Ep.41 - How The Stock Market Works Like Google Maps (3 Minute Read)
Read Time: 3 Minutes
If you've been reading the news, then you know the stocks have been tumbling for over a week. Headlines suchs " Dow's Biggest Single Day Plunge in History" have been a sensentational one-liner that scared a lot of people. What exactly is happening? Let me explain in an analogy to Google Maps.
THE STOCK MARKET WORKS LIKE GOOGLE MAPS
How Google Maps works:
- Estimated Time: We set a destination. Google Maps spits out an estimated travel time (e.g. 40 minutes), based its best guess given all the factors on the road.
- Continuous Adjustment Based on New Information: Your travel time adjusts by the second as you start driving, because conditions on the road also changes second by second. There are two types of changing factors: macro and micro. Macro factors are city-wide and micro factors are street-specific.
- Macro Factor: This could be city-wide. If there's heavy rain in L.A., you will see your travel time increase.
- Micro Factor: This could be street-spedific. If you are driving through Hollywood Blvd, and there's an accident there, you will also see your time increase.
The stock market works in the same way:
- Stock Market Index: There are many stock market indices. For simplicity, let's use S&P500 as its best proxy. It is 2,581 on 2/8/18. The number of 2,581 is analogous to estimated time from Google Maps, as it is the best guess of the market at any given point.
- Continuous Adjustments Based on New Information: The stock market adjusts every second based on new information. Just like Google Maps, some are macro, and others are micro.
- Micro Factor: One of the most popular micro factor is whether a company's earnings are above or below the market expectation. In other words, if Amazon makes more money than what the experts predicted, it will increase the price in the stock market.
- Macro Factor: Now, one of the most important macro factors that impacts the stock market as a whole is interest rates. The relationship is inverse. When interest rates increase, the stock market slows or even drops. Why? Just imagine how you use your credit cards. You want a low interest one, because no one want to pay interest rates. When the interest rates rise on your credit card, you will have less to spend elsewhere.
RISING INTEREST RATES ARE THE CAUSE OF THE TRAFFIC JAM
Similar to how travel time on Google Maps constantly adjusts with new information on the road, the stock market constantly adjusts up and down with new information on the market. The single most important factor that caused the tumbling in the stock market is the fear of continuous rising interest rates, which is exacerbated with the new sheriff in town, the new Federal Reserve chairman, Mr. Powell. Why? This is because he's new and we have no track record to say if he's going to continue push up interest rates or otherwise. In a nutshell, there's uncertainty and confusion.
No One Remembers The Normal In the Past :We tend to have very short memories and over-emphasize recent experiences over those in the distant past. Why is that important? We have become accustomed to an unusual level of market condition of low interest rates, which the "we" from 2008, all knew it would not last. Now it actually disappearing.
- Interest Rate on Auto Loans: Here is a personal anecdote, I bought my first car back in 2004, and I remembered the interest rate was 6.5% on a 60-month financing term. That was the normal back then. But if you go shopping for a car, you can easily find somewhere between 1.99% and 2.99%. Yes, financing was that expensive back then! No one thought it was expensive, because it was the "normal".
- Interest Rate on 30-Year Fixed Mortgage: In the past 3 or 4 years, people who bought homes enjoyed low rates between 3% and 4%, depending on the year. That's definitely not normal by historical standards.. If we go further back before 2008, the same mortgage interest rate hovered between 5.5% and 7% in the 2000s. What does it mean? On a median house of $567k in L.A, the difference of monthly payment between a 3.5% and a 6%, is $853 a month. Yeah! people in the past were paying a lot on interests, and it will be our reality again!
ALL EYES ON THE NEW SHERIF
The new Fed chairman Powell has an incredible amount of influence, by making it clear everyone, what he intends to do with interest rates. The sooner he makes it clear on his stance, the sooner the market will calm.
There is only one thing we know for sure. The interest rates have risen, and the old days are not coming back. In other words, all of our big ticket items, such as cars, student loan, and mortgage payments, will likely be more expensive.
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