Why Have Markets Risen?

The Motley FoolIt’s hard to believe that even though we are more than three years into the current bull market, some people still deny that the stock market has recovered.

Mind you, the more cautious amongst you probably have a totally different bone to pick. You are perhaps wondering how much longer shares can continue to rise.

It’s perfectly natural to be sceptical. It is also normal to be cautious. But it is important to understand the underlying reasons why global stock markets have risen.

Stock markets around the world have risen because there are more people wanting to own shares than those who want to sell them. It’s really as simple as that.

It’s the market

So, when there are more buyers than sellers in the market, the increase in demand forces up share prices. When the reverse happens, in other words, when there are more sellers than buyers, then stock prices tend to fall.

That is how the stock market works. It is a place where people vie to buy and sell shares.

But why are more people turning to shares? What has changed that has prompted increasingly more people to look at stock market investing?

To understand the reason for this change in sentiment, we need to look to Ben Bernanke, the chairman of the US Federal Reserve. When Bernanke embarked on his strategy of Quantitative Easing (otherwise known as printing money) he went out of his way to push down US interest rates to ultra-low levels.

He reckoned that by driving down interest rates he could orchestrate a rise in asset prices.

And that is precisely what has happened.

The economic cycle

He deliberately forced down interest rates so anyone who owned assets such as shares would feel wealthier. So, as asset owners feel richer, they would in turn spend more, which would then lead companies to invest more money, hire more people and produce more goods.

It’s not magic. It’s economics. It’s what you would expect when trillion of dollars are pumped into global economies. And it’s working.

However, Bernanke’s strategy, which has been replicated by Mervyn King of the Bank of England, Mario Draghi of the European Central Bank and Haruhiko Kuroda of the Bank of Japan, has produced an unintended consequence.

It has forced cash savers to turn to shares because savings accounts interest rates have been driven down to pitiful levels. So low in fact that the interest rates paid on cash savings are significantly below the rate of inflation. In other words, savers are losing money in real terms by staying in cash.

But not everyone has been converted to buying shares yet, which suggests that the stock market could creep higher as more people move their money out of cash and bonds into shares.

Price is what you pay

As the stock market continues to improve, it means that shares may no longer be as cheap as they were in 2008.

But as Warren Buffett once said: “Price is what you pay, value is what you get”.

He was referring to the importance of understanding the difference between the intrinsic value of a company and its market price.

The former is what a business is worth based on factors such as its debt, its growth rate and the amount of cash the company is likely to generate in the future.

The market value, on the other hand, is what the market is willing to pay for the company. This is typically the market capitalisation of the company.

Value is what you get

But appreciating the distinction between the market price of a company and its intrinsic value is vital for successful investing. That’s because the market is not perfect and often gets it wrong.

So, if you can find shares whose intrinsic values are higher than their market values, then you have unlocked the first door to successful investing. That’s because you are buying an asset in the market below its intrinsic value.

Following the financial crisis of 2007, it was easy to find shares that were selling below their intrinsic value. At the time, many, if not most, shares were selling below their intrinsic values. But as markets climb it gets progressively harder.

But value is still out there. It’s simply a case of knowing where to look. So instead of asking what the market is doing, a better question for Foolish investors would be where can we find companies selling at below their intrinsic value? Where can I find a dollar-stock that’s selling for 50 cents? And that’s what we enjoy doing at The Motley Fool.

This article first appeared in Take Stock – Singapore.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.