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I apologize if this is gonna be very basic, but I am a beginner. My question is: why do markets (expressed as indices) grow? Is it because money is constantly moved from the real economy into stock markets, but the ingoing flow surpasses the outgoing flow?

Suppose no money can flow in or out a market, besides what is already in. Would that market (or a stock index that represents that market) just reach a dynamical equilibrium? I would say yes, but please correct me.

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The general answer is no, a closed market with only money circulating within the market, and that money never leaving it or entering it, cannot increase its aggregate price level - provided that the quantity of goods being sold on that market also remains constant. Price wise however, it can display variations over time, so share values can change - even if the money circulating that creates them doesn't.

The main reason market prices grow and shrink in the real world is that not only are new companies always being listed, but money is entering them and sometimes leaving them at different rates. In a typical western economy for example, the money supply is continuously growing due to bank lending, a percentage of that growth it being invested in the stock market through pension funds, and so there is a linkage between monetary growth and the market.

Consequently any time some kind of conduit between lending and stock market purchases gets created, things tend to get exciting. cf. 1929 US Crash.

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I'm not really sure what you're asking, but I'll try to answer what I think the question is. In an equity market, people trade certain financial assets. The first point is, trading these assets on a secondary market is not consumption, and it's not investment. If you buy a stock for 100 on NASDAQ, you basically give the previous owner of the stock 100, and you get a piece of paper in return. That piece of paper entitles you to a share of earnings of the company, and that's why you think it's worth something. You can either enjoy the earnings over time, or sell the thing later.

So you had $100, and you could have consumed something, or you could have invested it, but you chose to trade that choice to someone else. Now he has to decide whether to consume or invest. In terms of the "real" economy, nothing happens. And nothing happens when you sell that stock. Money never "comes into" the market, and it never "leaves" the market. It just gets transferred between the buyers and sellers, and shares get transferred in the opposite direction.

So we see the question of what happens if money can't come into the system doesn't really make any sense. So what do indices reflect? They reflect some kind of expectation of the aggregate value of the shares in an index. That value is the expected discounted streams of earnings of the companies in the index. When the expectations rise, the indices rise. When they fall, the indices fall. Obviously, if we expect inflation, we expect earnings in nominal terms to rise, so that will make the indices rise. But that shouldn't be thought of as "more dollars chasing the same number of stocks." It's purely an earnings effect. The only thing that can make a stock more valuable is if its earnings expectations rise. Supply and demand, as understood in consumer goods markets, do not have much of anything to do with secondary equity markets. Just because people have more money to buy stocks with does not mean anyone will spend 100 dollars to buy a stream of earnings worth 95 dollars. (I say "much of anything". It would make this post too long to go into details, but if there is a surplus of demand for financial assets, risk premiums will drop, and prices will rise. This is a long story for a relatively small effect.) I should mention another reason indices rise, because it's why we expect them to rise faster than economic growth. And that's because there's a selection bias in companies in indices: very poorly performing companies are booted, and more successful up-and-coming companies replace them.

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  • $\begingroup$ +1, but I think this could have been said more simply as "Stock markets grow (or fall) based on future expected earnings in the company stocks being traded." $\endgroup$ – Soren Jul 6 '15 at 1:12
  • $\begingroup$ Some things to think about. Are there more or less total shares being offered on the NYSE now, than 30 years ago? Is there more or less total money in the larger US economy now, than 30 years ago? Why don't more shares pay dividends? $\endgroup$ – Lumi Jul 6 '15 at 17:26
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Price movements don't need large money inflows.

Indices are generally built on spot prices, meaning the price of the last deal. This deal reflects the valuation of the company, but not the volume of transactions.

The market capitalization of Microsoft is $360 bn (MSFT). It's growing for the last 30 years, but it's only the number of shares outstanding times the price of one share (44). If someone starts buying MSFT, he pushes the share price up, while spending a fraction of percent of the total valuation. But this can't last forever because soon too many people will sell MSFT, and the guy will need more money to increase the price per share.

The fundamental factor that keeps the prices high is expectations about the company's earnings. This is why people don't sell MSFT when someone is trying to buy it. But you don't need much money to synchronize expectations and the price per share.

That said, prices do react to the money influx, which can be triggered by changes in the interest rate and international capital flows.

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Index level change is different from the change in the underlying stock. The way the index is calculated will determine the effect of change of underlying assets. As a stock trader, I change my valuations of stocks all the time. Valuations depend on many factors including economic environment, expected profitability of the stock company and interest. The supply and demand curve for each stock in the index will change constantly as the environment and investor sentiment changes. But this does not mean that the index will change because of the implication of a closed stock market.

The implication of a closed stock market is that market capital is constant. any dollar increase in stock A means that there must be an identical dollar decrease in stock B . The change in index level will depend on the way each stock is represented in the index e.g the weighting method " Capital weight, price weight, equal weight...etc".

For capital weighted indexes such as S&P 500, there is more representation of larger firms than smaller ones in the index. In our hypothetical example of the closed stock market, as more $ shift from stock A to stock B, the more the market will be affected by changes in the company with larger market cap.

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The key concept is what exactly "markets (expressed as indices) means. The term stands for "market value" of public cooperations (those issue stocks, in America this simply means the S&P 500). As you can see, market value does not necessarily mean the same as the total money the corporations hold. There are three reasons why market values can increase:

  1. When the financial environment exceeds previous expectation. For example, if the US government announce a better fiscal quarter of inflation/housing prices, the market rallies up in response because everyone (not literally, but most of investors) expects stocks in hands will worth more in the future. The current market value increases.
  2. When there exist less worrisome threats. Basically, when the markets can safely be sure that the critical events have passed (the US financial crisis, ...), the market recovers. Business cycle can be of help here.

These two reasons, in my opinion, are of "artificial money" created by expectations of investors. The last reason might be of real money.

  1. When demand exceeds supply. I am thinking of a simple example. Holding every other S&P 499 constant, if Apple issues their financial report claiming that last quarters they sold better than ever, more investors (in quantity) want to buy more stocks of Apple. The price of Apple stocks increases (though they are not issuing more stocks). This increase the market value of Apple (and of those investors holding the stocks already). In turn, this excess drives up the whole market.

The last reason might not be seen often in my opinion.

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  • $\begingroup$ Thank you for the answer, but I am still a bit confused. How can an index of an isolated market, where no further money can enter nor exit, grow? Say investors expect a firm to do better than another in the same market, they would probably like to sell the stocks of the latter and buy those of the former. But (i) they have to find somebody that buys their stocks and somebody that sells those they want to buy. And (ii), admit that this happens, wouldn't the two effects cancel out, when you consider a global index? Ultimately my question is: can money be "created" in an isolated market? And how? $\endgroup$ – Alepr85 Jul 5 '15 at 14:01
  • $\begingroup$ there are 3 questions. 1) yes, market value here is of those in stock market, not of the whole economy. For example, a completely new investor enters the stock market, bringing their money into the market. Also, market value is of evaluation, not necessarily cash. 2) yes. Because of the evaluation, money can be created without actual cash. You need a clear definition of money. For example, demand deposit is a type of money. $\endgroup$ – Thien Jul 5 '15 at 14:15
  • $\begingroup$ As long as being accepted as a mean of payment, anything can be treated as money. For example, an isolated market can create digital money (Bitcon), and by trading using it, the market can grow in terms of value (how investors evaluate the market) $\endgroup$ – Thien Jul 5 '15 at 14:17
  • $\begingroup$ I think money and value are getting a bit confused here. The price of stocks can rise on a market, but that doesn't mean that either the money supply or their value has increased. The typical and widespread mistake made is to think that all stocks listed on the market have the same value - they don't. Only the small number of shares currently being traded has that price, if all the shares were sold at once, prices would drop considerably. $\endgroup$ – Lumi Jul 5 '15 at 14:21

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