DF Paulaha
Cell phone rings.
Profit taking.
Profit taking?
Right. You asked. And I’m telling you.
You’re telling me the reason the Dow lost 200 points yesterday is profit taking?
That’s what they say.
Who are they?
The ones who know.
Know what?
Know about stock prices. The experts. The wise guys. The explainers and predictors.
What is profit taking supposed to mean?
It’s simple. Here’s a definition from Investopedia: “The action of selling stock to cash in on a sharp rise. This action pushes prices down temporarily. When traders are profit taking, the implication is that there is an upward trend in the security.”
You’re kidding, right?
Not at all.
So how is it supposed to work?
The Investopedia explanation is as good as any: “For example, in the media you might hear something like this: Markets were down today as traders took some profits off the table. It's common for prices to retract to some extent even in bull markets.
Might hear it? I hear it all the time. So the idea is, stock prices are rising, and even though investors expect prices to keep rising, they sell out to take a little profit.
That's it.
Do you have any idea how silly that sounds?
What's silly about it?
Why would they sell if they expect prices to keep increasing? If they sell to take a little profit, then they lose when they buy back in.
Not if the profit takers know prices will fall after they sell.
How could they know prices will fall? You just said they expected prices to keep rising. If prices don't fall after they sell, they lose when they buy back in.
I guess they know their selling will cause prices to fall.
Really? You really want to say that?
Why not?
Because it sounds like you’re saying prices are manipulated.
That can't happen.
Then it's a phony explanation for a drop in prices. An explanation the experts seem to use when they don't have a clue about what really happened. Do you want to pretend you can predict a drop in prices based on the profit taking idea?
It doesn't work like that.
I didn’t think so. I can't count how many times I have heard the experts say a drop in stock prices was due to profit taking.
That's what I'm saying. It's a long standing idea. Sort of a tradition.
I guess. Do you want me to tell you how many times I have heard the investment experts say they are predicting prices to fall tomorrow because of profit taking?
How many?
None. Zero. Never heard it.
What's your point?
That if the profit taking explanation for a drop in prices is real, someone is manipulating prices.
That could never happen. The markets protect us from price manipulators.
Markets can’t protect anything, because markets do not exist.
What?
Never mind. So you’re saying the experts quickly interview a bunch of people and institutions who sold stock yesterday and ask if they sold to take a little profit? To see if that explains the 200 point drop?
That’s impossible. There’s no way of knowing exactly why someone bought or sold yesterday. And it would be impossible to identify all the sellers and to interview all of them in a few minutes.
Then why don’t they say that? Why don’t they just say they don’t know? It seems to me, the investment experts, the wise guys, the explainers and predictors are lying, are incredibly gullible, are incredibly stupid, or, which is hopefully the case, simply have no clue as to what is happening. They are counting on me, and all other investors, to accept their phony profit-taking explanation.
Do you have a better explanation?
Well, I'm not the expert, but it seems to me that if stock prices fall during a bull market, or anytime, it's because more shares were offered for sale at the temporary price than were being bought.
But can you explain why?
Maybe not ahead of time. And not if there aren’t any facts to explain what happened. But I wouldn't pretend I could help someone by lying to them. It seems to me that when prices are changing and there is no good explanation as to why, someone is probably making money on the deal.
A conversation about irrational expectations
DF Paulaha
Hello.
Hello. I wanted to let you know one of your stocks lost ten percent yesterday.
Why?
Because the earnings per-share reported by the company were less than what Wall Street predicted.
How much lower?
The predictors predicted the earnings per share would increase to $1.15. The company reported earnings of only $1.10 per share.
That's not much of a difference.
It's not always the size of the difference that matters, it’s that earnings do not meet expectations.
Let me get this straight. Someone who does not work for the company and who does not have any of the numbers the company has predicts what the earnings per-share will be for the company for a quarter that hasn’t ended yet. Or hasn’t even started.
That's it.
But the company itself can’t know what its earnings per share are until the quarter ends and it can look at the real numbers. So how can someone who doesn't have any of the numbers make an estimate that means anything?
That's how it works.
You're kidding.
Not at all.
Okay. An expert makes an estimate of what some company's earnings per-share will be for a three month period that hasn't ended yet. Or hasn’t even begun. Then, when the real numbers come in and the company can calculate its actual earnings per-share, the Wall Street guys say, Whoa, baby, we better bail out of this one; the company didn't meet expectations.
Exactly. That's how it works.
That has to be one of the dumbest things I have ever heard. Maybe the dumbest.
What's wrong with it?
Well, given that no one, including the company itself, can possibly know what the exact earnings per share will be until the quarter ends and all the real numbers are in, wouldn't it make more sense to say if the actual earnings end up being different from the experts’ expectations, that the predictors were wrong?
What difference does it make?
To begin with, the predictors’ predictions are nothing more than made up numbers. Whether or not they use past numbers or a little model to make their predictions, they are still made up numbers. What if the actual earnings per-share beat the expectations?
Then the stock price is almost certain to increase.
Because the Wall Street guys say, Whoa, baby, we better get on this horse; that company just beat Wall Street’s expectations.
Sort of.
What are the odds of someone predicting a company’s future earnings per share right down to the penny?
Pretty much zero. It’s impossible.
And everyone knows that.
They should.
And even though everyone should know it, when the actual earnings per share are greater than predicted, the stock price increases, and when earnings are less than predicted, the stock price falls, even if there was a large increase in profits?
Right.
Which means the game of predictions causes constant and unending stress and uncertainty for investors.
Right.
And you don't see the insanity of having the price of a stock increase or decrease because its real earnings-per-share for a quarter are greater or less than some made up number?
Like when?
Like on Thursday, January 23, 2017, when Alphabet Inc (Google’s parent) stock lost 2.7 percent. The reason, according to the media, was Alphabet Inc reported fourth-quarter profits below what experts and analysts had predicted. So when Alphabet Inc told everyone about its real numbers, investors started selling and analysts started predicting again. The analysts could not have known what was actually happening inside Alphabet Inc (and they certainly couldn’t know what had not happened yet); now they had Alphabet Inc numbers. And when investors saw the real profits were less than the predicted profit per share, they sold and the price of Alphabet Inc stock fell.
Just because Alphabet Inc’s profits did not hit the predicted number?
Right.
What about revenue?
Alphabet Inc’s revenue actually increased 22.3 percent.
Isn’t that good?
Of course, but that’s what happens when actual profits fall short of expectations.
How could revenue increase that much and profits not?
Oh, profits did increase.
How much?
Profits per share were $9.36.
What was the expert prediction?
$9.64.
You have to be kidding.
No. That’s how it works. Revenue increased 22.3 percent, but profits per share were only $9.36 instead of the predicted $9.64. So the stock price falls. It ends up it was because of taxes.
That is one of the dumbest things I have ever heard.
What’s wrong with it? It happens every day with one stock after another.
It’s not real.
But it’s part of the game.
That’s what I said.
You sound like one of the people in the children's story who couldn’t see the emperor’s new clothes.
Maybe. Let me ask you a different question. About Sunday afternoon football. Just before each televised game, a panel of experts, normally former players and coaches, picks a winner and a final score for a game that hasn’t been played yet. When the game is over, and the Packers won, no one says, Too bad. I guess the Packers didn’t really win, because Terry picked the Lions. Or, I guess the Packers didn’t really win, because they didn’t win by as many points as Howie guessed. What viewers, and the other predictors, say is, Looks like Howie was the best predictor today.
So what are you saying?
I’m saying it’s about the predictor, not the team or the game.
That’s what I am telling you. Stocks are the same. It’s the same because a lot of experts like to predict earnings for a company for a time period that hasn’t happened yet.
The difference is, at the end of the three-month period, when the actual numbers come in, instead of seeing who was the best predictor, investors are told it is about the company, not about how good a guess the predictors made.
So you’re saying the experts aren’t real experts?
Not at all. They are just as much experts as the experts predicting the outcomes of football games. They may be smart. But they are not wizards. They are making guesses. They may be educated guesses. But they are still guesses.
So what are you saying now?
I’m saying it’s unnerving to see stock prices rise and fall because the experts miss with their predictions, their guesses. I’m saying it is scary to see how easy it is for investors to accept false ideas when the false ideas come from those we like to think are experts. I’m saying it seems fishy—do low predictions keep a stock price down before earnings are reported? Do high predictions keep a price up? I’m saying, does someone profit from high or low predictions?
You make it sound like the experts might be part of a rigged game.
I didn’t say that.
Good, because there is no way the game of predicting profits or sales or revenue can be rigged or manipulated.
Why not?
Because the market regulates all of that. The market protects investors from manipulation. So it can’t happen.
The market does that?
Right. The market is a better regulator of the financial industry than the Federal Reserve.
Says who?
Says Alan Greenspan when he was being pressured to regulate the big financial firms that were betting money they didn’t have on derivatives.
Until it blew up and gave us the Great Recession. Then he wasn’t so sure.
He still believes in the market.
And if markets did not exist, would you still be so sure that the profit-taking game isn’t a way for those who know it is a scam to make a lot of money?
What do you mean?
There is no market.
What?
Nothing. Thanks for the call.
The supply and demand fallacy behind the Minneapolis 2040 Plan
Dennis Paulaha, PhD Economist
(Minneapolis Star Tribune; July 24, 2018)
The argument behind upzoning in the Minneapolis 2040 Plan is that if the quantity of housing units is increased by removing or relaxing building standards and allowing single-family tear-downs to be replaced with duplexes, fourplexes, and commercial buildings in neighborhoods currently zoned for single-family homes, the increase in supply will stabilize or reduce prices.
The problem is, quantity is not the same as supply. And we can be in the supply and demand business only if all housing units are identical, buyers do not care which house they buy, and all houses sell for the exact same equilibrium market price.
And because none of that is true, we are not in the supply and demand business.
We are in the quantity business.
And one of the best examples of increasing the quantity of housing units and the population density in a city is the massive condominium complex recently completed in Wayzata. Did low-income and middle-income people rush to buy the new units, given that, without traffic, they are only 10 or 15 minutes from downtown? No. Because units start at $1 million each.
In the real world, developers build houses and condos they think will give them the greatest profits, which does not mean, the more they build, the lower the price.
In Minneapolis, builders have been tearing down single-family homes they buy for $350,000 to $400,000, and replacing them with million dollar houses. Why? Because it’s profitable. And when they do, the quantity of houses (or what the Plan mistakenly calls supply) stays the same, but the price goes up. The tear-down builders make profits while making the neighborhood even less affordable.
In other words, if someone wants to claim increasing the quantity of housing units in a neighborhood or city lowers prices, they can look at Wayzata, Uptown, downtown, Edina, the north loop, or anywhere else large condo developments are taking place. They can also look at new houses being built in the suburbs. Does building new houses in Edina or Minnetonka mean prices go down? No. Prices are up to the builder, and may be affected by some negotiating with the buyer. But no builder is going to think that because the house he just completed adds to the quantity of houses in the neighborhood, or the city, he will have to sell it for a lower price. That’s absurd.
Am I saying house prices are not affected by the number available for sale and the number of buyers at any point in time? No. I am saying the price of any house is not the result of supply and demand determining an equilibrium market price. It’s one house or housing unit at a time, sold by a builder or an owner, and the more buyers there are, and the more money buyers have, and the fewer houses there are for sale, and the lower mortgage rates are, the higher the negotiated price is likely to be. But that is not the same as the textbook idea of supply and demand, where all units are identical.
Finally, if a three bedroom, two bath single family house is torn down and replaced by a building with four apartments or condos, and the price of each condo unit is less than the now destroyed single-family home, can we say prices have fallen? Not if we want to be truthful, because we are talking about apples and oranges. The price of a condo unit that is smaller than the single-family house that was torn down and which, according to the 2040 Plan, will have a smaller (and shared) yard and will not have off street parking, cannot be compared to the price of the now-gone single-family house.
You are not getting the same thing for less money. You are getting something different for less money. And you can’t use those numbers to say prices went down. We should also not fool ourselves into thinking builders will buy houses for $400,000, tear them down, and build fourplexes with units that sell for less than $200,000 anyway. Even if they could, they wouldn’t want to, because that would mean giving up profits. The most likely outcome of upzoning is that single-family houses will be replaced with condo units that sell for more than the single-family houses that were torn down to build them.
All of which explains why upzoning is more likely to increase, not decrease, prices, and why it will not increase either affordable housing or diversity in upscale neighborhoods.
