Author Topic: What if the Dow goes to 0? Need help understanding (Long)  (Read 2175 times)

Offline ejsandstrom

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What if the Dow goes to 0? Need help understanding (Long)
« on: October 15, 2008, 11:32:42 AM »
I am a stock market idiot. I am going to to ask this at a very base level. I know very little about the financial markets, so my question is this.

What if the Dow drops to 0. My infantile understanding of stocks is this. Company A wants money for what ever. So they release stock and people buy that stock at X price. So lets say for ease of math they release 1million shares and they sell for a dollar. Company A gets a million for their whatever ( lets say to make powdered water) . Now the guy (Joe) that bought that stock has it. He can sell it, or keep it and wait for a dividend. Now if the company is doing well and will turn a profit and inturn pay a dividend. So say that is .10. So now he has .90 into his share. Bill sees that Joe just made .10 and he wants to make that next year so he tells Joe " I will buy your share" Now Joe liked making money off of it so he says "its going to cost you $2" Bill says OK. Now Joe made 1.10 and he is happy but company A never changed a thing. They don't get any portion of that. But now because Company A is one of the company's on the DJIA the Dow goes up. Now there are a million other people with shares that are happy that they just had their investment POTENTIALLY double. That is if they sell right now. We will say that 250,000 do and they double up, but now the market is flooded with people selling company A. Now people are only paying 1.25 at the close. All the while Company A is never effected. So if we would put this in a chart form the Dow would have doubled with Joe's sale and then eventually closed only up .25. OK so the next day Company A says that the million dollar idea wont work be cause water is wet. So they wont be paying a dividend. They arnt really out any thing because they printed stock and sold paper and created money with out needing to produce something. With this news the people that were holding the stock as an investment don't want it any more. So they try to sell it but because everybody knows the problem with water, so they wont pay $1.25 for it, but they will pay .25. So it lost 80% of its "value" but was company A hurt? No not really. Now you could say that if you bought at $1 you lost 75% of your investment IF you sell. But if you cant afford to loose money, would you invest it? No, so you lost some walkin around money but that's it. That is my idea of how the market works in a microscopic way.

The only people that really get hurt are the guys that make a living selling stock. And sure now Company A cant try to raise another million as easily, but if they make all of their money by turning air into a gas, they keep the lights on.

So the real question is this. As "Joe" that doesn't have a dog in the market, why should you be in dire straights if the Dow goes to 0. Do the lights go out? Is every business going to close over night? What about private company's like Cargil. What if We as in the grand form decided to do away with the stock market as a whole. Please leave out any arguments about 401ks and such.

Please keep the flames to a low level, because as I said I don't understand the market as a whole. Now displaced phase excitation is a whole other story..


Thank
-E

lancelot

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Re: What if the Dow goes to 0? Need help understanding (Long)
« Reply #1 on: October 15, 2008, 01:18:46 PM »
Here's a really brief reply.

The market averages/indexes generally reflect certain kinds of companies.  For the DJIA, its the 30 largest publicly traded companies by market capitalization.  Not to go into too much depth, but there are advantages to being publicly traded--one of the biggest being the preferential access to investment capital that comes from being publicly traded (since accounting rules are more stringent for publicly traded companies, better information about those companies is available for potential investors, the company has better control internal investment and how much to pay out as dividends versus interest payments [which aren't as flexible], etc.).

Paretto-efficiency (perfect free-market capitalism) requires/assumes perfect information (I know, definitely not that realistic--even less so now that the bankers have engineered their own bailout).  The point of free markets is that the market exchange price should closely reflect a company's profit and growth potential.  So the stock price goes down whenever the million Wall Street analysts predict profit and growth potential to go down, so that there are more sellers than buyers.

If the markets (the averages/indexes) tank on Day 1, it's true that there isn't an immediate effect on Main Street on Day 1.  Usually, however, when markets tank, that's an indication that investors expect profits to decline (alot, and in some cases becoming losses).  When those companies (the largest in the nation) start losing $$, people start losing jobs, wages decline, internal investment declines, external investment declines, etc.

So yes, if my 401K tanks today, it doesn't mean I'm screwed tomorrow morning.  It usually does mean, however, that those companies are going to start laying off people, and those people will be SoL when that happens.

The whole point of Sarbanes-Oxley, and FAS Rule 157, the dreaded "mark to market" accounting rule we've been hearing so much about, was to improve the quality of the information investors had at there disposal to make investment decisions (to be better able to predict whether profits were gonna rise or fall, if you will).  Unfortunately, with this whole bailout and treasury takeover, looks like more transparency is going to be the exception, rather than the rule.  Without perfect information, free markets just don't function as they should (bubbles form and pop, as is happening now).

So to answer your question in a sentence, when markets tank, if analysts have access to the right info, it's because Wall Street profits are about to go way down, which in turn, is ultimately bad for Main Street. 
« Last Edit: October 15, 2008, 01:20:42 PM by lancelot »

Offline ModernSurvival

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Re: What if the Dow goes to 0? Need help understanding (Long)
« Reply #2 on: October 15, 2008, 01:30:48 PM »
Great answer!  Way better then I could have done.

Let me answer one more point though, the concept of going down to "zero".  It ain't gonna happen, that would be that no one anywhere in the world was willing to pay even a dime for shares in 30 largest publicly traded companies.  In fact if one goes bust then it gets replaced with the company that was formerly #31.  The Dow and the other Indexes are just gauges to look at overall market performance, even with the Dow on its back companies like Coke are doing quite well.  There are thousands and thousands of companies in the Dow exchange, we should not loose site that the DJA is only 30 of them. 

The down turn is bad, real band but it is not the end of the world, not this time anyway.