The Problem with Wall Street

Transparency. That about sums it up. Investors are led to believe that common stocks can be bought and sold profitably based on readily available, quantifiable metrics that indicate value. The best example I can think of is the P/E ratio. Just about every financial professional is guilty of this sin. Take a look at Jim Cramer, for example. In one of his books, he spouts off twenty-some-odd rules for investing in the market. The truth is that Cramer probably made his money behind the scenes--in transactions not available to the average investor.

The problem with metrics is obvious--they are available to everyone and they do not predict the future. In reality, the true value of a company and its corresponding stock price could be determined with precision if we had a few key pieces of information--prevailing interest rates over long periods of time, future earnings, inflation/deflation rates, and the future P/E multiple. If one had all that information, then a simple discounted cash flow would render a fair present value for stocks.

Unfortunately, nobody knows the future, and that's the reason why stock prices fluctuate so much, even though the companies tied to the stocks do not necessarily change dramatically on a daily basis. The best book I've found relating to this subject is Rule #1 by Phil Town. That book does a good job discussing the incorporation of future uncertainty into today's stock prices.

In reality, stock prices are based on buying and selling pressure--the economic ideas of supply and demand, which assumes rational behavior on the part of investors if one wants to equate the value of a stock with the value of its underlying company. The bubbles of the past (tech, real estate, oil, etc.) are good evidence that investors are clearly irrational at times. That irrationality is the key to long-term profits. One need only buy stocks when prices are irrationally low based on overly conservative estimates of the future. Easier said than done, I know.

As a corollary to that idea, is the method of trading based on technical analysis. Admittedly, I don't know much about the theory underlying this method of trading beyond saying that it too is based on the idea of supply and demand and the notion that short-term irrational behavior must correct based on largely psychological premises. The trading methods have built in safety mechanisms such as "buying at support with a tight stop," which makes this seem to be a safer method of investing. I mean hey, if you bought the market ten years ago, you're even now. Again, Rule #1 is a good source.

The main thrust of this post is really just to point out that there's a lot happening behind the scenes on Wall Street to drive stock prices. The Street is not transparent, and market manipulation surely happens. Professional financiers bend laws to the limit in order to take advantage of average investors, which is why the methods of wealth accumulation used by those who make serious money--the same people who are selling books and giving out stock advice--are not discussed openly. So always evaluate the agendas of people who seem to want to help, because they are probably trying to help themselves to your money.