Wednesday, June 21, 2006

Money Flows and Stock Prices

One of my pet peeves is hearing people talk about money "flowing into or out of" stocks in an attempt to explain changing prices. Obviously for every seller there is a buyer, and vice versa, so money can't flow into or out of asset classes the way so many pundits assert. As such I was gratified to see John Hussman make this point in one of John Mauldin's "Outside The Box" newsletters [dated Feb 6th, and yes that is how far behind I am in my reading and blogging :-( ]. Here are the relevant paragraphs from the original piece:
Few arguments make me wince as reliably as statements that disregard the concept of equilibrium. The fact is that stock markets don't go down because investors withdraw money from the stock market and put it elsewhere, and they don't advance because investors take money from elsewhere and put it “into” stocks. Bear markets occur without any net removal or redeployment of funds out of the stock market. Likewise, bull markets do not rely on “net inflow” of funds from investors. A moment's reflection should make it obvious that for every person selling stock and taking money “out of the market” stands a buyer of the stock who is putting that exact same number of dollars “into the market.” The whole concept of “money flow” is nothing but an oversight of this fact.

Except for new issuance of stock, money never flows “into” the stock market – merely through it. Even in new issuance, what's really going on is that new savings – new income left over after consumption and taxes – flows directly from individuals to the corporations issuing the stock, in order to finance new investment. I say “new” savings because if the investor gets the funds to buy the newly issued stock by selling other securities, some other investor would have had to buy those securities with their savings, and that argument can be repeated indefinitely until the only source of the funds, at bottom, must be somebody who earned new income and didn't spend it. So stock issuance represents a transfer of income saved by individuals to corporations, who then deploy those savings by investing in factories, equipment, and other assets. As always, savings equal investment in equilibrium.

Similarly, except for buyouts, takeovers and net repurchases of stock, money doesn't flow “out” of the stock market when an investors sells. (I say “net” repurchases because the majority of stock repurchases made by corporations are executed merely to offset the dilution that occurs when corporations grant stock and options as compensation. So net repurchases represent a transfer of income saved by corporations to individuals who then deploy those savings.)

The idea that bear markets don't require a withdrawal of funds from the stock market, and that bull markets don't require an “inflow” of funds, can be difficult to accept at first. There's a natural tendency to think of the stock market as one big “representative” investor, and that this huge Gulliver allocates his pool of savings across stocks, bonds, T-bills and so forth, driving prices up and down as those allocations change. But that's not the way markets work. The whole concept of a secondary market (a market for securities that have been issued) is that all issued securities must be held by someone – when buyers meet sellers, the money held by the buyer goes into the hands of the seller, and the share held by the seller goes into the hands of the buyer. There is exactly the same number of shares outstanding after the transaction as before, and exactly the same amount of “money on the sidelines.”


Blogger SN said...

Thanks for the reference. Seems like a good source.

6:49 AM  
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10:41 AM  

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