The Stock Market - A Beginner's Guide

The stock market is a creature in and of itself. At times it makes sense and at other times, no one can explain why it acts the way it does. What is clear is that, over the long run, the stock market will climb and climb faster than almost any other traditional investment. With that said, there are also moments (that sometimes last years) when the value of the stock market gets out of whack with the underlying companies and with the economy. I’ll try to explain my views below.

1. How the stock market works 

 The stock market is driven by supply and demand. The number of shares of stock dictates the supply and the number of shares that investors want to buy dictates the demand.  It's important to understand the for every share that is purchased, there is someone on the other end selling that share (or vice versa).  The stock market is really just a big, automated superstore where everyone goes to buy and sell their stock.  The main players in the stock market are the exchanges.  Exchanges are where the sellers are matched with buyers to both facilitate trading and to help set the price of the shares.  The primary exchanges are the Nasdaq, the New York Stock Exchange (NYSE), all of the ECNs (electronic communication networks) and a few other regional exchanges like the American Stock Exchange and the Pacific Stock Exchange.  Years ago, all of the trading was done through the traditional exchanges (like the NYSE, American and Pacific Exchanges) but now almost all of the trading is done through the Nasdaq, which uses ECNs and thousands of other firms with access to the Nasdaq to facilitate trading.

Here's an example of one of the many ways that the stock market works:

You open an account with E*Trade.  You send E*Trade a check for $1,000.  E*Trade deposits the check into a trading account that is listed under your name.  You log onto E*Trade and place an order to buy 100 shares of a stock in Company A, which is currently trading at $5.  E*Trade uses it's network to tell the Nasdaq and all of it's related networks that there is demand for 100 shares of Company A's stock.  The Nasdaq finds someone who is willing to sell 100 shares of Company A and, instantaneously, they execute the trading of stock between you and the person selling the shares.  The trade information is sent to a clearinghouse where the information is processed and the shares will now be registered to you.  Basically, the clearinghouse will designate 100 shares of Company A to E*Trade and E*Trade will designate those 100 shares as yours.  The actual stock certificates are typically held "in street name" and never really need to exchange hands (although you could request that the stock certificates be transferred to your name). In a nutshell, that's how the stock market works.  The stock market is really just like any other marketplace - it facilitates the exchange of goods between interested parties and works to reduce distribution costs and set prices.

How stocks are valued

Stocks have two types of valuations.  One is a value created using some type of cash flow, sales or fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for a particular share of stock and by how much other investors are willing to sell a stock for (in other words, by supply and demand). Both of these values change over time as investors change the way they analyze stocks and as they become more or less confident in the future of stocks.  Let me discuss both types of valuations.
First, the fundamental valuation.  This is the valuation that people use to justify stock prices.  The most common example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio.  This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based on measurable attributes.  This form of valuation is typically what drives long-term stock prices.
The other way stocks are valued is based on supply and demand.  The more people that want to buy the stock, the higher its price will be.  And conversely, the more people that want to sell the stock, the lower the price will be.  This form of valuation is very hard to understand or predict, and is often drives the short-term stock market trends.