Does stock market create wealth?

russ_watters

My guess would be that this is a company who's value is heavily influenced by speculation. Typically, a company trying to buy another company must bid more than the current market cap because:
1. Via supply and demand, trying to buy a large quantity of stock is a new demand.
2. Knowing that someone wants to buy the company gives current and new prospective stockholders renewed confidence in the value. I wasn't referring to you and as I know very little about your finances, I have no idea if you are generally a smart or stupid investor, but if you send me a copy of all of your financial statements, I can provide a more informed judgement.

russ_watters

This is silly. Stock is by definition ownership of a company. The fact that you don't have the ability to make decisions about the company on your own based on your small share doesn't change that. Other forms of shared ownership can work the same way, such as some joint bank accounts or a married couple who owns a house. You've improperly defined "profit" based on a built-in assumption that the stock itself has no value. Your argument is circular.
This is better because at least you correctly define the company as having value, but it is still incomplete as it assumes the value to be fixed. Again, you are using circular reasoning to prove that it is zero-sum.
But we know that this is false, don't we? The amount of money in the system does vary. It grows. Therefore:
And by implication, if one person gains another has to lose. It's still wrong. Doesn't matter how many times you say it and your argument is getting worse, since even as a Ponzi scheme the amount of cash in the system is not fixed.

Let me put a finer point on the not-zero-sum issue: Over the past 100+ years, the stock market has averaged a roughly 5% annual growth rate after inflation. That means that millions of people, over several generations, have put money into the stock market and then later in life have taken out roughly 4x as much as they put in.

enosis_

I think it's a good idea to think of a stock purchase as an investment in a business. If the business does well, your investment increases in value. If the business fails, your investment loses value.

russ_watters

A little more on this and the zero-sum assumption: It is true that every individual transaction is zero-sum. This is necessary in a fair system: otherwise one party is cheating the other. But don't confuse this into meaning that the entire system has zero value. What you are missing is what happens in between those transactions. In between those transactions, the economy grows. And both sides of the transaction grow together. They are reflections of each other. The next buyer has more money because the economy grew and s/he earned it. The company s/he's buying is worth more because it sold more widgets and has earned more money.

Don't fret about growing stock value requiring a growing amount of cash available to buy stocks: there will be a growing amount of available cash as long as the economy is growing.

And just to mention the other side of the coin; buying a car and selling it later is a losing proposition. The value depreciates over time because the car wears out. The car isn't magically worth less the next time you sell it (there is no violation of the zero-sum game of a transaction), it really does have less value.

russ_watters

...then consider fine art. Fine art has roughly zero inherrent value. Impressionist paintings were once considered amateurish, then people decided they like the style and vision. Now they have huge values. But what if peoples' sense of style changes again? At least impressionists display style and vision, if not skill. What about pop art? What if people decide a can of soup, painted with no particular skill is barely worthy of a high school art class? Boom. Worthless.

Tosh5457

As for the definition of profit, it doesn't matter when you only look at balances.

It's ridiculous that you didn't quote the part where I assumed that the money varied... And it's also ridiculous that you're using the argument that because the money in the system varies, then it's not a zero-sum game. You're forgetting the fact that when money enters the system, there is 1 more player in the game, therefore my conclusion still holds. That argument of yours also works to "prove" poker is a non-zero sum game
What you're saying is that there is creation of money.

Dividends and more money coming into the market coupled with positive expectations due to the ever-growing economy (this last factor doesn't make it a non-zero sum game, while still allowing the investors that had stock to get profit).

The money on the side of the buyers growing is the same as saying more players with money entered in the stock market game, and that alone doesn't mean it's not a zero-sum game, it still is. Now on the other side, the companies grow, that's true. But that richness they earn don't pass to the stockholders. You argue it does, and I argue the only mechanism that exists for that are dividends. You can't describe the mechanism by which that happens. Of course if you accept that stocks can grow in the long-term just because of offer and demand in the secondary market you don't have to assume that mechanism exists, but since you can't accept that you have to assume it does.

Tosh5457

Good that you bring up that example, because it shows how vague a term value is. It's so vague that I can say there is infinite or 0 value in the world and nobody can say if I'm right or wrong. You're trying to prove me wrong by using a vague term like that, you have to rethink what you're doing.
I propose a definition of value using money - the value of any product is the money that it can be sold for. Using that definition I arrive at the conclusions I said before. Nonetheless, I don't think that term even needs to be defined, because what I'm saying applies to traders' balances, which is in money. If you can give another definition for value and explain why it's a convenient definition we can continue the discussion, or else I can't discuss with you because you're using a ill-defined concept to prove me wrong.

BWV

I can't believe this is still going on. All the proof anyone needs is to accept that if a unit of stock has a right to a stream of cash flows earned in by a business in the real economy, which is not a zero sum game, then a market for these certificates is not a zero sum game. If owing privately held business is not a zero sum game then how can owning a partial interest in a public company on be one?

Why don't you find some real economists who support your view and have peer-reviewed research supporting it?

russ_watters

Yes, correct definitions and assumptions matter. If you assume things that are wrong, you will likely get wrong conclusions from the logic. That's a basic principle of logic. I consider it ridiculous that you say you accept that the economy has a continuously increasing (over the long-term) total value, then build models that assume otherwise! It seems like you are losing focus on what your argument is here. The problem isn't the money in the market, the problem is with the value of the stocks. We both agree that investors are continuously pumping cash into the stock market. What we're disagreeing on is whether there is a corresponding change in real value of the stocks themselves based on the value of the companies. Er, no:

Standard tournament poker has a fixed initial value and a fixed starting number of players, with players dropping out as they run out of money. It is an inherently degenerative situation, which is why it doesn't find an equilibrium but rather results in a single person holding all the money.

Casino poker on the other hand has a continuously changing quantity and roster of players and continuously changing pool of money. If you were to remove the house "take", it would overall be zero-sum, with winners and losers exactly in balance. Many people erroneously believe the stock market follows this model. It doesn't because the betters in the casino are trading cards, not stocks. Cards have no inherent value, stocks have a value....that is increasing.

But you said a growing roster of players. A casino poker game does not have a growing roster of players over the long term, but the economy does. Perhaps that's where your problem lies:

The fact that the economy is growing partly due to population growth, which therefore leads to more investors adding more money to the system, may make it appear similar to a pyramid scheme. But a closer look shows that the economy and stock market grow faster than the population (indeed, many European countries are shrinking, not growing). Why? Added value. Time (labor), intellectual property creation, and cash dug out of the ground (crops and minerals) add value to the economy faster than consumables (food, cars, etc.) take money out.

The growing population is giving you a false impression that the market is a pyramid scheme. Even if the number of investors remained static, the value would still grow in a growing economy.
There is creation of money and value! That's the entire issue we're arguing about!

I have to say, it seems like you're really shooting from the hip here and losing track of the argument -- like you're not trying to learn but are just arguing for the sake of arguing, regardless of where your argument leads you. That is true only if the amount of money each player brings in when he/she enters stays constant. It doesn't. If each new player brought in as much money as the last, it could be like a pyramid scheme because growth would require new investors. But again, the growth rate exceeds the rate of new investors entering because the economy is growing faster than the population. You missed something here because I have never argued that the value passes or has to pass to the shareholders. Others have argued it, but I avoided it because it is an unnecessary complication: It doesn't have to for stocks to have or gain value. Dividends are really a separate source of revenue entirely. A company could grow at a rate equal to excess revenue, which results in it never turning a profit, but in growing it still gains value for the stockholders. Or it could stick the profits in a bank account, with the same result.

Again, you are making the mistake of thinking that a person has to be able to directly access the assets of the company in order for their stock to hold value. All that has to exist is the theoretical possibility that they could. I think you are letting the size of companies make you think there is something else going on in larger companies than happens in smaller companies. In smaller companies, it is easy to see:

Owners of companies are shareholders, regardless of the size of a company or if the owners do any of the work. But if you look at small, direct ownership, it becomes easy:

If two people each use $10,000 to buy equipment start a company together, each now owns half of a $20,000 company. If the company turns a $10,000 a year profit for 20 years, but the owners stick that money into a bank account instead of taking it out of the company in bonuses, the company now has $20,000 worth of equipment and a bank account with $200,000 in it, for a total value of $220,000.

Now one of the partners wants to retire. He has a piece of paper that says he owns half of the company. The partnership agreement and negotiation will determine exactly what he can do with it and how it works, but typically the options are:
1. Sell his half of the company to the other partner. Now the initial investment was $10,000 but since the sole owner could just sell the assets and pocket the money in the bank account, it doesn't make sense to sell $100,000 in cash and $10,000 in equipment for $10,000. The sale price has to be about $120,000.
2. Sell half to a new shareholder. Same valuation.
3. Force the other shareholder to dissolve the company. Same valuation.

No matter how you slice it, when the shareholder wants out, he pockets $110,000 for a return on his investment of $100,000. Whether a new shareholder enters the game or not.*

Now here's the part where you seem to be slipping up: At any time during those 20 years, the shareholders could make the decisions above. The fact that they don't doesn't mean that the company has zero value (or a constant value of $20,000) in the meantime. The company has a higher value because they could.

*This made me think of another important point. One of your issues here is that you think that money can only pass through the market from the company to the shareholders without dividends. Actually, it can: the company can buy back the stock. Sometimes they do that and the buyback price does not have to equal the original issuing price. I'm annoyed I didn't think of that example before.

russ_watters

You completely missed the point of the example. The example was highlighting a difference not a similarity. I assumed it would be obvious, so I didn't explain the other side of the coin:

Fine art has zero inherrent value. Products with uses do have inherrent value -- even if that value is difficult to calculate. The value of a house can never be exactly zero because even if no one wants to buy it, you can still live in it. A gallon of oil can never have exactly zero value because even if the commodity price crashes, you can still heat your house with it. Etc. And a company has a bank account with money in it, physical assets and the potential for more in the future.

So yes, I can say you are wrong. And I can see that your main problem here is a misunderstanding of the concept of value. You've applied this misunderstanding to the stock market here, but as I suspected that's just entrance point to a larger problem. Er....if you do that, then you miss inflation and this becomes even easier. *POOF* more money. *POOF* more money. *POOF* more money. We literally print it and inject it into the economy. So no, I don't think you really meant that this is just about the number of dollars. The problem still is your understanding of the concept of value. That statement was just another symptom of it. You've backed the wrong horse: money (particularly paper money) has little inherrent value and in some cases actually has had enormous swings in useful value due to run-away inflation and collapsing countries. So money can have a high value (never infinite though) or essentially zero value. If you're looking for a stable measure of value you picked probably the worst way to measure it.

The reality is that money is just a carrier medium for value (or "wealth", the word you used in the title). If the world's economy collapsed and rendered all money valueless, the lack of cash would not change the actual value of needed products, just the way it is expressed (though changing priorities would change the actual value). Values might be compared directly: A house is worth four cars. A car is worth fourteen cows. A share of facebook stock is worth eleven chickens and half a squirrel, etc. All the elimination of money does is make stocks messier to trade.

If you meant to also include the assumption that inflation is assumed to be nonexistent for the purpose of the model then the value of money is fixed and the quantity of money in the market grows, reasonably accurately reflecting the growth in the actual value of the market.

Want to simplify matters even further? Assume P/E ratio is fixed as well, eliminating the effect of speculation. Then money has constant value and stocks still have increasing value, in direct and fixed proportion to the earnings of the company.

No, these assumptions do not help your model produce the outcome you are looking for, they are just causing you additional confusion.

russ_watters

Not a bad idea, even for our side of the argument. Peer reviewed may be a problem for such a basic issue, but there is no shortage of investor help sites and publications that discuss this. It is a very common question and googling "how stocks gain value" provides some good results that read as if they were written for this thread:

The first link discusses our entry-point into the problem, listing the two basic ways that stock values change (speculation that changes P/E ratio and increase in real value), a clearer description of what I was talking about in post #8: http://www.investorsfriend.com/price_increases.htm

But this doesn't explain the mechanism of how that value is responsible for the gain in stock price. But this one does and even better is about gaining value without considering dividends -- even asking why it isn't a pyramid scheme(!): http://beginnersinvest.about.com/od/...investment.htm

This article is right on point and also includes an example that admittedly I based my above example on (my version is simpler). Bottom line remains the same: Berkshire Hathaway is a good example because it has never had a stock split and never paid a dividend. So its value is soley due to the value of the companies the fund owns.

Tosh5457

Ok I'll just ignore your multiple fallacies and misunderstandings, I know you're absolutely convinced I'm wrong, and I'm absolutely convinced you're wrong. So let's just get to the fundamental point where we disagree, which you correctly pointed out:

To be clear, we're talking about stock holders that don't use their voting rights and companies with no dividends, which applies to the great majority of the traders, and it's what I'm interested in. But first I need to know, what do you mean by real value? Is it the money it's worth on the secondary market, or other thing?

russ_watters

We don't need to argue about the concept of value. We are getting bogged down in details when the problem is really that you don't accept a fundamental fact:

We both agree that if a company has a big, fat bank account, then by definition, the owners of the company - the stockholders - own the money in the bank account.

You believe that since the stockholders can't access the money in the account, it can't or shouldn't affect the stock price.

You are wrong on the premise and therefore wrong in the conclusion: they do, so it does. It may not be easy and few may choose to do it, but stockholders can access the wealth of the company. That's the fundamental fact that you refuse to accept.

The complexity of large companies is probably what is tripping you up, so I encourage you to start by reading the examples given for small companies and accepting it for them.

AlephZero

No. The only reason a stock's price rises is because there are more buyers than sellers. Your quute is just two ways to rationalize WHY there are more buyers.

And the fundamental mistake of most economic theoriies is the assumption that decisions made by humans are always rational.

nitsuj

If the company instead had a loss of 10k a year for 20 years do the investors now owe that money?

Is the disconnect only one way? >debt not mine as an investor...but profits are?

There is a very very clear segregation between what a stock holder is entitled to, and it absolutely isn't (not that it couldn't be written) the cash in a bank account.

At what point is the there a direct connection from a companies equity to the stock price?

Even an IPO is valuation. There is no calculation assets - liabilities = equity / number of shares = share price.

Of course it is up the buyers to determine what the value is.

There is no way to account for all variables.

For you simplified example there could be a host of issue. Was the retiring partner an expert who was the real value of the company?

Is their product/service now obsolete? Will there be higher then ever demand for their product/service.

russ_watters

Investors paid the initial start-up money to the company and that's their primary risk. It's basically a loan. If a bank also loaned money to the company, it took a similar risk. Or if the company didn't pay its vendors, it would owe them. A company can't just run a continuous loss: the money has to be loaned to the company to cause the loss. At some point, people stop loaning the company money and it goes bankrupt.

Who gets what back is complicated and based on bankruptcy laws. Typically, shareholders are among the last ones to get money back. They have the most to gain if the company does well and the most to lose if it does poorly. Do you have a reference to that assertion? It contradicts the source I linked above and logic: That's why investors complain if a company has a large cash reserve, but isn't paying a dividend. Er, no: that calculation is done (much more complicated, of course) and the company sets the IPO price. You have that exactly backwards.

Didn't you follow the Facebook IPO debacle? The controversy was over the fact that the investment company doing the paperwork to make the IPO happen was also the one who calculated the selling price, which gives them a conflict of interest. When they jacked-up the price right before the IPO, then the stock plunged right after, the initial investors felt they got cheated.

russ_watters

Yes, that's an explanation of why. There is nothing to be arguing about there. Even though you said "no", you didn't actually disagree. I doubt any economist ever makes such a mistake. It certainly doesn't appear here: #1 in that quote is all about irrationality. So I don't know why you'd bring that up. Doesn't seem to have any relevance.