What are the financial markets (equity/stock, bond/debt/credit, commodity) good for?

During the workweek of August 24, 2015 through August 28, 2015, the well-followed and well-covered (by the press, at a minimum) Dow Jones Industrial Average index and the Standard & Poor’s 500 index experienced daily increases and/or decreases in excess of 2%.  Even though most market observers probably would not think that a 2% change in the price of a certain stock from $100 to $98, or from $100 to $102, was a big change to worry about, such percentage changes so many days in a row in the equity indices seem to generate massive euphoria or worry amongst market observers.  I am not sure if such euphoria or worry is rationale or irrational.  But I do believe that the financial markets are extremely important and useful aspects of our society.

Starting with the bond markets, which sometimes also are referred to as the credit or debt markets, is probably the easiest place to begin explaining why the financial markets are so important.  The bond markets, and specifically the integrity of the bond markets and the prices and yields of bonds, are of paramount importance in a capitalist society because the interest rate that investors demand for lending money to a borrower provides real-time information to potential investors about the risk of default (not meeting financial obligations in a timely/scheduled manner) of a given borrower.  When functioning properly (with brokerage firms making a profit on making markets in bonds and investors buying and selling bonds that meet the investors return requirements), the bond markets act as a risk-siren and opportunity-siren (frequently in the exact same bond security, but to different investors), providing information that enables risk-averse and risk-inclined investors and lenders to select organizations to provide capital to; moreover, when the markets are functioning with integrity, the lent capital (also referred to as ‘temporary’ capital) is usually more stable for the borrowers than if the lender is ill-informed of the risk characteristics of the borrower and therefore seeks to end the lending relationship.  Therefore, it is critical that the information that borrowers provide to the debt markets is accurate.  If not, and such inaccurate information is used by lenders, which provide critical capital to borrowers that have smart ideas for that capital to generate higher returns than the interest rate that the lender charges the borrower, lenders may lose faith in the integrity of the information that borrowers provide.  For example, if securities industry analysts assert that a borrower has a strong ability to make interest payments and repay principal when such ability is actually quite weak, then lenders will re-price risk rapidly, and in the case of the U.S. housing financial crisis of 2008-2009 lenders when information systematically lacked integrity, and lending sources may cease lending to massive components of an economy.  As such, the efficient and generally accurate pricing of repayment risk of borrowers is critical to economic stability and economic growth in a capitalist economic system.

In contrast, the stock market is driven (or should be driven) by quite different dynamics.  In almost all cases, but with a few variations, owning a share of stock represents a residual interest in the earnings of the stock issuer.  Shareholder rights to proportional earnings of a company are subject to more fluctuations than bondholders contractual legal rights to cash flows of a company.  As such, stocks probably should be more volatile in price ranges than bonds because more factors may affect the perception of the potential residual earnings power of an organization, and such factors will probably change more often than the factors that affect perceptions of organizations’ ability to repay borrowings, which rank much higher in an organization’s capital struck than the ‘permanent’ equity capital that stockholders provide to corporations.  For example, a corporation, AFTER meeting its obligations to bondholders and other creditors, may decide to invest in building inventory or adding to research and development expenses, rather than paying out more profits to shareholders; few, if any, organizations would intentionally put research and development expense or inventory build-up ahead of paying obligations to bondholders or other lenders – if an organization did that, it would probably only get the chance to do that ONCE because the bond market participants would penalize the borrower severely through demanding higher interest rates or by suing in the legal system.

After working primarily in the financial markets for almost 20 years, I live in a town where many of the residents work in the financial services industry, and I teach many of their kids at the high school level.  I also am fortunate to continue to interact-with and consult-to some outstanding professionals in the financial services industry.  These people and their organizations are very important to our capitalist society because they play a role of helping price loans and risk, which drives investments or in some cases prevents investments.  Their work fuels economic growth and regulates what entrepreneurial and business growth opportunities should be pursued and which should not.  I think it is very important that we continue to encourage some of our best and brightest young people to keep improving upon the integrity and efficiency of these vital tools of our capitalist society because the financial services industry and our markets ARE very good for society when these markets function with integrity and efficiency.