To think about how the world of currency has evolved throughout the ages, it seems clear there is much we take for granted in how our current financial markets operate. Only speaking for the United States here, but it is as if people are trained to think about the value of goods and services compared to their salary. Salary, much like the cost of living, varies wildly from one location in this country to another. The median income in some parts of rural Alabama can be around 20k per year while in parts of the New York City metro area, it tops out at over 110k. A house costing 75k in Alabama will seem out of reach for locals compared to their average salary, while their northeastern neighbors are thrilled when they can buy something for under a million.
It seems like this has already gone off the rails from the opening statement, but nothing could be further from the truth when we consider that those salaries and costs of living people are using for the benchmark of their spending ability are measured in the national currency of United States Dollars (USD). That statement seems obvious, but there are implications behind it few people ever take the time to understand. The money we use every day, that people lie, cheat, and steal to obtain, when necessary, is not just worth the amount printed on the face of the bill because our government said so.
From the beginning of time societies used tangible assets to obtain the goods and services they needed. Often, this was in the form of gold, silver, or other precious metals. In some instances, it might have been livestock, lumber, or other commodities. Before the United States eased off the “gold standard” in 1933 and Richard Nixon fully abandoned it in 1971, the value of every dollar bill in your pocket was directly linked to the current price of gold and the quantity of said gold on hand. There was a warm and fuzzy feeling to know that something was backing or providing the value to that money that we now take for granted. The gold standard helped to maintain the value of money by hedging against inflation and staving off deflation, two of the biggest thieves to the purchasing power of your bank balance.
So, what determines the value of money today, and how does that have anything to do with it being fictitious? The value of the USD, and how it stacks up compared to other world currencies or exchange rates, is calculated in three main ways. Before looking at each one, it is important to realize this is not a perfect science as it is subjective to the views and intentions of those who work behind the scenes to make the case for a value most of the world can rely on.
One factor used to determine the value of any currency is the exchange rate mentioned earlier. An exchange rate is the value someone from another country would pay to obtain currency from another country. If you have ever traveled internationally or know people who have, you might have heard whisperings of not going to certain countries at certain times because their currency was too high. And on the contrary, when a country’s currency is weak, or undervalued compared to the USD, that is a perfect time to get the most value out of your money. The issue with this valuation factor is the basis on supply and demand, much like everything in life, and is set by currency traders who seemingly use arbitrary criteria evaluating actual currency supply and demand.
If there was an actual physical formula at play, we would see drastic declines in the value of the USD every time the federal government prints more money, or in other terms, increases the deficit by borrowing more money. This is effectively increasing the supply of currency without ever changing the underlying demand on the global stage. As the supply of anything increases while demand remains the same, the value by right should decline. The fact that it doesn’t in this equation illustrates there may be less tangible and scientific factors at play, like emotion and unfounded opinion. There is also the underlying premise of GDP (gross domestic product) that can be used as an argument for how our deficit is not as high as this example might imply, but that is a different topic that needs a dedicated article.
The second factor impacting the value of the USD is the demand for US Treasury notes. Think about a note as a short-term loan to the American government where they will pay a fixed rate of return from 1 – 10 years. Historically, the United States has enjoyed the highest possible credit rating from all the major rating agencies, indicating it was almost guaranteed any money lent to them would be repaid as promised. In 2011, the S&P cut that rating by one notch, which may not seem like a big deal. However, it was done for the same reasons mentioned in the prior paragraph – rising deficits and an increased obligation to pay interest on their debts. To think a currency can be considered stronger based on how willing others are to lend that government more money can quickly become a recipe for disaster as debts keep growing and the ability to repay gets blurred. Think about a college kid with a credit card who gets their limit increased every time the card maxes out; at some point, something has to give.
The third and possibly most dangerous factor in the value of a currency is the amount owned by other governments. The more USD a country like, let’s say China, owns, the higher the value of the currency. While the underlying principle of others seeing enough value to stockpile something makes it worthwhile is valid in general, there is also concern about their ability to change their minds. China owns so much USD that simply slowing, or stopping the purchase of more currency could hurt the value of the USD and the American economy. Should they turn around and decide to sell off most or all of what they own, it would result in a catastrophic devaluation of the USD that would cripple the economy.
There are reasons countries don’t do things like this, though, mainly because it would result in them now trying to sell a currency they just made virtually worthless and losing money on their investment. However, countries like China are notorious for manipulating the value of their currency, so it is difficult to tell at any given time what the Yuan is worth. If they buy USD with a Yuan artificially valued at 5x what it is really worth and then turn around and sell off their USD holdings, China could easily win an asymmetric currency war by sustaining less damage to their economy than what they inflicted on ours.
This concept has precedent in other factors of the global markets as well. OPEC, or the Organization of Petroleum Exporting Countries, routinely manipulates the global price of oil by using its substantial control of the overall supply on the market. If OPEC wants to crush a competing country, they simply increase the available supply until the price drops far enough to where their competition can no longer sustain production. Once the threat is eliminated, they can scale back demand and push prices higher than ever to recoup any money they may have lost.
If the thought of all the ways the USD can be controlled by external factors isn’t scary enough and doesn’t give pause to consider if it is worth what we think it is, then the possibility of everything valued in the USD being just as fleeting should be petrifying. One of the largest sources of wealth, or seemingly so, in this country and the world, is valued in almost identical ways to the value of currency. Yes, that is the stock market.
Most of the wealth in the stock market is controlled by the top 10% of investors, much like 10% of world powers control global currency. They own the bulk of the supply and, therefore, have the means to directly impact stock prices, and in turn, the perceived value of a company. Supply and demand directly impact the cost of everything we encounter in life. The difference between the stock market and something like a precious metal, though, is that technically supply of the first is infinite, whereas the value of the second is finite. We cannot manufacture more gold or silver than what the earth has provided us, which provides some fact-based rationale behind how prices are set. With the stock market, again like national currency, companies can issue additional shares or play creative games to manipulate the price through stock splits, reverse splits, buybacks, and other strategies.
So what is a stock? Simply put, it is an ownership interest in a company. Let’s use Apple, for example. Currently, their shares are selling for $275/each. We constantly hear that companies like Apple, Google, and Amazon are trillion-dollar businesses. The formula behind that valuation is merely the current price of 1 share of stock multiplied by the amount of shares outstanding, which for Apple is 4.375 billion.
$275 x 4,375,000,000 = $1,203,125,000,000 market capitalization
Yes, Apple is, on paper, worth over 1.2trillion dollars. But does that mean that everyone who owns a share of Apple today would get back their $275 if they were to go out of business? Absolutely not. As with the USD, the factors determining Apple’s stock price on any given day are subjective, man-made, and subject to manipulation by those who value the company and those at Apple who control the flow of data used to perform these calculations.
The first thing to understand about that 1.2 trillion-dollar value is that it in no way reflects the amount of money Apple has on hand (now in Apple’s case they may very well have it, but that is not usually the case). Every person who gave Apple money to buy their stock invested in that business, and then Apple was free to turn around and use that money for whatever they wished. Maybe it was to fund a new factory or develop a new product. Or maybe it was to pay a CEO $100 million salary, fly top executives around the world on private jets, and fund their opulent lifestyles. Shareholders have no control over where their money goes once it is invested, they just need to have faith that the company will operate responsibly.
Financial analysts are integral in helping the public determine the risks with investing in publicly traded companies. They use a host of ratios including: price to earnings, forward price to earnings, earnings per share, liquidity, and free cash flow. Individual investors rely on this data to hedge against making poor decisions and possibly losing life savings (based in USD). This analysis is all based on the information provided by the company, which can be a pitfall, and does not account for the supply and demand piece.
There was a time when markets reacted accordingly to good and bad news, in a timely fashion to when those announcements were made. So, a bad earnings report or falling short on a specific target would result in the stock price declining. Conversely, a great earnings report or new product announcement would drive up the price. But in the current world of artificial values, good news often results in price drops because it was not good enough, and bad news can buoy a stock since analysts expected it to be worse.
Why is that?
Much like with the USD, large institutional investors control the bulk of individual company stock. These institutions range from hedge funds and mutual funds to governments or private billionaire investors. Regardless of the name assigned to the party, they all can dictate the price in the market. Think back to the example of China selling all its USD holdings overnight and crashing the currency’s value. If one party owns millions of shares of Apple and chooses to sell, it will increase the supply of Apple shares on the market, thus creating a perceived decline in the demand. Most of the trade will likely be executed in the range of the $275 a share we spoke about earlier, but the sheer transaction size is going to cause the remaining shares to decline precipitously in value.
In the last example, that means everyone else still holding their shares of Apple has less value than before. Now imagine if someone else holding millions of additional shares saw the sharp price decline and panicked, deciding they were okay selling for a reduced price (call it $225 for easy numbers), that would then drive the price down even further for those still holding their shares. Generally, the smaller average investors are left holding the bag when the big guys engage in market making, but that is not the point.
One of two things can happen at this point.
The first scenario, and the one that winds up happening more often than not, is another large investor, sometimes the original investor who drove the price down in the first place, will now see Apple trading at a reduced price of ($175 again as an example) and decide to buy it. If you have been following along, you should realize this diminishes supplies, creating a perceived demand, and the price will rise again. When certain players can virtually decide how to influence a stock price at will, it becomes difficult to understand how there was ever any underlying value to begin with.
The second scenario is far less likely. But that does not mean it should not be explored to understand just how fictitious the so-called wealth created by the stock market is. Imagine now after the price hit $175, the dominoes begin falling. Another investor dumps millions of shares, and so on. Eventually, those still holding shares, or trying to sell shares, are stuck with something that has become worthless. Knowing that is a possibility, it is insane to think Apple is worth 1.2 trillion dollars, as not every person who owns shares will ever see the current trading value of $275 per share.
Even without looking at such extreme examples, although the mechanics behind them are important, the most obvious sign stock value is as fictitious as the value of the underlying currency at any point in time is how quickly an interruption in their core business can cripple them. To understand this, one only needs to look at the banks, automakers, and airlines. Each of the top players in these sectors is worth billions if not hundreds of billions of dollars. Yet when times get rough, all that market capitalization does nothing to prevent them from needing bailout money, funds that come out of the pockets of the honest tax-paying citizens who bear the brunt of their plummeting stock prices.
In conclusion, our entire economy is based on nothing more than blind faith that those who control monetary policy and create valuations are operating in the best interest of the general public, and that they are competent in their fiduciary duties. When we take into account that our government is rarely prepared to respond to any unforeseen financial disruption without borrowing obscene sums of money, and those CEOs who are paid millions upon millions of dollars to run companies into bankruptcy at the expense of their shareholders keep their jobs, it is hard to have any confidence that a dollar today will be worth anything tomorrow.