The best analogy I have found to illustrate this concept is that of tides. Tides are caused by the gravitational force between the Earth, the Moon, and the Sun. To simplify, when the Moon is closest to the Earth, it pulls on the water, causing a high tide. Since the Earth stretches, a high tide also occurs at the opposite point. Because the Earth completes a full rotation every 24 hours, we therefore observe two high tides and two low tides each day. During this cycle, water is not created; it moves from one place to another.
In the stock market, the principle is the same. When a stock rises, it is because buyers dominate and are willing to pay more. When a stock falls, sellers dominate. In both cases, it is a temporary imbalance between supply and demand.
When a stock gains value, additional capital is being directed into it. When you buy a stock for your portfolio, the money comes either from selling another stock or from adding new funds to your account. You are allocating that capital to this new idea at the expense of other opportunities.
This rotation occurs at several levels. It can take place within the same sector. For example, you may sell Walmart shares to buy Costco shares. In doing so, you are moving money within the consumer staples sector.
There can also be rotation between sectors. For example, you may sell your software stocks to buy semiconductor stocks. Capital moves from one place to another. In this regard, you have probably noticed recently that some stock market movements are diametrically opposed. One morning, you see higher-growth, higher-risk sectors rising while defensive sectors are declining. The next day, the opposite happens: defensive sectors advance while higher-risk sectors decline. Money moves from one sector to another. In the industry, we call this phenomenon « risk-on, risk-off ».
This rotation also applies to asset classes. An investor may decide to withdraw money from a bond portfolio to increase an equity position. Money moves from one asset class to another.
Capital can also move from private markets to public markets. Imagine that you are a real estate investor. You are looking for opportunities but find that your investment returns have become less attractive. You then could sell properties and invest in the stock market. If the real estate market becomes highly attractive again, the reverse may be equally true.
Certain mechanisms can also temporarily create capital and influence flows from one place to another. Investors can use leverage to generate liquidity, for example through real estate refinancing or a brokerage margin account. This creation is temporary, however, since it must eventually be repaid. Investors may also choose to save more at the expense of immediate consumption. Central banks, for their part, can inject capital into the economy through expansionary monetary policies, such as lower interest rates. Governments can also stimulate the capital available in financial markets through fiscal policies, such as tax cuts, or through infrastructure investments.
Although my examples cover only a few scenarios and are somewhat simplistic, my objective is to convey that a rising stock is driven by the arrival of new capital. This capital can come from a variety of sources. Sometimes, interest in a sector or asset class is so strong that it attracts capital from everywhere, to the detriment of others. The diversity of sources from which capital can be drawn may explain the magnitude and duration of certain market movements.
Even though some tides are stronger than others because of the position of the Sun and the Moon, they do not rise forever. Sooner or later, the water will move elsewhere. In the stock market, nothing is linear. The movement of capital from one place to another generally creates new opportunities in neglected sectors or asset classes. Like the Earth, which never stops turning, these new opportunities will in turn move capital from one place to another. Money is not created, it moves.
Jean-Philippe Legault, CFA
Senior Portfolio Manager at COTE 100
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