why secondary markets (ii)

Yesterday I wrote about what secondary markets are.

I didn’t mention perhaps the most important fact–people should be, and are, willing to pay a higher price for a security that they can buy and sell relatively quickly, cheaply and more or less anonymously.

They should, and do, pay an even higher price for shares in a company that is legally required to produce accurate financial statements that are easily accessible to actual and potential holders. That hasn’t always been the case, even in the US. In 1995, for example, I had to pay $125,000 a year to get microfiche copies of companies’ SEC filings, three months late, that are available today online, immediately and for free.

It’s worth even more to be able to see what people have paid for a stock in the past. To me, it’s not really key to be able to see what others are doing minute to minute, but that information is available, too.

It doesn’t hurt, either, if a market can rely on a large number of affluent institutions and individuals with enough interest in stocks and bonds to provide a deep pool of liquidity is all but the most dire of circumstances.

The general point is that in this situation, one where there’s a very robust secondary market, companies can raise capital more cheaply and easily (and are therefore stronger and more profitable). You and I can also become part-owners of these enterprises easily and cheaply and with less risk.

leading economic indicators

Macroeconomists studying the US have a list of indicators experience has shows tend to signal in advance the direction general economic activity, either on the way up or the way down, or both. Of these, the most reliable is the US stock market, which tends to peak six months or so before the business cycle turns down and to pick up half a hear ahead of recovery from recession.

Why is this? I don’t think anyone knows for sure. Personally, I think there are two factors. The more generally accepted is changes in Fed policy intended to slow down or speed up the economy and signaled through changes in short-term interest rates. Pulling back on the monetary reins can be detected immediately but takes a while to be reflected in GDP statistics. Secondly, especially as the economy picks itself up off the floor, companies see on their order books that things are getting better. They start to procure more raw materials and to halt layoffs/hire again. Almost immediately the grape vine signals that everyone’s job is now safe …and that information begins to leak into the stock market.

I mention the special place of the stock market among leading economic indicators because it’s the only motivation I can think of for the peculiar academic notion that there is not only a connection between a country’s GDP and its stock market, but that the market is fully priced when its capitalization is equal to 1.0 x nominal GDP. I don’t see any reason why this last should be. I view it as the logical equivalent of saying that the sun comes up when the rooster crows, therefore the sun comes up because the rooster crows. (Btw, the total market cap of US stocks today is $44 trillion vs. GDP of $22 trillion.)

I first heard this “explanation” of the correlation of GDP with market cap in the late 1980s as a “proof” that the Tokyo market, then trading at 2x GDP, was wildly overvalued vs. the US, which was trading at 1x. The fact that short rates in Japan were at 2.5% vs about 8% in the US was completely ignored by adherents of the GDP link. (Yes, the Japanese market turned out to be a house of cards, but so too did the junk bond market in the US.) Also ignored was the fact that at that time the German stock market was trading at 0.2x GDP (mostly, I think, because Germans have never been very interested in stocks and because the great bulk of German GDP isn’t listed).

the stock market is a place where buyers and sellers meet

This is a truism, but it has two big implications.


One is that the market will be created in part by the firms that want to raise capital. in the US, homebuilding, which is a significant part of the economy, is by and large a cottage industry of independent builders. They put up a few houses at a time and depend on bank financing. Despite their economic heft, they have minimal direct representation in the stock market. Automobile sales and servicing make up about 5% of US GDP. But this industry is dominated by foreign firms. The combined market cap of F, FCAU and GM, all steady market share losers over the past 40+ years is about 0.2% of the Wall Street total. Oil and gas is about 8% of GDP, but the Energy sector, which includes substantial foreign holdings, makes up about 2% of the S&P. Most important, although disclosure is imprecise, as best we can tell about half the earnings of the S&P 500 are derived outside the US.


The other side of the coin is that the market is also made by what investors want to buy. For the past several years, the preferences of buyers have been very clear–they don’t want to buy stock in traditional companies–especially not ones with status quo-defending managements–in a time they think of as one of substantial, rapid structural change and they do want to buy shares of companies with global reach. The pandemic, and the administration’s failure to cope with it, have intensified this trend.

The upshot of this is that there’s no reason why the dynamic action of buyers and sellers in this marketplace should end up mirroring or mimicking domestic GDP.

In fact, given the unique breadth and depth of US financial markets, there’s also every reason for foreign sellers to want to at least partially finance growing businesses by issuing stock here. This gives us a unique opportunity to hold foreign growth companies. It makes Wall Street an important national asset. Also, to the degree that foreign issuers rely on the US for financing, the domestic stock market becomes a potential force for exerting influence over them and their business practices.

More tomorrow.

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