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Why stock bubbles matter

  1. Jun 10, 2012 #1
    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?
    Last edited: Jun 10, 2012
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  3. Jun 10, 2012 #2


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    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 .....
  4. Jun 10, 2012 #3


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    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.
  5. Jun 11, 2012 #4
    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!
    Last edited: Jun 11, 2012
  6. Jun 11, 2012 #5


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    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.
  7. Jun 11, 2012 #6
    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?
  8. Jun 11, 2012 #7


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    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)
  9. Jun 11, 2012 #8
    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)?
  10. Jun 11, 2012 #9


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    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.
  11. Jun 11, 2012 #10


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    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.
  12. Jun 11, 2012 #11
    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.
    Last edited: Jun 11, 2012
  13. Jun 11, 2012 #12
    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.
  14. Jun 11, 2012 #13
    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?
  15. Jun 11, 2012 #14


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    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?
  16. Jun 11, 2012 #15
    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.
  17. Jun 11, 2012 #16
    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.
  18. Jun 11, 2012 #17


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    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.
  19. Jun 11, 2012 #18
    No you don't. The entitlement (speculation) is
    1.) company pays out dividends
    2.) company retains earnings, and via slick management grows the business exponentially
    3.) combination of the two

    In the context we are talking, you don't own anything other than paper stating a particular claim, sometimes of value.

    The details of any particular note, share, debt, bond what have you covers pretty much any transaction that can be considered.

    So it is possible to buy "shares" in a company, and have that include some claim to real property that can be "cashed in" by the holder.

    I hear what you are saying with the last comment. But consider the size of a stock market IPO company and in turn the disconnect between IPO today, and profits tomorrow.

    Im not sure what you mean by "selling stock doesn't seem to create anything".
    Last edited: Jun 11, 2012
  20. Jun 13, 2012 #19
    It makes sense, really. It's just the jargon that can be difficult.

    Facebook? :D

    I meant when outsider shareholders sell shares to other outsider shareholders. But yeah, I think even this reselling can have influence to the company because it can change stock price, which influences company via means discussed above.
  21. Jun 16, 2012 #20


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    Stock prices reflect the present value of expected future earnings from the companies in the market. Arbitrary changes to either the discount rate or expected levels of profitability could in in theory have no effect, positive or negative effects on the aggregate economy. An increase in discount rates would translate into a higher cost of future investments by companies and therefore reduce future levels of investment, negatively impacting the rate of future economic growth. A transition from a less competitive market where companies were able to extract economic rents to one with normal profit margins would reduce the value of equity shares but benefit the aggregate economy.

    Bubbles however refer to periods with abnormally low costs of capital and bad allocations of investments. Too much capital was invested into the information technology sector in the late 1990s and too much was invested into real estate in the last decade. This misallocation of capital created large disruptions in the real economy with the latest cycle including all the issues of a debt deflation and banking crisis
  22. Jun 18, 2012 #21
    Don't you find that too general of a statement?

    What's the timeline? Can a company have no earnings yet still improve equity?

    The income statement is nice from a management perspective. A particularly "heavy" investor maybe interested in Operations.

    But I would guess the balance sheet & Cash flow statement are far far better from an investment analysis perspective.

    The valuation you mention above (Present Value of annuities, i.e. bonds, simple notes) seems better suited for simply annuity type investments. Something stocks shares definitely are not.
  23. Jun 18, 2012 #22


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    it is a general statement, but nonetheless is true.

    There is no timeline other than the infinite future

    sure accounting statements are important, but I was not trying to specifically refer to GAAP earnings, just earnings in the economic sense (or cash flows if you prefer that term)
  24. Jun 18, 2012 #23
    How do you calculate a PV of future earnings if future earnings is "infinite future".

    I have heard of valuation of stock being based on the dividend/retained earnings. And that being compared to the market valuation of the stock. To help determine how much "fluff" is in a stocks market price.

    Do you agree with the general statement "Supply & demand determine a stocks market price."?
  25. Jun 18, 2012 #24


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    the PV of a stock can be modeled as earnings / r-g where r is the discount rate and g is the growth rate. 1/r is the formula for a perpetual annuity BTW. This is commonly used for dividends, not earnings but with Miller-Modigliani changes in dividend policy (or cap structure) should not impact the price of the stock.

    Of course supply and demand determines the price for anything, but this is a tautology. What drives the supply and demand for stocks?
  26. Jun 18, 2012 #25
    from "Stock prices reflect the present value of expected future earnings from the companies in the market."

    to "the PV of a stock can be modeled as earnings / r-g where r is the discount rate and g is the growth rate. 1/r is the formula for a perpetual annuity BTW. This is commonly used for dividends, not earnings..."

    I think the second one is much better said.

    What drives the supply and demand for stocks?

    Too much to cover with a general statement other than supply demand. If you speak specifically, than it's an influence in the price.

    oh and PV of a stock means what ? Is it not the PV of the anticipated annuities?
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