How the Markets Really Work - Hardcover

Chapter One

What the Heck Are Prices, Anyway?

Let me try to answer a few of the most important questions my bedraggled old Soviets asked me way back when. They asked, if the world's financial markets are so important, what exactly do they do? And, why do they do what they do better than, say, government bureaucrats or computers or the KGB? How do the markets really work?

The answer to these questions is that financial markets don't really do all that much, it turns out, except provide capital to businesses, set prices, and distribute investment risk among a willing group of market participants.

They do what they do by bringing together interested buyers and sellers for various instruments like stocks and bonds in an organized fashion so those participants can haggle on-line, on the phone, or in each other's faces. Everything beyond that-from computerized clearing mechanisms to the bizarre hand signals used by the floor traders-is an add-on. Markets are places, real and virtual, to which market participants bring their money and their minds. In one form or another, people have been using markets since civilization began.

Providing capital is actually the easy part. No one can play the markets game without money or the ability to raise it. Players might come to the market individually, managing their own retirement accounts, or they might walk in with billions of dollars that they are paid to manage for other people. The slogan in the marketplace is the same as the slogan in the casinos of Las Vegas: "You got to pay to play."

Because so many people like the markets game, money has been rushing in to buy market-traded financial instruments. Most of that money used to reside inside the musty vaults and whizzy hard drives of banks, which dominated finance for hundreds of years, from the Middle Ages to the late 1980s. But the dominance of banks has been fading while the markets' star has been on the ascent. Money has been migrating from passbook accounts to the markets in pursuit of higher rates of return. In exchange for the opportunity of earning higher returns, investors have agreed to stomach significantly higher risk.

In the mid- to late '90s (no one knows the exact date, for sure) something changed with regard to how we manage our money. For the first time ever, people put more money into mutual funds than they had on deposit in their savings accounts. The trend to move money into the marketplace was not limited to the United States, although, as usual, Americans were a little less temperate than their counterparts in Europe and Asia when it came to diving into the markets. Trillions of dollars, marks, yen, and pounds flowed out of banks and into the markets everywhere. Even during the steep market corrections of 2000-2001, money continued to flow into the markets throughout that time.

During the last two decades or so, the amount of money invested in the financial markets globally has grown from about $2 trillion to about $20 trillion. In sync with that rise, the American markets grew from about $1.1 trillion to a high of about $13 trillion in 2000, before slipping back to about $11 trillion in 2001, when the markets tumbled. Eleven trillion dollars is a huge sum of money. It is equal to about one and a quarter times the value of all the work done by everyone in the United States and by every American company annually. Put another way, Americans have so much faith in the capital markets that they have invested in them the value-equivalent of more than a year's worth of all they make. Every day, a significant portion of that money (as much as a third!) changes hands as the prices for stocks, bonds, futures contracts-and everything else that is traded-gyrates up and down.

The world's financial markets are flush with cash and are expected to become richer still, growing as much as ten-fold in a decade's time. With so much money invested in the markets, there is plenty of capital available for companies. With so much capital available, parts of companies that at one time had little or no value can now be priced and sold, a phenomenon economists call the monetization of non-monetary assets.

Before the markets grew so large, the research and development and manufacturing arms of AT&T were considered overhead expenses-something the company needed to do in order to support its real business of providing long-distance telephone calls to its customers. But with cash flowing into the markets, AT&T could bundle, monetize, and sell those divisions, now called Lucent, in the stock market, thereby adding cash to AT&T's coffers while giving fledgling Lucent sufficient capital to invest in its growth.

Similarly, because of the growth of the capital markets, GM and Ford were able to sell to investors chunks of their captive parts suppliers. And because of the super-rich capital markets, dozens of not-yet-profitable (and maybe-never-profitable!) dot.coms and other early-stage Internet companies were able to raise cash by selling shares in the public markets. If you have enough cash, almost everything is for sale.

If the markets are a vast, global ocean bed, the amount of money in that ocean bed sets what economists call the price level. More cash means higher price levels (not necessarily for individual stocks) but for the market system as a whole. President Kennedy's famous quote about prosperity and the nation's poor-"A rising tide lifts all boats"-can also be applied to the causative relationship between money and prices. More money also means more items can be sold. If money is like an ocean, stocks, bonds, and other financial assets are like sponges designed to absorb the cash at hand.

To raise money in the markets, all a company has to do is go to a licensed underwriter-a Goldman Sachs, Salomon Brothers, Merrill Lynch, Credit Suisse First Boston, or any of the dozens of others-and ask them to sell shares, issue bonds, or sell some other product in the marketplace. From that standpoint, the individual markets are reservoirs of capital where money resides in its most liquid form (to keep the water analogies flowing). Companies want to sell shares-which are really ownership stakes-in markets that are rich, since that is where their chances are greatest of getting the highest price. Hence many European, Asian, and Latin American companies sell shares in New York, home of the world's largest and most cash-rich markets.

Liquid markets with lots of money and lots of participants offer big advantages to investors as well. Because so many people invest in those markets, in the blink of an eye, money invested in Microsoft shares can suddenly be freed to purchase shares in arch rival Oracle. Real estate, duck decoys, or handmade shotguns may at times see their value increase more than stocks, bonds, and futures contracts, but they change hands in markets that are far less liquid than markets for financial instruments. As a result, you might want to sell your duck decoy collection but be forced to wait months before you can find a qualified buyer. With financial instruments, a mouse click is usually sufficient to sell a stock instantly to a buyer who is waiting in the wings.

Creating financial offerings like stocks and bonds that will attract capital is the easy part, especially when the markets are brimming with loot. Setting a price for what is sold is where things get a little murky.

HOW PRICES ARE SET

Setting prices and sharing risks are more complicated undertakings than creating products because so little of what determines a price is under any single person's (or institution's) control. That is because prices are multi-level, multi-person, multi-organizational processes involving a host of different tangible and intangible elements all in a constant state of flux.

Price setting for individual products is a highly information-intensive, nerve-jangling business, far beyond the purview of computers. It is an act that is so complicated that when the old Cold War Soviets tried to do it for real-world goods (let alone financial instruments!) from a central office in Moscow, everything quickly got out of whack.

How much should you charge for a pair of decent shoes? It depends on the prices that you have to pay for labor, leather, shoelaces, dye, wax, tools, factory machines, energy, and rent. It also depends on how much money each shoe-making factory has to borrow (at what cost, for how long, and from whom), whether the workers have a share in the profits-whether there are profits!-and even whether the factory has to pay for the disposal of its waste and garbage and for its water and gas.

Then, if you are a shoe-price-setting bureaucrat somewhere in Moscow, you either have to determine the price for all the constituent goods that make up everything you use to make your shoes, from the price of petroleum to make dyes, to the price of beeswax to make polish, and so on down the line; or, if you cannot set those prices yourself, then you have to meet with your counterparts in the ministry of petroleum products and/or beeswax and work out a set of prices between you. But each of those prices is also dependent on other things, so all of the price-setting bureaucrats eventually have to meet to set prices together.

But once prices are set, what happens when the ministry of beeswax has to confront a bee-killing virus and must buy bees from abroad? And what happens when the ministry of petroleum needs money to invest in new wells because its old ones have run dry? Or when it has to buy new types of drilling tools and rigs from some other country at vastly raised prices?

As you can see, to do it right, price-setting bureaucrats must deal with a massive number of complexities. They also have to change their prices frequently to account for shifts in supply or demand and to take account of things such as weather. But that is not how governments work; they move methodically, infrequently, and at a glacial pace. As a result, in the old Evil Empire, some prices were not changed for decades, creating v...

A former reporter and editor at the New York Times and the Harvard Business Review who now works at PricewaterhouseCoopers, Kurtzman here offers insight into how the stock and bond markets function. He explains how these markets operate and what they do (e.g., package debt in the form of bond offerings, establish pricing for securities and commodities, connect those who seek capital with those who provide it, and other activities) but also how they are influenced by information and global activity (for good and bad) and how investors can use markets to their advantage. Kurtzman emphasizes the need to look for value in the markets and also discusses a technique used by Warren Buffet and many other investing pros discounted cash flow analysis (DCF), which involves knowing how you think a stock will perform over the time you will own it. As examples, Kurtzman uses anecdotes and concrete examples (especially of the recent Internet bubble), making it easy to understand his approach to the subject. Many people are involved with markets through their own investing, pension plans, and 401ks, and this well-written, inexpensive primer provides good introductory material that will be useful to many library users. Steven J. Mayover, Philadelphia
Copyright 2002 Cahners Business Information, Inc.