CLXXXV – Imaginary Rai Stones

So in my previous musings on the stock market and my subsequent addendum, I walked through a scenario where Rai Stones were used as “Equity” and Fish were used as currency. This helped me to think about my ideas in the time since those posts, and I offer the fruit of that here.

(y) – Addendum Simpliciter

Economics is complicated because we are dealing with multiple variables measured by dollars. The Island of Yap uses giant stone toruses (Rai Stones) as currency. They are so big they can’t be moved, so they just record who owns which giant stone torus. Lets take a page from that book to create a simpler example.

CLXXXIII – Economic Thought Experiment

There’s a fallacy I may have described here which I call the “Dow fifty-thousand” fallacy, so named for a book written in the late 90’s predicting that the Dow Jones Industrial Average will reach fifty-thousand by the early 00’s. In 2001, the tech bubble burst, and that long-shot dream became the new poster-child of tragic ironies, replacing the unsinkable Titanic.

What this has taught me is that if all the trends are going up, the only safe bet is to wager it will go down, and eventually I’ll be right. I do this with a lot of things, and usually that means I’m an optimist, because if times seem hard, I’ll bet the opposite with high confidence.

But the interesting thing insofar as it pertains to the stock market is that we haven’t really seen a period of prolonged decline. The stock market does tend to rise over time. It will make gains over a decade and lose them all in a week. That tends to be the way of things, on the aggregate. If the man who wrote “Dow 50,000” moved his timeline to “sometime in the next century” instead of “sometime in the next decade” he probably would have been right.

Social Entropy

So that leads me to the thought experiment. What else tends to always increase? The first thing that came to mind is population. Populations tend to grow logistically. It makes sense that some portion of that population will invest in the stock market, and if the population is growing then the number of people investing will grow, and the amount of capital in equity markets will likewise grow. Thus, an ever-increasing stock market is something like a bet on an ever-increasing population.

This is true in the case of a single company, too. If Acme Anvil Co sells anvils to the entire United States, then it’s sales will increase as the population of the United States increases. As it’s sales increase, it’s equity increases, it’s stock price increases.

How strong is the correlation between the stock market and the population? We could do a basic statistical analysis to determine this, but I think there are other variables at play. A basic rule of thumb for post-industrial society is that the older a population is, the more free capital it has. So if the investing population skews older, then it will appear that the capital invested is increasing faster than the population.

We can also adjust for the amount of capital actually available to invest. When Government spends money, that money is injected into the economy and some portion of it, by a chain of custody, will end up invested in equity markets. This will also tend to bolster those markets against population-driven volatility.

So I think we can deduce that equity markets will tend to rise at a greater rate than the population simply based on the two variables of demography and government capital flow.

What I am interested to know is how much of the change in equity markets can be explained by these three variables. As population increases, I would expect the markets to increase by at least the same rate. As the elderly population increases or decreases, I would expect the markets to increase or decrease by some multiple. As Government spending increases, I would expect the markets to increase by some multiple.

Consider The Following…

Theoretically we can create a model that tells us whether or not the markets are increasing relative our population. If the markets are increasing slower than (or decreasing relative to) our population, then that means that stock markets aren’t adding value so much as moving wealth around. If the markets are increasing faster than our population, then that means that stock markets are adding value for everyone involved.

How do I justify these conclusions? Lets imagine there is a population of ten-thousand individuals, some unknown number of whom are invested in a rudimentary stock market. The total equity is $10,000, so we can suppose that on average for every person has $1 in the market.

If this population increased by one-thousand individuals, and total equity increased to $11,000, this means that by doing nothing other than adding population, the markets increased 10%, exactly on par with our expectations.

If the population increased by one-thousand individuals and total equity increased to $10,500, then this raises questions. We don’t know who all is investing, but the total equity increased by less than $1 per person, so either the new individuals didn’t all invest one dollar, or the fraction of people who were investing weren’t investing very much, or the firms they were investing in were not in demand by the new population. There are a lot of ways to explain this behavior.

If the population increased again by one-thousand individuals to a total population of twelve-thousand, and total equity decreased to $9,000, then we have a new concern. On the whole, money is leaving the equity markets or value is being lost. This supports the idea that on the aggregate money has moved around our little population–though without knowing specific demography, we can’t know where.

If the population increases again by one-thousand individuals to a total population of thirteen-thousand, and total equity increases dramatically to $15,000, then we know that some value has been added from somewhere else–and because I’ve got imperfect information about this thought experiment, we don’t know where it is coming from but we do know it is a disproportionate addition.

The Price Is Right

This raises one last thought. I’ve been intentionally using the term equity and avoiding reference to stock price. Stock price behavior may or may not be rational, but the total equity is a reflection of the behavior of the marketplace.

Let’s put it this way. We have a market of ten-thousand individuals, and a firm goes public at a valuation of $10,000, and sells ten-thousand shares of it’s stock.

We have equity movements and we have price movements. Suppose a big institutional investor comes along and wants to buy 20% of the firm. They add $2,000 to the equity and acquire two-thousand shares of stock. The stock price remains one dollar. But lets suppose for whatever reason people suddenly think this firm has invented the next big craze, lets call it Widget 2.0. Demand for those ten-thousand shares increases and suddenly the stock is trading at $5 per share. Lets suppose our institutional investor sold his entire 20% stake at $5 per share. He sells two-thousand shares, receives $10,000. The firms total equity is now worth $50,000, but they only contributed $10,000, so they have an “unrealized gain” of $40,000.

That was a surprisingly complicated example, so let me break it down. Equity movements relate to ownership, and set a fixed starting point on what something is valued. Price movements reflect market conditions and not something tangible. The institutional investor made a $2,000 equity move, and then Widget 2.0 caused a stir and the price movement increased the value to $50,000.

TL;DR

Stock price reflects demand. If a population is increasing then demand will increase so a stock price will increase.

Total Equity reflects invested capital. If a population is increasing then the amount of money available to invest will increase so the amount of money actually invested will increase.

A stock price can decrease even if a population is increasing if the population doesn’t want that stock.

If Total Equity decreases it means money is being taken out of the markets, or the amount of money actually invested is decreasing. If this happens while a population is increasing then it means money is changing hands and/or social behavior is changing relative equity markets.

If Total Equity increases at a greater rate than the population, then that means that additional money is entering the markets from some other source, possibly the Government.

What I want to know is, how does our economy look when evaluated by this theoretical model?

AMDG