Why can't we all agree to create a self-fulfilling prophecy with regards to the stock market?

Question

To start off, I'm very green in my understanding about finance or the behavior of the stock market, but it does seem to me to be driven largely by fears & emotions of investors. If investors feel optimistic, they'll buy more stock, and on aggregate, this behavior drives up the market. The opposite happens when investors are fearful of the future or of shrinking stock values.

Given this, I have (I'm sure) a stupid question. As it relates to the stock market, why can't we create a mutually agreed-upon pact that we'll all be optimistic about the future, not sell our stocks, and watch the market climb in happy merriment?

I realize that in a free market we can't force anyone to hold onto stocks or sell them. But another way to ask my question might be: why can't we create a self-fulfilling prophecy of optimism in the market, thus benefiting everyone with investments in the stock market? If we're all optimistic about the market's prospects (or at least act like it), doesn't everyone benefit? Who wins when we're scared of the future?

Answer 1

Instead of stocks, let’s apply this logic to houses.

Houses are expensive. However, if I buy a house at a high price, I’m okay if I can sell it for more than I bought it for at some point in the future. As long as the prices continue to climb, everyone is happy, right? So let’s decide to make a law that says that a house can never go down in value; whatever the house sells for today, the next time it is sold, it must be at a higher price.

Now, let’s say that I am ready to move to a new house, and I want to sell my current house. With the new law, I now have a minimum price that I am required to sell at. However, what if no one wants to buy at that price? I’m stuck. The only thing I can do is wait until someday when someone comes by and decides to offer that minimum price. It might be a long wait.

Before the new law, if I needed to sell in a hurry, I could simply lower my price until there were buyers prepared to offer at that price.

This is exactly how stocks work. When you own a stock, no one is forcing you to sell at any price. You can decide to hold onto your stock as long as you want until you find a buyer that is willing to pay the price you want. But you may have to wait a long time if your desired price is too high. Because just as you have the freedom to sell at any price you want, the buyers also have the freedom to buy at any price they want. And a sale only happens when a buyer and seller agree on a price.

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You say that you aren’t suggesting government regulation, but the principle is the same. If I decide personally to only sell my house at a profit, I may be stuck if I can’t find a buyer willing to pay my price. And I’m competing with my neighbors who are also selling.

But let’s pretend that I succeeded in convincing a large number of people that my house, and even my city was on the way up, and that housing prices will only continue to rise.

This goes on for a while, and housing prices in my city continue to rise. However, at some point, they get so high that there aren’t enough buyers that have enough money to move into my city. Perhaps the buyers will move to a different city, or they will build their own house, or they will rent an apartment. In any case, at that point home sales will stop until prices inevitably fall.

And again, it is the same with stocks. When I want to sell my stock, I am competing with everyone else trying to sell the same stock or different stocks. I am also competing with every other type of investment offer. I am competing with the bank that pays interest, real estate investments, precious metals, bonds, etc. At some point, my price will get so high that the other investments are simply a better deal.

Answer 2

Why can't we create a self-fulfilling prophecy of optimism in the market, thus benefiting everyone with investments in the stock market?

Because a stock market is not a magic money-printing machine. Whenever you sell a stock, that money comes from the person who bought that stock. The whole system can't generate more money than people put into it.

To simplify the situation, let's say the stock market is just you and me. I sell you a worthless piece of paper for $1. Tomorrow you sell it back to me for $2. The day after I sell it back to you for $3, and so on and so on. It seems like the paper becomes more and more valuable. We are getting rich!

But do the two of us actually get any richer? No, we just keep moving an ever growing stack of money between us... a stack of money which comes from our pockets. And while we do that, that money is bound in our system. We can not spend it on anything else. So we actually have less liquid capital to work with. In practice we are actually getting poorer.

At some point in time one of us will say "stop it, this is stupid. I will keep the money and not buy that paper back". At that point, that person will have earned money. But the same amount of money is now missing from the other person. It was just a game we played which redistributed our money. It didn't create any.

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This is why experienced investors start to become nervous about "bubbles" which are "about to burst" when a market is climbing uncontrollably. They realize people started to play the game described above. The assets people trade are no longer traded for the actual economic value they represent. They are traded for what optimistic people believe even more optimistic people will pay for it in the future. The experienced investors know that it's just a matter of time until some people stop playing the game and just keep the money of the other players.

Answer 3

Watching the market climb in happy merriment doesn't earn you a single penny until you actually sell your stock. No matter how optimistic you are, sometimes you will still want to sell:

• because you need the money now
• because there's a stock that performs even better, and you're losing money by not investing in it, even if the stock you have keeps going up.

Once there are sellers on the market, the charm of self-fulfilling prophecy disappears, because buyers will only be willing to buy if the selling price is low enough.

Answer 4

A stock is worth only what someone will pay for it.

There are two reasons to buy a stock:

1. It pays a dividend. The amount of this dividend justifies buying the stock (much like collecting rent justifies buying a rental property).

2. It can be sold to someone in the future for more money.

In both of these cases, as the price rises, it becomes harder to sell. Eventually, you will not be able to find a buyer, and at that point, you either cannot sell it, or you must reduce the price to sell it.

In the first case, assume there is a stock that pays $1 / year. If I buy it for $10, it will have paid for itself in 10 years, and will then be profitable. That seems wise. But what about at $20? Or $200? Every time that price increases, the stock becomes less and less of a good buy. At some point, no one will buy it.

In the second case: There is a stock that sells today for $100 a share, but the company made a billion dollars profit. Their stock price is likely to go up. Now it's next year and the company's stock is $150, but they report no profit. Am I still thinking that the price is going to go up? What if the next year, it's at $170, but the company reports that they lost twelve billion dollars. Is that stock price going to continue to go up? There could be some pact where you never sell at a lower price than you bought it, but eventually that company is going to go bankrupt, rendering its stock worthless (because no one will buy it). As you get closer and closer to that point, it is more likely people will defect (sell the stock at a loss, rather than holding it and losing everything) to mitigate their losses.

Answer 5

You are right that the market cap of a publicly traded company is determined by the sentiment of the investors trading that company's stock. You are also right that investor sentiment is fairly arbitrary. However I cannot imagine a world where investor sentiment remains completely uncorrelated to the company's value indefinitely.

As an extreme example, imagine a company's chance of going bankrupt is increasing. Why would the investors trading that company's stock be willing in aggregate to continue to play hot potato with the company's stock, paying increasingly higher prices knowing they are increasingly likely to lose their entire investment.

Even in a world where stock price was completely independent of a company's value, perpetual optimism is not a stable equilibrium. Investor sentiment could only indefinitely raise the price if demand was indefinitely and monotonically increasing. Demand is necessarily noisy because individuals will need to sell their stocks to get cash at random times and people will be bringing new money to the market at random times. So, if the price is solely based on sentiment and demand is noisy then the price is noisy. If the price is noisy, optimism about monotonically increasing prices could not survive.

Answer 6

This is not too far from how the world actually works.

If everyone knew stocks would always go up:

1. Everyone would buy stocks until they were out of cash.
2. Having no cash, people could pay for their groceries in stocks.
3. Corporations could always raise more money by issuing more stock.
4. Everyone being out of cash, you'd think no one could buy this new stock. Unless...
5. Banks, knowing stocks are an infallible investment, would issue loans with stocks as collateral. The intense demand for borrowing money causes banks to lower their interest rates, and there's no lower bound on how low they will go because stocks can't fail so they never lose money.
6. Everyone, individuals and corporations, takes advantage of this free money from banks, so everyone has a gazillion dollars.
7. Everyone wants a beachfront mansion, but there isn't enough wood to build them, nor is there any labor because everyone would rather stay home buying stocks.
8. Consequently, prices for materials and labor go way up, so although everyone has a lot more money, that doesn't translate into more buying power.

This is called hyperinflation, and it happens from time to time. But usually there are "brakes" on this viscous cycle of borrowing money to buy things then using those things as collateral to borrow more money.

First, minimum deposit requirements. Banking regulations require that some fraction of their balance sheet can't be loaned. So if I put $100 in a bank, the bank can't then re-loan all of it. Some of it needs to be cash in a vault, on deposit with a central bank, etc. Requirements vary based on the type of account and jurisdiction.

Also, central bank interest rates. If a bank gets a request to withdraw more than they have cash on hand, they can borrow from a central bank, which will charge interest. Or they can avoid borrowing from the central bank, but that means they can't loan as much money.

Furthermore taxes siphon money off the economic vortex. The government can then decide what happens to the money.

These knobs get twiddled by policy makers to keep the "self-fulfilling prophecy" just realistic enough to generate healthy economic activity, while not exploding into hyperinflation. (They also get twiddled to further political careers.) Some examples of monetary policy in play, in no particular order:

• Negative interest rates in Europe
• The market correction earlier this month in the US
• Tax cut stimulus
• Quantitative easing

Answer 7

Let's assume everyone agrees to this and nobody tries exploiting it.

So stock prices go up and up and up. Everyone is happy and getting richer with every stock they buy and sell. Right?

But wait. Where's that money actually coming from? Other people! Investing their savings. But what happens when everyone has invested everything?

At some point, all the money will be in the stock market. If you need some, you sell a stock, but someone else needs to pay you. So they sell some stock. But someone needs to pay that. So they sell some stock. Do you see where this is going?

Now I left something out. Stock isn't just paper, there's a company behind it generating money (hopefully). But that money isn't dependent on the stock price so it becomes minuscule when the prices rise more and more.

So let's print more money. But wait. Doesn't that make prices rise? So actually the real value of the stock is now falling because it's rising. Damn.

(This is all completely over simplified and ignores a number of important topics, but:)

My point is: where does the money come from?

Right now the companies are generating money and stock value shows how much the market values that future possible money. If you take that away you need a different source of money -> other investors. Because those cannot pump infinite amounts of money into the market, at some point this scheme breaks. It suddenly deflates. That's why it's called a bubble.

Answer 8

why can't we create a self-fulfilling prophecy of optimism in the market, thus benefiting everyone with investments in the stock market?

You could probably maintain something like that for a very long time, if everybody in the world was on board. However, people can make money when the stock market goes down. A lot of money, in fact. The great stock market crashes always make a small swath of extremely wealthy individuals who had been betting that the market would drop. There would be people who saw the potential for great wealth through cheating and dragging down the market - some of them will try it, I can guarantee you.

Any position, high or low, which deviates from the 'real' value of a security or instrument can be exploited by arbitrage or some other technique. Your optimism/pact is not immune to this.

Answer 9

Because the market must always have an equal number of optimists and pessimists. For every optimist (someone buying shares, or otherwise taking a long position) there has to be a pessimist (someone selling shares, or otherwise taking a short position). Without pessimists, the optimists can’t do anything (and vice versa). The market price is the price at which the numbers of optimists and pessimists are exactly equal.

Answer 10

Mutually agreed upon persistent optimism would be exploited. If a market participant knows you'll irrationally buy for higher and higher prices no matter the news or performance of the company a strategy could be derived to exploit that. Then the persistent optimism fails.

To your second question, the short side of the trade wins when the market falls.

Answer 11

If share prices are below the productive value of the underlying assets, then I think the questioner's suggestions of benefit from a rise is correct.

It is when asset prices are higher than the productive value of the underlying assets, that the problems mentioned by other commentators above can become dominant.

Of course this begs the question as to whether the market is under or over-valued. The traditional way of deciding this was simply for people to look at typical companies, and see whether they wanted to invest in those assets or not. For example, when I look at the current FTSE100 earnings of 3.4% (I.e. Price to Earnings of 28.8) and then add another 2% for earnings growth to get an expected 5.4% return, I think it is worth investing. In doing so I raise the price of shares, and so reduce the long term return. Even if this mechanism has largely been replaced by Central Banks deciding if things are overheated or not, at least in the long term it should still be rational to ignore the Bank of England pundits and act according to the market fundamentals.

Note that this ignores the problems produced by the changes in share prices needed to get to their real asset value. However these might be better tacked by a more imaginative capital gains tax policy. In any case, a most interesting question.

Answer 12

Although there are legal limitations to coordinating such a buying pact, there are ways you can effectively do this with great results.

Call your broker and turn off the borrow.

Many sellers in the markets are simply borrowing shares for their short selling position.

If you and all your friends make it so that the shares owned are not borrowable, then you nuke many of the sellers and vaporize a lot of the selling pressure.

People that have already borrowed for an active short selling position will be forced to return the shares, which is done by buying back. The cascades on itself and causes a short squeeze, sending prices through the roof.

You can look stocks that are primed for a bigger squeeze by finding the open interest of short sellers and how many 'days to cover' there are. Days to cover is just based on the average daily volume of a stock, and how many days it would take for short sellers to buy back that much given how much is usually traded. The more days to cover reported, the more desperate a short seller will be exacerbating the squeeze.

(The flip side is that there is probably a good reason they are short.)

Answer 13

The existing answers fail to convey a very important point: if nobody sells the stock, how is the price defined? Price is dependent on there being both buyers and sellers at all times. If nobody is selling, the price cannot be defined.

Markets work well only if there are both buyers and sellers, and an equal amount of both of them. The price is defined in such a manner that at that price, there are as many buyers as there are sellers.

Of course, if nobody sells, one can type into Excel progressively increasing values for the stock using a flawed theory of valuation. That's just accounting fraud, however, and the fraud will become clear once there will be sellers.

Answer 14

"Cartel game"/ Why can't three or more one-side market participants to agree upon the price which benefits them all?

Same as always, it actually works. But, until someone is closing his participation in that "treaty". If "treaty" was used by unequal participants, the bigger one like "buffett" or "gates" can pay for the inside information about the market and quit before the collapse. Rendering other "newcomers" or "true believers" in loss.

Check the recent case of General Electric. Buffett paid for information and quit the business before it collapsed.

Result. Ideal market with full information does not exist. So one participant will never know what other participants are doing or the full underlying information about the asset (which could be bought only by high-ranking funds).

Answer 15

What you describe applies fairly well to the conceivably simpler, and simpler-to-understand, concept of money. Money — as opposed to shares in a company — has no intrinsic value whatsoever. Its value is entirely determined by a mutual agreement, often backed by a government or government agency. When that agreement fades, money can very quickly lose its value. That has happened in the past with hyper-inflation, and almost happened recently with the Euro.

So yes, the concept works, in principle.

Answer 16

Market behavior is by definition irrational, so individuals agreeing to do something would violate that basic, yet very important, principle. Even if people did agree to behave rationally when trading, there would be no logical reason for them to agree upon a single outcome. The only reason people buy and sell stocks is that they have the immediate value of being stable, or the perceived value of rising in the future to be sold off before they drop. There is no 'common good' in the stock market, and if there were, people still would not rationally act to achieve it.