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Value and Stock Market Declines

October 22, 2008

Tags The FedInterventionismValue and Exchange

Headlines blare about the relentless selling pressure and historic declines in value that have hit stock exchanges around the globe. The free fall has financial pundits and politicians wailing about the trillions of dollars lost in the US markets. Ironically, these were the same people who warned us that failure to legislate a financial bailout plan would result in catastrophic stock declines.

All this hand wringing over value is a relic of an accepted neo-Keynesian misnomer. Unfortunately, the modern-day idea of value has produced a hallucinogen that causes people to take leave of financial common sense. It is known in economic circles as the "wealth effect."

Individuals perceiving a rise in the prices of assets they possess will feel wealthier, and therefore be induced to increase their spending either by depleting savings or through debt. I will not bore the reader with the intricacies of public policy that bring about this effect, but obviously this has been the goal of the Federal Reserve and the current interventionist madness emanating from Bernanke and Paulson. "Market-stabilization policy" is another one of those euphemisms for making people feel richer so that they continue to act financially imprudent.

The Austrian concept of value is ordinal rather than cardinal. Almost subconsciously we rank goods in order of personal preference. The whole basis of trade is derived from our individual ranking systems whereby we exchange something of less value, including money, for something of greater value. We often state that the value of a transaction is x amount of dollars. But this ignores the other side of the equation, which is the good that the money was exchanged for. Pricing in terms of money merely acts as a measuring device where the benefits of a particular resource allocation can be analyzed. The only thing we know for certain in a transaction involving money is that the buyer gains more benefit from the good than money and the seller receives more benefit from money than the item they sold. It says nothing about other preferences.

In the stock market, parties exchange money for pieces of paper that denotes ownership in a corporation. In the modern era, holders of stock can track up to the second the price of the last transaction. Through a simple calculation, investors can hypothesize the money gained or lost from a sale by multiplying the number of shares held by the price of the last transaction. But this imaginary trade says nothing about the next trade or the actual one the investor may eventually be involved in. The whole idea of stock valuation — and for that matter any other asset — becomes a dreaming exercise. Until the very moment the shares are sold, it can be surmised that the stockholder values the stock ownership more than the money offered for those shares.

On October 22nd of last year, Joe Smith bought 1,000 shares of Crocs Inc for a total cost of $64,000. At the close of business nine days later, the stock could have been sold for about $75,000 for an approximate profit of $11,000, but Mr. Smith held his stock feeling that at the current price the shares were more valuable. The following morning, November 1st, the shares of Crocs plummeted following the release of earnings that fell dismally short of expectations. Crocs ended the day with a closing price of about $47 per share. According to today's headlines on the stock market, the papers would have proclaimed in bold type, Smith Loses $28,000 in Value as Crocs' Shares Dive. But Joe Smith possessed a stock certificate, not money. So how can you lose $28,000 that you did not have in the first place?

This also says nothing about Rich Jones who sold his shares to Joe Smith on October 22nd. Mr. Jones exchanged 1,000 shares of Crocs for $64,000 and has lost nothing. When the price of Crocs shares closed at $75 on October 31, the next morning's headline could have read, Jones Forfeits $11,000 of Value as Shares of Crocs Rises, which to many would have sounded totally absurd.

Taking this analysis one step further, suppose our Mr. Jones was a short seller and that, when the price dropped to $50, he decided to buy in order to cover his short position; and the seller in this new transaction just so happens to be Mr. Smith. Joe Smith realizes a loss of $14,000 while at the same time Jones pockets a profit of $14,000.

Profit and losses affect the real money balances of the individual, which alters our value preferences. Gains from asset sales may allow an individual to use more of their current income for pleasure than saving for retirement, or vice versa where a loss will force an individual to allocate income more toward savings and away from pleasure.

The cry over stock-market losses not only confuses the true concept of value but totally ignores an important element to any transaction: the seller. It is as if the decline in stock prices is being caused by an act of God or by evil aliens in a world in which the money side of the equation does not exist.

Contrary to the shrill of the sirens, trillions of dollars were not lost. The money has been redistributed away from stocks toward other goods or assets, which, considering the present economic calamity, could figuratively be a newly formed lump in a mattress. Furthermore, no loss in value occurred; individuals have merely altered their preferences.

No doubt many who exchanged their money for stock ownership are facing potentially heavy losses in wealth that may take more than a lifetime to recoup. On the other hand, those of us who sold stock have no risk to further loss or, in the case of a short seller, have profited handsomely from the declines. In purely nominal terms, the holders of money still gain even at small rates of interest.

The consequences of inflation, higher taxes, and more regulation that result from government bailout plans, however, are sure to make losers of us all. Not only will our personal wealth be destroyed but our liberties will vanish as well. The loss of freedom is surely a value that cannot be measured.

 


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