Anthony Davies

© 1998, Cline & Davies Research Alliance

The Wall Street Journal reported (September 2, 1998) that the recent decline in stock prices has left investors $2 trillion dollars poorer. That’s almost $50 billion in losses per day over the six-week decline. As a nation, we only generate about $16 billion in income per day. If things continue at this rate, this year’s national income will drop to zero in six months. This dire prediction sounds implausible, and it is. The general populace is relatively new to equities and, as such, we tend to suffer from what I call "liquidity illusion". We confuse "paper wealth" with "money wealth". It is true that, on paper, investors have lost $2 trillion over the past six-weeks. But it is not true that investors are somehow left holding a bill for $2 trillion that they must now pay. Nor is it even true that there is $2 trillion less of wealth from which investors could draw money if they wanted. Liquidity illusion says, "if I have one share of stock which I could sell today for $10, and I have another share of stock which I could sell today for $10, then I have two shares of stock which I could sell today for $20." Liquidity illusion makes us believe that 2 + 2 = 4. The fact of the matter is, however, that 2 + 2 = 3.

Consider a simple example. Bill Gates is reportedly worth $80 billion. Let us assume for a moment that all of this wealth is in the form of stocks. Does having $80 billion worth of stock mean that Mr. Gates could conceivably sell his stock and buy $80 billion worth of goods? Suppose Mr. Gates wanted to buy $80 billion worth of goods. He would have to liquidate (i.e. sell) his $80 billion in stock. But, $80 billion worth of stock is a lot of stock. Remember that stock prices are no different than, for example, car prices. If car dealers find themselves holding more cars than people want to buy, car prices fall. Similarly, if Mr. Gates put $80 billion worth of stock up for sale, the number of shares of stock for sale on the market would be so great compared to the number of shares of stock people wanted to buy that stock prices would plummet.

"Just a minute," you say. "Suppose Mr. Gates sold one of his shares of Microsoft stock on September 2, he would have received $101.25."

"Correct," I say.

"And if he had sold two of his shares of Microsoft stock, he would have received (2)($101.25) = $202.50."

"Correct again," I say.

"Then following this logic, if he tries to sell 50 million shares of Microsoft stock, he should receive (50 million)($101.25) = $5.062 billion, right?"

"No," I say. "You are suffering from liquidity illusion. Remember, 2 + 2 is not 4, but 3…"

When Mr. Gates puts his 50 million shares of Microsoft stock up for sale, the number of shares of stock for sale on the market will be greater than the number of shares of stock people want to buy, and so the price of Microsoft stock will fall. Suppose the price of Microsoft stock falls to $65. Mr. Gates will have received $3.25 billion from the sale. On paper, Mr. Gates’ shares in Microsoft are worth $5.062 billion. But, if he tries to liquidate the shares, they will only be worth $3.25 billion. Herein is the fundamental truth of paper wealth: paper wealth exists so long as we don’t try to convert it into cash. If we try to convert paper wealth into cash, we may find that the value of the wealth drops. But, and here is the irony, if we don’t try to convert the paper wealth into cash, the value of the wealth will remain high.

So, have we collectively lost $2 trillion over the past six-weeks? Yes and no. Our portfolio values are $2 trillion less than they were before. But, had we tried six-weeks ago to cash in our portfolios, we would not have received $2 trillion in cash. In fact, we probably would have received less than what our portfolio values are today. So, in an ironic way, we might say that we are actually ahead of the game. We have more wealth today, despite the stock market decline, than we would have had had we cashed in our portfolios back in July when the market peaked.

And that is the up side to a down market.

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