Something rich investors can do because they are rich.  For having money means you don’t have to use your money to make money.  Because having money gives you collateral.  The ability to use other people’s money.  At very attractive interest rates.  In fact, it’s these rich investors that benefit most from the Fed’s quantitative easing that is giving us near-zero interest rates.

People on Wall Street are having the Time of their Lives during the Obama Administration

We are in the worst economic recovery since that following the Great Depression.  Yet the stock market is doing very well.  Investors are making a lot of money.  At a time when businesses are not hiring.  The labor force participation rate has fallen to levels not seen since the Seventies.  People can’t find full-time jobs.  Some are working a part-time job because that’s all they can find.  Some are working 2 part-time jobs.  Or more.  Others have just given up trying to find a full-time job.  People the Bureau of Labor Statistics (BLS) no longer counts when calculating the unemployment rate.

This is the only reason why the unemployment rate has fallen.  If you add the number of people who have left the labor force since President Obama took office to the number the BLS reports as unemployed it would bring the unemployment rate up to 13.7% ((10,459,000 + 10,854,000)/155,724,000) at the end of February.  So the economy is still horrible.  No secret to those struggling in it.  And the median family who has seen their income fall.  So why is the stock market doing so well when businesses are not?  When profitable businesses operations typically drive the stock market?  For when businesses do well they grow and hire more people.  But businesses aren’t growing and hiring more people.  So if it’s not profitable businesses operations raising stock prices what is?  Just how are the rich getting richer when the economy as a whole is stuck in the worst economic recovery since that following the Great Depression?

Because of near zero interest rates.  The Fed has lowered interest rates to near zero to purportedly stimulate the economy.  Which it hasn’t.  When they could lower interest rates no more they started their quantitative easing.  Printing money to buy bonds on the open market.  Flooding the economy with cheap money.  But people aren’t borrowing it.  Because the employment picture is so poor that they just aren’t spending money.  Either because they don’t have a job.  Only have a part time job.  Or are terrified they may lose their job.  And if they do lose their job the last thing they want when unemployed is a lot of debt they can’t service.  And then there’s Obamacare.  Forcing people to buy costly insurance.  Leaving them less to spend on other things.  And increasing the cost of doing business.  Another reason not to hire people.

So the economy is going nowhere.  And because of the bad economy businesses have no intentions of spending or expanding.  So they don’t need any of that cheap money.  So where is it going?  Wall Street.  The only people who are borrowing and spending money.  They’re taking that super cheap money and they’re using it to buy and sell stocks.  They’re buying and selling like never before.  Making huge profits.  Thanks to other people’s money.  This is what is raising stock prices.  Not profitable businesses operations.  But investors bidding up stock prices with borrowed money.  The people on Wall Street are having the time of their lives during the Obama administration.  Because the Obama administration’s policies favor the rich on Wall Street.  Whose only worry these days is if the Fed stops printing money.  Which will raise interest rates.  And end the drunken orgy on Wall Street.  Which is why whenever it appears the Fed will taper (i.e., print less money each month) their quantitative easing because the economy is ‘showing signs of improvement’ investors panic and start selling.  In a rush to lock in their earnings before the stock prices they inflated come crashing down to reality.  For without that ‘free’ money from the Fed the orgy of buying will come to an end.  And no one wants to be the one holding on to those inflated stocks when the bubble bursts.  When there will be no more buyers.  At least, when there will be no more buyers willing to buy at those inflated stock prices.  Which is why investors today hate good economic news.  For there is nothing worse for an investor in the Obama economy than a good economy.



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Property Rights and Contracts

Posted by PITHOCRATES - March 26th, 2012

Economics 101

We put a lot of Money and Time into Maintaining Property we Own so we can Enjoy it Exclusively

Have you ever bought the Brooklyn Bridge?  I hope not.  For if you have someone probably conned you.  Unless you bought it from the New York City Department of Transportation (DOT).  Because they currently own the Brooklyn Bridge.  And are the only ones who can sell it.  But the last I checked they weren’t selling.  So I doubt they sold it to you.  If you are about to enter into negotiations to buy the Brooklyn Bridge I suggest you do a title search first.  To verify that the seller in fact owns the property.  Has the right to sell the property.  And that the seller is selling the property ‘free and clear’.  To make sure you don’t have to pay any outstanding construction bills for work completed on the bridge that the DOT didn’t pay.  Then and only then should you buy your bridge.  So you can enjoy the pride of bridge ownership.  While charging tolls.  And getting rich.

This illustrates a central point about buying and selling things.  Property rights.  Which lets us buy things.  And sell them.  For to sell something we must first own it.  And to buy something we must know that we can own it.  Because if we’re not sure we can own it we’re not going to exchange our hard-earned money for it.  And once we own something we’re going to use it however we wish to use it.  At least that’s what we expect to do.  If we buy a house with a pool in the yard we’re going to want to use that pool exclusively.  Because we paid for it.  And keep it clean.  By maintaining the pool filters and pumps.  Adding chlorine.  Vacuuming the bottom.  We’re going to put a lot of money and time into maintaining that pool so we can enjoy it.  Our little tropical paradise in our own backyard.  But we’re not going to do all of that if just anyone can walk into our yard and use our pool whenever they damn well please.  For if that were the case we wouldn’t spend the time and money in the first place.  We’d look for a pool we could use for free.  Like everyone else who thought they could walk into our yard and use our pool whenever they damn well please.

Or would we?  Let’s say someone in your neighborhood just moved in.  They put in a nice in-the-ground pool.  Spent a fortune on it.  Kept it pristine.  And used it exclusively.  They were happy.  Until the subprime mortgage crisis hit.  And all of a sudden they owed far more on their mortgage than the house was worth.  So one night they just disappeared.  And let the bank have the house.  Once you notice their house is empty you think about that pool.  And decide what could it hurt if you went over for a swim?  You go there.  Notice they left the pumps and filters on.  And the pool is still pretty clean.  So you enjoy a swim or two.  Others find out.  And go over for a swim.  A lot of them.  The pool is crowded.  And not so clean anymore.  No one is skimming the garbage out of it.  Or maintaining the chlorine level.  Some of the kids are even peeing in the pool instead of getting out of it.  Soon the pool begins to smell bad.  Algae is growing.  The filters plug up.  With the water flow blocked the pumps strain and trip the circuit breaker.  Stopping the pumps.  And the filtering.  The crud they filtered out backs up into the pool.  Soon the water turns a greenish gray.  And looks more like a stagnant pond where dead fish float on the surface than the pristine tropical paradise it once was.

We can trace most Pollution and Environmental Damage back to the Tragedy of the Commons

Economists call this the Tragedy of the Commons.  Which is what happens when we poorly define our property rights.  In our example the pool was clean and enjoyable when someone owned the pool.  When no one owned the pool (after the previous owners abandoned it) the pool became dirty and no longer enjoyable.  Why?  Because when we own something we have an incentive to take care of it.  For our long-term enjoyment.  When no one owns it no one has an incentive to take care of it.  Some may try but others will continue to pollute.  Because they don’t own it.  And have no incentive to spend the time and money to keep it clean.  Especially when others are still polluting.  So no one tries to keep the pool clean.  They’ll enjoy it while they can.  And when the pollution gets so bad they will move on and find something else to enjoy. 

We can trace most pollution and environmental damage back to the Tragedy of the Commons.  If you love the beach so much that you buy a house on it you will keep your beach clean.  You’re not going to litter it with cigarette butts, empty bottles, food wrappers, used condoms, etc.  A public beach, on the other hand, is a different story.  Just as people will take their trash to a public field to dump it.  Because they don’t own that land and have no incentive NOT to pollute it.  And it’s cheaper than taking their trash to the private landfill that charges a fee.  Who helps to keep America beautiful by burying our trash.  And when the landfill is full someone else will buy it and make a beautiful golf course out of it.  Or something else.  As long as someone owns it something nice will happen with that land.  To maintain the value of that land to the landowner.

When you own something it has value to you.  Such as a logging company cutting down trees on land they own.  Because this land has value they will not over-log it.  And when they cut down trees they will plant new seedlings.  So the land continues to have value.  Because they will be able to cut down these seedlings after they grow into trees.  Or the future owner of that land will be able to.  Who will buy that land because it has value.  Whereas there is no incentive for a private logger working on public land NOT to over-log it.  Or to plant seedlings.  Because they don’t own that land.  Anything they don’t cut down some other logging company will.  And without any property rights to that land they won’t plant any seedlings.  Because nothing will prevent anyone else from cutting these down once they grow into trees.

Well Defined Property Rights allow Buyers and Sellers to Enter into Contracts with one Another

To do all of this buying and selling we need well defined property rights.  Clearly spelling out what the seller owns.  And what exactly the buyer is buying.  For example, a logging company buying a tree farm may want to drill an exploratory well to see if there is oil or natural gas under that land.  So he or she will want to make sure that the terms of the sale include all mineral rights.  Paying additional for these rights if necessary.  Or getting the tree farm at a lower price than other comparable tree farms because the seller wants to retain the mineral rights.

Well defined property rights allow buyers and sellers to enter into contracts with one another.  Contracts clearly state the terms of sale and any other special provisions.  Such as the seller retaining his or her right to have his or her pick of one tree anywhere on that land once a year in the month of December.  As long as buyer and seller freely enter into these agreements they expect each other to honor the terms of the contract.  And only when both parties honor the terms of the contract does the ownership of property transfer from one party to another.

Property has value.  Even the Brooklyn Bridge.  And well defined property rights protect that value.  Because the DOT owns that bridge they spend money to maintain that bridge.  A well-maintained bridge provides value for those who want to cross the East River.  Currently the various taxes they pay to the city and state make their way to the DOT.  To pay for that maintenance.  But if the city of New York found itself in serious financial trouble they could sell the Brooklyn Bridge.  To a private person.  Who wants to put up toll booths on the bridge.  The city gets a large sum of money to help with their financial trouble.  And the new private owner gets a revenue stream in the form of tolls.  And the city of New York will, of course, screw those crossing the East River.  Because they’ll now have to pay a toll to cross the Brooklyn Bridge.  But they won’t get any of their taxes back.  Because governments rarely if ever cut their taxes.  The city and the private person do well because they both have well defined property rights.  And a contract.  The people using the bridge don’t.  They had no contract with the city that clearly stated the terms for their use of that bridge.  And will continue to pay the taxes that paid their crossing fees.  As well as the new tolls.  Which is business as usual.  Because government always screws the taxpayers.  Who are always at a disadvantage when it comes to property rights and contracts when dealing with the government.  For government has the power to break contracts and take property.  Unlike private persons entering into contracts.  Who only transfer the ownership of property by mutual consent.



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