Since its inception, the stock market has been one of the most powerful and consistent sources of wealth creation available.
Although stocks see more volatility than other assets, they have also averaged a real return of 6.7% per year between 1925 and 2014, compared to just 2.7% for bonds and 0.5% for cash.
And over long periods of time, the extraordinary power of compounding can turn this differential into a wealth generation machine.
But What is a Stock Market?
There is no denying the stock market’s unparalleled ability to create wealth, but that doesn’t mean it’s always an easy sell to newcomers.
For most people, the very mention of the stock market conjures up images of a frantic floor at a busy stock exchange, people in suits yelling “Buy!” or “Sell!”, or even the sensational media coverage that can dominate the news cycle.
Today’s animation provides an easier reference point for potential newcomers – it comes to us from TED-Ed and it highlights the basics of the stock market, as well as how it works.
By understanding the original purpose of the stock market and also its history, we can better understand how the modern market applies to wealth creation.
In a nutshell, it provides a way for investors and companies to share the profit (and risks) of bold new endeavors, such as trying to invent a new cancer cure, discovering natural resource deposits, disrupting old business models, or innovating advanced technologies.
The stock market has allowed companies ranging from Amazon to Starbucks to succeed, and for investors to share in that success.
Basics of the Stock Market
Here are some other key questions that the animation helps to answer about the basics of the stock market:
How does a company get on the market?
A company needs to have an Initial Public Offering (IPO). This is traditionally done through big investment banks that help advise companies on the potential value of their company, and the market for their stock. More recently, companies like Slack and Spotify have IPO’d using a less traditional route.
How does going public help a company grow?
In the right scenario, listing on a stock market gives a company access to more capital. With more money, the company can make investments into new products and markets.
How is a stock price determined by the market?
By allowing millions of people to buy and sell shares of the company using the same set of information, it creates transparency and liquidity. Over time, this pushing and pulling creates a “fair” price for the stock.
What else influences stock prices?
Stock prices are not only influenced by what a company does – they are also influenced by external factors such as government regulations, market forces, competition, and changes in technology. Investor sentiment also plays a role.
Why invest for the long term?
Because short-term noise in the market can be hard to predict, most professionals promote long-term, reliable investment methods.
Some examples of this in practice would include low-cost index funds, mutual funds, or simply building your own diverse portfolio of stocks, bonds, and other investments for the long haul.
Past and Future
The stock market is very different today than it was when the first shares of the Dutch East India Company started trading in the 17th century.
Although the financial industry has increased in sophistication since those times, it still has the same general purpose – and it’s easier to get started investing than ever before.
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Interest Rate Hikes vs. Inflation Rate, by Country
Inflation rates are reaching multi-decade highs in some countries. How aggressive have central banks been with interest rate hikes?
Interest Rate Hikes vs. Inflation Rate, by Country
Imagine today’s high inflation like a car speeding down a hill. In order to slow it down, you need to hit the brakes. In this case, the “brakes” are interest rate hikes intended to slow spending. However, some central banks are hitting the brakes faster than others.
This graphic uses data from central banks and government websites to show how policy interest rates and inflation rates have changed since the start of the year. It was inspired by a chart created by Macrobond.
How Do Interest Rate Hikes Combat Inflation?
To understand how interest rates influence inflation, we need to understand how inflation works. Inflation is the result of too much money chasing too few goods. Over the last several months, this has occurred amid a surge in demand and supply chain disruptions worsened by Russia’s invasion of Ukraine.
In an effort to combat inflation, central banks will raise their policy rate. This is the rate they charge commercial banks for loans or pay commercial banks for deposits. Commercial banks pass on a portion of these higher rates to their customers, which reduces the purchasing power of businesses and consumers. For example, it becomes more expensive to borrow money for a house or car.
Ultimately, interest rate hikes act to slow spending and encourage saving. This motivates companies to increase prices at a slower rate, or lower prices, to stimulate demand.
Rising Interest Rates and Inflation
With inflation rates hitting multi-decade highs in some countries, many central banks have announced interest rate hikes. Below, we show how the inflation rate and policy interest rate have changed for select countries and regions since January 2022. The jurisdictions are ordered from highest to lowest current inflation rate.
|Jurisdiction||Jan 2022 Inflation||May 2022 Inflation||Jan 2022 Policy Rate||Jun 2022 Policy Rate|
The Euro area has 3 policy rates; the data above represents the main refinancing operations rate. Inflation data is as of May 2022 except for New Zealand and Australia, where the latest quarterly data is as of March 2022.
The U.S. Federal Reserve has been the most aggressive with its interest rate hikes. It has raised its policy rate by 1.5% since January, with half of that increase occurring at the June 2022 meeting. Jerome Powell, the Federal Reserve chair, said the committee would like to “do a little more front-end loading” to bring policy rates to normal levels. The action comes as the U.S. faces its highest inflation rate in 40 years.
On the other hand, the European Union is experiencing inflation of 8.1% but has not yet raised its policy rate. The European Central Bank has, however, provided clear forward guidance. It intends to raise rates by 0.25% in July, by a possibly larger increment in September, and with gradual but sustained increases thereafter. Clear forward guidance is intended to help people make spending and investment decisions, and avoid surprises that could disrupt markets.
Pacing Interest Rate Hikes
Raising interest rates is a fine balancing act. If central banks raise rates too quickly, it’s like slamming the brakes on that car speeding downhill: the economy could come to a standstill. This occurred in the U.S. in the 1980’s when the Federal Reserve, led by Chair Paul Volcker, raised the policy rate to 20%. The economy went into a recession, though the aggressive monetary policy did eventually tame double digit inflation.
However, if rates are raised too slowly, inflation could gather enough momentum that it becomes difficult to stop. The longer high price increases linger, the more future inflation expectations build. This can result in people buying more in anticipation of prices rising further, perpetuating high demand.
“There’s always a risk of going too far or not going far enough, and it’s going to be a very difficult judgment to make.” — Jerome Powell, U.S. Federal Reserve Chair
It’s worth noting that while central banks can influence demand through policy rates, this is only one side of the equation. Inflation is also being caused by supply chain issues, a problem that is more or less outside of the control of central banks.
3 Insights From the FED’s Latest Economic Snapshot
Stay up to date on the U.S. economy with this infographic summarizing the most recent Federal Reserve data released.
3 Insights From the Latest U.S. Economic Data
Each month, the Federal Reserve Bank of New York publishes monthly economic snapshots.
To make this report accessible to a wider audience, we’ve identified the three most important takeaways from the report and compiled them into one infographic.
1. Growth figures in Q2 will make or break a recession
Generally speaking, a recession begins when an economy exhibits two consecutive quarters of negative GDP growth. Because U.S. GDP shrank by -1.5% in Q1 2022 (January to March), a lot rests on the Q2 figure (April to June) which should be released on July 28th.
Referencing strong business activity and continued growth in consumer spending, economists predict that U.S. GDP will grow by +2.1% in Q2. This would mark a decisive reversal from Q1, and put an end to recessionary fears for the time being.
Unfortunately, inflation is the top financial concern for Americans, and this is dampening consumer confidence. Shown below, the consumer confidence index reflects the public’s short-term outlook for income, business, and labor conditions.
Falling consumer confidence suggests that more people will delay big purchases such as cars, major appliances, and vacations.
2. The COVID-era housing boom could be over
Housing markets have been riding high since the beginning of the COVID-19 pandemic, but this run is likely coming to an end. Here’s a summary of what’s happened since 2020:
- Lockdowns in early 2020 created lots of pent-up demand for homes
- Greater household savings and record-low mortgage rates pushed demand even further
- Supply chain disruptions greatly increased the cost of materials like lumber
- Construction of new homes couldn’t keep up, and housing supply fell to historic lows
Today, home prices are at record highs and the cost of borrowing is rapidly rising. For evidence, look no further than the 30-year fixed mortgage rate, which has doubled to more than 6% since the beginning of 2022.
Given these developments, the drop in the number of home sales could be a sign that many Americans are being priced out of the market.
3. Don’t expect groceries to become any cheaper
Inflation has been a hot topic this year, especially with gas prices reaching $5 a gallon. But there’s one category of goods that’s perhaps even more alarming: food.
The following table includes food inflation over the past three years, as the percent change over the past 12 months.
|Date||CPI Food Component (%)|
From this data, we can see that food inflation really picked up speed in April 2020, jumping to +3.5% from +1.9% in the previous month. This was due to supply chain disruptions and a sudden rebound in global demand.
Fast forward to today, and food inflation is running rampant at 10.1%. A contributing factor is the impending fertilizer shortage, which stems from the Ukraine war. As it turns out, Russia is not only a massive exporter of oil, but wheat and fertilizer as well.
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