September 25, 2022
by Stephen Stofka
This week the SP500 index closed down more than 20% from its closing price at the beginning of the year. Where did the value go? When stocks were rising where did the value come from? Trained in neoclassical economics, the economist John Maynard Keynes asked the same question. He criticized the conventional economic analysis because it focused only on the present, disregarding the flow of money and goods into and out of the marketplace. Let's explore that flow this week.
Let's imagine that there is a car company called Drive whose stock symbol is DRV. When its stock price goes down on Monday, there were more sellers than buyers. The quantity of shares has not changed but the market value has declined. Where did that value go?
Let's say that Sally bought 100 shares of DRV for $40,000 cash, or simply $40. I'll leave off the 1000s in this story. She could have spent the money on a new SUV – satisfying her current needs – but buys a stock which she hopes will someday be used to satisfy her future needs. A car dealer did not make a sale. Let's assume that the dealer has $36,000 cost invested in the vehicle.
What did the stock seller do with the proceeds? We might trace the money through many transactions in the stock market but eventually we come to Sam who took the proceeds from the sale of his 100 shares of DRV and bought a Drive SUV for $40. Sam's net cash position is $0. A measure of economic activity, Final Sales of Domestic Product (BEA, 2022), has increased by $40,000 .
To recap the beginning positions: Sally = $40 cash, Sam = $40 stock, Drive dealer = $36 invested in car. Total = $116K. Let's leave out income taxes, sales taxes and brokerage fees to keep the story simple.
A month later, the price of DRV goes down so that the market value of a 100 shares of stock is $36. The value of Sam's SUV is not affected – or is it? If Sally were to sell her newly acquired shares at the lower price, she could buy a less expensive car but not that brand of SUV. Thus, there is less demand and the market for SUVs is softer because of the decline in DRV's stock price.
Let's imagine that Sally and Sam meet at the grocery store. Sally likes the SUV and offers to sell her DRV stock to Sam for $36, the market value. Sam thinks that is a good deal. He now has the same quantity of shares that he had before. If he had held onto the stock, the market price of the stock would have gone down anyway. He has driven the SUV for 1000 miles for free except for the gasoline. The dealer has $36 cash, covering the cost of the SUV, and $4 in cash profit.
Let's recap: Sally = $36 car, Sam = $36 stock, Drive dealer = $40 cash. Total = $112K.
Sam and Sally each have $4,000 less than they started with for a total of $8,000 less. The dealer has $4,000 more than they started with. Where is the other $4000? Is it in the SUV's depreciation or the stock's lower market value?
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Photo by HAMZA YOUNAS on Unsplash
BEA: U.S. Bureau of Economic Analysis, Final Sales of Domestic Product [FINSAL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FINSAL, September 22, 2022.
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