Market Makers Make the Market

There is a relatively unknown force that keeps many markets moving, stocks included.  The “market maker” is a pivotal position within most all investment avenues.  A market maker stands ready to buy and sell, possibly at the same time, whatever assets they deal with.  In the case of any specific stock, the market maker will buy at a specified price and sell at a price a little higher.  this spread is where the market maker earns their income.  The benefit to the market is that liquidity is provided.  There may be a small interval in time when there are buyers but no sellers for a stock.  The market maker acts as a buffer here by absorbing that desire to buy by being obliged to sell their own holdings.

Market makers for stocks are typically large banks and investment institutions and are specifically registered as market makers.  They are required to be both a buyer and seller.  This risk is what justifies their reward.  The concept of the market maker goes outside of stocks.  Most commodities are sold through market makers.  Gold and Silver are the two common cases that you may have encountered in your daily life.  If you have ever been to a coin or pawn shop to buy gold or silver, the dealer will generally buy at spot price (market pice) and sell at a small premium above spot.  This is a market making function.  While not as formal as the stock market example, a local market maker will quickly lose business if they are selective about when they buy and sell or if their spread is too high.  Their worth is directly proportional to the amount of liquidity that they provide to their market.

One last note.  With all other factors the same, an increase in liquidity of an asset will increase the value of that asset.  Liquidity is a component of many comprehensive pricing methods.  Think about the difference between a house in an easy to sell area vs a house that may stay listed for a year or more.

Time to Buy Gold?

Holding Gold CoinI had a conversation with a friend recently in which he told me he was going to buy some gold as a result of the declining dollar and political unrest.  The chat went further down the path of needing something in the case of collapse of our economy and our currency.  While gold has performed well as an asset class (it’s not an investment) in the past, I cautioned that the time to buy gold was 10-15 years ago when nobody cared about it.  Since then it has been sensationalized in the news and would not be a smart buy.  The “smart money” has already sold out of their gold or has kept some and is looking to add fuel to the irrationality that the market is showing towards some metal that doesn’t really do anything other than sit there.

I have always maintained that it is important to be a good steward of your own personal economy, since that’s the one thing that you yourself can control.  This is why fundamentally, I have a problem with holding gold based on most reasons, including news sensationalism and irrational panic.  Gold does nothing for you.  At least nothing like what true investments such as learning a new skill, buying some real estate or company stock, going to college or trade school, or even taking a vacation.  Our county was not built into the beacon of free markets, and wealth creation based on holding some yellow rocks, but instead on the principles of self improvement, ingenuity, and productivity.

FPO investment concepts

Good Evening FPO Readers,

The information below outlines the FPO investment concept.

1. Our investments should be in asset classes that yield a product, not in items that can only appreciate and do nothing. Examples of this principle include timber land, oil wells, banks, rental property, rental equipment, agriculture, manufacturing, and even music and theatre.  For example, while gold itself does not adhere to our investment concept, owning the production of gold does.  The recommended method for this is direct purchase of stocks, bonds, and convertible securities of well managed mining companies.

2. Our investments, regardless of asset class should minimize middle-man activities. This primarily speaks to commissions.  This means trading an asset as cost effectively possible.  The goal is for us to prosper based on our assets, not for a broker/salesman to prosper on our assets.  We do the research and know what is right for us.  With the dominance of on-line trading, low-cost software can now handle most all of the middle-man tasks.  An example of this would be if we wanted to build a exchange traded fund for the entire gold sector, rather than buy a proportional group of shares of each of the companies, we would aim to build a simple, yet highly representative portfolio.  As long as adequate representation is met, this portfolio may consist of a mix of fewer stocks, gold futures contracts, derivatives, and owning corporate debt for a specific investment capital lending bank to the majority of the mining industry.  If this course of action reduces ownership costs, while meeting the same investment objectives, then it meets the second FPO investment concept.

Gold vs. S&P 500

Is it better to buy gold or the S&P 500?  The answer is both.  It’s the timing between the two that’s crucial.  To understand why, it’s best to take a practical look at the two asset classes.  Gold is commonly referred to as a “store of value”.  It is what it is.  Gold has a high value due to its anti-corrosive properties, its density, malleability, luster, and ductility.  However, it does not work or generate any cash flow or grow itself additionally.  This is where stocks come in.  Stocks are a product of ownership of production.  A company brings in revenues, pays fixed and variable costs, taxes, and corporate debt.  The remaining amount of earnings, positive or negative passes to the shareholder in a mix of dividends and reinvestment into the company.  The present value (discounted at the required/market rate of return) of the sum of these earnings establish the stock price of the company, which fluctuates on a daily basis.

The chart below is a graph of the ratio of the S&P 500/Gold Price with respect to time.  This chart does not take dividends into account.

Gold vs SP500

Using this chart it is easy to see which asset outperformed the other over any period of time. Over a given time period if the end ratio is higher than the start ratio, the S&P 500 outperformed gold. If the end ratio is lower than the start ratio, gold outperformed the S&P 500.

For example, take a starting point of 1970 and an point of 2000.  The ratios are 2 and 5, respectively. Over this 30 year period stocks outperformed gold.  The ratio for 1930 is 1.5 and the ratio for 1950 is 0.4.  In this period gold outperformed the S&P 500.
There are a lot of factors that will determine price movements and based on trading activities, politics, and the economy.

Any chart theory is not definitive, and should be used only as part of a complete investment approach.  This method is based on a best value trading of the Gold / S&P 500 pair.  Stocks represent the productivity, but a commodity can become increasingly scarce.  A possible approach would be to trade based on the historic ratio bounds.  In this case rebalancing would occur based on the ratio.  At 0.2, an investor would hold 5 parts stock to 1 part gold (0.2/1:1).  At 5, an investor would hold 5 parts gold to 1 part stock.

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