Sunday, June 21, 2009

What Makes the Stock Market Go Up?

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Over the last 100 years, the Dow Jones Industrial Average has gone up by a factor of about 150. But this is only about half of the return because it doesn't include dividends. So you can multiply this by another large factor to get the full returns. Of course stocks have had some major blips in the last century, but this represents a relentless rise in stock prices. Even factoring out inflation, stocks have made an impressive long-term run. In the short term stocks rise because there are more buyers than sellers, and when demand outpaces supply, prices must go up.

Over the long term it seems like the stock market creates wealth out of nothing. Science teaches us the law of conservation of energy, we often hear that there is no free lunch, and we talk of zero-sum games, but the stock market doesn’t seem to be bound by any such law. Over the long term, almost everybody who stays in the game seems to win.

What makes stock prices rise over the long term? The short answer is innovation and hard work. The increasing number of people is a factor too, but the main driver of stock market prices is the continuous improvements in our lives due to better ways of doing things, better tools, and better toys. When a company hits the market with a better product at a lower price, the average person’s life improves a little, and this ultimately translates into more overall value in the stock market.

Better processes make it possible to produce goods with less effort, which frees people up to do other things and make other goods. This ability to do more with less means that the sum total of all the things we can produce rises over the years, and this is reflected in stock market prices.

If you still believe in continued innovation in our society, then you should be comfortable with the long-term prospects of stocks as a whole.

2 comments:

  1. It is true that these companies create value out of thin air. Human beings do that every time they take something thing and use their brain and brawn to turn it into something more valuable. (I don't believe as some people do that value is created by trading, or else you'd have to conclude that the value of a Nortel share really was $1245 at its peak.)

    As you hinted (but never actually said) there is no law of conservation of value.

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  2. Patrick: Trading is certainly a factor in value creation, but it's effect is mostly indirect. The value created by an individual trade that comes from the two parties valuing goods differently is a small effect. However, the ability to trade makes it possible to specialize and ultimately creates rewards for the best producers of each type of item. The desire to be the best producer then drives innovation, which is what I've argued is the cause of value creation. So, trading may be a necessary piece of the value creation puzzle, but I would say that innovation is a more direct cause.

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