Monthly Archives: May 2013

What do all those numbers mean? Stock markets and their importance

They feature in nearly every news bulletin, paper and website. Their ups and downs, bubbles and crashes are reported on a daily basis. Yesterday for instance saw a dramatic plunge in the values of stock markets across the world. However the reality is that for many people unfamiliar with the world of finance, ‘a one point increase in the NASDAQ’ remains an alien phrase. This post will attempt to provide a basic understanding of what stock markets are and what the indices mean for you and me.

Stock markets fulfill two main roles. Firstly they allow companies to raise extra funds by issuing shares without the need for commercial loans. The stock market brings together companies wishing to expand their operations and potential investors looking to gain a return on their savings. Stock markets are therefore an important source of investment for firms. Historically they have allowed for the expansion of today’s largest corporations such as Coca Cola, Microsoft and ExxonMobil.

Secondly stock markets act as a platform for individuals to buy and sell shares through the use of stock brokers. The ease at which shares can be brought and sold is one of the main attractions of the market. This is in contrast to other less liquid forms of investment such as real estate – which can not always be as rapidly sold without loss of value.

Stock markets therefore have a positive effect on the economy in a number of ways:

  • Firstly they allow companies to expand, creating jobs and new products for the real economy.
  • They mobilize savings by allowing private individuals to invest their idle cash or bank deposits into profitable enterprises.
  • Stock exchanges facilitate improved corporate governance. This is because public limited companies have to meet the demands of a more diverse range of shareholders and the regulations set out by the stock exchanges themselves to remain listed.
  • Stock markets allow for governments to raise capital by issuing government bonds (government loans in the form of an IOU) to fund different economic development programs such as infrastructure building.

An economy with a growing and sophisticated stock market is therefore generally associated with a highly developed industrial and service sector.

So what do those numbers in the news mean?

Generally in the news you will see a list of the differing indices which are used to gauge trends within the stock markets. Instead of looking at the value of just one company, indices attempt capture the value of a number of companies or a sector listed at the stock exchange. It therefore allows us to see any movements in the combined aggregate value of these companies. The value of such companies or sectors is measured in two ways.

The first most common method measures total market capitalization (the total market values  of all the shares of the companies e.g. price of share x number of shares) and then uses a mathematical transformation to bring the number into a more manageable range. This is because many companies have market capitalization values listed in the range of tens of billions of dollars. The impact of the change in a companies share price on the index is therefore proportional the companies overall market value.

The second less common method only takes into account the price of the shares. In this type of index each company makes up a fraction of the index proportional to the price of its stock. This type of measure however ignores the size of each company and has therefore been subject to criticism. The Dow Jones Industrial Average is an example of this type of index.

Now I am not going to become bogged down explaining how these indices are mathematically calculated as many methods exist and all are subject to their different critiques. The main point to take from this is that an index reflects a transformed aggregate value for a number of companies within the stock market with reference to a base year.

A rise in a stock market index therefore reflects a increase in the total market value of the companies in the index. Similarly a fall in the index reflects a decline of a the total market value of the companies in the index.

Indices also differ in their coverage. Some attempt to capture the trends of the global market such as the S & P Global index. Other measures attempt to capture the performance of national stock markets. For example, in the UK the main index used is the FTSE100. This index measures and weights the values of the countries top 100 companies. Inaugurated in 1984 at the base level of 1000, the graph below shows the various progression in the value of the UK’s top 100 companies since the index began.

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 Some indexes go further and attempt to capture the whole market. The Wiltshire 5000 index represents the market value of all publicly traded stocks in the US. Such an index is known as a total market index. Lastly, some indexes measure specific sectors such as biotechnology or real estate.

Interpreting the indices for the wider economy

Generally stock market indices are regarded as a barometer of economic development. When the economy is strong and growing, the stock market is assumed to be flourishing. Similarly when the economy shrinks, it is assumed the stock markets will be struggling.

However although this makes sense logically for many reasons this is not always the case and it should be remembered that the stock market and the economy are not the same thing.

For these reasons it is entirely possible that you may have a booming stock market within a struggling economy. This has been the case recently in the UK where the stock market has seen an upward trend whilst the economy has been sluggish. Consequently we must be very careful when interpreting the stock market and utilizing it as a barometer for the economy.

Instead the stock market indices reflect the views of investors and these views are hard to interpret. As Adam Davison of the NY Times rightly states a stock purchase form does not come with a ‘reason’ field. This problem is further compounded by the existence of ‘herd’ behavior in markets which can lead to market bubbles. Investors may purchase stocks just because they see others doing so thereby increasing the price of the stock. This in turn inflates the index of the market and if investors find they have invested in an bad asset (such as with the sub-prime mortgage crisis) it can lead to crash.

In summary, stock markets are an important mechanism for facilitating investment in the growth of firms. Stock indices commonly reflect the performance of a specific sector, a whole market or a number of influential companies. However due to the nature of trading and the narrow scope of many indices caution must be taken when relating such markets to the wider economy.

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The next financial crisis

An intriguing and thought provoking video showing how we may not have learnt from the lessons of the last financial crisis and how the same tools adopted to fix this crisis were also the tools responsible for its cause.

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We don’t make anything any more…..

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One of the most common complaints which I hear working in a machinery retail outlet is that the UK doesn’t make anything any more. Looking around the store this is an easy argument to accept, indeed most of the machinery I sell including lathes, welders and circular saws all come with a ‘Made in China’ tag. Furthermore most of the media reverts to this constant rhetoric, I have seen numerous articles posted in the media over the years foretelling the final demise of the UK manufacturing sector. So what is happening? Are we in a perpetual decline where we no longer have the ability to make anything? Such statements could be no further from the truth.

To begin with here are some interesting facts from a 2009 Price Waterhouse Coopers report that might surprise you. Firstly as of 2009 the UK was the 6th largest manufacturer in world (Some more recent measures vary between 5th and 10th)this includes large global shares within individual markets – the UK holds a 15% global share in the Aerospace sector. Secondly, UK manufacturing output had reached an all time high just before the 2008 global crisis took hold. Lastly, UK manufacturing achieved a 50% increase in labour productivity over the period 1997-2007. Although struggling due to the global downturn in the recent years, the facts show that the UK manufacturing sector is far from dead.

It can be argued that this idea that the UK manufacturing sector is in terminal decline emanates from a number of relative not absolute comparisons. When the relative figures are observed one could be forgiven for believing the above statement. For instance the graph below shows how manufacturing has contributed less and less to the national economy in recent years relative to other sectors.

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Service sector growth has far outpaced growth in the manufacturing sector in recent times. This has further led to a decline in the relative number of manufacturing jobs. In 1980 manufacturing accounted for 25% of all UK jobs, by 2008 this number had fallen to 10%. Combine these figures with the fact that the UK’s share of global manufacturing has dropped significantly in the last few decades and you are left with a national sense of pessimism regarding the manufacturing sector. Yet as the paper argues the UK has been punching well above its weight for the last century in terms of size and population. It is therefore inevitable that we are to be caught up or overtaken in relative terms by countries with more abundant natural resources and supplies of labour as the Solow growth model predicts (the theory of diminishing returns states that the introduction of one more unit of capital into a capital scarce country will lead to a greater increase in output than in a country which is in comparison capital rich).

Despite the relative decline of the manufacturing sector as a component of total GDP, it is a rather unheralded fact that UK productivity in the sector has grown by 48% over the period 1987-2007.  The gradual decline of manufacturing jobs is arguably attributable to such productivity increases and more broadly our natural progression to a knowledge economy. Better technologies and workplace practices have meant that we can now produce much more per individual worker. In an similar process which was seen in the agricultural revolution, these technologies and processes mean we require less manpower to produce the same amount of output compared to say, 1950. This fact should be celebrated, not frowned upon as it often is due to its impact upon jobs.

The manufacturing jobs of the future will not be based as much upon an assembly line but instead in the R & D departments where companies attempt to find a niche markets and thereby gain competitive advantages. This is where the knowledge economy comes in, although the UK is not gifted with large surpluses of labour as in China, it does retain a high level of human capital (the level of knowledge and know how an individual possesses) and this will be the driving force of growth in the long term as new innovations are made. So in this sense it is we should not be pessimistically stating we don’t make anything any more, we should be looking with optimism at what we will be making in the years to come.

Some additional facts of note.

  • The UK has the 3rd largest automotive industry in Europe.
  • The UK is home to the 2nd largest maker of aircraft engines in the world (Rolls-Royce).
  • The UK has the 3rd largest pharmaceutical company in the world (Glaxo-Smith Kline)
  • The UK has the 4th largest oil refining capacity in Europe.
  • The UK manufacturing sector attracted £30 billion of net foreign direct investment in 2010.

This is quite a short post as I have only just returned after from the Philippines after a 3 week trip to see my girlfriend. I have intentionally omitted some of the more crucial challenges that the sector faces to focus on what it has achieved contrary to popular belief. Furthermore it should be acknowledged that the transition to a knowledge economy requires a strong manufacturing base and the current economic crisis may threaten this.

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