This morning, Renee Montagne of NPR’s Morning Edition interviewed economics editor David Wessel at The Wall Street Journal, who said of yesterday’s market plunge, “Look at it this way, over the last week the Standard & Poor’s 500 index and the stock market has lost about 10%; that means about two trillion dollars in wealth has evaporated.” Mr. Wessel should read my blog more often. On October 10, 2008, after another big drop, I explained in “Money (That’s What I Want)” that wealth does not evaporate when the market goes down.
The wealth in the stock market is real, not virtual or hypothetical. In October of 2008, 2,000 shares of Bank of America stock would have bought a new, fully-loaded Lincoln Navigator. Now, those shares wouldn’t buy a fully-loaded Ford Focus. For Mr. Wessel’s benefit, I will repeat, with a few changes, what I said then:
For an investor who buys and holds stock for a period of time, it seems that appreciation and depreciation come out of nowhere. Let’s say that Rosco buys a share of Youngstown Universal Cotter Keys, Inc. for one dollar. He holds the share of YUCK for a year and he gets $10 when he sells it. As far as Rosco is concerned, he just received nine dollars for nothing. Conversely, if Rudy bought that share from Rosco for $10 and it dropped to one, Rudy’s nine dollars just vanished like civil servants at quitting time. What if Rosco had not sold his share of YUCK and it went from one to ten and back down again? Were these virtual dollars with no more substance than my idle musings?
The money is real and even if Rosco bought and sold his share of stock for the same price, the fact that it rose and then fell nine dollars means that there were real money flows that enriched some investors and impoverished others. The money that the rise and fall of Rosco’s share of YUCK represents was real money that flowed into and out of the market, but was not gained or lost in the broader economy.
The first step to understanding how the money comes into and goes out of the stock market, is to consider that the rise and fall of the value of Rosco’s single share of stock is not an isolated event. If shares of YUCK go $1.00 to $2.00, it is because tens or hundreds of thousands of shares were traded and the final sales were for $2.00 at the end of the trading period. However, for the sake of simplicity, consider the situation where YUCK is being sold one share at a time.
Everyone who bought for a dollar and sold for two took a dollar in profit out of the market. If Rosco receives $2.00 from Rosie for a share of YUCK that he purchased for $1.00, Rosie puts two dollars into the market and Rosco takes two dollars out–his initial investment and a dollar of profit. If Rosie then sells to Reginald for $3.00, he puts that much in and Rosie gets back her investment plus a dollar in profit. Tracing a series of transactions up to the $10.00 price, then back to $1.00, it becomes obvious that the rise and fall of YUCK reflects the change in what investors are willing to pay for YUCK shares, but no money disappeared. In this hyper -simplified economic picture, every dollar that went into the market came from an investor’s cash account and every dollar that came out went back into a cash account. Therefore, all of the money that pours out of the stock market stays in the economy!
Expansion and contraction of the stock markets makes some poor investors rich and some rich investors poor, but the wealth of the country does not rise and fall with the stock markets. It just gets relocated within the economy.
A portion of the change in share prices reflects real growth or lack of profitability of individual companies. Investors scurriie away from U.S. auto manufacturers like dexedrine-dosed lemmings in 2008 because the car companies did not foresee rising gas prices–like, Who would have thought that the price of a limited resource would go up as supplies diminish?–and produce fuel-efficient vehicles. However, the shares were high a few years ago because Ford, GM and Chrysler had a big line-up of popular gas-guzzlers that yielded high profits. Some of the drop in U.S. auto stocks is therefore related to the companies’ market strength, but not all of it.
The price of YUCK shares may go up or down, based on YUCK’s profitability and financial health, but it may also go up or down based on investors’ perceptions of the cotter key industry specifically or the U.S. economy in general. Although some change in the market indices will be reflective of the health of the corporate sector, wild swings, such as yesterday’s dramatic drop, are not due to rapid variations in corporate financial viability. If the Dow drops 6% today, is the U.S. business climate 6% colder today than it was yesterday? As the Dow declined from 12,700 to 11,500, the country did not lose 9.5% of its value, or even 9.5% of the value of its businesses. The Dow fell due to a dramatic mood swing in the investing public away from stocks. That deflated stock values, but all that money is still out there in the U.S. economy.
Don’t panic! Although there will be cutbacks and business failures, the money that left the stock market is still out there. Sooner or later, investors will realize that they cannot make money on their money unless they put it where profits are being generated. That’s the stock market; and when money starts flowing back into stock, the markets shall rise again.
John B. Payne, Attorney
Garrison LawHouse, PC
Dearborn, Michigan 313.563.4900
Pittsburgh, Pennsylvania 800.220.7200
law-business.com ©2011 John B. Payne, Attorney