I'm an idiot; economic experts please help

Politics and religion
21

Lets say I own 100 shares of WTF Corp and each share cost $10. Some bad shit is brewing with the price of oil and I feel uneasy and want to sell and get money back, but the most anyone will pay is $9.50 a share. I sell anyways and just lost $50. Let’s say this effect cascades, and the guy I sold to gets antsy and decides to sell, but now $9 is all people will pay. he just lost $50. Let’s say over the course of the day this happens 8 more times and the share price closed at $5.

What has happened? 10 people all lost $50, and someone at the end of the day is holding 100 shares of WTF Corp. Maybe WTF Corp makes it back to $10 and the guy at the end of the chain doubles his money - that’s little consolation to the 10 of us who ate a pile of shit.

Maybe we’re talking retirement funds and it was $5,000 or $50,000 lost and not just $50. Maybe WTF Corp never recovers and just floats down at $5 for the next few years.

22

I dabble in markets, and used to work on them doing IT stuff years ago.
The thing is, unless you are mega-long-term, you don’t want to buy shares in X because you think X will make big profits next year. You want to buy shares in X because you think EVERYBODY ELSE will think X will make big profits next year. That way, the price will rise.
There is a massive herd mentality, and people swimming against the flow of the market often get crushed.

Take the Uk firms marks and spencers. (MKS). They are profitable, very established, have a great brand, fantastic customer loyalty, superb retail real-estate, and yet their share price is a disaster. It makes no sense. But what does make sense is not to hold on to those shares assuming everyone else is wrong. Even if they are wrong, the fact that their sentiment outweighs yours means you lose. (in the short term)

23

Yeah, that’s the main reason why I never do short term investing and focus on dividends and long term growth.

It’s conservative, and the returns are lower in the short term, but at the end I’ll have plenty of money.

24

That wouldn’t last in a true economic crisis, like runaway inflation. Another non-fiat medium of exchange would have to be created if the economy crashes hard enough.

25

Yeah, so? If you assume hyperinflation you can assume virtually anything.

26

Not unlimited. A small percentage of currency can still be backed by specie.

Well okay, but seeing as how banks consistently pushed to reduce the backing required further and further it might as well be unlimited. Because that pittance of real money they have isn’t going to stop any type of serious economic collapse.

Hell, I’m pretty sure that right now several major banks all over the world are already insolvent but just seem fine due to creative book keeping.

27

What did everybody think of the Wii back when it was first announced as the Revolution? How about when the initial details came across looking ultra-kiddie and gimmicky? How about now? How on or off mark were your predictions compared to reality?

What about the PS3 and the feeling that Sony was pretty fucked circa E3-2006? How did that pan out?

Are we idiots? We know games and the games industry right?

28

That’s as may be, but it’s not the fault of floating currency, it’s the lack of government regulation of the market. Just letting the money market boom and bust at will and taking the hands off approach when approving new financial instruments is a surefire way to provoke a poor reaction to floating currency.

29

Except that all currency is fiat to some extent - just the fact of its widespread use will inflate its value above the actual utility of whatever specie it is made or exchanged for. Sure, all the physical dollar bills in my wallet could theoretically drop in value to the point where they are as useful as a comparably-size piece of paper, but only if people stopped being paid in them, and before that happened there would be time to convert the numbers in my bank account to represent a different form of fiat currency. So the amount it can drop is definitely limited by the practical circumstances.

Wealth doesn’t disappear when the stock market goes down, only perceived wealth does. That’s because everyone considers the amount of wealth they control (from stocks) to be the sum total of the current value of their stocks. This is a good approximation under most circumstances, because when the market is normal, you can theoretically sell all your stocks and get pretty much full value. However, adding all those numbers together doesn’t tell you the real value of the stock market itself, because you could never liquidate the stock market completely at those prices. This is, of course, true for tangible things, too, it’s just less-likely that the value of those will fluctuate in the same way unless there’s a supply crisis (because there are usually regulations preventing someone from cornering the market).

30

I think you’re creating an artificial distinction between the two.

Let’s say I hold stock in a drug company. One day, the FDA announces that the company’s main drug must be pulled from the market. The stock drops 50%. Has my wealth changed? Sure it has - I now own a share of a much less valuable company.

OK, let’s extend it to a broader market. I buy a bunch of NASDAQ stock (especially internet stock) in 1999, because I think the internet is going to cause a growth boom, creating lots of profits for those companies. This thesis is widely held by other market participants, supporting the high valuations. Not overnight, but within the course of a few months or a year or so, it becomes clear that the original thesis was wrong. Sure the internet will be around and some companies will make money, but growth and profits are far less certain than I (and others) had expected a little while earlier. My portfolio of stocks drops 50%, as the profit and growth prospects of those companies fall. Have I lost perceived wealth or actual wealth? Well, I’m not totally sure what perceived wealth is, but IMO I have lost quite a bit of actual wealth.

31

The value of tangible items can fluctuate quite a bit too. Just ask anybody who bought a big 8 cylinder truck or SUV about a year ago.

And for that matter, the factories designed to make big vehicles are probably worth quite a bit less now too. Very close to where I live is a dual Chrysler plant, that, IIUC mostly made guzzlers of various sorts. IIUC, they’ve recently shuttered one of the two plants, and the other is in jeopardy.

32

Better example: ask me about the value of the house I just sold vs. its value 3 years ago.

33

Thanks for all the replies. They help quite a bit. Still, it seems like an awkward and counter-intuitive system if you want stable growth (w/o big bubbles).

Well, of course, the expectations of the primary participants is to make money. However, I figure the stock market would be setup with other goals in mind. If the system is just setup to make money, it’s going to be setup to benefit the participants and not necessarily society. I figure you’d want a stock market that promotes companies that have stable and long term profits because they continually meet the needs of society.

Money that otherwise might have been paid out as dividends, the company might choose to reinvest in growing the business. A growing business generally needs plenty of capital. Tech companies in particular have a history (in recent decades) of not paying much in dividends and reinvesting the profits instead. In theory, the investor comes out ahead this way - after a few years, the shares they own now represent a piece of a larger, more profitable company. Of course, it’s possible that things don’t go as planned for the company.

That makes sense, you reinvest in factors of production, but that doesn’t mean you can’t split some profits for dividends and others for reinvestment.

Again, as an investor, if I buy a share of stock for $100, and it stays flat and I earn $10 in dividends, that’s pretty much the same as if it pays no dividends but rises in price to $110. (Yeah, it’s not exactly the same, because of the tax issues, timing of dividend payments and so on, but it’s close).

From the vantage point of a single investor, sure it may be basically the same. However, it seems like a company has more influence over its profit margin from providing a good or service than the expectations of investors and the market. A company can’t keep a hurricane from hitting offshore rigs, but they can adjust their business to try and maintain their profits. Stock prices seem like a poor way to represent a companies worth to society given the volatility of perception.

A company does not directly benefit when its share price rises. But indirectly, it benefits in many ways. Companies do not do a single IPO then never touch the stock market again for 100 years. Instead, many companies use their own stock as currency in many ways. They do secondary IPOs. They compensate employees and execs with stock or stock options.

Again, this contributes to volatility because if the incentive is to raise stock prices, CEOs may focus on short-term policies that have long term negative consequences for the market.

I’ve described a few methods above (where there is a direct benefit to the company). There’s also an indirect way in which stock prices allocate money, market-wide. When a given public company’s stock price does very well, it inspires investors and entrepreneurs to invest in similar companies. Netscape IPO’d in 1995 and the price soared, IIRC. That in turn caught the attention of a lot of folks. Venture Capitalists actively sought out internet companies to fund. Entrepreneurs started new internet companies. Programmers sought out jobs in the internet business, hoping to profit from stock options.

Doesn’t that contribute to market bubbles?

I guess which is great if A) you start investing at 18-22 (or earlier) or B) you come from multi-generational wealth. Otherwise, it seems pretty shitty and should be an argument against social security being privatized into personal investments. Social security was designed to help people at the margins of society and generally aren’t people who invest that young (or enough for it to have a real impact on their lives).

Thanks again everyone for the replies. I understand it a bit better, but still seems like a counterinuitive system for reinforcing positive market behavior.

34

I actually meant to comment on this earlier when you mentioned you lost money on the house. I sympathize, but you made an offhand comment about at “any” other time you would have made 20% on the house. Really, any other time? What kind of appreciation did houses get pre-housing bubble?

35

Cool. Thanks. :) I’ll probably play around with it.

36

Mordrak, some quick responses, without doing a chain quote:

The stock market was presumably, originally designed to benefit the participants (companies and investors). But the government has been involved at various times, so you could say that the government influences the design as well. I think it is quite useful to society, as a means to pool risk and allocate capital. It’s certainly not perfect, but then, what large institution is?

Yes, companies can choose to divide profits between reinvestment, dividends, and/or stock purchases. That’s pretty much the norm, in fact, though I simplified things for my examples. (Not all companies do both stock purchases AND dividends, but I think most eventually do one or the other if they’re successful, and larger companies may do both).

You’re correct that companies can’t exert as much control over the market as they can over their own business.

I’d look at it this way:

The performance of a company’s stock is primarily a reflection of two things:

  1. The performance of the company itself, and the market’s assessment of its future prospects.

and

  1. Market-wide factors. Over time, the market reprices capital and risk. i.e. In harsh times, the market may demand a higher rate of return for ALL risky companies. To achieve the higher (future) rate of return, prices drop.

This is kinda confusing, but an example may clarify:

Going back to my earlier example, if the market values a non-growing company at a P/E of about 12, and that company can pay out all of it’s earnings as either dividends or stock buybacks, then that means that for $100 of stock value, the company is paying out about $8.33 in earnings. i.e. Investors should earn about 8.33% on this investment. Now, let’s say the market gets panicky, and across the board some investors flee from stocks and those who remain demand higher rates of return. Let’s say the new equilibrium return rate for a company like our example is 10% (up from 8.33%). Since the company itself isn’t earning more or less than it was before, to reach that equilibrium returng, the company’s share price must fall, to about $83.33. People who buy at that price will get earnings of about $8.33 for a price of about $83.33. But of course, investors who had held the stock before got hammered - they absorbed a price drop of almost 17%.

Re: the other part - the market assessing an individual company’s prospects. Yes, that is certainly tricky. If the market (as a whole) is kinda stupid, then CEO’s can ‘trick’ the market by focusing on short term profits, which the market may mistake as sustainable in the long term. But the market as a whole is surprisingly good at estimating the long term chances of a company. The market will pay a large premium for a company with the potential for fast earnings growth. In contrast, even if a company is making a big profit today, if the market perceives that the earnings are likely to fall, the market will probably not pay a whole lot for the stock. It’s a guessing game, but the fact that so very few people are able to out-guess the market (i.e. beat the market), means the market is doing a pretty good job, IMO.

Re: the flood of new capital into new industries. Yes, the market can overshoot, injecting too much capital into such industries, causing a bubble. (The concept of bubbles is debateable though - sure it’s easy in hindsight to say internet stocks were in a bubble in 99-00, but it’s much tougher to be confident of that in real time). Conversely, the market can undershoot, not injecting enough capital into fast growing industries. I’m not totally up on the relevant history, but arguably, the market underestimated the potential of PCs and PC software for much of the 80s and early 90s - if the market knew the value of the franchise that Microsoft was establishing, the price of Microsoft stock might have been higher, sooner, and the market might have been willing to fund more competitors. I think part of the possible over-reaction of the market to internet stocks from roughly '95-'00 was because the market realized it had been slow to react to the PC and PC software industry a few years earlier, though for the 'net, they arguably overreacted the other way.

37

I think some of the answers have muddied the water. Here are simple answers to your initial questions:

A) Yes, the current market value of a company is equal to the value of its outstanding shares. That’s a bit of an oversimplification, since some shares are excluded from that determination, but “yes” is the simple answer.
B) Yes
C) No.

It’s important to realize that there are different types of stocks, and companies typically have many different classes of stock, and each class has different attributes.

Class attributes can include:

  • the right to dividends, which could be entirely discretionary (which is usually the case) or which could be in fixed, guaranteed amounts.
  • the right to vote, to elect the board of directors of the company and to approve of certain major corporate events.
  • the right to participate in a liquidation or winding up of the company.

Most publicly listed shares are of common stock, which are essentially “regular or normal” shares, and they always have all three attributes set out above. Dividends for common shares are typically discretionary, and most companies actually never declare dividends.

Companies create different classes of shares because different investors have different needs, and companies want the ability to raise money from those investors. So some investors may want a regular income through a guaranted dividend program – so a company creates a class of shares that has that attribute.

Non-public companies often create various classes of preferred shares, which grant investors enhanced rights to dividends and proceeds upon a sale of the company, over the common shares, which are typically owned by employees and early investors. Public companies also issue preferred shares, and those shares typically resemble debt instruments and are closer in form to bonds or debentures than to common shares – offering a guaranteed interest rate, etc.

How does this benefit the company?

It does not, directly - the company gets nothing if you buy low/sell high, or vice versa, since the company is not a party to that transaction. But an active public market for its stocks makes it much easier for a company to raise money by issuing new shares to investors, since investors are much more inclined to risk investments that there’s an active market for, since they don’t have to worry about being stuck with stocks that it’s difficult to find a buyer for.

38

Right - I didn’t say that the wealth (by which I really mean “ability to purchase things they want/need”) of individuals doesn’t change - I simply said that the wealth doesn’t disappear into a hole somewhere, it gets redistributed. What I meant by “perceived” wealth is that in theory, given the relative values of stocks, dollars and physical commodities at a certain point in time, if the value of stocks drops, the value of dollars and commodities goes up, thus people perceive a disappearance of wealth even when it wasn’t their own stocks that dropped. This is because the things that we use to count don’t actually have fixed values.

Of course - it isn’t the same mechanism as the one I was describing with stocks, but yes, obviously the relative value of things is changing over time. My point is simply that it is all relative value. What does it matter that I own 1/200 millionth of a company that never pays dividends? Well, in theory, if you put together enough chunks that size, you can influence the company’s actions. Since influencing the actions of a company is worth something to people affected by the company’s actions, there is a base value assigned to a certain amount of control over that company. In practice, you can’t do anything with 1/200 millionth of a company (even if that company as a whole is worth $20 billion), but because someone could potentially scoop up a large number of lots that size and then do something, there is a baseline value from which the stock price can fluctuate based on the expectations of people who spend time analyzing these things.

My point, though, was that treating a pile of stocks or dollar bills as a ready and secure source of purchasing power is no more or less strange than treating a pile of gold the same way. If food is scarce, you are as likely to accept a dollar bill as you are a lump of gold in exchange for some, and that likelihood is based on how likely you think it is that someone else will accept the bill or lump for something you need.

39

Your first statement is true, but the second is an overstatement. Public equity stocks have historically been far more profitable investments over 10-20 year terms than any other type of liquid investment. They’re just better long-term investments than alternatives such as bonds, interest-bearing accounts, GICs, although they’re more vulnerable to short-term fluctuations.

Suggesting that they only have utility over multiple generations is badly misleading - if you’re not investing a decent percentage of your savings in equity securities (30%+), you’ll be far worse off by the time you retire. Which doesn’t mean everyone should jump in and try to be a day-trader - rely on an expert money manager or just pay a bank’s administrative fee to develop an investment portfolio that makes sense for you, given your income and likely future needs. Too many people are bored or intimidated by that stuff, and end up making their later lives a lot more difficult than they should be.

40

I sense this thread is about to go far off the original track :)

I would encourage virtually EVERYONE who reads this thread (most of whom are white collar professionals or will be at some point in their career, hopefully earning a solid salary) to learn a bit about investing. Whether you make $50K/year or $500K/year, whether you’re 25 or 55, you’re very likely to have some long term financial needs (college education for yourself or kids, a house, retirement, etc). You should probably be saving a decent percentage of your income. And if you save money, save consistently for several years, you should a decent nest egg. And if you have a decent nest egg, then the difference between paying somebody else to manage it for you, and doing it yourself through low-cost vehicles from a company like Vanguard may easily be >1% per year (including investment management fees, expense ratios, taxes incurred, and simply poor performance or unsuitable allocations). It could very well be much higher than that.

After some self-education, you may very well decide to use an outside advisor, but if you do, hopefully you’ll be better able to distinguish a truly useful advisor from some random broker in the strip mall down the street, or even some relative or friend of yours who may be in the investment business but may not be very skilled.

Anyways, we can divert this thread into a more full discussion of good and bad investment advice (as we see fit), or jump that off into a new thread (or a continuation of an older thread - I’m pretty sure we’ve had at least one, and possibly several, threads on the topic).