Where does the money go when prices collapse....

Feb 2009

Here's a headline I believe we will be seeing more of..... "Stocks fall on grim company earnings".

A few thoughts as to why, and maybe what to do about it........

1. Not only is the economy continuing to slump, but the appetite for risk and speculative endeavour has been castrated. Is a P/E of 10 really still cheap.... or is it actually sinking in that it means paying ten times what a company earns in a full year just for the privilege of owning a paper stock certificate?

And if the company doesn't pay a dividend, just how does one expect to realize those earnings? Step from behind the curtain 'greater fool theory', you are exposed at last as being the hidden engine behind extended bull (bubble) markets.

2. The dollar strength is killing (even unchanged) foreign earnings in dollars, subduing many of the commodity stocks over and above the economic effects. This is the opposite of what we saw when the dollar was in freefall and earnings were trumpeted as being tremendous.

3. There is less money chasing more stock - companies are issuing stock to raise cash just when vast amounts of capital are disappearing into 'money heaven'. I have read several debates about what happens to money when stocks and assets decline, "for every buyer there is a seller", etc. The key to understanding this, I believe, is to value paper and speculative assets at zero, which is ultimately what contribution they might be making to the money in circulation.

Take four people.... A, B, C, D. Each has $100 to create a mini-economy of $400, There is $400 in circulation.

Mr A paints a picture. Mr B likes it and pays him $100 to own it.

Mr A now has a picture - he values this picture at $100. He thinks he has $100 ('invested').

Mr B has $200 - his original $100, plus the $100 he received from art-enthusiast Mr A.

Messrs B & C have $100 each.

Apparent total - $500 if you include Mr A's piece of art (stock investment, house, boat, etc) but no, there is just $400 in money and a gentleman who hopes that someone, someday, will exchange at least $100 of their dollars for his investment asset.

So, if the 'art' market crashes and no-one wants the picture then where does Mr A's invested money go? What about the investment dollars he is holding in that wonderful canvas that nobody wants to buy?

The economy has collapsed, from $500 (the value including the picture as an asset) back to $400 (the fundamental value of the money and assets in the economy, as nobody now wants to speculate in art)

The $100 value of the painting never existed - it was a figment of imagination and assessment of the market. The picture is worth what someone will exchange for it. The dollars to pay come from the $400 in circulation.....unless new money is borrowed into the economy to increase it.

It takes just ONE transaction to revalue assets - all the other holders of such assets are affected even by doing nothing.

Apply that to the markets, real estate, art, cars and consumer goods and bingo - the money lost in asset values beyond their fundamental value is simply gone.

Add to that the cancelled debt (by repayment or default) which has sucked billions of dollars from the merry-go-round and it is easy to see how the amount of money chasing stocks is simply not what it was.

For sure, as the pundits assure us, there is cash waiting to reenter the market, but is it sufficient to regain old highs, or even recent rally peaks?

4. What to do (imo).

Be cautious, be patient, be independent in thought and deed. Don't trust the opinions of experts above your own common sense, and don't chase losses. Start again, enriched by the experience of taking a beating rather than be demoralised by it.

And, (here we go again ;-) ).... if in doubt, sell at least half.

5. Enjoy life. "Its just a ride" according to Bill Hicks - well worth viewing the short video of Bill's closing speech...
http://www.youtube.com/watch?v=iMUiwTubYu0


6. I'm still thinking about a number 6. Maybe someone can add one.

best of luck.

Category:

Education

Tags:

• money
• economy
• fed
• housing
• prices
• collapse
• inflation
• deflation

[Edocles]

What a waste of time. You've said NOTHING worth listening to: when prices go down, stuff is worth less. You never even touch on "Where the money goes". I want my 6 miutes &14 seconds back!!!!

[flaskofcoffee]

Hi Edocles. I'm sorry you feel that way, and can't agree.

Think of "price" as an asset in itself - a $500K home represents $500K of Money. If that drops in value to, say, $400K then there is $100K less money in the system. Not physical paper dollars in a pocket, but 'drawable' spending power which reduces as prices drop.

Put another way - if an asset you own goes up in value, you can sell it to release the increased wealth.... more dollars in your pocket.

[mangoswiss]

PS. Who's Nick? and what videos?

[flaskofcoffee]

Hi Mangoswiss.

"Nick" is 'TheModernMystic' on youtube. Originally, this video was a reply to one of his economic videos.

[redline601]

Oh shutup ..you boring little man

[flaskofcoffee]

Hi Redline.

Apparently an infinite number of monkeys would eventually type all the great books.

One little monkey has managed 6 recognizable words and 2 dots so far, it seems.

[Raycheetah]

Excellent, simple, and concise illustration of economic principles. 5 stars, favorited, shared! =^[.]^=

[cpswyl2]

Imagine trying to figure out how a car will get you from LA to New York by understanding the physics of its lubricant/oil. Cash, gold - it's all about a mechanism of exchange, lubrication of the economy. It's easy to lose track of value. Making sure when the music stops that you are left holding something of value/utility. Im starting to realise though, systems of exchange can change, and who can tell to what, but skills/talents/human value must count for even more.

[kevsuz]

i thought this was very good

[KhmerD0g]

money goes to commodities like sugar, cotton, wheat, gold, silver, oil, uranium, anything that people need and use. #LOL

[TheTrueJBV3737]

You have no idea what inflation even means? Look it up, the dollar is worthless, only items have value. Like physical gold, or 100 dollar bills for toilet paper.

[milestracy]

It appears that you have been taught by theory of the last twenty years. You neglect Bothe the English schools equilibrium theory and the Austrian monetary basis. The simple fact is that if you wright a check for more than is in your bank account you are in trouble. This is based on the THEORY that you live in a free economy. You don't live in that economy and to apply those natural laws to a slave bases economy is as Mises puts it an imaginary construct. You need to read the material from the

[Floralin]

Of course he has kept the picture simple by not mentioning tax , the intellectual property cost of Mr A (painting skill) etc ...

flaskofcoffee pls do one vid on currency trading ,i.e selling and buying positions.

[Floralin]

Thank you very much . That was very helpful.

[SBStreater]

Another nice video, but this one misses the mark slightly IMHO.

The painting is an asset which the seller could expect to be worth $50 before it is sold. So The total assets are $450 before and after the transaction. All the purchase/sale does is move assets around. Buying/selling does not create much wealth - actually making the painting does that.

In summary, you can make any accounting rules you like - but wealth has to be created.

[ogogosi]

Thank you for posting your thoughts. You are completely correct, and your explanation is just common sense really, but for some reason people don't see it.

Those who understand the matter think it is too obvious to need discussions, but there are many people who don't clearly see it so a bit of explanation can benefit them.