A commenter on my recent blog post – Where does money go in a crash? – offered a reply from their vantage point as an economics professor. They argued that while my explanation of what happens in a stock market crash might suit purely speculative markets, such as crypto, it failed to address markets grounded in so-called fundamentals. The commentator invoked the ‘dividend discount model' of share valuation as evidence for their case. They suggested that if, for example, Trump imposes tariffs that then reduce trade, and so the total quantity of potential future profits quite literally shrinks, and as a result, share prices fall to reflect this. As a consequence, they argued that value is destroyed, contrary to what I argued.
The comment made was thoughtful. The person making it is an assistant professor, presuming they were honest as to their email address. But I want to challenge it, because it misses three key points.
Firstly, price is not value. What the professor describes is a change in expectations, which changes prices. But expectations are not reality. If stock markets fall by 20% overnight on the news of tariffs, has the real productive capacity of the economy fallen by 20%? Have machines rusted, workers forgotten their skills, or resources vanished? No. If markets are rational – and that is a massive assumption – they have merely repriced shares based on the future cash flows shares can generate. The so-called “value” that is lost is the expected future flows of money, discounted to today. It is not a destruction of actual wealth, or of the capacity to create it. It is a reduction in the price people are willing to pay for rights to uncertain future profits. That is something quite different, and even then it relies on that assumption of rationality.
Secondly, the dividend discount model (DDM) is just a model. Economists like to suggest that prices reflect the present value of future dividends or profits. But that is a convenient fiction. In practice, prices fluctuate wildly in response to sentiment, momentum, liquidity, and short-term fears. If markets were as efficient as the DDM suggests, we would never have bubbles and crashes. In reality, markets routinely overshoot and undershoot likely values because they are driven by narratives, not by neat cash flow models. Even if tariffs do reduce future profits, there is still no actual transfer of existing “value”. There is a change in collective beliefs, and so in prices. However, beliefs can be wrong. Markets recovered from the Trump Slump in April within four weeks – however irrational, in my opinion, that recovery might have been.
Thirdly, and crucially, when stock prices fall, money does not disappear into a black hole. If I buy a share at £100 today and tomorrow it trades at £80, no one has physically lost £20. I have an unrealised loss. Only if I sell do I realise that loss, handing over in the process the £80 of value to someone who may later see it rise again. But no cash disappears. The money I paid went to the person who sold me the share. What's changed is not the money, but our perceptions of wealth. The overall money stock is unaltered by a crash. It's our perception of how much we're worth that takes the hit.
So why does this matter, and why make these points? That is because far too often, we allow market prices to dictate economic policy as if they were measures of real, tangible value. When stock markets fall, we are told that “wealth has been destroyed” and that we must protect investors to save the economy. But much of this “wealth” was only ever notional. It was just a reflection of inflated expectations. What matters is not the notional market capitalisation of firms, but whether people are employed, whether factories keep running, and whether households can put food on the table. These are very different things, as well as being the things that matter.
This is why I wrote my original video and blog post. What crashes reveal is the gap between financial markets and the real economy. They show that the emperor's clothes donned by market traders are often no more than speculative fabric. And it is precisely this confusion between price and value that allows markets to hold governments hostage, demanding bailouts or monetary easing every time expectations falter.
Markets do, in other words, tell stories about value. They do not measure it. And when the story changes, money does not vanish; it's just expectations, unfortunately denominated in monetary terms, that have changed. It's time we stopped pretending otherwise.
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The best way to think about ‘investing’ in stock markets is to treat it as ‘gambling’. Some bet on the favourite; others read the form guide, look at conditions and make an ‘informed’ choice; others bet by numbers or colours. Stock market investing is no different.
Some days you win, sometimes you lose, Sometimes both within a week/month/year.
The other analogy I’ve never forgotten about markets applies to trying to time buying/selling shared to profit short-term as akin to trying catch a sharp knife when it falls: sometimes you catch the handle, but sometimes you catch the blade and there’s blood everywhere.
Much to agree with
Alternative title:
“Is value destroyed when the Chancellor’s tears fall?”
I’ll repeat a comment I made last time: Where does money come from when share prices rise?
Is a new pile of value created by optimistic market sentiment, or destroyed by a more negative outlook? Until you sell and someone pays you, all those unrealised gains or losses are just hopes and dreams. You can’t eat them.
Correct
Exactly. If I buy a punnet of strawberries and then notice their price has gone down the next day because of more favourable harvest weather, I haven’t lost anything. I have bought something I wanted for a price I was prepared to pay.
In the case of shares, which don’t have a utility as strawberries do, the only people who have lost are the ones that bought yesterday with the intention of selling today. They are gamblers not investors, and knew they were taking the risk.
(In fact maybe a better comparison would be with someone who bought a betting slip for a horse in the Grand National and complained that it had lost its value once the horse had lost).
Thanks
You get it
And of course, people make the same mistake over house prices – thinking they are wealthy because their house is worth a lot, and worrying about the loss when house prices fall. As long it’s still worth at least what you paid for it, you’ve lost nothing. Whatever it’s current ‘value’, that means nothing until you actually come to sell it.
After reading Brad Delong for several years trying to wrestle with the big books, i am much more convinced that economists have different ideas about what value is when they talk of value. Markets deal with prices because those are what is visible. Economists talk of a price mechanism and not a value mechanism. It looks to me like they are different things entirely.
I remember the joy of trying to sell my previous house and before that my now ex wifes VW Jetta
Both went for less than they were ‘worth’ but that was what the only buyer I could find would pay
In the same way I got a much bigger pay out for my old Maestro when it was rear ended because although it was an old car it was my old car and previously my parents so it was a ‘known’ quantity to me unlike trying to buy a £250 car (In about 2000)
I’m reminded of a quote from Burton G. Malkiel’s classic book “The Random Walk Guide To Investing” (W.W. Norton & Co, 2005):-
“The sad truth is that there are only three kinds of financial prognosticators: those who don’t know, those who don’t know they don’t know, and those who know they don’t know but who get paid big bucks to pretend they know. What are they good for? Their primary interest is not yours, but theirs: they are very good at making money for themselves.”
In truth, they key thing is to choose the correct mix of assets commensurate with your age, emotional response to financial risks and potential losses, and to remove the ‘risk of prediction’ from your savings and investments by choosing low-cost index funds (with the exception, here in the UK, of long established investment trust company shares for income seekers, in my view).
In my humble one, it doesn’t matter a jot if shares have value or not. It’s akin to bsld men quibbling iver a comb.
All that matters is price. Am I selling for more than I paid? Be all and end all.
Nothing of value to this discussion, but please *do* continue calling them “market traders” at every chance.
Flat caps. Ex-army boots. Khaki coveralls. An incomprehensible patter. In the cold and the rain.
“Financial consultants” never gives me the same “spiv” image so necessary for coping…
Richard your completely right to argue that value is not destroyed, wiped out and/or lost when an economic-crises occasions a precipitous fall in ‘value’. That is because money is the sole measure of value (social worth) under capitalism
Consequently, falls in the (monetary) value of things – occasioned by economic-crises – are simply expressions of the way in which capitalism (automatically) judges their social worth.
As such, there is no such thing as ‘real, tangible value’ – value is simply a moral category masquerading as an economic one, which under capitalism imposes its judgments of social worth (price) on us; which for most of us depends on the price our labour fetches in the market
Capitalism produces goods/services for a profit, the sale of which demonstrates that they are judged socially useful by those whose needs have, in turn, been made effective by money.
As such, money determines what counts as socially productive, socially useful and socially needed under capitalism. There is no ‘real economy’ consisting of ‘tangible value’ behind, beneath or before monetary value, which secretly endows the latter with value. Philip Mirowski in More Heat than Light (1989) is brilliant on this
But monetary-value is a poor judge of productiveness, usefulness and need – even by capitalist standards. Hence the need for large-scale remedial state-intervention to judge social worth more humanely and rationally than money can. Especially during economic-crises when monetary-values are plunging. Indeed, without remedial state-intervention that imposes its alternative judgments of social worth on runaway market-forces there is no end to the damage, which economic crises can inflict
A collapse of asset-values does not, therefore, occasion the destruction of value – as value is not a ‘thing’, a ‘substance’ or an ‘entity’ that can be destroyed. It is a fluctuating judgment of social worth in a monetary form; to whose self-regulating mechanisms we are currently in thrall
Thanks
It needs to be said as well, the impact that the artificial construct that is a shared has on the real world. From tech companies “enshitifying” their own product so they can squeeze growth out of an already maximised market, to fossil fuel companies gaslighting us for decades (pun intended) just so their precious shareholders wouldn’t have to suffer a single moment of reduction in share value. It has potentially killed us all, this demand for growth. And think of this. Arms manufacturers are reporting record profits currently. How will they maintain this? Peace will destroy their profits, so it’s in their interest for peace not to have a chance. Scary stuff.
See a blog in the morning, which I an currently working on.
Brilliantly and succinctly put – as always. And an important point well made.
On another point, with all this talk going on about a wealth tax, do you think it might be a good idea to extract a list of taxing wealth options from your report? I think it might be a good idea to air the options again and the revenue yield from those options.
Effectively, that’s the whole report.
I am just a simple soul from the bottom of the world. I read all the comments without feeling the need to truly understand them, but I do get the general drift. I just wonder if underlying all this need for the wealthy to be cosseted and to have all this brilliant theory swirling around is that the they have no (or little) actual cash, but have borrowed against the future value of shares to buy their shiny toys. The influence of the wealthy on economic policy and practice just reflects very much their self interest, and probably the banks. If my simplistic view has any truth, then I wonder how the wealthy can ever be a happy bunch.
In real terms they are wealthy, even after any borrowing, which some have.