When Markets Crash: Part One

22 Jun

When Markets Crash: Part One

A CNBC headline from February 28, 2020 read: Global stock markets have lost $6 trillion in value in six days.

You read that correctly – $6 TRILLION in value. Have you ever wondered what happens to all that money when markets go down in value?

The short answer: it simply vanished.

Before we dive into this further, it is important for us to discern what we mean by value. It is common for us to use words such as cash, wealth, income, and money interchangeably when speaking of things that have value. Meriam-Webster defines value as the monetary worth of something, also known as market price. In the real world, we characterize value in terms of the assets that we own. This is known as our personal wealth and can be expressed by things such as our home, investments, or even the gold in Scrooge McDuck’s vault.

So again, we ask what happened to all that value?

A simple analogy can be helpful to illustrate what is happening here. In the summer of 2019, you and your family purchased a home for $300,000. In early 2020, you see that interest rates have dropped, and you are interested in refinancing your mortgage. As part of that process, an appraiser comes to your home and determines that based on recent, local market trends, the value is now $275,000. Your home has depreciated by $25,000 but where did the $25,000 go? The truth is it did not go anywhere. No one paid you $25,000 for the change in value. No one removed your guest bedroom to explain the drop in value. The $25,000 did not go anywhere, it merely disappeared. (Do not worry, the opposite of this example can happen as well!).

This is analogous to what is happening in the markets today. While it is true that certain individuals and institutions profit when stock prices go down (shorting stocks is a discussion for another day…), most of this wealth has simply been wiped out.

Whether it is homes, stocks, or baseball cards value is made up of two dualities: explicit and implicit value. Sticking with our earlier home analogy we can demonstrate examples of both types of value. Explicit value can be defined as the tangible ‘stuff’ that makes up the home. The home has four walls, a roof, copper wiring, and maybe French doors. Here we can see that explicit value would be how much it would cost you to rebuild a replica version of your home. It is clear to see that value in this example can be created or lost based on the cost of goods. Supply and Demand can drive changes in the cost of goods or services needed to construct a home. For example, what if the French stop making doors, and you now hold the last set of French doors in the neighborhood. Wouldn’t you expect the value of your home to rise based on the scarcity of this product?

Implicit value then can be associated with the abstract as opposed to concrete value. This value is driven by potential buyers’ perception of the home’s value. In our example, your home may be in a good school district, close to hospitals or near parks all which may drive up the value of your home compared to a home with similar physical characteristics in a different location. When investing in companies, potential investors view intrinsic value as what a company is ‘worth’ to them. It can be driven by less tangible factors such as emotion, projected earnings, and other personal biases. We now see how these factors can drive pricing volatility. Building two identical homes may lead to equal costs, but by simply choosing a different paint color we can drastically impact the selling price based on a potential buyer’s perceived value and preferences.

Value is a funny thing. Some days it seems as though it can be made or lost in the blink of an eye for no apparent reason. History has shown us that those who are patient and have a sound plan in place will be rewarded in the long run. It may seem scary or volatile at times, but it is important to remember that this is part of any long-term investment experience. In another world I would lead my trusty crew waiving metal detectors, shovels, and eye patches. Sadly, however I am afraid that the ‘lost’ $6 trillion cannot be found with a map and pirate accent.

This was Part One: A discussion on value and how markets fluctuations impact perceived value. Part Two will cover income and the impact market recessions have on income in our economy.