As time goes by, memories fade. Most people are unaware of the origins of many of our present day practices. For instance it seems that the original purpose of the limited liability company has long been forgotten.
Once, long ago, an individual with a good idea but little money needed funds to develop his idea and sell it to the public. In order to raise the funds he sold “shares” in the venture to others. In this way capital was raised and the word “capitalism” came into being. If the project proved successful, the resulting profits would be “shared” among the “shareholders."
As the years went by, things became increasingly formalized. In time, a market for the shares developed. A shareholder might need the money immediately and not want to wait for a future payout. A buyer may perceive greater prospects for the future than the present shareholder and thus look upon the purchase of the shares as a “good investment." But the value of the share transaction was still usually based on the expected size of the dividend or dividends to be paid out down the road.
Today all this has largely been forgotten. Over time sales increased. Formalized markets were established. The bundling of stocks into mutual funds and the many other modern methods of “getting into the market” obscured the original purpose of “buying shares." Few are those nowadays who buy shares for the dividends they will pay, indeed many if not most companies today pay no dividend at all.
If no dividend is to be paid, why would one buy shares in a particular enterprise? Because one expects that the share price itself will rise. In the real estate market this was known as “the greater fool theory." As long as demand for houses kept increasing, prices would keep rising and it would usually be possible to find someone who would pay a higher price for the property in question.
And why should demand keep increasing? Well, in truth, it wouldn’t, or at least would only keep going to a certain point. It will keep increasing as long as there are people with money available to get in on the action, or if the amount of money in circulation keeps increasing. And in recent years, of course, the money itself has not needed to be available. Your credit is good! Buy now, pay later! Banks magically create all the money you need so you can borrow, borrow, borrow and live the good life now.
The time comes, however, when even with endless credit, more and more people are unable to meet their obligations by paying off even the smallest installment on their loans. We are all familiar with the bursting of the housing bubble. As it became evident that too many loans were bad, and that saturation point had been reached when it came to new buyers, so lenders pulled in their horns, bad debts were written off, and the dominoes began to fall. The whole edifice was built, not on real money, but on debt promises to pay. But promises can be broken, and will be broken if the one who made the promise either never had the ability to pay in the first place, or sees that his house is worth less than he owes. He will walk away and the bank will be left holding the bag.
It appears to me that what we are now witnessing is the bursting of a stock market bubble. Unreasonable expectations, based on little more than hope and hype, with no consideration of eventual dividend payments, pushed stocks to unreasonably high levels. We are now witnessing share prices falling to more normal levels. Of course we continue to hear such bromides as “the market always comes back." This is true of course. The only problem is that after the 1929 crash, for example, it took 27 years for the market to come back to where it had been. Some of us don’t have that long to wait. And this time the mess is so massive that it could even take more than 27 years before 2007 prices are seen again.
The unbelievable arrogance of the Treasury Secretary et al. who actually think that their actions will “restore confidence” etc. boggles the mind. The market is made up of billions of individual decisions and will continue to be so. Many of these decisions are based on expectations arising from government pronouncements. However there is such deep distrust of governments today, and with the internet and cellphones immediately giving the lie to most official statements, it is doubtful that officialdom can have much effect on the eventual outcome of this market meltdown. Their only hope is that the public may understand even less of what is going on than they do.
My advice? Protect yourself with gold, then sit back and enjoy the ride.
October 17, 2008