On Feb. 5, 2018, the U.S. stock market plunged by around 4%. It wasn’t the first time, and it won’t be the last, so if you find your eyes glazing over at mentions of this index, that infamous precedent, and that zoological metaphor, not to fear. You can get the rundown here, or follow the links to our financial dictionary entries to read more thorough explanations.
What are stocks and bonds?
First of all, you need to understand what stocks are – and how to tell them apart from their sister securities, bonds. Both are ways for companies to finance themselves, that is, to raise money.
Stock, an individual unit of which is called a share, (basically) represents an ownership stake in a company. If you gobble up more than half of a company’s shares, you’re the majority owner; all of them, and you own the company outright. Stock is also called equity: just as you can have equity in a house, you can have equity in a company.
Shares often come with additional goodies: they commonly confer voting rights in elections to the company’s board and on issues of company policy. Also common are dividends: cash payments the company makes to shareholders on a monthly, quarterly, annual or when-they’re-feeling-flush basis. These payments are made on a per-share basis; votes are counted the same way.
Bonds are a different story. They are essentially loans the company takes out from bondholders, who can be retail investors – the little guy, you and me – or whoever else: pension funds, central banks and sovereign wealth funds are big bond buyers. Bonds don’t give their holders an ownership stake; they represent a debt owed by the company, which makes interest or “coupon” payments until the bond has matured – expired, essentially. Then the company pays back the face value. (This is a generic example; the exact terms vary.)
When things are running smoothly, shareholders have more clout than bondholders, due to their voting power. When a company goes into bankruptcy, however, the bondholders (or “creditors”) get first dibs on the company’s assets, while the once-mighty owners receive their cut of whatever’s left, if anything.
Talk to me about “the market”
Companies sell their stocks to investors in initial public offerings (IPOs); there’s no fun acronym for issuing bonds. They take in whatever cash those sales earn, and then they’re largely out of the picture, interest and dividend payments aside. Stock markets and bond markets are what are known as secondary markets, where people trade securities (stocks and bonds) among themselves.
This is where the value of shares and bonds goes up and down, where retail investors and hedge funds alike make their fortunes or meet their ruin. What happens on the secondary markets reflects the state of companies more than it affects them, but if a stock is tanking, shareholders are likely to get upset and vote the bums – the board members – out.
A note about pricing. Stocks are quoted in price per share. A share of Apple Inc. (AAPL is the ticker symbol) at the time of writing is worth $156.94. Companies can issue any number of shares: Apple has 5.37 billion shares outstanding. Multiply those to get the “market capitalization”: what the stock market says the whole company is worth. Currently that’s $839.9 billion.
Bonds are a bit more confusing. A bond has a price and a yield. Both move up and down in response to market sentiment, but in opposite directions. That’s because the company or government makes fixed interest payments, so if the price of the bond goes up, the yield – the payments as a percentage of the price – goes down, and vice-versa. So if you see that bond yields are “spiking,” that means the market is bearish on bonds. (See also, Bond Basics Tutorial.)
Bulls and bears
Sorry, bearish? Two totems dominate the market pantheon: the bull, the patron beast of rising prices, exuberance, greed, health and good cheer; and the bear, the patron beast of falling prices, fear, weeping and gnashing of teeth. A bull market is one in which prices are rising. A bull (person) is an individual who expects them to begin or keep doing so. You can be bullish on Apple, on 10-year Treasuries, on the entire stock market. It can be a permanent disposition or specific to a given security at a given time.
A bear market denotes a fall of at least 20% from the market’s recent peak. A 10% fall is called a correction; smaller declines go by a set of clichés including “wobbles,” “slumps,” “swoons,” “gyrations” and “williwaws” (okay not that last one). Truly painful plunges of 40%, 50% and 60% are crashes. In general, bull markets begin gradually, building momentum over time, but always – as an old Wall Street adage goes – “taking the stairs.” Bears, by contrast, “jump out the window.” Once the market hits its lowest point and begins to rise again, a new bull begins.
Note that if you’re bearish on a given stock, that doesn’t mean you have to sit on the sidelines. You can short a stock and profit if it goes down by borrowing a share, selling it, then buying it back later at a lower price and giving the share back. There are a couple of problems with this approach, though, originating with the fact the price of the stock can go up despite your most fervent wishes. And there is no limit to how far up.
When you buy a stock in the regular way (long), the worst-case scenario is that it goes to zero, and you lose your entire initial investment. With a short bet, you can lose far more, since the stock can keep going up and up and up and up. Worse, when you borrow a share, as with anything you hold without owning, you pay interest until you return it. Shorting is a dangerous game: even if you’re right, so long as you’re early, you’re still broke.
It’s easy enough to quantify what Apple’s stock did in a given day (market hours are 9:30 a.m. to 4:00 p.m. ET, by the way), week or year. There’s just one price, unless of course you want to get into the nitty-gritty of bids and asks. But what about the stock market as a whole?
It’s impossible, in a strict sense, to trade a share of “the market,” so it’s equally impossible to assign a price to it. The market is just the aggregate of all the stocks available to trade. But of course this aggregate experiences up-and-down movements which are useful to capture.
This is where indexes (or indices) come in. The most famous index is the Dow Jones Industrial Average – just the Dow in casual settings – and it is garbage. You should ignore it. It was designed in the 1890s using methods so shoddy that they boggle the statistically-inclined mind. Worse than its terrible architecture is the use the media makes of it. Pundits have a habit of referring to the Dow’s “points,” leading them to say things like, “today, the Dow fell as much as 1,579 points – the largest intraday-point drop in the history of the index.”
On that date, Feb. 5, 2018, the Dow fell 1596.65 from an intraday high of 25,520.53 points: the intraday low was 6.3% below the high. On Oct. 19, 1987, the Dow fell by far fewer meaningless “points” – just 508 – but from a level of around 2,000 points – not 25,000. Black Monday, as the 1987 flash crash is known, saw a 22.6% drop. Feb. 5, 2018 saw a 4.6% drop. What kind of “record” is that?
The media will mention the Dow every chance they get. Ignore them. There are a number of sensible, useful indices you can use to track the performance of the U.S. stock market. The most popular is the Standard & Poor’s 500 Index (S&P 500). No one would blame you for favoring the Russell 3000.
A note on the impossibility of trading a share in “the market.” Innovation in financial instruments has made something practically similar possible. By purchasing large stakes in a wide range of publicly traded companies, financial services companies have begun to offer funds that track indices such as the S&P 500 and yes, the Dow. These come in two broad types: index funds and the newer, more tax-efficient but less battle-tested index exchange-traded funds (ETFs).
Many investors prefer these instruments to picking individual stocks, calling their strategy passive – as opposed to active, stock-picking – investing. Warren Buffett, one of the most famous investors ever to live, urges the public to invest passively and made a bet with a hedge fund to prove it’s the best strategy. But Buffett made his fortune picking stocks.
Okay, you know the terminology. But this newfound knowledge has failed to arrest the market’s decline, you don’t know what’s causing it, and you don’t know what to do.
To misquote Tolstoy, “Happy markets are all alike; every unhappy market is unhappy in its own way.” When stocks are going up, that’s because going up is simply what stocks do. When they go down, there’s always a culprit – but there’s not always agreement about who it is initially, and it’s never who you expected.
In the heady days of 2006, it was inconceivable that securities based on mortgages could ever lead to market turmoil. There existed no safer bet than the creditworthiness of the American homeowner. Except the ones who were being given mortgages with no income and no assets. Chaos ensued, beginning in 2007 as foreclosures piled up and accelerating in 2008 as banks exposed to these mortages began to go under.
Since then the market has gone into tizzies for all and sundry reasons, although the bull market that began at the bottom in March 2009 has yet to end. In 2011 political battles over the national debt spooked investors, due to the fact that the entire post-War global financial edifice is built on the assumption that the U.S. government pays its debts. When Standard & Poor’s downgraded the nation’s credit rating, you would have thought a Lannister had defaulted.
In mid-2015 fear reared its ugly head again. This time it was China’s sudden devaluation of the yuan that sent the bears careening window-ward. Then in early 2016 it was the prospect of a hard landing by the Chinese economy, which had grown a breakneck pace for two decades, and threatened to yank away global demand for raw materials and manufactured goods alike. Simultaneously, a plummeting oil price – once considered a good thing – menaced the shale oil drillers who had borrowed so heavily from the big banks, which would see those loans go sour and it would be the mortgage crisis all over again. Both turned out to be false alarms, as did the prospect that European banks would go under.
Markets are built on sentiment. If someone has found the exact data points to feed into the exact algorithm to time the market’s ups and downs exactly, they’re not sharing it. Stock prices can rise higher and faster than they should: what Alan Greenspan famously called this “irrational exuberance.” (That was the build-up to the dotcom bubble, which collapsed, sending stocks into a bear market.) Markets can also fall for no reason – or for reasons that seem to make sense at the time. Bull markets begin when people get tired of freaking out. They run until panic sets in, for whatever reason, and the bears take charge. Rinse and repeat.
What is there to do? Wherever you find yourself in the market cycle, remember Buffett’s admonition to be “fearful when others are greedy and greedy when others are fearful.” Being contrarian, done right, can make you some serious money.