Where Did the Wealth Go?
by Michael S. Rozeff
by Michael S. Rozeff
The phenomenon we are witnessing is a savage bear market. This is a market in which asset prices tumble by very large amounts. Vast amounts of wealth disappear. The mildest bear markets reduce prices by 20%. The worst ones take prices down by 80—90%. The absolute worst case is when the stock markets disappear altogether.
The wealth destruction is bad for a great many people. Anyone who is nearing retirement and suffers a big loss has fewer years to make it back. The declines forecast recessions and depressions. Hard times for many. Young adults find it hard going and move back with their parents.
How bad is this one? Very bad. Not very long ago, there was a mountain of stock market wealth. That mountain has collapsed to almost half its size in the U.S. In Japan, the already low Nikkei Index has fallen to a 26-year low near 7,000. It once was 40,000. This is a decline of 82.5%. If the Dow-Jones Industrial Average declines this much, it will reach 2,450. No stock market has been spared. The Chinese stock market in Shanghai is down to 1,700 from 6,000 in one year, a drop of 72%. The collapses came in stages, with pauses before and after each stage. It has been like a three-act play. It is becoming a five-act play.
The bright side is that these declines open up investment opportunities. Experience helps one to overcome the shock of seeing prices decline so far, so fast. Experience helps one to profit after crashes and bear markets. For this purpose, I recommend Lowell Miller's book The Perfect Investment. Mr. Miller provides guidance on how to locate and invest in stocks that have crashed. Although the book is straightforward, you will not benefit from his expertise and methods without a good deal of study, patience, and experience. Mr. Miller does not recommend buying crashed stocks unless they have already made a "bottom." While he explains that in some detail, I also strongly recommend Stan Weinstein's book Secrets for Profiting in Bull and Bear Markets. If you had followed Mr. Weinstein's methods in this book, you would have preserved most of your stock market wealth. You would have become very concerned about the stock market as of August of 2007 or earlier and been out of it no later than January 16, 2008 when the Dow-Jones Industrial Average was 12,500. On January 14, 2008, an LRC article of mine that examined the incipient recession happened to remark: "The stock market is already in a bear market." I say "happened" because I do not make a habit of giving out investment advice to the public. A year earlier, I observed: "The overall level of the stock market is still richly valued, and until that condition is corrected the risk of stock market investing remains relatively high." The Dow was 12,500.
It is easier to figure out when to sell stocks and when to buy them back at crashed prices, which is what Weinstein's and Miller's books explain, than it is to understand why stock prices behave the way they do, which they do not explain. Their methods do not rely on predicting, but on observing. In fact, Weinstein explains how the market's actual behavior often conflicts with na´ve theories about how it should be behaving. For example, between 1980 and 2001, gold fluctuated in a trading range while consumer prices rose and rose. One might have thought that gold would be rising too, but it did not.
It is nice to have theories, explanations, and understanding. It makes us feel good. But quite often these theories are inadequate and misleading when it comes to timing and predicting security markets. It pays to observe markets. The most important thing to determine is the main trend. A trend in motion stays in motion. Don't fight the trend. In any choice between relying on statistical data, which is past data, and relying on the observed trend, choose the trend. The stock market is forward-looking. Its price changes start to reflect future events before they occur and can be seen in statistics.
Yet we are all curious. We wonder how things work. We wonder "Why does this happen?" About these declines, a student of mine asked me "Where does the money go?"
Crude oil, which was $140 a barrel in July, is $63 in October. Silver, which was $20 an ounce in March, is now $9. A recent inquiry read "Why have crude oil prices...dropped so drastically in such a short and seemingly random period of time?"
What was once wealth is no longer wealth. Where did the wealth go? Why does it disappear so quickly? Why does it disappear when it disappears? General answers are available. Precise answers are not. Specific explanations are bound to be controversial.
What is wealth? Aristotle taught: "And we call wealth all things whose value can be measured in money." Wealth is anything that can be exchanged to purchase something else. The air that anyone can breathe is not wealth. No one will pay for it who can get it free. Air that is compressed and can be sold is wealth. Oxygen that is separated from air and can be sold is wealth. The value placed upon that wealth, or what it will purchase in exchange, is not fixed and absolute. A house that sold for $300,000 a year ago may now have a value of $225,000. The U.S. government was filling vast caverns with oil bought at prices above $100 a barrel. Those inventories now have vastly lower value. Wealth has declined in value.
The general answer to these questions is "supply and demand." This is not very illuminating. For stocks, the supplies are fixed. IBM has virtually the same number of shares outstanding in October, 2008 as it did two months earlier, which is 1.35 billion, but the price no longer is $130 a share. It is $82. A drop of $48 a share on 1.35 billion shares is a tidy sum: $64.8 billion, to be exact.
What became of the wealth? For every share sold, one was bought. But they were bought and sold at declining prices. The house that was bought at $350,000 that cannot now be sold at $275,000 is still there. It is just that the price has fallen.
Stock market wealth has fallen because stock prices have fallen. Why have stock prices fallen? They have not fallen because there has been a shift in supply. There are still the same number of shares of IBM as there were before. There are the same number of houses. The houses do not even have to change hands for their prices to fall.
The fact is that sellers could not find anyone willing to buy IBM shares at $130. The sellers could have refused to sell at any price less than $130, but they did not. Their urgency to sell exceeded the urgency of buyers to buy, so that the sellers gave in and sold at a lower price. And this happened all the way down.
Why? Why have buyers only been willing to take stocks at lower prices and why have sellers been more willing to sell them at lower prices? It is this process that is recording or reflecting the wealth losses. And it is these transactions "at the margin" that determine total market values and wealth. Those who are not trading could have traded, but they did not. Their inaction ratifies the transaction prices of those that do choose to trade.
The economists' supply and demand model is not useful for understanding specific stock prices. The supply curve is vertical because the supply is fixed. The demand curve is nearly horizontal. But at what price?
A far more useful model is the finance model that uses arbitrage pricing to price securities. The price of a security cannot fall below or exceed the value of its future cash flows. If the price falls below the value of the cash flows, then there can be a "free lunch" or arbitrage profit available in the market. One can buy the stock and sell the cash flows. If the price rises above the value of the cash flows, then there is an arbitrage profit by selling the stock and buying the cash flows. Since free lunches (arbitrage profits) disappear in equilibrium, the price of a security tends to equal the value of its future cash flows.
The roots of this model reach back to the 1800s when actuaries began to understand present value. Irving Fisher in his 1906 work The Nature of Capital and Income used the model for risky bonds. John Burr Williams applied it to stocks in 1938 in his book The Theory of Investment Value. A stock price today is the cost of buying a future income stream. It prices out all the future cash flows that the security may provide.
The cash flows that a stock provides are its dividends and its future price at which it can be sold. In some simplified versions of this model, the key determinants of stock prices are the rate of growth of dividends and the rates of return at which these are discounted so as to find their present value. Higher growth rates make for higher stock prices. Higher required rates of return lower stock prices. Rather modest changes in either of these variables can cause rather large stock price changes. Suppose a stock with a dividend of $1. If its growth rate is 6% forever and the discount rate is 8%, that stock is worth $50. (A growing perpetuity with dividend D has the value D/(r — g), where r is the required return and g is the growth rate.) If its growth rate falls to 5% and the discount rate increases to 9%, that stock is worth $25. If growth disappeared completely, and the required rate of return stayed at 8%, the stock is worth $12.50. A dividend-paying stock can fall from $50 to $12.50 or 75% when growth expectations vanish. Stocks are risky.
What has happened to stocks worldwide is that growth expectations have declined and discount rates have risen. The growth rates have fallen because business conditions have turned poor. This would not suffice to bring stock prices down so sharply if it were not for the fact that business conditions, good and bad, tend to persist. Discount rates have risen because the risk of stock investing has risen. There are more uncertainties now about what is happening to profits and what will happen to profits than a year ago.
The wealth has disappeared because the future cash flows are thought to have diminished considerably. Hence, people are paying a lower price for those cash flows. At the same time, they value them at lower prices because their assessments of risk are higher.
Why have oil and other commodity prices fallen? In a recession, certain businesses find that they cannot sell their products at the prices and quantities they anticipated when they produced them. This causes their inventories to accumulate. They begin to run sales to move the inventory. They curtail their orders for more goods until they foresee business picking up again. This causes demand for basic raw materials that go into many products to decline.
It is quite surprising how sharply commodity prices can rise and fall. These items are costly to store as inventories, so that when demand shifts the price can be sharply affected. And demand can shift suddenly because the commodities enter into the production of many items. Anything that causes shifts in inventory accumulation or decumulation can influence prices. On the other hand, production can often be geared up reasonably quickly, and the prices then fall back. Certain foodstuffs are heavily influenced by weather.
Oil prices today are about where they were in October of 2006 and into 2007. Oil doubled in price from October of 2007 until July of 2008. That entire move has been reversed. The reason for the price rise was that the world economy was booming (as in China) and that a number of supply restrictions were in force. But in August of 2008, reports surfaced about oil demand dropping, such as China's 7% drop. The supply picture is less clear.
I expressed a view about oil prices in January of 2008 because I thought that $200 expectations were exaggerated and that the talk of peak oil failed to take into account the known dynamics of oil prices: "I do not expect $200 oil any time soon. I expect $85 oil first, and $70 oil first, and $50 oil first." Oil was then $100. It went to $140 and reversed. It is now $63.
I would not advise anyone to speculate in commodities who has not carefully studied the historical records of how these prices move and gone some distance in understanding why they moved when they did.
Where has the wealth gone? If Las Vegas or Shanghai build too many hotels, more rooms than travelers can use, the cash flows of these hotels will decline. Their prices will decline. The wealth that was thought to be there will diminish. Hotel rooms do not have an absolute value. The value can fall below what it cost to build that hotel.
The world has been on an inflationary spree. This was obvious from newspaper reports in early 2007 that reported that China was targeting a growth rate in its M2 money supply of 16%. Are you kidding? That's the target? Other countries were doing the same. India was running 15—20%. Today's news headlines tell us that Hungary's currency (the florint) has recently been hard-hit. Is this any wonder? The growth rate of Hungary's M3 money was 110% in 2006! The U.S. ran rates that were 10—13 percent in the 1970s. When these were reduced, the economy ran into recessions. Could China keep up such rates indefinitely? Not without creating serious inflation and economic distortions.
A serious worldwide recession was in the cards. Where has the wealth gone? Into mal-investments whose value now is a great deal less than what was anticipated when they were undertaken and financed by liberal credit engineered by the world's inflationary central banks.
October 28, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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