The Fundamentals are Not the Fundamentals

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The stock market and other financial markets do not rise and fall based on a strong or weak economy. The stock market and the economy are unrelated—ignoring superficial and loosely-related links—except to the extent that it is money supply that inflates both stocks and GDP.

But if financial markets move up and down primarily based on the quantity of money in circulation (i.e., “inflation”), then what good are the “fundamentals” in telling us how to value stocks? The fact is that they are very helpful in telling us the prospects of one company versus another, but they do little to tell us the prospects of the market as a whole. After all 95% of all stocks go up during bull markets and 95% fall during bear markets, since it is mostly the surge and shrinkage of credit and the volume of spending that inflates and deflates the market (most of the velocity of circulation of an economy takes place in asset markets). Similarly, the economic and earnings prospects of most companies increases during the credit expansion phase and contracts during the credit contraction phase.

Most tools used to analyze the fundamentals give only a vague idea of the value of a company and whether it is under or overvalued. Whether it is under or overvalued first depends on subjective assessments of value. But a particular value might be considered reasonable at one point in time, given the state of the economy, and unreasonable at another time. For example, in 1928, Public Service Electric and Gas Company earned $3.93 per share, and paid a $3.40 dividend and was valued as high as $137.5 per share. In 1932, it earned $3.46 per share, paid a $3.30 dividend, but sold for $28 per share.[1] It could be the case that the perception of value related to this company changed by those in the marketplace during the intervening years. A more likely reason for its dramatic fall is that as the money supply shrank dramatically between 1928 and 1932, there were fewer and fewer dollars to hold the stock price high, and it fell along with the quantity of money in circulation, as did most other stocks.

On the flip side, it was a substantial enough quantity of money, not the expectation of companies making even more money, that held stock prices at levels representing P/E ratios of $60 before the crash. To the extent that these perceptions could have been correct, they would have been justified only in the sense that the expectations would be for yet more money to be printed by the central bank, increasing company earnings still more. Stock prices and valuations can stay high for years, when it seems they should be falling, with no (seemingly) real explanation. They can also stay low for years, when it seems they should be rising. These facts are more indications that prices do not move based on fundamentals.

Market values are based on expected future earnings. The primary problem with trying to determine a market value based on future earnings is that aggregate earnings are mostly based (or at the very least partly based, as it is usually assumed), on particular economic conditions. Therefore, what is perceived as the expected future earningsunder certain economic conditions becomecompletely incorrect under other economic conditions. For example, at the end of a bull market when the money spigot is flowing and the volume of spending is high, a given market valuation might be appropriate. But within months, the flow of money might have slowed dramatically, accompanied by a reduction in the volume of spending in the economy and a reduction in profits; such changes would warrant lower valuations. At the least, all the assumptions that went into the previous valuation assessment, and more importantly, the actual forecasts and expectations, in the previous months were wrong. More to the point, the assumptions were wrong because they were based on a lack of understanding about finance, namely that the financials are largely determined by economics.

That’s right: it is primarily economics, not finance, which drives the financial fundamentals. Keep in mind that this is true in relation to the overall market, not in relation to how a single company performs relative to its industry or how one industry performs relative to another (though, as we have seen, economic changes can certainly affect one industry relative to another).

To reveal how it is the case that the economics drives the financial fundamentals, let’s look at the most basic financial element that determines the “fundamentals:” profits. Profits rise and fall with the ebb and flow of money and spending that arises from central bank credit creation. In order to understand how, it’s important to comprehend in detail what determines profit margins.

Nominal aggregate profits are usually seen as being generated by increasing productivity of the capital employed, and different versions of this theory incorporate the factors of time preference and opportunity cost. The most common understanding of profits is along the line of the following: if tools and machines can be used to create an additional quantity of goods, the difference between the value of the additional goods and the cost of the tools and machines that produced them is the rate of profit. But this theory usually boils down to having the production of physical goods explain the gap between monetary costs and monetary incomes. The reality is that productivity has nothing at all to do with economy-wide profits. Increased productivity can help a particular firm increase its profits relative to competing firms, but it cannot help all firms increase their profits together.

If the quantity of money in the economy were static, there would necessarily be the same dollar amount of total economy-wide revenues and the same dollar amount of economy-wide costs each year across all companies. For example, imagine that $10 Trillion was spent to produce goods and pay workers’ wages (business outlays) while $11 Trillion was spent on purchasing those goods (sales revenues). Imagine also that in the next year, output increased by 5%. No matter that the amount of goods produced increased in number, there could still be only $11 Trillion worth of sales revenues in terms of dollars,[2] and approximately $10 Trillion worth of costs—the number of dollars existing in the economy did not change. The additional volume of goods would serve to reduceprices; they could not increase the amount of dollars spent on purchasing goods or reduce the amount of dollars spent on producing goods.

Therefore, we must ask how it is that in any given year, total economy-wide business sales revenues exceed total business costs, when all the money business spend must necessarily show up as revenues to other businesses. Since all business spending comes back to businesses in the form of revenues, why isn’t there the same amount of revenues as there are costs (i.e., the amount spent)? Shouldn’t sales revenues equal business spending? The answer to this puzzle is that while business spending and revenues do in fact equalize, there is additional consumer spending in excess of the wages that are paid by businesses to its workers (keep in mind, businesses spend money in two primary categories: capital goods and wages). The amount of consumption—the amount of spending to purchase consumer goods—in excess of what is received in wages is termed Net Consumption by Reisman.

The additional consumer spending comes mainly from dividends, draw payments, stock buybacks and other forms of payments made by business to its owners (a smaller part of it comes from people consuming savings they already had). In other words, profits are mostly payments to capitalists to compensate them for going without the use of their money and instead allowing the business to use it in the form of factories, offices, and research and development, as well as to pay workers. Businesses that do not pay out dividends or other payments to their owners provide the return on the use of capital in the form of larger income statement profits, by way of ensuring a wider spread between revenues and costs. Net Consumption is essentially money that flows from companies to owners of capital and back to companies without hitting the income statement as costs; dividends and the like are not costs that show up alongside expenditures on capital goods and labor, they are a flow-through item.

More important to us as investors is how the derivation of profits changes in a world where the money supply is not static—in other words, in our current world of investing. In this latter case, the increase in the quantity of money, as noted briefly above, increases the rate of profit. The Net Consumption component just discussed is still present when an increasing quantity of money enters the picture, but added to the Net Consumption component is the component of Net Investment.

Net Investment is the monetary amount of investment created by the difference in purchasing power between the current time period and a previous time period when things cost less. It is the current amount of monetary spending by business which is recognized on income statements as sales revenues to other firms (every dollar of business spending by one firm is revenues to another firm) but is matched with income statement costs that were incurred previously in time when the price level was lower. The result is that, as long as there is an increasing money supply and corresponding price inflation, current business revenues exceed current costs; and the more the quantity of money expands, the greater the gap between revenues and costs. A more specific way of looking at it is that a company’s current productive expenditures exceed the amount of current costs because to incur the same physical expenditure of capital goods and to pay the same number of wages payments (productive expenditures)costs more today  than it did in previous years (costs). The difference between current productive expenditures and current costs is Net Investment.

With a constant amount of savings in the economy, there is not necessarily an additional amount of net real, physical investment added each year. Most of the increase—if there is any at all—is in monetary terms only. In other words, the same amount of physical investment that takes place each year has a higher price tag. Why? Because there is a greater quantity of money and, therefore price inflation, each year.

In a world of an unchanging quantity of money, for a given amount of revenues, a company’s general and administrative expenses, costs of goods sold, and depreciation expenses would be roughly the same each and every year. But with a growing money supply, these expenditures become more costly each year, and thus, a larger monetary amount is spent. The large portion of business costs which relate to inventories and capital equipment (large-scale investments) are typically recognized at a much later date than they are incurred, due to standard accounting procedures.

For example, steel sheet purchased to go into an automobile—a cost of goods sold item—might be purchased in June of year 1, but it is sold—in the form of a finished automobile—in June of year 2, when prices are 5% higher. Similarly, a factory—a capital good that is depreciated—which has a useful life of 20 years will have the first 1/20th of costs recognized the first year but the last 1/20th will be recognized 20 years later. Imagine the increased cost of a factory over twenty years. In the intervening years, inflation makes the cost of past purchases cheap relative to current purchases. Thus, with current spending showing up as revenues in the current year, but previous, lower-priced, expenditures showing up as costs, revenues are greater than costs. This creates a positive amount of monetary net investment in the economy. When the money supply is expanding, economy-wide business revenues rise while costs lag behind, widening the profit margin. When the money supply stops growing, revenues stop rising due to a fall-off in demand and a reduction in the volume of spending, and even fall, as discussed above, lowering the profit margin.

To summarize, profits equal Net Consumption plus Net Investment. Real profits equal Net Consumption plus Net Investment plus the increase in production and supply (the latter lowers prices in real terms, which constitute an increased rate of profit).

Earnings

The Net Investment component of profit is the main factor in determining changes in earnings during economic cycles. As the money supply increases during a bull market, revenues rise while costs fall behind, thus increasing profits and earnings. If still more money is pumped in at an even higher rate, revenues rise that much more above costs. Once the money supply slows or stops, revenues fall while the historical component of costs continue to climb. Profits and earnings therefore fall. During deflationary periods, revenues can fall below costs, but only temporarily. Obviously, then, aggregate “top line growth” can occur only with credit expansion (of course individual firms can gain revenue growth at the expense of other firms).

At the end of a bull market and the start of a recession, the common analysis is that “spending has fallen off.” Unbeknownst to those who talk in this fashion, what this really means is that the Fed’s slower rate of money pumping as slowed, resulting in business losses, which then results in bank losses and therefore the money supply and or the volume of spending (i.e., velocity) falling off. With a reduction in business and consumer spending, sales revenues fall while costs fall more slowly (since many of them are fixed, historical costs). The lack of net money creation causes revenues to fall and profits to shrink.

During a recession, the central bank tries to flood the economy with money because it believes that 1) simply enticing companies to invest will somehow bring prosperity, and 2) for its (justified) fear that a falling money supply will result in deflation and a collapse of much of the financial system.  When it begins pumping money into the economy, the new money is taken by business and spent, and therefore shows up as new and additional sales revenues. Greater sales revenues relative to costs raises the rate of profit. With business spending, hiring, and margins widening, official indicators point to a “recovery,” even if there is no real, sustainable economic growth (or employment); there might likely even be economic retrogression during this period.

Stock analysts usually try to determine what overall economy-wide profit margins (i.e., earnings) will be by looking at indicators such as retail sales, consumer sentiment, the consumer price index, manufacturing orders, new construction, government spending, and the like. But these indicators don’t tell much about future profits because they are all coinciding indicators to increasing or decreasing profits; they, like profits, are all derived from changes in the money supply. For a more specific example, consider the leading indicator industrial production. Economists will often tell us that there are signs of economic recovery due to the fact that industrial production is picking up. This does not tell us anything about the real state of the economy—the amount of goods and services being produced, and whether they are the goods that are truly demanded, or whether they are the goods artificially demanded based on credit expansion[3] —it simply tells us that new money from the Fed is flowing into the economy and causing spending and the prices of capital goods to increase. Specifically, it tells us that companies which produce capital goods are taking the new money the Fed has provided at low interest rates and making investments with it, and that they are seeing (monetary) “demand” from their customers who are spending their new money from the Fed.

The bottom line is that not only does the central bank create bull and bear markets and the improving and worsening economic conditions, but it also creates and reduces the very profits that are usually believed to be the basis for these first two factors.

Relative Valuation Ratios

It is because money has flowed disproportionately into asset prices in the last 25 or so years that relative valuation measures in recent years have averaged—over a 20-year period or so—the highest they ever have; market prices have remained at a new, elevated valuation level. Figure 8.1 shows that P/E ratios now average about 20 whereas they used to average 10-15, with the same and lower level of interest rates that existed in past decades (especially prior to the late 1970s and 1980s). The market used to bottom out in bear markets with P/Es at 5. Now they bottom out at 12 and 16, as is the case at the 2009 market bottom below. Stocks are now permanently more expensive because more money, proportionately, is chasing them than before. Plus, money is now more easily contained in asset markets without leaking out into the real economy than in prior decades.

Previously, an interest rate reduction of 100 basis points might have meant that P/E ratios should rise from, say, 10 to 12, based on fundamental analysis. Now, a 100 basis point reduction could mean that P/E ratios rise from 20 to 24.

Figure 8.1: Historical P/E Ratios

Source: Robert Shiller, Yale University

                Similarly, as Figure 8.2reveals, Tobin’s Q Ratio, a measure of the market value of a company’s stock relative to a company’s equity book value of the book equity, shows an elevated state in recent years, even if its level has fallen during the most recent crisis.

Figure 8.2: Tobin’s Q Ratio

In comparable fashion, relative indicators such as the price to sales, price to dividend, price to cash flow, price to book, and market capitalization as a % of GDP have reached new highs and elevated low-high ranges in the last quarter century. As money is created by banks, then borrowed and spent by companies to purchase goods and supplies from other companies, and to pay wages to workers who then purchase goods from other companies, aggregate company revenues, earnings, and cash flow increase. As the newly-created money flows into the stock exchanges, company market prices rise. Since more money flows into share prices disproportionately more than it flows into the companies themselves, prices—the the numerators of the relative ratios rise to a greater extent than the denominators.

The Discounting of Expected Cash Flows and Expected Valuations

                It is often said that all else being equal, lower interest rates lead to and enable higher stock market prices. This “common knowledge” is not necessarily correct. Prices are prices. Overall prices of stocks are determined by how much money flows into the stock market. If all the money that is available to flow into the market is already in the market, prices cannot rise higher just because a rate of interest is reduced per-se (except, of course, to the extent that money that was going towards paying extra basis points of interest instead go directly into the financial markets); they can rise only with more money available with which to bid up prices. When interest rates are lowered by the central bank, money is added to the system in order to lower the rates, and the new money subsequently flows into the financial markets. But the mere existence of a lower rate, without the accompaniment of an additional quantity of money, will not and cannot make the market go higher. Though admittedly, it might justify a higher price.

                The theory behind lower interest rates leading to higher prices is based on solid logic and math, but it is extrapolated incorrectly to mean more than it actually does. The basic idea starts with the notion of compounded interest, and then proceeds into the notion of the present value of money. As Brealy, Myers, and Marcus state in their textbook The Fundamentals of Corporate Finance:

We have seen that $100 invested for 1 year at 6% will grow to a future value of 100 x 1.06 = $106. Let’s turn this around: How much do we need to invest now in order to produce $106 at the end of the year? Financial managers refer to this as the present value (PV) of the $106 payoff…to calculate present value, we simply reverse the process and divide the future value by 1.06.

The explanation presented here is correct: $100 grown at 6% for X number of years will give us the future value. Similarly, discounting the expected future value by the appropriate interest rate—the required rate of return—will tell us how much we should pay now for a future investment worth a certain amount. If we pay more than the present value of the future amount, we are paying too much. If we pay less than the present value, we will have a gain. The incorrect assumptions and methodology, however, come along when one starts thinking that discounting future values with a lowered rate of return than before somehow creates a higher future value. It does not. A lower rate means that one can buy today at a higher price and still have a profit (based on their lowered required return). But just because one’s required rate of return falls does not mean that stocks should perform better. Discounting is simply a formula; it is not something that assigns a value.

The Time Preference Fallacy

                Part of the confusion with discounting present values stems from the required return component of the formula, which begins with what is called the risk-free interest rate that is obtained by investing in government bonds, which themselves are seen as revealing the time preference of savers who make funds available for lending.

I’ll explain starting from the latter first. Time preference is seen as revealing the preferences of individuals to consume today versus consuming in the future. A common explanation of the theory states that, naturally, people prefer to have money and to consume with it today instead of waiting to do so in the future. Therefore, a dollar is worth less in the future than in the present.

Now, time preference definitely exists, and it does dictate how much people consume today versus tomorrow. But it is not true that just because time preference exists, a present dollar is worth more than a future dollar. It therefore also does not mean we should discount future values based on a time preference of individuals. It simply means that some, or all, people chose to save some of their money in the future rather than the present. In fact, the very existence of time preference shows that some goods in the future are valued more highly than goods in the present.

People often prefer to save their money in the present once immediate needs are satisfied, and to instead use that money in the future. Thus a future dollar means more to them than a current dollar. For example, it is true that people would rather have an ice cream today rather than in the future, but once they’ve had an ice cream or two, they would rather wait till later to have the third, fourth, and especially the twentieth ice cream. Most people would rather consume less of a multitude of goods today so that they have something available to live off during retirement. Even in the absence of earning a rate of return on their money, people would still save for the future.

Additionally, in an economy in which the money supply is fixed—the assumption that must underlie basic finance and economic theories—there is a reason why some future goods might be worth more than present goods: they are more valuable to buyers in the sense that it costs less to buy them tomorrow than today. Why buy a car today for $30,000 when if you wait till next year it will cost only $29,000? Effectively—but not intentionally—the price is discounted to compensate one for waiting.

(As a sub-component of the current argument, it is often stated that interest is important in determining profitability. While this logic is true from a certain perspective and given the right context, it is important to remember that interest could not exist without profit, as interest is paid out of profit. Without profit, there would be no gain in paying interest, and therefore no means with which to do so.)

Second, even if no one ever wanted to save anything for the future, the risk-free interest rate does not reveal what the time preference is. One reason is that the interest rate earned on government bonds is not wholly determined by individuals in the marketplace: it is highly influenced by the Fed’s manipulation of short term rates and by the artificial supply and demand stemming from central bank money creation. Another reason is that government bonds are not the only place savings goes; it also goes into corporate bonds, stocks, commodities, real estate, precious stones, art, and antique cars, and even under the mattress. Thus, the full supply and demand for loanable funds is not present in the government bond market alone.

The “Risk Premium” and “Required Return” Fallacy

But the more important problems with the required return component arise once the so-called “risk premium” comes into play. Ben McClure, a former Wall Street equity analyst and director of his own research and consulting firm, explains the risk-premium component of the required return function in his Investopia.com tutorial, which explains how to discount future values for the purposes of investing. He begins by stating that:

According to financial theory, a stock’s value proposition starts there: stocks are risky assets, even riskier than bonds…Therefore, investors ‘require’ a higher return for taking on extra risk by investing in stocks instead of Treasury notes, which are guaranteed to pay a certain return[4].

                It is true that if riskier stocks did not yield higher returns, investors would not take on the additional risk investing in them. However, similar to the concept of “demand” that we learned about, the idea that investors “require” a higher return is unrealistic. Their “requirement” is meaningless. Just because they require, demand, or even hold their breath until they get what they want does not mean that they will get it. And it is the market participants themselves which must create the return by the very act of buying the assets which will give the return. The stock market does not deliver higher average returns because investors insist upon it. If it did, why shouldn’t investors insist on 100% returns per year? Or, why didn’t the stock market listen to their demands during the bear market of the 1970s? Yet, McClure (as well as most investment textbooks) states that:

If the required return rises, the stock price will fall, and vice versa. This makes sense: if nothing else changes, the price needs to be lower for the investor to have the required return. There is an inverse relationship between required return and the stock price investors assign to a stock.

                This statement seems to contradict the notion that the stock market has superior returns just because investors require it. But working within this vacuum, investors will certainly have more room to buy profitably today if the required return falls. Yet a change in the rate of interest—all else being equal—does not mean the stock market will, or should, go higher. Indeed, investors might invest more money because they think they have more of a margin to work with in making money. But thinking that lower rates mean a market must go up leads one down the path of thinking that overall, long-term market movements are based upon interest rate movements instead of money flow from the central bank.

Discounting in a World of Constant Prices

                Most of the confusion dealing with discounting present values stems from the idea that prices must always go higher. We must ask ourselves what purpose discounting would serve in an environment where the quantity of money never increased and stock prices, as a whole, never went higher over the long term (a very realistic scenario). Suppose we have an economy in “equilibrium,” where no new products or services are invented, and where no new money is created. In this case, since the volume of money and spending is constant, total company revenues would remain about the same, while selling prices fell. Each individual company would earn the same amount of money by selling a higher volume at lower unit prices; each company would have total costs that remain about the same by buying a greater volume of inputs at lower unit prices (as was the case during the 1800s). Since company revenues would be the same each and every year and entrepreneurial profits would not exist, each company would earn the same total amount of sales revenues each year. In this case, each company’s accounting profit would disappear after paying out dividends/interest to its owners or other providers of capital. Yet each year as owners spent their dividends on consumption (on average—some would, some wouldn’t), accounting profits would return.

                In this scenario, the future value of monetary company earnings would be equal to present value of monetary company earnings. What, then, would there be to discount? The value of the future company earnings would not (or should not) be discounted since their future value is the same in nominal terms as they are today. The same applies to future dividends; they would have the same nominal value in ten years as they do today—with the same quantity of money in the economy then as now, dividends would not increase. Even if we still accepted the time preference theory, future company earnings should not be discounted for time preference because the real future revenues are already compensating for time preference since their value is higher than today’s value. They are higher is because with the additional production and supply of goods, consumer prices would fall each year, raising the real purchasing power each year of both the dividends and the value of the capital.

                Thus, suppose we have a 10-year investment horizon. Suppose also that we have an investment in a company whose value in 10 years is expected to be $100—the same as the current value (remember: the future earnings and future value will be the same as the present since the quantity of money will be the same). At a discount rate of 10%, the current value of our expected $100 in revenues would be $38.55. What exactly does that mean? According to the finance text books it means that we should pay no more than $38.55 for our investment in the company to acquire those revenues. But why shouldn’t we pay as much as $100 for an investment whose future value is $100 (and worth more, not less than $100 in real terms)? We should! It would mean that we are “loaning” (with a long-term equity purchase) the company our $100 so that it can produce $100 in revenues (revenues-profit= cost).

Importantly, the company will also pay us a dividend each year for the use of our funds (which, for simplicity, we have not calculated); this is how we are compensated for going without our funds. Lower future prices take care of our time preference and dividend payments takes care of our opportunity cost.

Besides, we would never be able to purchase the company’s shares for $16.35 because it would never be priced that low in the market since its intrinsic value would always be $100. This example shows how the entire notion of discounting future values breaks down in a world where credit creation is non-existent.

It All Comes Down to Inflation

                So why, one might ask, does the current system of discounting future cash flows seem to work out (as far as the math, not the predictability) reasonably well in the real world every year? The answer is that what analysts, unknowingly, are calculating with their present value formulas are a compensation for inflation.

Indeed, analysts use earnings net of inflation or an inflation premium to compensate for the expected CPI, but the CPI reveals consumer price inflation, not asset or salesrevenue ordividend orearnings inflation. Inflation pushes up the value of assets, revenues, costs, earnings, dividends and the like much more than it pushes up prices, because the quantity of the former does not increase as quickly as the quantity of the latter. Each year, these companies whose assets and incomes are rising, are increasing the supply of goods in the economy with their production, and thus lowering consumer prices (inflation raises prices while at the same time goods production lowers prices; in the end, inflation wins out by a small margin).[5]Using a CPI number still leaves many basis points of inflation uncompensated for.

It is this uncompensated inflation which most of the interest/discount rate not associated with an inflation-premium addresses. In other words, I have stated that future values should not be discounted with an interest rate; this leaves an interest rate being used that should not be. I have also stated that there is inflation which is not addressed (earnings inflation) but should be. These two components largely cross each other out. While analysts think they are discounting future values (which they shouldn’t), they are actually discounting asset inflation (which they implicitly think they shouldn’t but they should). On a net basis, these two components often roughly approximate each other. But they are also often far apart from each other; there are many reasons for this and the results are incorrect forecasting and valuations.

Similarly, though inflation raises revenues, earnings, dividends, etc., it also raises securities prices, providing the purchasing power to market participants to be able to bid up prices to be in line with the present value of the inflated earnings. Sometimes money flows more into the companies’ actual revenues and costs (and at different rates for each of these, as we have seen), and sometimes it flows more into the securities prices themselves. The earnings and the securities prices act like a see saw balancing while still oscillating as each side of the see saw, or the see saw as a whole, is pushed higher and higher with inflation.

Commodities Fundamentals

                Many assumptions are made about commodities prices that, as happens with other asset classes, confuse the effect of money with the fundamentals. One effect of this confusion is the belief that commodities act in a certain way based on some natural economic phenomena. For example it is often stated that commodities take off at the end of economic growth cycles once the rest of the economy is overheated. Famed investor Jim Rogers points to research in his book Hot Commodities showing that stocks and commodities have been inversely related since 1880, with commodities having on average an 18-year cycle. This would indeed support the notion that commodities would tend to start rising at the end of equity bull markets. But if commodities take off once the economy is overheated, what would explain why commodities continue to run for many years after the economy “cools down”? And though there might have been a negative correlation for more than a hundred years, what would explain the positive correlation in the 2000s, where commodities and stocks rose simultaneously, and collapsed simultaneously in 2008? A common link—money—would explain it.

                There was not, in fact, a negative correlation between stocks and commodities during the 100 years prior to 1880. As Figure 8.3 shows, commodities prices were lower in 1880 than in 1780.

Figure 8.3: Historical Commodity Prices

Source: http://www.gannglobal.com/invest/commodity_history.gif

Throughout the mid 1700s and 1800s, commodities prices remained near the same index level, experiencing multiple “spikes” within that time frame. In other words, the overall price level of commodities stayed rather constant, as did consumer price levels during the same period. The spikes were due to the periods of time referenced earlier where banks created paper bills at rapid rates, causing prices to rise, until they reigned in credit for fear of losses, which resulted in a collapse of the money supply, and deflation. Figure 8.3 also reveals that commodities, which are usually priced in dollars, did not have “bull markets” that were more than spikes, until the international gold standard eroded and dollars began being created at exponential rates.Figure 8.4 shows that while the prices of commodities and most other goods were staying level or falling during the 1800s, stock prices were rising (though they were static during the 1700s), presumably because the supply of commodities and other goods increased faster than did the production of gold, but the number of equity shares did not.

Figure 8.4: Historical Commodity Prices

Source: MetaStock

                The point of the previous discussion is to show that 1) commodities price movements are mainly a function of the money supply (mainly the U.S. dollar money supply) and 2) that there are no reliable long-term trends or relationships regarding commodities.

                The first of the two points above leads us into the main part of our commodities discussion, which is the fact that most of the demand for commodities is not really demand for commodities. In other words, commodities prices do not really rise mostly because there is a need for them—they rise because the demand consists mostly of money, not a desire to consume an increased rate of commodities. As with all topics in this book, am not saying that real supply and demand make no difference. People and companies do in fact consume modestly more each year, putting upward pressure on prices. But the supply of commodities also increases moderately, putting downward pressure on prices. Absent the printing of money, these two effects would largely cancel each other out, leaving a commodities chart looking like the first half of the chart in Figure 8.3, but without the spikes. In other words, commodities prices would fluctuate moderately around a rather constant mean. But with increasing quantities of money, the monetary demand for commodities far outpaces any real demand, causing prices to rise and to fluctuate wildly due to the constantly changing rate of increase of money creation.[6] As an analogy, consider a fish swimming north in shallow water at a beach, with the beach to the east. The fish, moving on its own (representing true supply and demand), might swim east then west then east again as it is travelling north. But when a wave of water (representing inflation) pushes the fish towards the beach, the fish still maintains his back and forth east-west motion, but while, overall, being pushed further east towards the beach by the water.

To better grasp the idea that it is money, not true supply and demand mostly affecting commodities prices consider that during our recent commodities boom, it was alleged that food prices were rising due to, among other things, a reduced supply of food and increased demand for food from China.

Make no mistake: for various fundamental reasons related to production, supply, and demand, there was a lack of supply of some commodities available relative to the growing real demand for them. Still, this lack of supply was not the root cause either of the occurrence of shortages or of the extreme increase in world food prices (by over 80% in three years). Additionally, though many commodities such as wheat had been stagnant or in reduced production over the previous several years, other commodities had seen continued increases in production; other food groups such as cereals, fruits, livestock, and fish/seafood products had seen mostly increased supply. Data[7] from The Food and Agriculture Organization of the United Nations show that both agriculture production and food production per capita had risen since 1990, and stayed steady since 2000. In comparison, commodities prices had been rising since 1999.

Any “new demand” for food from China would necessarily have resulted not only in the Chinese themselves producing more food to meet this demand, but in the rest of the world doing so as well. (In fact, China increased agricultural production per capita by 22% between 2000 and 2007.) Can we really imagine that world food producers would not have spotted this demand and tried to make profits by satisfying it? They did, and had therefore been producing more food. The Chinese population is increasing by just over one-half of one percent per year. How, then, could the Chinese suddenly have a desire and need for 30% or so more food per year in recent years? Further: how could they pay for it, even if they had the want of more food? The Chinese did not have real demand to consume that much more food per year, they had 30% more paper bills in their wallets.[8]

If there were as much of a new demand for food in China as economists claimed—given a constant amount of money in the economy—there would necessarily be a corresponding reduction in the demand and prices of other goods. Therefore, the Chinese may well have been consuming more food, but this increased consumption would not responsible for (absolute) higher prices or shortages.

The ultimate proof of this argument arrived in summer 2008, when world commodities prices and thus world food prices collapsed due to a lack of monetary demand stemming from the “credit crunch”—the collapse in money and spending.

The same applies to oil prices, which is a commodity. We consumers do not go through periods were we suddenly want to consume double or triple the amount of gas that we did a year or two before—even during a “growing economy”—thus pushing gas prices higher. There is simply double or triple the amount of money flowing into oil markets.

A conventional explanation is that speculators are driving up prices. But speculators (and investors in general) cannot just run a price up for no reason. They cannot control the entire world market for oil. For every trading position they open, they must close. Therefore, their speculation must be correct or they will suffer losses. The slice of truth in the speculation argument is that investors and speculators (along with other individuals) are indeed making prices go higher, but not on their own by manipulating prices, but by simply investing more with the increased amounts of money available from banks. The speculators—at least those speculating price rises—can then be right, for a while, in their bets because prices will indeed keep going higher until the money valve is turned off.

Gold

                Gold is even less predictable than other commodities, because it has more diverse uses in an economy, including as an alternative money. As far as its use of money is concerned, it has traditionally been said that gold is a safe haven when there is uncertainty in financial markets and the economy. Yet this has notstrongly proven to be the case in the most recent crisis, as gold did not increase during the crisis. In fact, gold actually fell when other commodities collapsed in summer 2008, as the safe haven was then treasury bills. But it soon returned to new highs—the only asset class to do so.

For the last year it has been said that the Federal Reserve’s unprecedented amount of money creation in order to save the banks will result in not only massive price inflation, but in skyrocketing gold prices.  This might or might not be true. First, if it was a certainty, gold prices would have already risen—more than they have—as investors put their both existing and newly borrowed money in gold. But in fact, their money has been put back in all asset classes, as they have all rallied significantly since winter 2009. As that fact likely portends, new inflation created by the fed might likely flow into other asset prices as much or more than into gold in 2009, leaving gold an average performer, if not an underperformer. It is also because most new money might flow into asset prices that consumer prices might remain tame, leaving a normal CPI rate of growth. These arguments assume that the Fed’s reflation will work. It is still possible that the government’s manipulations cannot save the financial system from a Japanese style stuck-in-the-mud lending system where banks hold on to new excess reserve, or, from a financial collapse, if consumers withdraw their money for some reason or another, in which case there will be a massive collapse of the money supply, and all asset prices will fall.

                In the mean time, most observers seem to point to gold’s rise as a bubble. A few years ago, people constantly denied that bubbles existed, that markets could fail to continue going higher and higher. Now, since bubbles are virtually undeniable, it seems that people see bubbles everywhere, including in such things as gun sales, incandescent light bulbs, and ETFs. Clearly, people who don’t understand what bubbles are and how they are caused are confusing fads with bubbles.

                The act of pundits citing gold in 2009 and 2010 as being in a bubble is certainly more sensible than these other types of bubble identifications. But the odds are almost certain that this thinking too is flawed. Bubbles occur from expanding credit flowing into prices of assets, or even goods.

To better understand gold in 2009 and 2010, let’s start with gold in 2008. It is highly unlikely that when the reduced growth rate of money and velocity caused a credit implosion in all asset classes—global stocks, bonds, art, jewelry, and especially that of commodities—in 2008that a single commodity, gold, could stay as it did near its highs, while all other assets and commodities fell dramatically, due its being in a single, isolated, monetary bubble. Why would gold not fall when other assets fell? Gold remained near its highs due for two reasons. The first is its becoming more valuable as an inflation hedge and a store of value (as opposed to a commodity), and even as a medium of exchange, because more dollars were attempting to be created by the Federal Reserve—the Fed increased bank excess reserves by an unprecedented $1 trillion, an amount capable of increasing the money supply by $10 trillion, almost the size of the entire economy currently. The second reason is its becoming somewhat more valuable as a safe haven, since other asset classes were deteriorating. In 2009, with dramatic credit expansion, a dramatic rebound in capital markets occurred. Gold stayed at its highs even as money flowed out of it and into other assets. But in late 2009, as other asset classes begin to level off, gold struck out to new highs. Gold’s making new highs, after never really correcting as other asset classes corrected, points to its being relatively fairly and realistically valued all along.

                Still, there is more evidence of an absence of a bubble in gold. Asset price bubbles tend to appear as increasingly steeper price trends, which eventually begin growing exponentially. As the trend progresses, corrections, or pullbacks, are rarer and briefer, even if sharper. Gold, in contrast to having been on a run for decades as bonds and equities had, were in a twenty year bear market until the late 1990s. During its bull run in the 2000s, gold moved at a reasonable pace, maintaining a reasonable slope. Just when it really started to run, it would have a long, sustained correction period. Never did it take off exponentially at breathtaking speeds. This is the sign of a calm, methodical bull market, not a crazed, credit-induced, fast-paced bubble where people are falling over themselves to buy at the new high week after week, at an increasing pace.

                When gold is adjusted not only for inflation, but especially for real inflation in the form of money supply growth, it is still far below its highs of the early 1980s. The odds are much higher that gold will eventually catch up in real inflation-adjusted terms—putting it at a price of more than $3,000 an ounce—than continue to lag behind in price even as the fundamentals of gold—the supply and availability of gold versus that of dollar paper bills and checking account balances—becomes increasingly out of line (in favor of gold rising).

The Pretense of Risk

                The main problem with investing is that it is possible to lose, and not gain, money. This risk of losing some, all, or even a multiple (in the case of leveraging) of one’s money is a primary focus among individual investors and professional money managers alike. But just as changes in the quantity of money mask the real cause of the movements of financial markets, they also mask the real risk involved in investing in the assets.

                Asset price inflation actually changes the context of what risk is. For example one could argue that there were a multitude of risks to economic growth and the financial system in the late 1990s. While the Asian currency crisis, the Russian debt crisis and the implosion of Long-Term Capital Management, the near-collapse of the Brazilian economy, the Y2K scare, actual and threatening terrorist attacks in the Middle east and North Africa, a threatening economic crisis in Argentina, and rising oil prices made headlines weekly, the western stock markets, the NASDAQ in particular, continued their climb into nosebleed territory. They did the same in early 2010 while the markets were “threatened” daily with the fallout from the Greek debt crisis. But the market “ignored” those “risks. Why? Because even if they were risks to western equity markets, the brute force of newly-created money flowing into equity shares forced prices higher no matter what the risks. Besides, how significant are thereal risks when a force close to that of physics—newly printed money creating thrust and acceleration of asset prices and virtually preventing them from falling as long as it flows—is on ones side? In reality, the risks were not risks. A risk is something that could cause a market to fall; a market cannot fall if the force of money flooding into it is so great that it outweighs any selling pressure from scared investors wanting to exit.

                This explanation allows us to understand current accusations that during the recent financial crisis the stock market did not act rationally and efficiently, and most importantly, that it did not function smoothly and fluidly. One of the strongest advocates of this view, George Soros, states that “market moods have a way of affecting the fundamentals that markets are supposed to reflect[9]” In other words, Soros says that it is psychology and emotions which drive markets out of line with their fundamentals.

Yet, in support of this argument, he states “banks give you credit based on the value of the houses, but they don’t seem to somehow understand that the value of the houses can be affected by the amount of credit they are willing to give…and [being] willing to give more and more credit…has pushed up the value of the houses” In this last statement Soros reveals the real reason house prices rose and then fell, but he still states—as did John Maynard Keynes—that it was a detachment between the fundamentals and investor psychology that caused the crisis.

What Soros won’t admit, and what many don’t understand, is that the market did act rationally and it did adjust to the fundamentals—money and credit are fundamental! When money was flowing strongly, investors invested the money. When the flow of money was reduced, there was not enough of it to keep asset prices high and interest rates low (it is the sheer volume of money creation which forces interest rates below market prices). When interest rate rose, so did variable rate mortgages, which suddenly made home ownership more costly than people could afford. Because of this, mortgages were not paid off, which caused the value of asset-backed securities to fall, which caused losses in the financial system, which caused more losses. With the lack of credit due to the lack of creation of it, due to previous credit creation, and with mounting losses on bank balance sheets, more losses ensued and asset prices plummeted. Falling prices caused other investors to get scared and sell much of their holdings—that, is when the psychological effects come in and cause markets to overshoot, on the down side, their “fair value.” This psychological aspect what causes markets to be less than “efficient.”

Estimating Risk

                The disconnect between what the real fundamentals are and how people expect the market to act according to perceived fundamentals, is, in my opinion, the primary reason why those calculating risks cannot accurately anticipate events such as the 2008 crisis. Because risk analysts use the wrong assumptions—the wrong input variables in their models—their models do not predict accurately. Risk calculations are too often primarily based on means, deviances from means, and reversions to means. They do not anticipate complete “regime changes.” They focus on how often and how far and for how long assets might have a precipitous fall. These things are very important but are far from the whole picture. Or, models use faulty economic indicators and incorrect assumptions with respect to those indicators. The models don’t model the economy and the financials accurately, and they don’t focus on the things that will cause the entire trend, including its semi-periodic deviations and corrections, to experience a fall two or three times more dramatic (as in a large wave pushing the swimming fish up on the beach) and or longer-lasting than the typical, or even more extreme, traditional correction. In other words, they don’t incorporate the variables related to the true economic fundamentals which make prices go up and down—and up and down more or less “permanently.” Models should always incorporate things such as money supply growth and duration, total loans and leases of commercial banks, interest rate levels and duration, bank asset/capital ratios, the extent of leverage, and ratios for levels of debt burden, and the extent and duration (including the slope) of asset prices themselves. These are the kinds of factors which will reveal the amount of risk present in asset prices, not historical statistics focusing on mean deviations or on an earnings growth trend.

Michael Lewis’s recent Vanity Fair magazine article on the collapse of AIG tends to confirm this when discussing how professional forecasters didn’t expect a mortgage debt implosion. He states:

                Because there were many different sorts of loans, to different sorts of people, the logic applied to corporate credit seemed to apply to this new pile of debt: it was sufficiently diverse that it was unlikely to all go bad at once… for the bonds to default, U.S. house prices had to fall, and [AIG’s Joseph] Cassano didn’t believe house prices could ever fall everywhere in the country at once…Cassano set out on a series of meetings with Morgan Stanley, Goldman Sachs, and the rest—all of whom argued how unlikely it was for housing prices to fall all at once. “They all said the same thing,” says one of the traders present. “They’d go back to historical real-estate prices over 60 years and say they had never fallen all at once.”

The quote reveals that Morgan Stanley, Goldman Sachs and the rest relied on historical trends and deviations; they did not consider what was causing housing prices to rise now and why it might not last. (For proof that these assertions are not mere hindsight-is-20/20 analyses, reference this collection of research by those who understand this brand of economics far prior to the housing bust: http://mises.org/daily/3128.)

No matter what housing prices have historically done, it was clear at least by 2002 that something was different this time. For how could it be that from at least 2000, home prices in virtually all developed countries in the world, were moving higher, at faster than historical rates of growth, while recessions were taking place in these countries and after all of these countries’ stock markets had risen together and then fallen together? These facts and this overall profile should have caused any halfway knowledgeable trader or investor to know that things were a little strange. By 2004, it should have been clearly seen by almost anyone that housing prices were in a bubble—even if one does not really fully understand the parameters of a bubble.

For real estate prices to rise at double digit rates for seven-plus years around the world, for the “fundamentals” such as house price-to-income ratios, etc., to be so out of historical alignment (where the median income individual could not afford the median-priced home), for there to be such an excitement by everyone you know about their appreciating home price and their plans to buy a new house or investment house because of the money they could make (and ¼ of all sales were pure speculation—the highest level ever), little else should be needed to reveal the classic symptoms of a quintessential asset bubble.

Wall Street should have known that what goes up so quickly not only comes to an end, but falls quickly (in terms of securities prices; I fully admit that I had no idea that housing prices themselves would fall so fast, and that the financial collapse would be so sudden and widespread[10]). More importantly, the street should have understood that prices were not rising because of population growth or increased demand or because of a good economy. The reason was that a flood of money had been created and inserted into the market. The phenomenon occurred—and ended—in tens of countries simultaneously because the monetary system of all of these countries are linked and coordinated by via official government policies. Had Wall Street understood the economics behind the fundamentals, it would have been watching money supply and interest rate figures most of all, and would have anticipated prices to begin falling sometime within two yearslater than the Fed began raising interest rates in July 2004. In fact, prices peaked about two years later, depending on the city (though the real trouble didn’t come until another year after that in summer 2007.

Interest Rate Risk

                A different category of risk is the risk relayed by interest rate spreads in the financial markets. It is usually assumed that high rates or high rate spreads entail high built in risk premiums. But just as the basic Fed Funds rate is artificially low, so are longer term bond yields    .In fact, it is the fact that the Fed Funds rate is lowered that long-term bond yields are lowered as well. Short term rates are reduced by having the Fed buy bonds from banks or the customers of banks, and paying for them with newly-created money. With banks gaining new reserves—and excess reserves—from this process, the demand for Fed Funds is reduced, and the interest rate is lowered.

                But the new reserves constitute the basis of new credit and new loans in the real economy, including the source of new and additional funds for stock and bond purchases (and just the fact that there is a continual demand for bonds from the central bank creates a demand in the marketplace to hold bonds). As more new money is created and more bonds purchased, the more bond prices rise and bond rates fall.

                As more and more bonds are bought, the sheer flow of money into bonds keeps rates low. To add fuel to the fire, Fed officials all but actually promise that the money will keep flowing, and give far ahead notice to bond participants as to when they might be reducing the pace of money creation (i.e., when they might raise rates). Therefore, bond buyers face little risk of falling bond prices; this is even more of an incentive to keep buying bonds.

This constant demand driving bond prices higher reduces the risk of even riskier bonds, as long as the money is assured to flow. Therefore yield curve arbitrage takes place, leveling out rates across the curve. Not only are both the perception and reality of risk diminished, but the surge of money flowing into bond (and equity) markets keeps volatility low, reinforcing the illusion that there is little risk (and in fact there is, until the credit expansion slows). For these reasons, real risk is not reflected in bond yields.

Correlations and Diversification

                The primary way to reduce risk in a portfolio is to diversify an investment across uncorrelated assets. If one asset falls in price another will likely rise.  If an asset consisting of 10% of the portfolio falls, the other 90% will likely not, and most of one’s money will remain relatively safe. This is the traditional view—and rightly so.

But today, this logic is less realistic and the strategy is less effective. Why? Because more money is now chasing each asset class, causing the boom and bust of each asset class to be in synch with other asset classes. As world central banks have become more interconnected and as foreign central banks have been recycling increased amounts of newly created money in a piggy-back fashion based on dollars they receive from trade with the U.S., more money is invested at the same time in the same assets in every country. Also, as more institutional investors access and leverage more new money, they transmit the new money throughout the world in similar fashion. If one asset class is not performing well, investors, with their newly borrowed and levered money, “attack” the slumping asset class and pump it higher. The result is that money flows more and more into each asset class at the same time.       

                This is why, for example, both stocks and commodities moved together in the 2000s, instead of alternating cycles. Similarly, it’s why emerging markets equities are no longer inversely correlated with developed market equities. Even art and antique cars generally move up and down with stocks. Is real estate the new comer to this correlation effect? Perhaps.

Kel Kelly @ May 28, 2010