56. Understanding the Stock Market and Indexes

Transcript:

Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld.  Today, we're talking about the stock market and I wanted to focus a little bit more on exactly what is the market and how does it work?

Okay, thanks again for joining me today. Jordan is a little bit under the weather, so you're just stuck with me today. But we're going to be talking about the stock market. If this kind of thing is interesting to you, I’ve noticed that a lot of downloads have been coming from more of the investing focused podcast that we've done recently, please fire off an email and just let me know give me some more of this, I'm interested in this. I love to hear from you guys. I respond to every email that I get. So I'd love to hear from you in this regard too. But today we're going to talk about the market and a little bit more understanding of what that is, how does it work? And then a little bit more about indexes too. And what indexes you should actually pay attention to if you're watching financial news.

So when people talk about the market, I don't think a lot of people actually have a great understanding of what that actually is. You know, there are many different markets, but when people use that term, the market, generally people are talking about the stock market and they're talking about stocks and the people who buy and sell them.  So in economics, the term market is actually just used for a group of buyers and sellers. It's not necessarily like your supermarket grocery store that we would know a market has. So as such the “market” is more of a concept than an actual place. The real tangible market is something called an exchange.  So like the New York stock exchange or the Toronto stock exchange, these exchanges they're facilitating the buying and selling of stocks and they ensure that things operate orderly and smoothly as much as possible. Things always happen, of course, but that's kind of the place that happens. Nowadays, most of that is digital, but these places still exist, but they exist more online than in person. So there are exchanges, like I said, in Toronto, New York, all over the world and they facilitate the trading of stocks in that country. So how does this actually work? Let's backtrack and talk about stocks more specifically and how a company can become a stock in the first place.  So before a company can be listed on a stock exchange, they go through a process called an IPO or initial public offering. This is called the primary market. It's primary because this is the first time a share is being sold and then the proceeds are being sent back to the company. So say you have, let's talk about Airbnb for a second.

So Airbnb, they went public through an IPO I believe it was last year. And so before that they were a private company and they were owned by individuals no different than you and I, but also a group of investors and things like that. And so to raise money, they would go through an IPO and they would sell some of the shares in that company to the general public, to investment banks and things like that.  And so they have more money in their pocket for growth and expansion.

Using another company.  I'll use them as an example here, Rivian. If you've heard of them before they are an electric vehicle company, they make trucks and SUVs. Personally, I think they look really cool and I'd love to get one. But that's seems like it's a long ways away. They're a company that's had a lot of good ideas, they've got cool technology, but they're not making a ton of vehicles right now. So when they're a private company and they decide to go public, they are needing to raise some money to actually get their production off the ground, they're not really in growth mode yet because they haven't really even started production.

So in their case, they went public around this time last year, might have been about November of 2021. They sold 153 million shares. For 78 bucks a share, okay. 153 million shares for $78 a share in their initial public offering. That doesn't mean that those are all the shares that exist. So the founder and executives will retain a bunch of shares for themselves that won't be sold to the public right away.  So the company's worth quite a bit more, but the shares that were sold to the public, 153 million at 78 bucks a share. That means they raised 12 billion through their initial public offering.  So it's generally quite difficult or in many cases, impossible to participate in IPOs as an individual investor like you and I, but large institutions and investment banks are usually the first buyers of an IPO. Then once the IPO day has passed now, these shares are available to be bought and sold on what we call the secondary market and this is what the “market” is that we're generally talk about. So the secondary market is where stocks are sold between individual investors and institutions, not directly from the company. So in the primary market, that's where the company raises money by selling shares, now in the secondary market is where most investors actually get involved. But in that case, you are buying your shares from someone else. So if you go to your brokerage and you buy a share of Rivian, you're not giving your money to Rivian, to be used for making electric cars. You're buying from the person who sold it. So if I'm selling to Jordan, Rivian, doesn't have any stake in that transaction.  We're just changing ownership between the two of us. So if you bring in the laws of supply and demand here, if you buy a share of Rivian, someone else has to sell it. And if there are more buyers call it that demand, then sellers, the price will go up. Right? So if more people want to buy something that isn't available, the price is going to go up.

That's what we're dealing with right now with inflation. So this kind of thing incentivizes current owners to sell when the price goes up, but it also weeds out buyers who don't want to pay that much. So this constant price movement is a feature of public markets because it really evaluates in real time what someone or the average person is willing to pay for something. So it's always going to be more expensive to somebody but all depends on how you personally are valuing that company. The idea of efficient markets is that the current price takes into account all the information about that stock in any given time.

There's a lot of disagreement on that potentially, but the way that people act via buying and selling really determines the price in real time. So when a stock is going down, that doesn't necessarily mean the company is worse. That just means that on that day, there were more people that wanted to sell that stock than buy it.

Okay, let's go back to Rivian for a second. So on their first day of trading, the stock price went from their IPO price of 78 bucks up to a $100 on the first day. So all that means is that there are more buyers than sellers on that first day of trading. Again, Rivian as a company, doesn't see any benefit of that price increase, because the shares are treated between owners, not the company itself.

Does that mean the company is inherently more valuable. It's like, well, to the general public on that day. Yeah, I guess so right, because there are more buyers than sellers for that stock. And so they're willing to pay a higher price for it. So to figure out how much a company is worth in real time, we use a term called market cap or market capitalization. And very simply, it's just a little bit of math, it's the number of shares that exist multiplied by the share price. So hypothetically, if there's a million shares at $10 a share that company has a market cap of 10 million. And at the time of recording this, Rivian has a share price of about 32 bucks and a market cap of about 28 billion. Okay, so we're dealing with really big numbers here, and Rivian's a really new company and there's still a lot of speculation, of course because it's new, but that's how you determine market cap. And I'm going to come back to that in a second, but if you understand what market cap is, you can know that there is small companies by market cap and large companies and medium size of course too. So we will use terms like small cap and large cap and those just refer to small companies and big companies. When we're talking in this scale here, a small company is usually companies that are worth 5 billion or less, billion with a B. And so these are still massive companies for sure, but different than apple that is into the multiple trillions with a T. So anyways, when we talk about markets, a lot of people default to thinking about things like the S&P 500 or the Dow Jones or the TSX. If you don't know what these are, even if you do know what they are, I'll just clarify that these aren't markets, these are indexes or indices.  Okay. So what is an index? Well, let's go back to our Rivian example here. So Rivian is just one company, but there are tens of thousands of companies that are publicly traded around the world. And so if Rivian moves in one direction one day and it moves a direction another day, it doesn't really tell you what the stock market in general is doing.

So to understand what the average investor might be experiencing or what the average stock is doing, indexes were created. And an index is just a hypothetical grouping of companies and the index tracks, the average performance in that group. Okay. Let's use the S&P 500 for example. So S&P, don't get too hung up on these names, all of these indexes will have the name of a ratings agency or a company that actually creates the index in front of it. Don't worry about S&P or Russell or Wilshire or Dow or anything like that. But just to understand what these companies are and what the indexes are, let's use the S&P 500, for example.

S&P or Standard and Poors is the organization that maintains the index and they are responsible for adjusting it and determining which companies are included and which are excluded. So the S&P 500 is essentially the 500 largest companies in the us waited by market cap. There's that term again right. So the largest companies buy market cap are the largest components of the index, and it's not just equal participation. So Apple is the largest company in the S&P 500 and they currently make up over 7% of the index. Let's use another company that you've heard of before, Costco. Costco's number 25 in the list, the 25th  largest company by market cap, but they only make up 0.7% of the index.

So the movement of the S&P 500 is mostly determined by the change in price of the biggest companies. If Apple, Microsoft, Amazon, and Tesla all have awful days. The S&P 500 will get dragged down a lot more than if smaller companies like Nike, Salesforce and Starbucks all have bad days.  And the opposite is true too.

So I'm a big basketball fan and when I was thinking about these indexes, I was like it's kind of like the NBA a little bit. So the S&P 500, I think is kind of like the NBA, because it's a stars league.  You know, the LeBron James of the world. The players have great impact over the outcome of the games, much more than other sports potentially.  So you can think of an index kind of like a basketball team and that the stocks are individual players on that team. And so some players are stars and we'll score more than others, but the team is made up of a bunch of players who can still have an impact. So, a lot of you are listening from Toronto.  I'm a bit of a Raptors fan myself, more of a San Antonio Spurs fan, but you got to have a Canadian team or an east coast team to cheer for too. So anyways, the Raptors Pascal Siakam, that is their high scoring player. He averaged 23 points per game on the Raptors last year. If he scores double his average to 46 points, probably a pretty safe bet that the Raptors as a team will likely score more than they do on average. This is kind of like Apple having a great day in the S&P 500. It kind of the star player moves the needle for the whole team. But if Malachi Flynn who averages four points a game, doubles his average to eight points, the team probably doesn't have much of a different outcome. This is kind of like McDonald's having a great day.  It's good for them, but it doesn't necessarily change the outcome for the whole group. If every bench player, however, doubles their average in a game, they can move the needle for the team. Think of the Visa's, Home Depot, Coca-Cola, Facebook, Walmart. If they all start having positive movements, it means a lot less what Apple does if it's kind of a rising tide lifts all boats a little bit.

This is kind of like the Raptors bench mob back in 2017, where they had, you know, five or six guys that came off the bench and just really carried the team much more than any individual starter did in those years. So anyways, don't overthink the analogy here, but the biggest players had the biggest impact over the results in an index.

Anyway, so back to the indexes here, there's a bunch of different indexes intended to show different parts of the market. So the TSX or Toronto stock exchange 60, the TSX 60 for example, will show the performance of the 60 largest companies in Canada. The FTSC 100 will be the hundred largest companies in the UK, the Nikkei 225 is the 225 largest companies in Japan and so on and so forth. Most companies that have a stock exchange will have a corresponding index. So you can kind of see what's going on with the stocks in those countries.

So as you can probably tell from my examples there, lots of these indexes look at the largest companies or again, what we call large cap companies, but there are indexes for small cap companies too. For example, the Russell 2000 looks at the 2000 smallest companies in the US.  The TSX venture exchange is something a little bit different there, but you know, there's all these different ways that you can look at other parts of the market too. But the ones that get the headlines are usually the large cap, broad based market indexes. So most of what I've discussed here are those broad based market indexes. These are lots of companies over a variety of sectors, but they're the biggest players. However, as an investor, you're not necessarily only investing in large cap companies. You might have more specific sectors like oil and gas or technology, but you also might have different investment styles, like dividends, value, growth, momentum, low volatility, all these other things.  And so there are indexes to track all of that too. So now it almost starts to get a little bit confusing. So which indexes should you pay attention too?

Well, if you've been listening to me for any period of time, you know, that I think watching financial news is largely a waste of time and it provides more confusion than reassurance and financial media usually wants you to freak out because the more you freak out, the more you come back to their site and read their ads.  But anyways, so I think it's less important which indexes you look at and more important to know what story they're telling and how that relates to your investment strategy and goals. So, for example, if you're looking at the S&P 500, you're looking at the large companies in the United States. If you're only invested in Canadian stocks, watching the S&P 500 largely won't mean anything to you in your portfolio. Vice versa, if you're only invested in US small cap stocks, looking at the TSX 60 won't mean anything because our banks and oil and gas companies will have very little effect over small companies in the US.  That being said, the large cap companies usually are the ones that are moving the needle the most for the whole group and sometimes they can drag the economy and other stocks along with them. So for that reason, I kind of like watching large cap indexes for the areas that I'm invested in. So I've always recommended people be globally diversified in their portfolios, so for me, that means some in Canada, some international and a little bit more in the US. So for me watching the TSX composite index, the S&P 500, the Russell 2000 and the MSCI world ex US index are probably the most indicative of what my portfolio is doing on a daily basis. Because I have some in Canada, so that'd be the TSX composite. I have quite a bit more in the US, so the S&P 500 looks at the big ones. The Russell 2000 looks at the small ones and the MSCI world ex US looks at the biggest companies in the world that aren't US companies. So if you look at the world index, all of the biggest companies, there are the same as the S&P 500, because they're the biggest companies in the world anyways.  So if you strip out the US there, you can kind of see a little bit more, but what's going on in the global stock market.

You might have noticed that I've barely mentioned anything about the Dow or the Dow Jones industrial average. My one recommendation here would be to pay no attention to it whatsoever. I think five minutes spent looking at the Dow was five minutes wasted. It is unbelievable how much attention the Dow gets and how useless it is for the average person. The reason I don't like it, well there's a few reasons, but the main one is that it's a price weighted index, which I think is insane. And it's not representative of the economy of the stock market as a whole. So there's 30 stocks in there, it changes from time to time. And a lot of them are a little bit more old economy.  Some of them are newer, but maybe not representative where the economy is today, but price weighting as opposed to market cap weighting makes a huge difference.  Dow Jones gives more waiting for higher priced stocks instead of higher value stocks. So for example, if a company has a million shares at 10 bucks, they have a $10 million market cap rate. Remember that example from before. But at the same time, if a company has 500,000 shares at 20 bucks, they still have a $10 million market cap.  It's the same size of company. However, for the Dow Jones, that because the second company has a $20 share price, they would have double the weighting in the index. And thus the more that that company moves, the more the Dow moves. So dumb. The reason that people pay attention to the Dow is that it's old and it's established and people for whatever reason know it.  And so I just roll my eyes anytime the Dow Jones comes up. There's a really great podcast from planet money from NPR. I'll try to link that in the show notes here of why the Dow Jones is a useless index to watch. Anyways, I don't need to turn this into a Dow Jones rant session, but that would just be my one recommendation there. Don’t worry about that one.

Okay. So that's just kind of my general overview of what the market is. Again, when people talk about the market, they're talking about the stock market and generally speaking, that is the secondary market where stocks are being sold and bought between individual investors and institutions. Again, when you buy a stock, you don't buy them directly from the company.  You're not giving them money for doing that. You're buying it from another person or another company that's selling it to you. And so when all these companies are listed on a stock exchange it's tough to really track what's going on in aggregate. So there are indexes that are created, and this is what people think of again, when they think of the market.  But these are just groupings you can't invest in directly. You can get close, but you can't directly invest in an index.  Things like the S&P 500, the Russell 2000, the TSX composite. These are all indexes that kind of track what's going on. However, because there's so many indexes that track so many different things, make sure you know what you're looking at and how that actually relates to how you're invested personally.

Because I invest globally. I like to take a look at a few indexes from time to time that track stocks in Canada, the US and overseas, just so I can have a basic understanding of what's happening in the world. I do this for a living, so I think being informed is important. But for you as an investor, you don't necessarily need to spend a lot of time looking at these things.

But if you are taking a look at the financial news, when you look at an index know what it's doing. If you have a question about it, maybe look it up. If you Google it, Investipedia and Wikipedia, actually give really good breakdowns of what these different indexes are and what they're tracking.

But if you have any questions about those, feel free to send me an email. If you like this kind of content I’d gladly do more of it. I'm realizing I got a lot of questions about just like really, really essential things related to investing that I haven't spent a lot of time on. So things like understanding what is the market before we talk about different investment styles probably makes a lot of sense.  So if this was valuable for you, hit follow on the podcast player that you're listening to, or subscribe or whatever languages they're using on your app. But again, thanks so much for listening and we'll see in a couple weeks.

 Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan.  Evan Neufeld is a Certified Financial Planner and Registered Investment Fund advisor.  Mutual funds and ETFs are provided by Sterling Mutuals Inc.