FOOL'S EYE VIEW
Why Has the Stock Market Fallen?

By Bruce Jackson (TMFGoogly)
March 20, 2001

Let me tell you a story, a story all about people. By the end of the story, you'll have the answer to the question posed by the title of this article.

A Market - A Stock Market

My dictionary defines market as "a meeting together of people for the purpose of trade by private purchase and sale..." A stock market is defined as "the market for stocks throughout a country."

People determine the level of the stock market at any given time. In a market, if the demand for goods is high, people must be prepared to pay more for those goods. Likewise, if demand for goods is poor, people will expect to pay less for those goods.

People are emotional. They are sometimes happy. They are sometimes sad. They are sometimes greedy. They are sometimes fearful. They laugh. They cry. They make rational decisions, based on facts. They make irrational decisions, blatantly ignoring the facts. They are sometimes predictable. They are sometimes unpredictable. People are emotional.

"Tech Shares"

In the early part of last year, demand for a particular product was very strong. That product was called "tech shares." Demand was strong because the product was effectively a money making machine. All you had to do was buy one of them, and a few days, weeks or (if you had to wait a really long time) months later, this "tech share" product could be sold for a significantly higher amount than its purchase price.

Some people got greedy. They let their emotions take over. They made irrational decisions.  Even though the media was saying it, Mums and Dads were saying it, wise old investors like Warren Buffett were saying it, and it was seemingly blindingly obvious to everyone that these "tech shares" were overvalued, greedy people still bought them.

Naturally, demand for "tech shares" was high. People therefore had to be prepared to pay high prices for this product. Although the price kept on going higher and higher, people kept buying the product. People had found the perfect "get rich quick" scheme, and were milking it for all it was worth.

Feel Good Factor

Many people made good money out of participating in this "get rich quick" scheme. The effect was greater in the US, where individuals have a higher proportion of their wealth invested in the stock market. As the price of "tech shares" continued to rise, many people became wealthier, on paper at least.

With their new found wealth, people went on a collective spending spree. In the corporate world, Chief Executives spent money with gay abandon. They were rewarded with an even further increase in their wealth, as measured by their company stock options, if these people announced an increased investment in anything vaguely resembling this thing called the Internet.

Individuals spent more money on consumable goods, like a new personal computer, because they felt richer. People had the feelgood factor.

A Burst Bubble

As with all "get rich quick" and pyramid schemes, they eventually end in tears. Some people stopped believing that the demand for these things called "tech shares" would remain at their elevated levels. Why? It's hard to put your finger on the exact reason for the change in sentiment. Maybe some people became fearful, and sold these "tech shares" in order to lock in a profit. Maybe some people started realising that the product ("tech shares") was faulty. Maybe a degree of rationality was entering the market.

As demand for "tech shares" declined, people became less wealthy. Some people even lost money. Companies, run by people, were worth less money. People announcing a new Internet strategy for their company suddenly saw their share price decline rather than rise.

As a result, PEOPLE STOPPED SPENDING MONEY.

And that's why the stock market has fallen.

Footnote:

A further explanation may be necessary, in order to bring us up to today.

As the stock market fell, people became poorer. Their future expectations of their potential wealth were reduced. They slowed their discretionary spending. With their higher exposure to the stock market, this was particularly acute in the US.

Companies, run by people, also slowed their discretionary spending. As their sales slowed, because PEOPLE STOPPED SPENDING MONEY, they cut back their spending. The people who invest in the stock market still expected the companies to hit their profit targets, so with sales falling, the only way to do this was to cut costs -- i.e. to STOP SPENDING MONEY. "People" had caused a vicious downward spiral.

The Stock Market Today

Demand for "tech shares" has dried up. Prices have declined. They may decline further as the pace of the downward spiral increases. People are poorer, especially in the US.

Houston, we have a problem.

Here's part of the solution. People need to re-anchor their wealth base. Forget the past, forget what they might have been worth. Get real.

They should expect £10,000 invested in the stock market today to be worth somewhere in the region of £67,000 in 20 years (based on a 10% growth rate). During the tech share boom, some people were expecting 25% per annum returns from their portfolios, and therefore assuming their £10,000 would be worth north of £867,000 in 20 years' time. Some difference!

People need to remember that when they buy a share, they are buying a small piece of a company. They need to also remember that over the long-term, the share price of a company will be 100% correlated to the company's profitability. I'll leave the final word to legendary investor Benjamin Graham.

"In the short-term, the stock market is a voting machine. In the long-term, it's a weighing machine."

P.S.

• "Tech shares" may also go up in the future.
• Consider investing at the time of maximum pessimism.
• ISA sales have slumped in comparison to March 2000. Surely if people were willing to invest in the stock market a year ago, when the stock market was riding high, they'd be even more willing to do so again this year? Work that one out! Check out the Fool's ISA centre.