Saturday, September 2, 2017

The stock market and paper wealth

This post explains what I have learnt about the stock market and the creation and destruction of paper wealth.

Let's a company issues 1000 shares at $10 at its initial public offering.  This means $10,000 of new money enters the market from the sideline.  Thereafter people bid on those 1000 shares.  So let's say someone (Person A) wants to buy 10 of those shares and is willing to pay $12.  They would put in a bid for that price, and if a seller emerges (Person B), they exchange 12x10 = $120 dollars and the buyer of the stock (Person A) now becomes the owner of those 10 shares.  In this process, everyone holding a share of this company now thinks that their shares are also worth $12.  So the collective total of all 1000 shares of the company is now considered to be $12000, even though there was only one transaction of 10 shares at that price.  So if some other person (Person C) that was holding 100 shares of the stock that they bought at the IPO price of $10 (worth a total of $1000), they see their wealth has now increased by $200 because those 100 shares are now worth $1200 even though they didn't buy or sell anything themselves.  Paper wealth destruction happens in a similar fashion.  If everyone tried to sell at the same time and there were no buyers, the value of the stock would drop to nothing (this is what happens in the case of companies that declare bankruptcy).

So many news articles talk about money on the sidelines.  This is very misleading.  Every time someone sells a stock and takes money out of the market, there is someone else that is putting an equivalent amount of money into the market.  The only time money enters the market is during IPOs and secondary IPOs (issuance of additional stock).  The only time money leaves the market is when a company has its shares bought out for cash and discontinues trading.

New money enters the economy through other methods that I do not yet fully understand such as monetary policy, fractional reserve banking, and changes to the money supply.  These methods affect the amount of money that is available to chase assets such as stocks, bonds, and real-estate.

The number of publicly traded companies

The number of publicly traded companies has been steadily going down as reported by Fortune:
37% decline in the number of U.S.-listed companies since its 1997 high. With more companies opting for private fundraising over the hassle of public markets (looking at you, Uber), the number of public companies has fallen to 5,734, about on par with the early ’80s.
This may be a potential contributor to the current overvaluation of stocks because more and more money is chasing fewer stocks.

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