How low can the stock market fall?

John W. Schoen Senior producer • Profile • E-mail

The stock market's wild gyrations show no signs of letting up. As market indices rack up huge losses, a Florida reader is wondering: What happens if it just keeps going down?

What would happen if the stock markets went down to zero?
— Malcolm J., Seminole, Fla.

The stock indices we're all riveted to these days are a rough measure of the value of companies that have sold stock to the public. (There are many companies — some very large — that don't show up in this measure because they haven't sold ownership shares to the public.)

The price of a company's stock reflects several factors. At a minimum, it represents a proportional share of the value of the assets owned by the company. These include things like buildings and equipment, along with cash or other investments on the company's books. This is sometimes referred to as "book value." No matter how badly the economy stumbles, these assets are still worth something. If the company folded tomorrow and sold off everything it owned, the proceeds would be paid out to shareholders (after creditors).

In some cases — when a company files for bankruptcy protection, for example — shareholders get nothing after those creditors are paid off. But in order for all shares of all companies to be worthless, the total liabilities of all public companies would have to exceed the combined assets of those companies. We're nowhere near that point, and it's hard to spin a scenario where we ever could be. (Though I'm sure we'll see a few in tomorrow's Answer Desk Inbox.)

In any case, very few stocks trade at book value because most companies are worth significantly more than their assets. The most important measure of a stock's value is the company's ability to make a profit — and to increase those profits in the future. If you invest in a company that pays dividends, the value of that income stream is reflected in the stock price. In order for all stocks to go to zero, you'd have to eliminate the earnings value of all stocks. While the total profits of all companies may go down in a bad recession, that number doesn't get anywhere near zero.

The last factor to consider is the collective psychology of buyers and sellers of stocks. While investors may study piles of data to gauge the value of a stock, they don't always behave rationally. The recent sharp drop in stock prices is based largely on the justifiably high level of anxiety about the banking system and uncertainty about how deep and long the economic downturn will be. Current stock prices may already reflect the worst-case scenario.

If they don't — and if we get even more bad news about banks or signs of a deeper recession — stock prices may fall further. But at some point, no matter how far they fall, stock prices reach a level where the risk of spending your last dollar to buy a share is more than offset by the odds that the economy will eventually recover and you will have made the investment of a lifetime. Investors who are stepping up as buyers today may be making just that kind of bet.

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