Misunderstanding Markets

Or: No, stock valuation increases aren’t the same as income

There was a week long period where these were the only headlines I saw:

• CNBC: “These 7 billionaires’ net worth is up more than 50% since start of the Covid-19 pandemic”
• BusinessInsider: “How billionaires got $637 billion richer during the coronavirus pandemic”
• GlobalNews: “U.S. billionaires richer by $434 billion since coronavirus pandemic began”
• Forbes: “As Coronavirus Fears Derail Market Comeback, 10 Billionaires, Including Bezos And China’s New Richest Person, Gained $23 Billion In One Week”
• Forbes, again: “Billionaires Are Getting Richer During The COVID-19 Pandemic While Most Americans Suffer”
• BusinessNews: “America’s billionaire wealth jumps by over half a trillion during COVID-19 pandemic”
• CTVNews: “U.S. billionaires have regained US$565 billion in wealth since the pit of the crisis”

Evidently, there’s a lot of billionaires out there getting richer on the back of the pandemic — at least, that’s what I’m getting from the headlines and actually reading the articles.

I think a lot of this is predicated on a misunderstanding of how stocks work — and it’s not limited to billionaire net worth. I consistently see posts that show an incredible misunderstanding of how markets work and how the stock performance of a company benefits a company.

There are four things I want to cover:

1. Unrealized gains are illusory
2. The link between founder wealth and company stock is tricky
3. Growth is easy to inflate by changing reference points
4. A company’s stock going up matters less for the company than you think

As an aside: before you get upset, thinking this will amount to a “billionaires are good, actually” type of post, I’d ask that you wait until the end to make judgements. Billionaires may be bad, but you don’t need to misrepresent the facts to prove that.

Let’s get into it.

Unrealized Gains are Illusory — Sort Of

The way we talk about net worth as it pertains to stock holdings is flawed. We tend to make a lot of implicit assumptions about how unrealized gains translate to direct purchasing power and material wealth. But first, let me explain what unrealized gains are:

Suppose you bought a share in Shopify, a company that helps businesses create ecommerce platforms. You bought it in 2017 for $70, in the hopes the stock would gain in value. It’s now July 31st, 2020, and the stock has since grown to $1,370 dollars, nice pick!

So you have a stock you bought for $70, that is now worth $1,370: are you $1,300 richer? Not quite. If you want to get that $1,300, you need to sell the stock. When you sell a stock, a few things happen. Selling your stock triggers what we call a capital gains tax, which is calculated by applying your marginal tax rate to 50% of your realized gains. For example, if your tax rate is 30%, the calculation would look like this:

Capital Gains Tax = Capital Gain x 50% x Marginal tax rate

OR

Capital Gains Tax = $1,300 x 50% x 30%

Capital Gains Tax = $195

Your $1,300 gain has now become $1,105 — a number that would change depending on your actual marginal tax rate.

But what if you decide not to sell your stock? What if you decide to hold onto it, indefinitely? You’d never see that $1,105 or your initial investment, but it would certainly make your net worth look bigger. What if the Shopify stock tanked? It may be at $1,370 now, but if the company abruptly went bankrupt, the value could drop down $0. Even though your net worth looked like it had been increasing, the value you have built up in the stock can be destroyed in a way that pure cash can’t be.

Founder Wealth and Company Stock

Unrealized gains make it hard to reason about net worth. I’m going to use an extreme example: Jeff Bezos

Jeff Bezos is worth roughly $178 Billion, and he owns or have voting rights of approximately 15% of Amazon’s outstanding shares. Amazon’s market cap — the sum total value of all outstanding shares — was approximately 1.3T when Bezos’ net worth was mentioned in the news. 15% of $1.3 Trillion is $195 Billion, higher than Bezos’ estimated net worth. So maybe he owns less than 15%, but suffice to say the vast, vast, vast majority of his net worth is tied up in Amazon stock.

The extent to which Bezos’ net worth is tied up in Amazon stock means his net worth is about as volatile as the company’s valuation. In the past year alone, Bezos’ net worth has gone from $70 Billion to around $178 Billion — all driven by Amazon stock gains.

Let me be clear: Jeff Bezos has billions of dollars of cash and material assets lying around. There are very real concerns about inequality that people like Bezos should make us think hard about. However, it’s tough to reason about how we should talk about Bezos’ wealth increasing. If he committed to never selling another share of Amazon, he’d still own the shares but never see the material cash he could otherwise gain. His net worth is, in some sense, provisional on the idea that he can liquidate his stock at current prices in its entirety, and that capital gains tax is not a factor (as unrealized gains, Bezos’ net worth is a sizeable fraction less than current numbers once he actually cashes out).

Additionally, the mechanics of how someone like Bezos could cash out his stock is tricky. There’s only so many people in the market for Amazon stock, and if Bezos decided to sell everything off, the valuation of his stake in the company would tank as he starts needing to sell shares at lower and lower prices to attract more investors.

All of this is to say that “Jeff Bezos is now $6 Billion richer during the pandemic” and other similar statements is skipping over a lot of really interesting and really complicated questions of what constitutes material wealth gain. Doubly so when the anti-billionaire crowd claims these billionaires aren’t paying tax on these gains — they will, but only when they cash out of their holdings, just like everyone else.

As a side note: the billionaires who have seen significant wealth gains? They appear to be the tech-founder types like Bezos who, whatever you may think of them, have created the infrastructure that allowed for us to continue buying things during lockdown. “E-commerce founder makes lots of money during a period where e-commerce skyrocketed in importance” isn’t as provocative a headline, I guess.

Reference Point Trickery

I’ve spent a lot of time talking about Bezos, but I started with talking about corporations gaining in value over COVID. I’m going to argue that a lot of claims about the valuation increases of companies during COVID are the result of what I’ll call “mathematical trickery”.

Suppose you own Shopify stock worth $1,000 on March 1st. On March 2nd, the stock drops in value to $500. On March 3rd, the stock rises again to $1,250.

Did your stock go up by 25% or by 150%? If you have a start date of March 1st and an end date of March 3rd, you’ve gone from $1,000 to $1,250. If you start from March 2nd instead, you’ve gone from $500 to $1,250.

Where we set our reference point matters.

This is the S&P stock index — it’s a composite of a lot of stocks and is pretty representative of “the market”. Notice the massive drop at around March 2020 — stocks crashed after the pandemic became a global concern and we started seeing strict lockdowns and other economically restrictive policies.

A couple weeks later, the US signed a $2 Trillion economic stimulus bill, and the market saw its best week since 1938, rising 24% despite the single biggest increase in unemployment since the US started recording unemployment figures. Is this proof the stock market doesn’t care about unemployment? Nah. This is reference point shifting at its finest. If you compare the S&P during the pandemic to its pre-pandemic state, we have a net loss. It’s only if you use the very lowest trough of the S&P and compare it to the jump after a stimulus bill was signed that we see this massive 24% increase.

When people tell you that stocks gained X% even during [bad event], the question you need to ask is: gained relative to what?

This is where we get the thinkpieces in major publications talking about how much company stock went up during the pandemic or how much money billionaires made off a global health crisis. Values dropped at the start, and stimulus saw a rebound — the long-term gains are less than the headlines suggest, and I can’t help but see it as media sensationalism. The same can be said of many claims regarding billionaire net worth increases . The reference point you use matters!

Stock Gains Don’t Go to the Bottom Line

… Ok I may have lied at the start of this post. I did see all the news articles about billionaire net worth gains, but this was the post that pushed me over the edge.

My qualms about LinkedIn influencers aside, this post represents a fundamental misunderstanding about the relationship between stock valuation and company assets.

When a company issues shares, they sell them off to investors. These investors hold the stock and reap the benefits of any gains, while the company can use the proceeds of its stock issuance to fund additional growth efforts or continuing business operations. So what benefit does a company get when its stock goes up:

1. Status
2. The stock price is higher for future issuances
3. Sometimes acquisitions are done by giving the owner of the acquisition target company stock, so a higher price means an increased ability to acquire companies

Notice how I didn’t include “stock price going up means a company has more cash”. Microsoft stock going up given their reported interest in purchasing TikTok does not gain them $75 Billion in any meaningful sense — that gain is going to Microsoft investors, not the company.

Takeaway

One of my biggest pet peeves is people arguing for things I support, but doing it badly or in bad faith.

Want to talk about raising taxes on the super-wealthy? Great! I think that’s needed — see my article about genetic heritability being good cause for

Want to talk about the stock market being decoupled from “real” value? Fantastic! See: The Big Short, and virtually any other source that talks about bubbles in markets.

Want to talk about problems of inequality? Amazing! See my post about Piketty’s Capital in the 21st Century and how we should reason about wealth (re)distribution.

But there’s no reason you need to lie, misrepresent numbers, or select only the most convenient examples for your side. Reality is bad enough as it is. Inequality is bad enough as it is. You shouldn’t need to rely on fundamental errors in reasoning to prove your point.

When people do this it feels like a murder trial where you have all the eye-witnesses and video evidence you need to convict, and then inventing a story about the murderer kicking your cat.