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Do Undervalued Markets Crash?

Original post by Walter Johnson of Demand Media

Undervalued markets are an investor's dream. “Undervalued” implies that there is value being created that, for various reasons, is not attracting the needed funding. This implies, in turn, that if those investors seeing an undervalued -- or untapped -- market invest in it now, then they will make a killing later when the market adjusts. The concepts of an overvalued and an undervalued markets merely suggest a market in temporary disequilibrium.

Equilibrium

Capitalist economics revolve around economic forces reaching equilibrium. Supply and demand is the most simple example. Suppliers can only produce as much as demand requires. This point of intersection is the equilibrium, and is expressed in prices. If demand increases, there is a temporary dis-equilibrium -- in that the price of the good goes up. If demand decreases, this too, is dis-equilibrium, and prices drop. Since markets seem, all other things being equal, to adjust constantly, an undervalued market will not crash, but rather attract the investment and attention needed for it to fill its proper market niche.

Markets

When prices fall due to a drop in demand, this in no way implies that the fallen price actually mirrors accurately the market potential of the product. It means only, in many cases, that people have yet to comprehend the value of the product, possibly due to faulty information from media bias or other sources. Once people do grasp its value, the market demand will increase, leading to a sharp price increase.

Crashes

Only overvalued markets crash. Even the “crash” metaphor itself makes no sense for undervalued markets. In stocks, for example, an overvalued market is when stock prices go so far upward that they no longer have any relation to the actual productive capacity of the firms represented. It is overvalued because betting on stocks has reached such a level that the stocks themselves are disengaged from the firm's actual financial health. The price is driven by stock investors, not the firm. Since many of these stock purchases are leveraged, the overvalued market is based on debt. When banks get panicky as the economy begins to slow, these debts are called in. The result is a market crash.

Undervalued Markets

All other things being equal, undervalued markets, whether stocks, bonds, commodities or real estate, do not crash. The market will seek to recreate its equilibrium by bringing more investment into that market. For overvalued markets, the crash is itself often a form of market discipline, bringing the overvalued bonds or commodities into equilibrium with economic reality based on production. It is conceivable that an undervalued market can “crash,” that is, become even more undervalued, only when the information available to investors about that specific market has been suppressed. The concept of “fair market value” implies that consumers have full knowledge of the products and the market. For an undervalued market to bottom out would imply that this information has been suppressed or overlooked for some other -- non-economic -- reason. This seems only a theoretical possibility, however.

                   

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About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

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