How the Stock Market Works

Originally posted at the Brew Board, for the benefit of the miscreants therein. Or thereon.

It's the first day of a week off, and so I have a bit of spare time. About a week, to be exact. So I will be annoying the Green Board in new and exciting ways. Someone a while back asked to be explained what the stock market is, so I thought I'd give that a go. Please keep your hands and feet inside the ride at all times.

Say BrewBasser has a company, it's gotten pretty big, and it is doing well. He makes, let's say, assault rifles (his new model, the "Lonnie Mac10" is very popular). He's selling the guns in the local Chico California area and everyone loves them, but he wants to branch out with new gun stores (Crazy BrewBasser's Guns fer Killin'). But he just doesn't have the money and the bank doesn't want to loan him any.

So what he does is go public. First, he divides the company up by a certain number, let's say one million. Each of these is called a share. He can't really divide the company by a million, picking a brick for one share and a drill bit for another share, so he basically says that each share gives ownership of one millionth of everything in company. A millionth of the drill bit, a millionth of each brick, and a millionth of the painting of Orudis and 80Schilling in the hallway, named "The Fox and Hound in Repose", painted by famous painter LeDis.

He makes up some fancy looking documents called stock certificates, and when a person buys them, they have bought a tiny part of the company. They don't actually have to hold the certificates any more, but they used to.

He can sell these shares to his friends and neighbors, he doesn't have to make them publicly available, or he can sell on the open market to just anybody. That's what BrewBasser does. He goes to a stock market, which is just like any market, but instead of selling apples or LeDis paintings, it just sells shares of stock in a lot of companies.

The main one in the US is the New York Stock Exchange (NYSE), but there are stock markets around the world. Australia has one called the ASE (Australian Stock Exchange), Japan has one called the Nikkei, etc. etc.

They give you a nice, easy to remember series of letters, this is your ticker symbol to represent your company. The ticker symbol for Bank of America, for example, is BAC. The symbol for Google is GOOG. This is from the days when stock traders got all their info across an early precursor to the internet called the stock ticker, which printed out stock symbols and prices on tape in some broker's office, from the stock market. They had to be short because thousands of companies were being sent around on this ticker tape machine, and they wanted the names to be really short because tape costs money. This was how you found out what your stock was selling for. You sat around staring at a freaking tape coming out of a machine, waiting for your symbol to come up.

The NYSE gives BrewBasser's company the symbol GUNZ. Now people can find out what his company is selling for by entering the symbol at a site like Yahoo Finance.

Let's say The Stain, in his first foray into the stock market, buys 100 shares. The stock price is $12, so this cost The Stain $1200, which he had to sell his car for, and now he rides a bike to work and his neighbors laugh at him. Ah, but they won't be laughing for long. Or, they'll be laughing even harder. It all depends on how things go.

To add insult to injury, the people who arrange for the stock to be sold (brokers) charge The Stain $10.95 for the transaction. Nothing is free, especially in the stock market. The Stain creates a post on his favorite bulletin board to decry this injustice.

So BrewBasser sells the shares, and keeps 51% of them for himself, because if anyone, or any group, gets more than 50% of that stock, he no longer has control of the company and they can throw him out. When you sell shares, you're selling parts of the company, and anyone who owns more than half controls the company, no matter who started it or who works there. This happened to the founders of Cisco - they sold more than half the company and got fired. They still owned whatever shares they owned, but they no longer had a job at the company they founded.

So, BrewBasser opens five new stores with the $12 million dollars he raised in his Initial Public Offering (IPO, basically the initial sale of the stock.) The new stores do great, because everyone loves how BrewBasser has somehow skirted California law and made them all fully automatic. Woohoo!

When a company that is publicly trades does well, then the stock price goes up, because the company is worth more. It does not necessarily go up by the exact amount of how the value has changed, though. Valuation of stocks is insanely complicated, and also can be driven by emotion.

Why is Bank of America (BAC) worth $20 a share, then a week later worth $11 a share? This is a question I would like the answer to myself. Very much. The value of the company did not decrease by almost half, but people got scared, and thought that because of the economy, it probably wouldn't make much money in the future. The stock price reflects what people think the company is worth, and is going to be worth in the future.

But people love BrewBasser's company and see a big future for it, so the stock price goes up like a rocket. $15, $39, $100, $230, finally today it is at $295. At this point, BrewBasser decides to split the stock, because he wants the stock price to be affordable. So he splits the stock 3 to 1. The Stain's stock is now worth 1/3rd of what it was before, but he has 3 shares for every 1 share he used to have, so now he has 300 shares, and they're worth $98.33 each. His stock is worth $29,500 now.

You don't have to split stock, by the way. Berkeshire Hathaway, Warren Buffet's investment company, has never split, and one share now costs $90,000. It used to be $147,000. Warren Buffet doesn't give a crap whether you can afford his stock or not.

Also, some stocks pay dividends. This is basically taking the profit that the company has and splitting it up by one million, and paying each share that amount. So every quarter, The Stain gets on average 25 cents per share. With the new 300 shares he has, he's making $75, and let's say since he's just turning around and buying new stocks every time that happens.

By the way, people have gotten rich on small numbers of shares over a long time. Early investors in Wal Mart who owned only a small amount, who held their shares did very well. Stocks can go up an unlimited amount.

The Stain decides he doesn't want to be exposed to just one stock, because what if the California Legislature closes that loophole that lets BrewBasser sell automatic weapons? The company will probably be severely affected and the stock price will crash. So The Stain sells 2/3rds of his holdings and spends 1/3rd on another stock (a company called "Folsom Example Stories, Inc.", ticker symbol WTF). He also decides that even having money in two stocks is too limiting, so he invests in what is called a mutual fund.

A mutual fund is simply a collection of other stocks. There is a huge and frightening array of mutual funds. Some mutual funds only buy tech stocks like Google, Apple and Microsoft. Some only buy industrials like GE, Kraft Foods and Chevron. Others only invest in big companies, or small companies, or any combination anyone wants to invent.

So then, one day, things start to go to hell. How do we know its going to hell? We can't watch individual prices, they're too volatile and tell us too little about the economy as a whole, or the sector we are interested in. Some nice people make a list of stocks, and they call that an index.

One of the most popular and influential indexes is the Dow Jones Industrial Average. When people say "The Dow went down 400 points today", this is what they mean. The Dow is not a stock or a fund, it's just a list of companies and their stock prices. There are 30 companies on the Dow right now, all very large companies that are thought to represent big companies as a whole pretty well. These companies include GM, AT&T, Walt Disney Company and McDonald's.

So basically, when the Dow starts to fall, the biggest, most stable companies in the country are making less money and becoming less valuable. This is a good indicator of the stock market as a whole, and the future economy.

There are other indexes too, like the NASDAQ (which is tech companies) and the S&P 500, which tracks 500 companies.

We could talk about the myriad of other securities and how to trade them, but you're probably bored and stopped reading five paragraphs ago. But just as an example, you don't have to buy stocks thinking they're going to go up (which is called "buying long" or "going long"). If you think they're going to go down, you can sell them short, which is basically selling stocks you don't own and buying them later, hopefully at a lower price. But if the stock actually goes up, you lose money, and since it can go up an unlimited amount, you can lose an unlimited amount. Short selling was stopped when the market was really tanking, but now you can do it again.

So the Dow is going down, and The Stain interprets this as a sign of a coming economic downturn. He thinks agricultural companies are going to do ok because no matter what happens, people gotta eat (this is a popular strategy today actually). So he finds a mutual fund that invests in agriculture stocks. He chooses DBA.

Now he owns stock in many companies by owning the fund.

Then things go right to hell. Companies are laying off, people are spending less, and the economy is in the crapper. Worse, California elected Gavin Newsom to be governor and he closed that gun loophole. But The Stain is a very clever individual. He is friends with the secretary in Newsom's office, and she tells him that the new law is going to happen. The Stain, seeing the BrewBasser's company is going to be ruined, sells all of his stock in the company. The next day, the law goes through and BrewBasser's stock goes down 90%.

If you know something that the general public does not, and you buy or sell a stock based on that info, that is called insider trading, and it is thoroughly illegal. Martha Stewart went to prison for this. The Stain only had 100 shares of stock in GUNZ though, so his sale doesn't look out of the ordinary. If it had been 100,000 shares, the SEC would soon be knocking on his door and asking all kinds of uncomfortable questions. Damn do-gooders.

The agriculture stocks do ok, as expected. Unfortunately, Folsom Example Stories, Inc. goes out of business because there's just no money in writing example stories. That stock plunges and The Stain loses all of that investment, but since he diversified, he's still doing ok.

BrewBasser goes on to start a new company, Full Auto Beer, but it just isn't the same. He falls into a vat at the brewery, and stays there for a week.

Famous painter LeDis ended up in a huge controversy in the art world: It turned out that he worked for the military and contributed money to the McCain campaign. This was intolerable, and he was hounded out. He eventually made a living analyzing the migratory movement of African Swallows, which is not good work because as we all know, African Swallows are non-migratory.

Finally, The Stain returns to his neighborhood, triumphant. He takes the money he got from selling GUNZ and buys a custom Ford F-150, black, totally sweet ride. He drives down the street now with pride as he surveys the wrecked lives of his neighbors, most of whom are now unemployed, alcoholic and involved in prostitution in some way.

"Revenge is a dish best served cold, ****ers" he cackles under his breath.