Today, S&P cut Japan's credit rating for the first time in 9 years, down to AA-.
Following WWII, Japan enjoyed abundant growth through the 1970s, rising to a fever pitch during the 80's, but beginning in 1990 has suffered economic decline, even during times when consumer spending was immense and the world economy favored Japan as much as one could hope. Japan's industries are still highly competitive and successful, and they continue to produce some of the best cars and electronics in the world. But there was an unspoken counterbalance to Japan's success, which was hardly reported on at the time, nor in recent news either.
In the 80's, while the world was heaping praise over Japan's economy, with ongoing predictions that it was set to become the next world economic superpower, there was an elephant in the room: Japanese growth went hand-in-hand with massive government debt. Earning a million dollars in sales is good, but not if you have to borrow two million dollars to cover production costs. Even those who knew about Japan's borrowing at the time might have viewed it as sensible infrastructure spending that would one day result in healthy net profits. But that is not how it played out, or if it did, it is Japanese industry who now enjoys the benefits, while the government and people are saddled with debt.
The entire Japanese economy has been stuck in a protracted recession since around 1990, and compounding the problem of earlier spending, the Japanese government succumbed to Keynesian policies of additional government spending projects in futile, unsustainable, and ultimately fruitless attempts to stimulate their economy. Today, Japan's debt situation is worse than Greece's (who has been facing civil unrest over their credit issues) with a whopping 200% public debt to GDP ratio, which is second in the world bested only by Zimbabwe. For as bad as U.S. mispending and debt are, we are closer to 75% debt-to-GDP, which is comparable to the better European economies like Germany.
From the CIA world factbook: Japan's GDP is $4.3T dollars, and public debt is 196% of that, which would be $8.5T. Tax Revenues are pretty robust at $1.8T (around 75% of the U.S. government's net income; consider Japan's GDP and population are both about a third of ours). Government spending is $2.3T.
I would say tax revenues like that are outrageous, but apparently the Japanese are okay with it. For years Japan has maintained a zero interest rate policy with quantitative easing, similar to ours, or rather the inspiration for ours, so their treasury bonds have been cheap. Even if government debt averages 5%, which is probably an overestimate, yearly interest payments would be $420B which sits easily within Japan's annual income. In fact, their national-debt-to-tax-revenue ratio isn't that far from what we have in the U.S., with the main difference being per capita taxes are way higher in Japan.
So, it is definitely not panic time for Japan, and the numbers don't even look terribly concerning, so I don't fully understand this recent downgrading of their credit rating, unless fewer tax revenues are forecast due to Japan's aging demographics.
I guess the point is: Japan offers evidence for the failure of Keynesian policies. Best the U.S. not follow their lead. Another point: China's situation today is not greatly different than Japan's back in the 80's.
Thursday, January 27, 2011
Friday, December 3, 2010
Public Debt Recap
When George Bush took office in 2000, the U.S. public debt—the amount the Federal Government owes in treasury bonds—was $3.4 trillion. When George Bush left office, it was $5.8 trillion. For all of his misspending, it pales compared to our current situation. Today, as of this writing, with Obama holding office for a mere 2 years, the public debt stands at $9.2 trillion.
The average tax payer owes around $7000 for each trillion dollars of government spending, so Obama has spent over $20,000 for each tax paying citizen in two years. Do we have $20,000 per head worth of a better country? I guess that is a personal decision each citizen needs to make.
This is what the government owes. It is different than the gross national debt, which is in the neighborhood of $14 trillion—this is what we always see on the national debt clock. The extra $5 trillion is intra-governmental debt, or debt that will one day need to be taken in order to meet Social Security and Medicare obligations. But to the degree the federal government functions as a single economic entity, which it does, it is not debt that actually exists, not yet, and truth be told, anything could still happen regarding Social Security and Medicare obligations.
The public debt is what the government actually needs to pay back today, and I think is overall the more sensible number to look at than gross debt when considering government solvency.
$9.2 trillion is a lot of money, which leaves a lot of question about the government's ability to pay it back. GDP estimates are around $14 trillion for the U.S., and yearly tax revenues (first column in the link) are in the $2.5 trillion range for the federal government. If the intest on the public debt stands at 5% on average, which I think overestimates it given how very low rates are now, then yearly interest payments on $10T would be $500B, which sits pretty manageably within $2.5 trillion of revenues, provided revenues hold constant and do not recede.
I'm going to guess the government could at least double the debt before default (or hyperinflation) would be a genuine concern. To the degree that government spending draws money away from private markets and burdens the productive capacity of the economy—the recent exponential growth of debt is still unwelcome.
The average tax payer owes around $7000 for each trillion dollars of government spending, so Obama has spent over $20,000 for each tax paying citizen in two years. Do we have $20,000 per head worth of a better country? I guess that is a personal decision each citizen needs to make.
This is what the government owes. It is different than the gross national debt, which is in the neighborhood of $14 trillion—this is what we always see on the national debt clock. The extra $5 trillion is intra-governmental debt, or debt that will one day need to be taken in order to meet Social Security and Medicare obligations. But to the degree the federal government functions as a single economic entity, which it does, it is not debt that actually exists, not yet, and truth be told, anything could still happen regarding Social Security and Medicare obligations.
The public debt is what the government actually needs to pay back today, and I think is overall the more sensible number to look at than gross debt when considering government solvency.
$9.2 trillion is a lot of money, which leaves a lot of question about the government's ability to pay it back. GDP estimates are around $14 trillion for the U.S., and yearly tax revenues (first column in the link) are in the $2.5 trillion range for the federal government. If the intest on the public debt stands at 5% on average, which I think overestimates it given how very low rates are now, then yearly interest payments on $10T would be $500B, which sits pretty manageably within $2.5 trillion of revenues, provided revenues hold constant and do not recede.
I'm going to guess the government could at least double the debt before default (or hyperinflation) would be a genuine concern. To the degree that government spending draws money away from private markets and burdens the productive capacity of the economy—the recent exponential growth of debt is still unwelcome.
Saturday, November 27, 2010
QE2
To the degree that taking out a second credit card when deeply in debt can be regarded as "prosperity," America's current economic state can be regarded as "recovery."
At least Wall Street has been doing well with ongoing government interventions. Elsewhere economic activity would have to be viewed as tepid, but certainly things aren't crashing and burning. So recovery I guess it is.
Driving this recovery, the Fed first dropped the prime lending rate to zero, for the first time in history, late in 2008, where they've been ever since and show no signs of turning around. Any recovery has to be viewed in the light that the Fed is handing dollars to banks and investment banks scott free.
These lower borrowing costs trickle down to the rest of the nation as somewhat lower mortgage rates, lower bond rates in general, and, I've argued, higher stock prices.
But when that's not good enough, when the Fed has to do more before deflationary forces assert themselves, there is quantitive easing. Here the central bank starts buying bonds—typically treasury but any kind will do—with freshly printed money. This accomplishes two things: (1) it drives bond rates down since bond sellers no longer have to offer interest rates which are as attractive, so borrowing costs overall are lower, and (2) it introduces a bolus infusion of cash into the economy, which is a temporary inflationary force to be reversed as the bonds mature and the minted cash returns to the bowells of the Fed.
The Fed began quantitative easing early in 2009, for around $2 trillion worth of treasury bonds and GSE debt, which recently came to completion.
Surveying the economy, the Fed determined that more quantitive easing was necessary to stave away deflation. So, earlier this month a $600 treasury bond purchase was initiated by the Fed, known as "QE2." this wasn't unexpected to anyone following Fed activities, but did happen quietly and with little fanfare. Pretty much, it is a continuation of "QE1" rather than anything distinct.
It does suggest that what economic forces and motives that dropped interest rates to 0% in the first place, and then initiated the first round of quantitive easing, are still with us today.
Enjoy your recovery.
At least Wall Street has been doing well with ongoing government interventions. Elsewhere economic activity would have to be viewed as tepid, but certainly things aren't crashing and burning. So recovery I guess it is.
Driving this recovery, the Fed first dropped the prime lending rate to zero, for the first time in history, late in 2008, where they've been ever since and show no signs of turning around. Any recovery has to be viewed in the light that the Fed is handing dollars to banks and investment banks scott free.
These lower borrowing costs trickle down to the rest of the nation as somewhat lower mortgage rates, lower bond rates in general, and, I've argued, higher stock prices.
But when that's not good enough, when the Fed has to do more before deflationary forces assert themselves, there is quantitive easing. Here the central bank starts buying bonds—typically treasury but any kind will do—with freshly printed money. This accomplishes two things: (1) it drives bond rates down since bond sellers no longer have to offer interest rates which are as attractive, so borrowing costs overall are lower, and (2) it introduces a bolus infusion of cash into the economy, which is a temporary inflationary force to be reversed as the bonds mature and the minted cash returns to the bowells of the Fed.
The Fed began quantitative easing early in 2009, for around $2 trillion worth of treasury bonds and GSE debt, which recently came to completion.
Surveying the economy, the Fed determined that more quantitive easing was necessary to stave away deflation. So, earlier this month a $600 treasury bond purchase was initiated by the Fed, known as "QE2." this wasn't unexpected to anyone following Fed activities, but did happen quietly and with little fanfare. Pretty much, it is a continuation of "QE1" rather than anything distinct.
It does suggest that what economic forces and motives that dropped interest rates to 0% in the first place, and then initiated the first round of quantitive easing, are still with us today.
Enjoy your recovery.
Thursday, October 28, 2010
Thomas Jefferson said...
"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks to the people!"
Wise words indeed, succinctly stating the problems of leaving the printing of legal tender in the hands of a single authority, such as an organized banking cartel. But the solution he poses, which is a democratically controlled money supply, has problems too.
He states banks gain power and property through inflating the currency, and then deflating it—in other words lending inflated (lesser value) currency out then having deflated (greater value) currency paid back to them. We've certainly seen the inflated part of the equation, and I anticipate soon we will see deflation, and Thomas Jefferson's warning bearing out in reality. In housing we see significant deflation already, and a new wave of foreclusures and further price drops will be here soon. Paper money and credit cycles are an old game.
But paper money in the hands of the people would quickly devalue through inflation when everybody starts voting themselves pay raises and forgiveness of their debt. Whereas banking controlled money supply will have inflation followed by deflation through which the banks profit from the amplitudes of currency fluctuation both high and low—a democratically controlled money supply will see rampant inflation, moving to hyperinflation probably, and no looking back.
Back when paper money was backed by gold or other precious metals, there were episodes of inflation and deflation, but small compared to what we see today. So, many who favor stable currency support reversion to a gold standard, where natural limitations on the amount of gold keep inflationary and deflationary forces in check. I think a gold standard is sensible and support it, but the compromise of power that would entail to people who currently hold power, I don't see that as a practical solution.
Now, the Federal Reserve Bank is governed by a mix of appointees from both private banks and the President (and approved by the Senate), so there is some democratic influence. By numbers, government appointees have a slight majority over bank appointees, but in practice, the Fed tends to side with banking interests. Possibly a checks and balances system from a separate review committee, with government appointees of two year terms rather than 14 (as currently exists for Federal Reserve positions), might be able to put the brakes on uncontrolled Federal Reserve policy.
I don't know, since I doubt any democratically driven body would ever want to stop inflation; when banks and the Fed want to start the inflation party, no governmental body is going to stop them. But, once that happens, it would be only banks and wealthy interests motivated to reel things back with deflation, creating some semblance of balance over time. Those who hold wealth, particularly bonds, would not want much inflation, and one can only guess where the power lies. We see now that Congress and the President remain opposed to any deflationary correction, so I'm not sure that thowing more democratic control into the system will make much of a difference.
The solution is--if the gold standard is inviable--a more distrustful social attitude toward credit, such that fewer people get caught up in the inflation/deflation traps the banks seem to set every few decades.
Wise words indeed, succinctly stating the problems of leaving the printing of legal tender in the hands of a single authority, such as an organized banking cartel. But the solution he poses, which is a democratically controlled money supply, has problems too.
He states banks gain power and property through inflating the currency, and then deflating it—in other words lending inflated (lesser value) currency out then having deflated (greater value) currency paid back to them. We've certainly seen the inflated part of the equation, and I anticipate soon we will see deflation, and Thomas Jefferson's warning bearing out in reality. In housing we see significant deflation already, and a new wave of foreclusures and further price drops will be here soon. Paper money and credit cycles are an old game.
But paper money in the hands of the people would quickly devalue through inflation when everybody starts voting themselves pay raises and forgiveness of their debt. Whereas banking controlled money supply will have inflation followed by deflation through which the banks profit from the amplitudes of currency fluctuation both high and low—a democratically controlled money supply will see rampant inflation, moving to hyperinflation probably, and no looking back.
Back when paper money was backed by gold or other precious metals, there were episodes of inflation and deflation, but small compared to what we see today. So, many who favor stable currency support reversion to a gold standard, where natural limitations on the amount of gold keep inflationary and deflationary forces in check. I think a gold standard is sensible and support it, but the compromise of power that would entail to people who currently hold power, I don't see that as a practical solution.
Now, the Federal Reserve Bank is governed by a mix of appointees from both private banks and the President (and approved by the Senate), so there is some democratic influence. By numbers, government appointees have a slight majority over bank appointees, but in practice, the Fed tends to side with banking interests. Possibly a checks and balances system from a separate review committee, with government appointees of two year terms rather than 14 (as currently exists for Federal Reserve positions), might be able to put the brakes on uncontrolled Federal Reserve policy.
I don't know, since I doubt any democratically driven body would ever want to stop inflation; when banks and the Fed want to start the inflation party, no governmental body is going to stop them. But, once that happens, it would be only banks and wealthy interests motivated to reel things back with deflation, creating some semblance of balance over time. Those who hold wealth, particularly bonds, would not want much inflation, and one can only guess where the power lies. We see now that Congress and the President remain opposed to any deflationary correction, so I'm not sure that thowing more democratic control into the system will make much of a difference.
The solution is--if the gold standard is inviable--a more distrustful social attitude toward credit, such that fewer people get caught up in the inflation/deflation traps the banks seem to set every few decades.
Thursday, September 9, 2010
How Money Supply Limits Prices
Today I’d like to revisit an idea that was the focal point of my last blog, The Ca$h Bull: which is the relationship between money supply and prices.
It is common observation and defined in the Quantity Theory of Money that when money supply increases substantially and rapidly, prices tend to rise. That the reverse is true seems sensible as well, though it is rare for money supply to contract so historical examples would be uncommon.
I tried to more precisely define the relationship of money supply and inventory by equating the two: that the sum of all things for sale would self-adjust in price to equal the money supply. I did this because I was trying to define a value for cash, and postulated that the money supply is exactly equal to the sum of all goods that can be bought with it, much like all stock certificates added together would exactly equal the value of the corporation that sells them. The value of a dollar is the collection of all goods for sale, divided by the number of dollars in circulation. That was the theory.
It was pretty detailed how I built the argument and led to some concepts which I think are still valid, but as I delved into the nuts and bolts of the mathematics, I concluded it was completely wrong, and terminated the blog because I didn’t see any way to reconcile the rest of the blog with that realization. In short: inventory prices do not gravitate toward the standing money supply, rather inventory prices gravitate toward zero. In an ideal economy, everything is sold the moment it is produced. That which does not sell immediately becomes a burden on production, where either prices will have to drop or production will have to slow to accommodate standing inventory. The ideal inventory is zero. What inventory that does exist is simply a necessary error in real systems based on lag between production and sales.
So then, how can money supply and prices relate as we see in the Quantity Theory of Money? The relationship comes through both money and sales velocity, not standing amounts.
Inventory (in dollar amounts) cannot be sustainably produced in an amount that exceeds rate of spending. If goods are produced faster than money can be spent, then excess inventory goes unsold. In the next round of production, not only what is produced has to be sold, but it has to compete against unsold inventory, and if any inventory remains standing in a prolonged way, it means that producers are not being paid for their work. For standing items to sell, either production must slow or prices drop.
Now, say the money supply is doubled and dispersed through the population. Now twice the amount of money is capable of being spent per unit time, which either allows more to be produced at the same price, or more to be charged if production is kept the same. Say money supply stays the same but you double the rate people are inclined to spend it, then same thing. So absolute money supply is not a hard and fast limit on production capacity—to the degree people can be encouraged to spend money faster, prices can still rise even with a stable money supply.
But eventually there is a limit to the rate of spending—the rate people spend money cannot rise to infinity. Even with policies that encourage spending, eventually society reaches the upper limit, and at that point, whatever that rate of spending may be, money supply becomes the limiting factor of production.
So, if society is spending money at its natural rate, in a way that cannot be increased in a sustainable way, then the only way for prices to increase is for money supply to increase. The maximum production (in dollars) over a given time period is limited by maximum rate of spending over the same period of time.
It is common observation and defined in the Quantity Theory of Money that when money supply increases substantially and rapidly, prices tend to rise. That the reverse is true seems sensible as well, though it is rare for money supply to contract so historical examples would be uncommon.
I tried to more precisely define the relationship of money supply and inventory by equating the two: that the sum of all things for sale would self-adjust in price to equal the money supply. I did this because I was trying to define a value for cash, and postulated that the money supply is exactly equal to the sum of all goods that can be bought with it, much like all stock certificates added together would exactly equal the value of the corporation that sells them. The value of a dollar is the collection of all goods for sale, divided by the number of dollars in circulation. That was the theory.
It was pretty detailed how I built the argument and led to some concepts which I think are still valid, but as I delved into the nuts and bolts of the mathematics, I concluded it was completely wrong, and terminated the blog because I didn’t see any way to reconcile the rest of the blog with that realization. In short: inventory prices do not gravitate toward the standing money supply, rather inventory prices gravitate toward zero. In an ideal economy, everything is sold the moment it is produced. That which does not sell immediately becomes a burden on production, where either prices will have to drop or production will have to slow to accommodate standing inventory. The ideal inventory is zero. What inventory that does exist is simply a necessary error in real systems based on lag between production and sales.
So then, how can money supply and prices relate as we see in the Quantity Theory of Money? The relationship comes through both money and sales velocity, not standing amounts.
Inventory (in dollar amounts) cannot be sustainably produced in an amount that exceeds rate of spending. If goods are produced faster than money can be spent, then excess inventory goes unsold. In the next round of production, not only what is produced has to be sold, but it has to compete against unsold inventory, and if any inventory remains standing in a prolonged way, it means that producers are not being paid for their work. For standing items to sell, either production must slow or prices drop.
Now, say the money supply is doubled and dispersed through the population. Now twice the amount of money is capable of being spent per unit time, which either allows more to be produced at the same price, or more to be charged if production is kept the same. Say money supply stays the same but you double the rate people are inclined to spend it, then same thing. So absolute money supply is not a hard and fast limit on production capacity—to the degree people can be encouraged to spend money faster, prices can still rise even with a stable money supply.
But eventually there is a limit to the rate of spending—the rate people spend money cannot rise to infinity. Even with policies that encourage spending, eventually society reaches the upper limit, and at that point, whatever that rate of spending may be, money supply becomes the limiting factor of production.
So, if society is spending money at its natural rate, in a way that cannot be increased in a sustainable way, then the only way for prices to increase is for money supply to increase. The maximum production (in dollars) over a given time period is limited by maximum rate of spending over the same period of time.
Wednesday, August 25, 2010
Core Thesis
I realize this blog is off to a slow start.
Part of it is: the United States is still far away from this titular “zero hour” as I call it, where governments can no longer sell treasury bonds. The U.S. is years away, but some countries like Iceland and Greece are there. Even with bailouts from the Eurozone, Greece is still there, and Iceland has no France and Germany it can rely on for help. State governments are heading there. For municipal and county governments, “zero hour” would be happening in many places, but for now public services they provide are shifted to higher levels of government. As long as a local government is under the umbrella of a larger solvent or credit worthy government, debt burdens seem to mostly be shifting higher up the totem pole, placing additional stress on the larger government.
Another part is: bailout activity has been slow in the news lately. Not that hundreds of billions aren’t pouring forth from the Fed and Treasury Department in support of wealthy banking interests, but reports on noteworthy details have been meager in the news lately.
So let me take a moment to explain why “zero hour” matters to me. I oppose the government rescue of our economy after the credit bubble popped. I believe the best solution is for the corporations that caused this mess to go bankrupt, and prices to fall as they naturally would in a free market, particularly for houses and other investment classes. I am opposed to government attempts to maintain house prices and credit-based assets above the market price, as it is doing now, and believe that it only delays the solution to the current economic downturn, which is lower prices.
When it comes to spending tax money, our government is showing little self-restraint. Worse, politicians are not only spending tax money they actually have, but are borrowing it from future taxpayers to benefit politically-invested interests today.
This government practice will stop when one of two things happen: either (1) a democratic majority agrees with me and start voting in politicians who will seek to stop bailouts and otherwise support responsible and sustainable government spending, or (2) the government runs out of money. The U.S. government already spends more than it takes in with taxes by selling Treasury Bonds, so #2 will only happen when the government can no longer sell Treasury Bonds, or more precisely, when people no longer buy them.
This I see as an advantageous outcome because it brings society back to a point where it has to live within its means. Even if a large chunk of our tax dollars is wasted in the future to pay interest on misspent bailout money today, and maybe the government services we receive are only half what we are paying in taxes because of interest payments on the debt, I still feel a society with a less meddlesome and more economically restrained government is better than the mess that exists now.
So I think zero hour is a good thing and welcome it. What would be better though is to control spending before we reach that point.
Part of it is: the United States is still far away from this titular “zero hour” as I call it, where governments can no longer sell treasury bonds. The U.S. is years away, but some countries like Iceland and Greece are there. Even with bailouts from the Eurozone, Greece is still there, and Iceland has no France and Germany it can rely on for help. State governments are heading there. For municipal and county governments, “zero hour” would be happening in many places, but for now public services they provide are shifted to higher levels of government. As long as a local government is under the umbrella of a larger solvent or credit worthy government, debt burdens seem to mostly be shifting higher up the totem pole, placing additional stress on the larger government.
Another part is: bailout activity has been slow in the news lately. Not that hundreds of billions aren’t pouring forth from the Fed and Treasury Department in support of wealthy banking interests, but reports on noteworthy details have been meager in the news lately.
So let me take a moment to explain why “zero hour” matters to me. I oppose the government rescue of our economy after the credit bubble popped. I believe the best solution is for the corporations that caused this mess to go bankrupt, and prices to fall as they naturally would in a free market, particularly for houses and other investment classes. I am opposed to government attempts to maintain house prices and credit-based assets above the market price, as it is doing now, and believe that it only delays the solution to the current economic downturn, which is lower prices.
When it comes to spending tax money, our government is showing little self-restraint. Worse, politicians are not only spending tax money they actually have, but are borrowing it from future taxpayers to benefit politically-invested interests today.
This government practice will stop when one of two things happen: either (1) a democratic majority agrees with me and start voting in politicians who will seek to stop bailouts and otherwise support responsible and sustainable government spending, or (2) the government runs out of money. The U.S. government already spends more than it takes in with taxes by selling Treasury Bonds, so #2 will only happen when the government can no longer sell Treasury Bonds, or more precisely, when people no longer buy them.
This I see as an advantageous outcome because it brings society back to a point where it has to live within its means. Even if a large chunk of our tax dollars is wasted in the future to pay interest on misspent bailout money today, and maybe the government services we receive are only half what we are paying in taxes because of interest payments on the debt, I still feel a society with a less meddlesome and more economically restrained government is better than the mess that exists now.
So I think zero hour is a good thing and welcome it. What would be better though is to control spending before we reach that point.
Sunday, July 4, 2010
Yields and Risk
Over the couple years I've blogged on the economy, I have been pretty bad at prediciting the behavior of the stock market. Despite this, I would like to share a couple of insights over this time.
I have blogged before on the inherent fluctuation of the market, as it swings back and forth around the trend line. Financial commentators will always have an explanation for why the DJIA went up or down 50 points today—they will always find some piece of economic news to link it to—but really, 50 points, and probably even 100, is well within the margin of error, so swings up and down of that degree are just artifactual noise and have no meaning. Admittedly, if you want to be invited back on CNBC as a financial commentator, you had better find a better answer than: "Today's 75 drop was probably mostly just random noise and bears no particular association with any financial event. It will probably reverse course tomorrow."
So today, I would like to discuss two other factors that play a role in stock valuations that buck the trend line and account for movement outside of the margin of error.
Yields are the bottom line of any investment. Unless an investment delivers a competitive yield, or return on your principle, it has no value as an investment. Now speculative run-ups can happen and have happened a lot lately where the prices of stocks or houses or whatever rise in a detached way from yields and people can make a lot of money from capital gains—but this is the definition of a bubble, and it is always time-limited and a risky game to play. In the heart of a bubble, investors will say things like "new paradigm" and believe that the principle is now detached from the yield, but sooner or later, things will return to earth. It is a speculative game and the last of the greater fools will eventually get burned.
While yields have generally been pretty low in the last rise of the DJIA, since its lows in the 6000s in March 2009, this last bull market may have actually been supported by fundamentals. The problem is, with the Federal Reserve lending out money at close to 0%, investments have not needed to perform very well to be marketable. If you are an investment bank that can borrow money from the Fed at, say, 1%, and then invest it in stocks with a meager 2 or 3% yield, that is still profitable. If interest rates are closer to their historical average at 5%, a 2 or 3% yield would be unprofitable, and the base price of stocks would have to fall before it would be sensible to buy them as an investment. The recent peak of the DJIA in the 11000s is understandable given the generally poor yields of all investment classes today.
A less tangible factor that affects stock valuations is risk. If one fears a business going bankrupt, even a 20% yield is uncompetitive if it causes you to lose your entire principle. If a business is extremely stable, its stock hardly needs to outperform treasury bonds to be a worthwhile investment. If the overall business environment is optimistic, yields can drop, raising the base price of the stock. Conversely in a worrisome climate, yields must rise for the stock to be competitive.
Since yields are fairly fixed and cannot go up or down on a whim, it is the principle, or base cost of the share, that must adjust to the desired yields. In a climate where low yields are tolerated then stocks prices have room to rise, or if higher yields are needed, then there is a downward pressure on share price.
So, random variations, yields, and risk are the current factors I have in my mind that account for shifts in the value of stock, or other investment classes. Random variations account for small changes of up to a few percentage points. Yields are straightforward and easy to measure, and if a stable corporation can outperform Treasury Bonds by a percentage point or two, its price is understandable and consistent with fundamentals.
Risk is the x-factor in all of this. It is hard for outsiders to gage what the inherent business outlook will be, and in addition, risk is mitigated by upcoming government bailouts which again is knowledge that will be privy only insiders.
The stock market has declined significantly lately. Though yields are poor they are in line with those of other investments. So, using this model, recent declines are accounted for by a general sense of risk in the system.
I have blogged before on the inherent fluctuation of the market, as it swings back and forth around the trend line. Financial commentators will always have an explanation for why the DJIA went up or down 50 points today—they will always find some piece of economic news to link it to—but really, 50 points, and probably even 100, is well within the margin of error, so swings up and down of that degree are just artifactual noise and have no meaning. Admittedly, if you want to be invited back on CNBC as a financial commentator, you had better find a better answer than: "Today's 75 drop was probably mostly just random noise and bears no particular association with any financial event. It will probably reverse course tomorrow."
So today, I would like to discuss two other factors that play a role in stock valuations that buck the trend line and account for movement outside of the margin of error.
Yields are the bottom line of any investment. Unless an investment delivers a competitive yield, or return on your principle, it has no value as an investment. Now speculative run-ups can happen and have happened a lot lately where the prices of stocks or houses or whatever rise in a detached way from yields and people can make a lot of money from capital gains—but this is the definition of a bubble, and it is always time-limited and a risky game to play. In the heart of a bubble, investors will say things like "new paradigm" and believe that the principle is now detached from the yield, but sooner or later, things will return to earth. It is a speculative game and the last of the greater fools will eventually get burned.
While yields have generally been pretty low in the last rise of the DJIA, since its lows in the 6000s in March 2009, this last bull market may have actually been supported by fundamentals. The problem is, with the Federal Reserve lending out money at close to 0%, investments have not needed to perform very well to be marketable. If you are an investment bank that can borrow money from the Fed at, say, 1%, and then invest it in stocks with a meager 2 or 3% yield, that is still profitable. If interest rates are closer to their historical average at 5%, a 2 or 3% yield would be unprofitable, and the base price of stocks would have to fall before it would be sensible to buy them as an investment. The recent peak of the DJIA in the 11000s is understandable given the generally poor yields of all investment classes today.
A less tangible factor that affects stock valuations is risk. If one fears a business going bankrupt, even a 20% yield is uncompetitive if it causes you to lose your entire principle. If a business is extremely stable, its stock hardly needs to outperform treasury bonds to be a worthwhile investment. If the overall business environment is optimistic, yields can drop, raising the base price of the stock. Conversely in a worrisome climate, yields must rise for the stock to be competitive.
Since yields are fairly fixed and cannot go up or down on a whim, it is the principle, or base cost of the share, that must adjust to the desired yields. In a climate where low yields are tolerated then stocks prices have room to rise, or if higher yields are needed, then there is a downward pressure on share price.
So, random variations, yields, and risk are the current factors I have in my mind that account for shifts in the value of stock, or other investment classes. Random variations account for small changes of up to a few percentage points. Yields are straightforward and easy to measure, and if a stable corporation can outperform Treasury Bonds by a percentage point or two, its price is understandable and consistent with fundamentals.
Risk is the x-factor in all of this. It is hard for outsiders to gage what the inherent business outlook will be, and in addition, risk is mitigated by upcoming government bailouts which again is knowledge that will be privy only insiders.
The stock market has declined significantly lately. Though yields are poor they are in line with those of other investments. So, using this model, recent declines are accounted for by a general sense of risk in the system.
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