PF Investing Club: The Stock Market & Compounding Interest

[TeethWhitener]

I don't know why economists use the words they do.

I don't think economists use the words "consensus price." They use "consensus estimate" which refers to the consensus expected earnings for a company over a suitable time period. They also use "consensus price target," which refers to the price they expect the stock to be listed at after a suitable time period. But I've never heard economists using the phrase "consensus price."

Just so we're clear, the actual market price of a stock is set by competition between market makers. Stocks are not bought and sold directly between traders. So for example, market maker A offers to buy a block of 100 shares of XYZ for $10 (bid price) or sell a block of 100 shares of XYZ for $11 (ask price). Currently the bid-ask spread is at $1. If one trader wants to buy 100 shares for $11/share and another trader wants to sell 100 shares for $10/share, the market maker facilitates the sale and makes a small profit of $100 (#shares multiplied by bid-ask spread). If there is no or low demand for this transaction, the bid-ask spread will stay pretty large. Now let's say that something happens to company XYZ and all of a sudden traders want to exchange a million shares. Now all of a sudden, the potential profit at the $1 bid ask spread is $1M. This nice chunk of change catches market maker B's eye, who undercuts market maker A by offering to buy for $10.25 and sell for $10.75. Now the potential profit for market maker B is only $500k, but B is more likely to complete the sale than A. In order for A to make any money, he has to outcompete B. Thus liquidity demand drives lower bid-ask spreads.

That said, any market maker can offer any price they want. (NB--I don't know what the full regulatory rules are, so this might not strictly be true, and at any rate, it certainly depends on your jurisdiction) If market maker C comes along and offers to buy for $11 and sell for $10, guess who all the traders are going to flock to. But C has no economic incentive to do that.

The more important point was the one farther down - today's price of a security reflects its future income stream.

Sure. That's uncontroversial. I also understand and respect the impetus to leave the thread at basic personal investing advice. But I doubt it hurts to know a little bit about how the market actually works.

 

[collinsmark]

'Bit of humor for the day:

(Source: http://www.smbc-comics.com/comic/regression)