It's probably happened once in your lifetime. You throw socks in the dirty clothes hamper and then wash and dry. When you fold the laundry, you end up with missing socks. Where did they go?
You might feel the same about the value of your stock portfolio in 2016. The first week of 2016 erased $1 trillion of value from the S&P 500. That would be akin to wiping out the entire market value of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Facebook (NASDAQ:FB), Intel (NASDAQ:INTC), Netflix (NASDAQ:NFLX) and Yahoo (NASDAQ:YHOO). Where did the $1 trillion of lost value go? The answer to this question lies with understanding implied value.
If we start with an initial public offering, IPO, or subsequent action, a company exchanges stock for cash from shareholders. Looked at on a balance sheet, company cash goes up on one side and shareholder equity goes up on another. Let's use the fictional company Acme (any Roadrunner fans out there?) as an example.
If you purchased Acme for $100 during the IPO and then sold it for $50, you lost $50. Where did the $50 go? Intuitively, you may posit that your loss flowed to the investor who purchased the stock from you. But that investor's personal ledger would show $50 cash out and Acme stock in.
Maybe you think the company issuing the stock is $50 richer. Their balance sheet with respect to the initial transaction did not change. They still have the cash, or whatever they turned it into, on one side of the balance sheet and shareholder equity on the other.
You may even feel that your brokerage is $50 heavier. The brokerage is a bit richer, but only as a result of the transaction charge for selling your stock.
Until recently, investors were more cognizant of their gains. Supply and demand drive stock prices and reveal more about our original question:
Where did the value go?
In our earlier example, the price of the stock fell because of a decrease in demand and perhaps more specifically, the investment community's perception of the stock. Investors were only willing to bid $50 for your stock despite the fact that you bid $100.
So an operative question might be, "why are investors only willing to bid $50 for something that I thought, and perhaps many other investors thought, was worth $100?" If we examine supply/demand factors, one could suggest that there is an increased volume of stock due to more share issuance by Acme. Other things being equal, the increased supply should reduce the stock's value. On the other hand, credit conditions may have tightened and investors cannot borrow money as readily from their brokerage or other sources. This credit tightening, again other things being equal, will reduce demand and hence the bid price for the stock.
The last few years has seen the opposite occur, that is companies like Acme have been buying back their shares. This action reduces supply, which should buoy prices. Arguably, share buybacks have elevated the major stock market indices. I used to ask people at the peaks of the stock market in 2007 and 2000 what their plan was for cashing in their stock gains. When they did not have an answer, I noted one of my investment laws.
Of course, the folks to whom I asked this question never considered an exit. They were simply happy to read their brokerage statements. Successful long-term investing requires systematic profit extraction. So if their brokerage statements indicated they had a $1,000 profit on a stock, I suggested their profit was implied. As a reference, those that have traded commodities are aware of IRS requirements of marking open futures positions "to the market" at year's end. Those are implied gains or losses. Those gains or losses do not become explicit until the position is closed. When I told those folks that they weren't $1,000 richer, yet, they looked at me askance.
So in the example, if you purchased Acme originally for $100 and saw its value rise to $150, were you really $50/share richer? Your implied gain is $50/share. That $50/share gain left you smiling but then when it came time to sell, the bids were only $50/share. Not only did you "lose" that $50/share gain, now you are coping with a $50/share loss from your original investment. Where did the lost value go?
The simplest explanation is to suggest that the money vanished into thin air or in reality never existed. Unlike your socks, which are probably somewhere in your house, the $50 you lost cannot be tangibly found in your sale transaction. When the stock fell from $150 to $100, the $50 in implied value lost cannot be assigned.
The factors causing a stock price to rise and fall are largely based on investor perception, which might be based on revenues, earnings forecasts or other factors. These numerical calculations fall into the realm of "logical" perceptions and efficient markets. There is also another large component at work and that is investor emotion. Investors herd. This is a very natural human instinct that causes people to follow others if for no other reason than to be part of the crowd.
These investor perceptions, whether logically or emotionally based, create the implied value noted in the Acme example. This is the nature of financial assets, they are rife with implied value.
On the other hand, the value of grocery items, brand premiums aside, are priced with explicit value consideration. The price of eggs, butter, and milk, for example, are not as influenced by an implied value component. If a group of people wanted to corner the market in butter, then the price of butter would reflect some implied value over which the price of butter should really be, or its explicit value.
If we go back to our stock example, there is an explicit value assigned to a company's shares. This value is known as the accounting value or book value. If a company takes all its assets and subtracts its liabilities, we have the book value of the company. Divide this figure by the number of shares outstanding and you get the book value per share or its explicit value.
Let's suppose Acme has 1 billion shares outstanding and its stock price drops from $100 to $99. That price drop translates into an implicit loss of $1 billion in market value. That does not mean the company experienced an explicit loss of $1 billion.
Whatever your thoughts may be about the current market run since 2009, it is fair to say there is a great deal of implied value in stock prices. If you were fortunate enough to buy near the bottom in 2009, you are sitting on a ton of implied value. If you held on through the market trough, you may have regained some of the implied value you lost along the way. If you are a recent entrant to the market, you have purchased something with a great deal of implied value.
Implied value is powerful. If an individual has a stock portfolio with a large amount of implied value, that person may be considered quite wealthy. The same goes for owners of a publicly traded company. That sort of wealth may compel creditors to loan them money. This has its own peril since the collateral is full of implied value. This can be the topic of another article.
The stock market is a great example of implied value. Once implied value become less important than explicit or intrinsic value, the game changes and selling occurs. At moments of great stress, the selling becomes a panic and prices fall. Stocks may fall to less than their explicit value. The most important takeway is that a single transaction between buyer and seller can alter stock values for all other holders.
What the market giveth, the market can taketh! Your gains are never really yours until you sell and take the cash. Now, where the heck is my other sock?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.