Quote of the Day: The Difference between Real Wealth and Paper Wealth

Keep in mind that when paper wealth is “lost,” nobody gets it. Quantitative easing has not made the nation “wealthier”, nor will the massive paper loss we expect over the completion of the market cycle make the nation “poorer.” As I detailed in June (see When Paper Wealth Vanishes):

“As in equal or lesser speculative bubbles across history, there’s a common delusion that elevated stock prices represent wealth to their holders. That is a fallacy, and we can hardly believe that given the collapses that followed the 2000 and 2007 extremes, investors (and even Fed policymakers) would again fall for that fallacy so readily. The actual wealth is in the cash flows that are ultimately delivered into the hands of shareholders over time. Individuals can realize their paper wealth by selling now to some other investor and receiving cash in return, but only a small proportion of investors can actually convert current paper wealth into cash by selling to other investors without disrupting the bubble. The new buyer then receives whatever cash flows the stock delivers into the hands of existing holders, and can eventually sell the claim to the remaining stream of future cash flows to yet another investor. Ultimately, a share of stock is nothing but a claim on the long-term stream of cash flows that will be delivered into the hands of its holders over time. The current price and the future cash flows are linked together by a rate of return: the higher the price you pay today for a given stream of future cash flows, the lower the rate of return you can expect achieve by holding that investment over the long-term.”

Emphatically, the wealth of a nation is not measured by the price that the most reckless speculator will pay for the last few shares that change hands at the most exuberant moment of a bull market, multiplied by the entire number of shares outstanding. No, the wealth of a nation is its accumulated stock of productive real investment, human capital, and resources. Everything else cancels out because every security owned by some holder is also the liability of some issuer (see Stock Flow Accounting and the Coming $10 Trillion Paper Loss).

Securities are ownership claims on a long-term stream of future cash flows. Paper gains don’t create aggregate wealth, and paper losses don’t destroy it. Think of it this way. Suppose a security promises you a $100 payment 10 years from now. If you pay $32 for that security, you’ll get a 12% annual return on your money. If you pay $122 for that security, you’ll get a -2% annual loss on your money. Does the economy have more “wealth” in the second case? No. The security represents $100 in 10 years, regardless. Now, you may be able to sell the security to someone else for $122, and let them hold the bag over the next 10 years. In that case, you may end up with more wealth, but your gain will come at someone else’s loss. In short, aggregate wealth does not increase just because securities become overpriced. Aggregate wealth is not destroyed just because valuations normalize.

Put simply, many investors, and even some policy makers at the Federal Reserve, are under the delusion that paper market capitalization represents real wealth to the economy as a whole. The truth is that the wealth is in the productive assets of the economy and the long-term stream of cash flows they generate. Price fluctuations can certainly affect the distribution of wealth. Those who repeatedly buy stocks from others at depressed prices, and sell them to others at elevated prices, will accumulate the purchasing power of others. Those who repeatedly do the opposite will surrender their purchasing power to others. But the aggregate wealth of the economy as a whole is unaffected by those price fluctuations.

(bold mine)

This incisive excerpt, which refutes popular wisdom, is from the weekly outlook of analyst and mutual fund owner John P Hussman at his website