Market cap is a marginal measure of desirability of shares in the entity represented. It mostly measures the expectations of the most flighty investors over short timescales. If a company issues a billion shares but only one of those is traded in any given day, the price of that single share agreed between the single seller and the single buyer entirely determines the market capitalization of that company.
In practice there is usually a lot more volume, but the principle remains. Almost all shares of any given entity are not traded over the timescales that determine share (or index) prices and hence market capitalization. In addition, market price has very little to do with the value of an entity’s assets. Such assets may be instrumental in generating profits, but the relation is weak and very far from linear.
GDP, too, does not measure what you appear to think it measures.
I admit my mistake in intuitively assuming that GDP and stock market valuations should be closely linked. But it still seems strange to me why they aren’t, and I want to understand that better. Shouldn’t they at least be highly correlated in an idealized model?
Think of stocks as a kind of prediction market for a company’s value. The stock price should reflect expectations about its future earnings, but those expectations are built on something—maybe a new technology they’ve developed, or an undervalued specialist. If that’s the case, then why isn’t the market naturally structured in a way that adjusts salaries dynamically based on predicted contributions? Why don’t we have, say, ‘patent usage shares’ that investors can buy to increase expected royalties on a promising technology?
In an efficient system, I’d expect the market to fragment into these kinds of sub-sectors—where you can bet not just on the company as a whole, but on specific assets or individuals within it. And you love all these equal-surplus deals, so you’re interested in getting that kind of accurate valuation. If you believe a specialist is undervalued, you don’t just buy the company’s stock, you invest in their salary in exchange for a share of the revenue they generate. If you believe a company’s R&D is its most valuable asset, you invest in the future licensing income of its patents rather than the entire stock.
If this kind of structure existed, wouldn’t stock prices and the actual underlying value of companies align more closely? And if they don’t, does that mean GDP is failing to capture certain kinds of value—like knowledge, which isn’t easily tradeable? Or should stock prices themselves be less volatile than they currently are?
I also don’t see how the fact that share prices are set by the latest trade changes this dynamic. If I’m missing something fundamental here, I’d love to hear your perspective. I understand that simply saying ‘the market is irrational’ is not a good correction—it’s probably smarter than I am—but maybe it isn’t structured in the most optimal way, for example, it doesn’t pay people for their expected value, or there’s something key I’m overlooking?
Going into all the ways in which civilization—and its markets—fails to be rational seems way beyond the scope of a few comments. I will just say that GDP does absolutely fail to capture a huge range of value.
However, to address “share prices are set by the latest trade” you need to consider why a trade is made. In principle, prices are based on the value to the participants, somewhere between the value to the buyer and value to the seller. A seller who needs cash soon (to meet some other obligation or opportunity) may accept a lower price to attract a buyer more quickly. In our hypothetical and simplified one-trade-per-day scenario, that seller may accept up to 20% less than the previous day’s trade price, though they find a buyer at only 5% less. So the company’s market cap drops 5% even though 99.9999% of the investors and potential investors still value it exactly the same as yesterday.
This scales up since there are many highly correlated and often very short-term factors that influence desirability of shares vs cash vs bonds vs commodities vs …etc. It’s not just “what do I think this is worth to me”, but also “what do I think that other people think that the market price will be tomorrow” and so on, and this can result in self-fulfilling predictions over surprisingly long time spans.
Market cap is a marginal measure of desirability of shares in the entity represented. It mostly measures the expectations of the most flighty investors over short timescales. If a company issues a billion shares but only one of those is traded in any given day, the price of that single share agreed between the single seller and the single buyer entirely determines the market capitalization of that company.
In practice there is usually a lot more volume, but the principle remains. Almost all shares of any given entity are not traded over the timescales that determine share (or index) prices and hence market capitalization. In addition, market price has very little to do with the value of an entity’s assets. Such assets may be instrumental in generating profits, but the relation is weak and very far from linear.
GDP, too, does not measure what you appear to think it measures.
I admit my mistake in intuitively assuming that GDP and stock market valuations should be closely linked. But it still seems strange to me why they aren’t, and I want to understand that better. Shouldn’t they at least be highly correlated in an idealized model?
Think of stocks as a kind of prediction market for a company’s value. The stock price should reflect expectations about its future earnings, but those expectations are built on something—maybe a new technology they’ve developed, or an undervalued specialist. If that’s the case, then why isn’t the market naturally structured in a way that adjusts salaries dynamically based on predicted contributions? Why don’t we have, say, ‘patent usage shares’ that investors can buy to increase expected royalties on a promising technology?
In an efficient system, I’d expect the market to fragment into these kinds of sub-sectors—where you can bet not just on the company as a whole, but on specific assets or individuals within it. And you love all these equal-surplus deals, so you’re interested in getting that kind of accurate valuation. If you believe a specialist is undervalued, you don’t just buy the company’s stock, you invest in their salary in exchange for a share of the revenue they generate. If you believe a company’s R&D is its most valuable asset, you invest in the future licensing income of its patents rather than the entire stock.
If this kind of structure existed, wouldn’t stock prices and the actual underlying value of companies align more closely? And if they don’t, does that mean GDP is failing to capture certain kinds of value—like knowledge, which isn’t easily tradeable? Or should stock prices themselves be less volatile than they currently are?
I also don’t see how the fact that share prices are set by the latest trade changes this dynamic. If I’m missing something fundamental here, I’d love to hear your perspective. I understand that simply saying ‘the market is irrational’ is not a good correction—it’s probably smarter than I am—but maybe it isn’t structured in the most optimal way, for example, it doesn’t pay people for their expected value, or there’s something key I’m overlooking?
Going into all the ways in which civilization—and its markets—fails to be rational seems way beyond the scope of a few comments. I will just say that GDP does absolutely fail to capture a huge range of value.
However, to address “share prices are set by the latest trade” you need to consider why a trade is made. In principle, prices are based on the value to the participants, somewhere between the value to the buyer and value to the seller. A seller who needs cash soon (to meet some other obligation or opportunity) may accept a lower price to attract a buyer more quickly. In our hypothetical and simplified one-trade-per-day scenario, that seller may accept up to 20% less than the previous day’s trade price, though they find a buyer at only 5% less. So the company’s market cap drops 5% even though 99.9999% of the investors and potential investors still value it exactly the same as yesterday.
This scales up since there are many highly correlated and often very short-term factors that influence desirability of shares vs cash vs bonds vs commodities vs …etc. It’s not just “what do I think this is worth to me”, but also “what do I think that other people think that the market price will be tomorrow” and so on, and this can result in self-fulfilling predictions over surprisingly long time spans.