“When stock prices plunge, where does all the money go?”
In light of the recent roller coaster ride the market is taking most of us on, it was a rather apt time for such a discussion!
When the stock market plunges, market value would literally be wiped off the face of the earth. A huge chunk of money for your new house, for your children’s college fees, for your new shoes literally vanished into thin air.
For some individuals that held equity through the Global Financial Crisis (GFC) in 2009, it would seem incredulous for money just to evaporate. Even a stalwart such as Singtel Telecommunications Ltd (SGX: Z74) of the Straits Times Index wasn’t spared and lost close to S$24bil of market capitalization during the worst period of the GFC.
Back in 2013 (not too long ago) the trio of Blumont Group Ltd (SGX: A33), Asiasons Capital Ltd (SGX: 5ET) and LionGold Corp Ltd (SGX: A78) had close to US$4billion in market value wiped out in a day (that’s with a B, with 9 zeroes behind). An event much more recent was the plunge in the Chinese stock market – specifically the Shanghai Stock Exchange which tracks all stocks traded at the Shanghai Stock Exchange. Placing things into perspective, in June 2015 the Shanghai Stock Exchange Composite Index traded at over 5,000. At end August 2015, you were looking at somewhere at the 3,000 mark. That’s a cool 40% drop within ~2 months. So where does this ‘value’ go to?
To better illustrate this phenomenon, let’s explore this in the context of a company.
DOES THIS MEAN THAT THE COMPANY LOSES MONEY WHEN PRICES FALL?
First let’s explore how a change in market price affects the Company. To simplify this, let’s use property investments as an example. The primary market would be the initial transaction between the developer and the buyer, which would be the only time the developer receives proceeds. The stock market equivalent would be an Initial Public Offering (IPO) where the company is offered to outside (public) investors to raise capital for the first time. This capital raised normally goes towards the company for its expansion plans (normally it does) and/or other purposes mentioned in its prospectus.
Once a company has listed and starts trading on the secondary market, just as a developer doesn’t benefit after the initial transaction, the company doesn’t receive any money from changes in market capitalization during trading.
A price plunge in 50% doesn’t cause a 50% drop in revenue or profits for that company. However, a 50% plunge in revenue or profits might lead to a drop in share prices. Let’s assume a company with an EPS (earnings per share) of $2 and market price of $20 indicating a 10x PE. In general when prices fall, it is more likely for the PE multiple to maintain and/or fall rather than rise so if profits tank by 50% to $1, in order to maintain the same multiple of 10x PE, prices would fall to $10.
It’s always the business that dictates prices, market prices tends not to affect the general day-to-day operations of a company. It is quite safe to broadly say that a Company doesn’t gain or lose cash from their operations solely based on daily changes in market capitalization.
SO WHAT HAPPENS TO ALL THE MONEY?
Robert Shiller puts it bluntly: “The notion that you lose a pile of money whenever the stock market tanks is a fallacy.”
And in our opinion, stock prices change simply due to the supply and demand of the opinions of market participants. A stock price can be described as the collective opinion of the market.
However, some people believe that a plunge in market prices was an indication of more sellers than buyers. But how is that possible? Think about it, there’s always a buyer for every seller. Always.
Why prices plunged was because sellers were getting more pessimistic and were willing to accept a lower price for their holdings. And when more people see that the price is dropping, they might want to sell out and might quote a lower price to sell out. And this might lead to a vicious cycle.
Value In Action
Imagine paying $2 for a certain stock but the following day you had to pay off a debt and had to liquidate at $1 (Market consensus for that particular day). The 50% loss was definitely real, by liquidating you lost 50% of your investment but does it mean someone else gained 100% of your losses?
Or is someone just bidding at a lower price due to pessimism? Think about it.
Market capitalization is just based on the market supply and demand of opinions at that moment and can just fluctuate. As Uncle Buffett likes to say, “Price is what you pay. Value is what you get”.
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