WALL STREET GIBBERISH, 2001 FIRST QUARTER NEWSLETTER

Given the sharp drop in the stock market over the past year, a common utterance is the purported resulting loss of wealth. Usually this is expressed as "investors are five trillion dollars poorer because of the drop in the stock market." This is based on comparing the total market capitalization of U.S. stocks then and now and the calculation is quite likely to be accurate. The problem is that the significance of market capitalization is misrepresented.

The market capitalization of an individual stock is easy enough to compute. Just multiply the number of shares outstanding by the price of the stock. To find the capitalization of the entire market, all we need to do is add up the values for all the publicly traded stocks. No problem there. That total capitalization of the market is useful for comparisons to a different time or to compare the size of markets in various countries. It is also useful for comparison of individual companies.

The problems arise when one attributes economic meaning to this theoretical value. It is theoretical because there is no way that all the shares of an individual stock, much less the market as a whole, could be bought or sold at the current price. Since market capitalization is not a meaningful economic quantity or even a true measure of the total wealth in stocks, differences in that value at various times do not have economic, rather than comparative, meanings.

Aren't we poorer overall because of the drop in stock prices? No, if one realizes for every seller of stock there is a buyer. The trading of stocks by itself does not create or destroy wealth. (This is not to be confused with the capital formation function of stock markets that enables companies to invest proceeds of stock sold to the public in order to expand, become more efficient, and create jobs, all of which can generate wealth.) Trading moves around money and stock certificates with some loss to friction in the form of brokerage costs and resulting taxes. Individuals may be affected by losses in their portfolios. For them, gains or losses "on paper" can be meaningful, but not for the market as a whole because it would be impossible for everyone to sell at or near the top.(1)

There is a potential wealth reducing effect from lower stock prices: the reverse of the "wealth effect," which leads to in a drop in discretionary spending and slower economic activity. Considering that U.S. economy is about ten trillion dollars as measured by GDP, any reduction resulting from the drop in the stock market is going to be only a small fraction of five trillion dollars.

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Footnote:

  1. And who could we sell to except ourselves? The only way everyone could take all their money out of the market at once would be if aliens arrived and somehow were able to pay in earth currencies, most likely dollars. In that case, Dr. G. would no doubt have a fit over the rapid and huge expansion in the money supply!

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