Why stock bubbles matter

Alesak

Hi,
this question popped into my mind while learning for a macroeconomics exam. Suppose there is a stock market crash. Why does it matter to real economy?

For example, if all stock prices drop by half suddenly, everyones wealth would be halved, but that would be only numbers in accounting sheets. No real money even needed to change hands.

If someone had 1000USD and bought one stock and then crash came, he would have 500USD. The only effect would be money transfer from the current owner to the previous owner. So basicaly as I understand it, stock crashes just tranfer wealth from one group of stock-market participants to other. Who really cares about that?

phinds

Suppose, to take an extreme example, I put my money in stock X and over the years I keep buying more and it keeps going up and when I retire I have a nest egg that will allow me to live in comfort.

Now the market crashes and I have 1/2 of what I had and there is no way I can even get by, much less live comfortably.

How do you figure that that would not matter to me?

And since the profit-taking on my purchases all happened well in the past, there is NO offsetting increase in anyone else's wealth.

Now, I'm not going to buy that new pair of shoes so the shoe store goes out of business and then the owner of that store isn't going to buy a new suit, so the clothing store goes out of business. .... etc .....

Pythagorean

it's really simple: price changes. It's like buying a car for 1000 dollars, never using it, and having to sell it for 500. That 500 dollars didn't go to anybody; it simply lost value because value is in the eyes of the beholder (i.e. the collective market price).

You could sign up to a stock account and buy stocks for twice the price if you wanted to, there's no set rate, there's a bunch of people willing to pay this and a bunch of people willing to pay that. I'm not sure how the broadcasted prices are determined, but most people buy and sell really close to that value.

Also... sometimes... there's nobody around to buy. You can't just sell any stock you own to nobody, there has to be people bidding on the stock you're selling. So if a bunch of people suddenly find a particular set of stocks unappealing, the people left holding the stocks are pretty much screwed.

Alesak

So basicaly you are saying that it would lead to drop in agreggate demand.
My point is that stock market is (almost) entirely isolated from function of companies that are traded on it. Unless the company issues new stock to raise capital, what does the company cares about stock price? I know management might hold stocks, shareholders might fire managements etc... but if stock market crash happens for example for psychological reasons, the company will run it's factories, sell it's products and so on without any direct disruption.
So in this case, I think that the only impact of stock market trading is people buying stocks giving monsey to people selling stocks. Just transfer of money, nothing is created or destroyed.

Suppose we have two people, first owns a stock for 1000USD and 500USD and second has 1500USD. Total money is 2000USD. The second buys it for 1000, then market crashes and the stock is worth 500. So after the fact, first has 1500USD and the second has stock for 500 and 500 dollars. So total money is still 2000USD. It was just a transfer, the first person can spend it as well. So, from macroeconomic perspective, how does it matter?



Maybe there really aren't any serious consequences. After all, the biggest (or second biggest, not sure right now) was crash in 1987 with nothing special happening after.
I googled some more, see for example this, especially point 4.


Also, there is vaguely relevant article on wikipedia: Paper wealth. If anyone has some interesting links, throw them in the pit!

Pythagorean

For the company, it's basically like their own bank reserve. If nobody is buying your stock, as the company, you can't leverage it if you're ever in a pickle.

On the other hand, if you're stock is trading with volume, you can always leverage to innovate or save your companies arse or engage in costly opportunities that will pay off later.

Alesak

Hmm, but the company doesn't hold it's stock. You mean some companies have reserves of their stock that they can dissolute in the market in case they need money for operation?

I don't understand the second paragraph. Trading with volume?

phinds

It seems to me that you have paid no attention whatsoever to what I said. You say (where I bolded it above) that the company will continue to sell its products. Based on my example, it will NOT sell its products (not as many anyway)

Alesak

I've seen it, it just doesn't seem very significant. Let me quote from the link I posted:

Of course, some internet magazine is not the most reliable source, but it makes sense to me. Is this what you meant?

It would be interesting from who to whom is the money transfered when the stock market moves in some significant way. From poorer (i.e. household investing there but not knowing much about it) to richer(who presumably understand it better)?

phinds

Yes, it's what I meant, and I think your source downplays the importance of it.

You KEEP looking at the stock market as a zero-sum game. It isn't. If I buy a stock and hold it for 20 years and sell it for a huge profit, no one has taken a loss.

Pythagorean

The companies hold stock.. that's how they can go public and sell it in the first place... and companies get money from selling stock!

Volume is a measure of how much the stock is being traded. As I said in the previous post, if nobody is buying the stock, then whoever holds the stock has a worthless promise. As a company, if you want to sell stocks and take out loans to raise capital, your stock better be trading... by "trading with volume" I meant trading a lot, so that you can sell stock at any time because someone is always buying.

nitsuj

lol, If I find a cool looking rock and sell it to you for $1,000. No one takes a loss...

Equity, follow the equity. Note, even hyped up stock is "equity". Most long term investors I think would prefer "real" capital. Buffet has done well with this.

Pythagorean hits it on the head with valuation being the issue, more specifically leveraging against it. More specifically yet, the tit "liening" (joke) against such "fluffy" equity.

From an accounting perspective this has/is being address via reporting requirements that more specifically detail investments and the valuation method, if allowed for the particular "equity".

So Alesak, it's like it is from the point you mention. It's only on paper where there is speculation of tomorrows activity, with real cash spending today based on that speculation.

Alesak

It's hard to tell. Are you talking from personal experience, i.e. did it happen to you?


I think this is interesting realization. In short term, it is zero-sum game of just money changing hands(when discounting IPO and raising capital and stuff) and people trying to out-guess each other but in long term it creates value. I will need to think more about that.

Alesak

Yeah, I understand that, so the second effect of stock price changes is how hard it is for company to raise cash. For example I see google owns about 20% of it's own stock. Any idea how much it happens in practice, like how much usual company relies on stock markets to raise cash?

Also, what does leverage to innovate mean?

phinds

Here's another scenario for you, and this is something that happens a reasonable amount.

I buy stock X and hold it for years as it goes up very nicely. A takeover company, in concert with the management, realizes that the company is REALLY going to be even more profitable in the long run, so they take it private and in the process give me a whole ton of money for my stock. The company does very well and all the managers and the buyout firm make a ton of money within a couple of years and continue to make money. Who is it you think lost money in this?

Alesak

Do you know how it works in reality? Like, if I own 5% of shares of some company, do I actualy own some land, factories...?



It is as I said above; in short term it's like this, but in long term it creates value. For example if you bought some apple stocks on their IPO, you would make a huge profit and that would be alright, because you giving them your money is what allowed these huge profits. But yeah, reselling stock doesn't seem to create anything, so it seems to be zero-sum game.

Alesak

Well, no-one, it seems to fit into that value-creating category. Maybe it could be said like this: transaction between company and investors create value but transaction between shareholders, in the narrow sense, do not matter for the company - until it wants to interact with shareholders again, which again falls in the first category.

Pythagorean

Simply, I mean that they have more access to money to invest in opportunities that come up. But also that you can just spend money on increasing the chance such an opportunity will come up (i.e. invest in research and development).

Leveraging something means you let somebody hold onto it while you borrow money until you pay the money back. Basically, if you want to borrow 100k, you have to put some initial amount down (like 10k). So you are leveraging that 10k to borrow 100k. Leveraging implies that you're going to multiply what you're borrowing.

By innovate, I just mean come up with new ideas for making money. For instance, if Google sees an opportunity, they have the leverage to jump on it, they can afford it. A business with low stock value might very well see the opportunity but not be able to do anything about it since they don't have enough value to leverage the loan that their venture would require.