Financial topics

[OLD1953]

Then you have to explain away Japan, China, Sweden and Germany, all of which have more government interference in their economies than does the US.

[mannfm11]

If you fit a line to the DJIA on a log plot prior to 1914 you get one slope and if you do it after 1971 you get another slope. The reason is that prior to 1914 the US mostly had a real gold standard and after 1971 they have been printing a lot of money. In the years between there was a transition away from hard money. Since the DJIA is measured in dollars it is disturbed when the number of dollars are growing exponentially and the value is dropping because of this. You sort of have to add the growth rate of companies onto the inflation rate of the dollar to get the new growth rate of the DJIA. So the P/E values that are sensible since 1971 are not the same as the ones that were sensible prior to 1914. So this time is different.

I am going to dispute this for the very reason that stocks are financial assets and not nominal money ones. If you go to Robert Shillers data, which he used to write the book "Irrational Exhuberance", you will find that inflation between 1895 and 1920 was as bad as it was between 1975 and 2000. He posts not only the monthly prices in the equivalent to the SPX, but also the CPI figures as well. [url]http://www.econ.yale.edu/~shiller/data.htm I spent well over 100 hours working on this data.

There is more to this as inflation is brought about by credit. The difference between the gold standard and the current standard is that at some point people would get nervous about the solvency of banks and bank notes and line up to get the gold out of the banks. Until then, they could inflate as much as they dared. The value of money is in the payment of debt and inflation occurs when debts are easy to pay, which is totally contrary to what people think. People are led to believe that it is the reverse, that inflation makes debts easier to pay, but in reality, inflation is the continued increase in credit, which keeps a steady supply of money in circulation. Once credit has reached its limit, which is where we are today, you can't inflate it any more and debts become harder to pay and the term "This note is Legal Tender for all Debts Public and Private" begins to mean something.

There are 2 sets of liabilities in a credit system, the lenders and the borrowers. The lender creates credit in return for liens or notes, depsnding on whether the debt is secured or not. In doing so, they create a liability of theirs to circulate as money. A credit crunch develops when the capacity of major financial players to pay their debts is in question, ala Citicorp, Bank of America, Lehman Brothers, Royal bank of Scotland, Credit Suisse, Bear Stearns, General Electric credit, etc. In the meantime, these outfits sustain their lending monopoly by a series of short term and long term loans between themselves, one portion of the system carrying the excess lending in some form of the other portion. Once the creation of credit ceases, no more excess money is created and liabilities of banks and their customers become harder to service. We have reached that point.

The notion that the Fed has fixed this is far from correct. What the Fed did was create funds out of assets the banks found unmarketable in order that they can service the debts between themselves. The game going into this mess was to create make believe money in the form of swaps and repurchase agreements and other derivatives that allowed all players to pretend they could come up with the money to service tehir liabilities. It only took the weakest link breaking for this game to end.

What values stock is dividends as they can be discounted in the future. I attempted to condense what I had developed out of Shillers data in 2003 in this post on my blog. http://mannfm11.blogspot.com/ Where the whole inflation idea falls apart is high inflation requires higher discount rates in order to normalize cash flows and discount value. Thus, with 2% inflation, one could use an 8% discount rate for the SPX. Using averages, dividends grow a little less than 1% over inflation, depending on the health of the inflation. So, if we have dividends of $22 on the SPX, which is close, the formula for valuing the SPX would be P=D/K-g, with k being 8% and g being 3% or inflation plus 1. The proper value in this light would be 22/(.08-.03) or $22/.05 or $440.

This formula prices the market to return 8%. If you price the current market based on the 2% dividend, then you have figure that you are paying roughly 250% of real value and to get to real value after inflation, the factor would utilize a 3% growth rate on one had on the $440 price and a 2% growth rate on the other. Thus in 72 years, inflation quadruples price, meaning the target at buying at 1100 on the SPX in real value against what the index is really worth is still short. 440 will double 3 times at 3%, meaning the market would be fairly valued at 3360 in 72 years. In theory, if the dividend increases 3% every year, then buying at 1100 would yield you 2% plus 3% or 5%, not 8%. In order to make 8% on the SPX, it has to be priced to yield 8%. So, at the current 2% dividend and 2% inflation and 1% real growth, the SPX would pay a 2% dividend next year at SPX 1133, based on a current 1100 price.

So, real return is dividend plus roughly 1%. What isn't counted in this is the losses that could come about. When credit growth stops and even reverses as it is doing now, earnings erode. So, we might be looking at P=D/k-g, where g might be -5% for the next 20 years. So, if inflation is -2% and growth is -5%, k is going to be 4% and k-g is going to be 9%. In this case, the $22 dividend is worth about 242.

One must remember that all there is out of stocks is the flow of dividends plus the liquidation value of the stock. Sure companies are acquired, but usually they are acquired by an estimate of the income they can pay to their acquirer, which is the dividend. In order to grow, a company must reinvest its surplus, so the option is not to fail to spend the surplus in excess of dividends. Companies that are buying back their stock are liquidating. You might take a look at a company like CSCO for example, which has spent a fortune on buying back stock over the past 10 years and is now worth about 25% of its peak value in 2000. A growth company that has continually bought back its own stock and paid nothing in dividends has resulted in almost no real gain to their shareholders for the past 11 years.

I use this formula because it was what I learned in the school of finance where I received a degree in the 1970's. Plus, there is no other formula to value a financial asset than discount. There is also, over the long haul, not much of a way to beat risk free assets in return. The theory can do it, but it only goes on as long as there is inflation. If you check inflation figures and take out for capital gain taxes, you will find that the Dow holder in 1966 didn't get even until the mid 1990's. All he drew was dividends, which were substantial and if a company paid none, the holder of the stock made nothing after inflation for that long. If the company went broke in the intervening 30 years, the shareholder was left with nothing. How do you think the shareholders of Citi feel now with stock at $4 and their ownership diluted?

Lastly, John pointed a finger at boomers and X-ers. The market in 1966 was as richly valued as it was in 1929. The oldest boomer was 20 in 1966. Why did they do it again?

[vincecate]

Then you have to explain away Japan, China, Sweden and Germany, all of which have more government interference in their economies than does the US.

I think that the growth of an economy is partly dependent on the amount of government interference and also on the derivative of this. If the government interference is growing fast that is extra bad. It seems Sweden has been reducing government control of the economy some. I think part of Japans lost decades was too much government. And China over the last 30 years really freed up their economy, on average.

[vincecate]

I am going to dispute this for the very reason that stocks are financial assets and not nominal money ones.

I don't really mean to imply I know the right valuation formula. And the change in inflation does change what makes sense. Clearly at 20% inflation we need a much lower P/E than at 1% inflation. So inflation bringing up stock values assumes a steady inflation, which is not what I am predicting either. My point is just that we are on pure fiat money now, so this time is different. Using P/Es from back when the US was on a gold standard, or even partial gold standard, seems wrong.

There is more to this as inflation is brought about by credit. The difference between the gold standard and the current standard is that at some point people would get nervous about the solvency of banks and bank notes and line up to get the gold out of the banks. Until then, they could inflate as much as they dared.

I think "fractional reserve banking" is a big problem. The difference that you mention is a big difference. Now there will be no deflation back to just gold money.

And I agree that you can get more money than the Fed has printed, and get deflation pressure as credit contracts. But I think that with fiat money, after long enough, the Fed will print so much money that it will more than make up for the credit being paid down. I think any defaults against the Fed (say banks going bust or mortgages they own) are not deflationary as the money is not taken out of the system. To me the question is just how long that takes for the Fed to make inflation. I think within the next year but I don't really have any crystal ball.

My stuff on bankis: http://pair.offshore.ai/38yearcycle/#banksgobust
On the Ponzi gold standard of 1914 to 1933: http://pair.offshore.ai/38yearcycle/#1933

[John]

Dear Vince,

> If you fit a line to the DJIA on a log plot prior to 1914 you get
> one slope and if you do it after 1971 you get another slope.

The same could be said of almost any 20 year period. Exponential
growth curve fitting requires a long period of time, encompassing as
many cycles as possible. The DJIA only began in 1896 (not 1871, which
is when we have figures for the S&P), and the period 1896-1914 is way
too short for a valid exponential curve fitting.

1914 was indeed a very significant year, for the same reason that 1987
was a significant year. It occurred 57 years after the Panic of 1857,
leading to the "false panic of 1914." The following article discusses
and compares both false panics.

** Investors commemorate the false panic of Monday, October 19, 1987
** http://www.generationaldynamics.com/cgi ... 19#e071019

John

[The Grey Badger]

And the best of all possible sources for prices over the centuries is David Hackett Fischer's "The Long Wave." He uses basic commodity prices and runs his data back into the medieval era.

One thing notable is that price data is not the smooth sine-wave curve one may imagine, but as he says, a wave, that starts slowly, builds up, and breaks ... and levels off at the higher level of prices. The mechanism he gives for this is very similar to the generational turnover John cites, when the last people with direct experience of things have died off and the younger generations start trusting that a rosy state of affairs is the natural order of things.

The 20th Century Price Wave began about the time of the Missionary Awakening and is due to crest any moment now, if it hasn't already, and then we're in for a period of what he calls Equilibrium: very slow growth and low interest rates.

The last such wave-and-equilibrium started in the 18th Century, which I have already pegged as a mega-Crisis era, crested during the post-Revolutionary High (in the States), and touched off the Victorian Equilibrium. And note that the 19th century was in equilibrium with respect to commodity prices *despite* the massive industrial development that occurred then.

I have "The Long Wave" shelved right next to "Generational Dynamics" and "Fourth Turning."

[jwfid]

Hi everyone,

It seems like everyone forgets the change to the mark to market rule last year. I wonder what the p/e ratio would be right now if that rule had not been suspended and GAAP continued to be used.

Joe

[aeden]

Hi everyone,

It seems like everyone forgets the change to the mark to market rule last year. I wonder what the p/e ratio would be right now if that rule had not been suspended and GAAP continued to be used.

Joe

Up A Creek and People rent stocks. Smart to dumb ratio as posted focuses the
target ratio.
The "smart money indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders. The "Smart Money" indicator is neutral as of late.
In fledgling democracies, an incumbent government can use a free trade agreement also to reduce the likelihood of dictatorial takeover, thus helping “consolidate” democracy only.
Meanwhile, focus on who is taking the means of production. Billion have been seized in assets by the leftards and the historical consequences are always clear.
http://thetechnicaltakedotcom.blogspot.com

Rent dissipation economies are inflation driven period.

[Higgenbotham]

If you fit a line to the DJIA on a log plot prior to 1914 you get one slope and if you do it after 1971 you get another slope. The reason is that prior to 1914 the US mostly had a real gold standard and after 1971 they have been printing a lot of money. In the years between there was a transition away from hard money. Since the DJIA is measured in dollars it is disturbed when the number of dollars are growing exponentially and the value is dropping because of this. You sort of have to add the growth rate of companies onto the inflation rate of the dollar to get the new growth rate of the DJIA. So the P/E values that are sensible since 1971 are not the same as the ones that were sensible prior to 1914. So this time is different.

I am going to dispute this for the very reason that stocks are financial assets and not nominal money ones. If you go to Robert Shillers data, which he used to write the book "Irrational Exhuberance", you will find that inflation between 1895 and 1920 was as bad as it was between 1975 and 2000. He posts not only the monthly prices in the equivalent to the SPX, but also the CPI figures as well. http://www.econ.yale.edu/~shiller/data.htm I spent well over 100 hours working on this data.

There is more to this as inflation is brought about by credit. The difference between the gold standard and the current standard is that at some point people would get nervous about the solvency of banks and bank notes and line up to get the gold out of the banks. Until then, they could inflate as much as they dared. The value of money is in the payment of debt and inflation occurs when debts are easy to pay, which is totally contrary to what people think. People are led to believe that it is the reverse, that inflation makes debts easier to pay, but in reality, inflation is the continued increase in credit, which keeps a steady supply of money in circulation. Once credit has reached its limit, which is where we are today, you can't inflate it any more and debts become harder to pay and the term "This note is Legal Tender for all Debts Public and Private" begins to mean something.

There are 2 sets of liabilities in a credit system, the lenders and the borrowers. The lender creates credit in return for liens or notes, depending on whether the debt is secured or not. In doing so, they create a liability of theirs to circulate as money. A credit crunch develops when the capacity of major financial players to pay their debts is in question, ala Citicorp, Bank of America, Lehman Brothers, Royal bank of Scotland, Credit Suisse, Bear Stearns, General Electric credit, etc. In the meantime, these outfits sustain their lending monopoly by a series of short term and long term loans between themselves, one portion of the system carrying the excess lending in some form of the other portion. Once the creation of credit ceases, no more excess money is created and liabilities of banks and their customers become harder to service. We have reached that point.

The notion that the Fed has fixed this is far from correct. What the Fed did was create funds out of assets the banks found unmarketable in order that they can service the debts between themselves. The game going into this mess was to create make believe money in the form of swaps and repurchase agreements and other derivatives that allowed all players to pretend they could come up with the money to service their liabilities. It only took the weakest link breaking for this game to end.

What values stock is dividends as they can be discounted in the future.

This discussion brings up an interesting conundrum really. What values stocks is earnings/dividends. What puts a floor under stock values is book value, but that is only to the extent that the assets (valued at book) can generate any earnings and dividends. The assets on a company's balance sheet aren't worth as much in an environment that is too unstable to generate earnings. If inflation equates to instability, book values can fall and there is no good floor under stock prices.

The post Bretton Woods regime has become unstable. The "money" created could be divided into two classes: predatory (speculative) and capital used for legitimate business purposes. Predatory capital can be used to generate or even to deflate bubbles very quickly and it can also go into hiding. What we've seen post 1971 is an exponential increase in predatory capital. Oddly enough, where predatory capital chooses to hide irrespective of fundamentals creates false assurances, which can lead to sudden crashes. Base money can be multiplied 100 fold by a hedge fund and used to drive stock prices up or down. The algos don't care whether they are long or short. There's only one thing they care about and that's making money. In fact, the more money they make, the higher the ratio of predatory to legitimate capital. My guess is the net effect is to suck value out of the real economy. It can become self feeding.

A question came up in an old thread about the gold standard and whether significant deflation was ever experienced when the gold standard was suspended. The Bank of England has a graphic from 1790 to date that covers some of that. I'll try to find the link later. You can click on this graphic to highlight various regimes. From 1797 to 1821, when the gold standard was suspended, there was a period of instability in inflation rates. Both the highest and the lowest inflation rates for the 200 year period were seen between 1797 and 1821.

Suspension of a gold standard may be more indicative of a growing unstable environment than anything else. In other words, that's why the gold standard was suspended to begin with.

My guess has been that the post 1971 effects will be similar. The 1797 to 1821 regime probably averages to zero inflation. That's what I suspect the post 1971 regime will average to when all is said and done. The lack of a gold standard allows for a larger multiplication of leverage, which allows for a larger bubble. That in my mind is the key factor. Stock values are tethered to earth by the returns that the companies can throw off and that's harder to do in an unstable environment where there is an excess of predatory capital and a deficiency of real economy. John's charts clearly show that. PE's have gone out of sight, far above any PE's that have been seen historically. I agree with John and mann that we are on course for the worst stock market crash in all of US history.

[JonLaw]

John:

I think that you are wrong with respect to the stock market issue.

The problem with the financial system is in the soverign debt/currency itself. That is to say, that the problem with the system is not the "overvaluation" of the stock market, which was much much more overvalued in 2000, but rather the fact that the Fed/Treasury is busy issuing soverign debt to replace the fradulent debt that was previously issued in lieu of actual value.

The stock market is properly valued based on either inflation or the volatility of inflation. With inflation low and not very volatile right now (only because the fed/treasury is supplementing actual demand with fake demand) the stock market is not too overvalued.

However, the soverign debt market is a pending catastrophe.

- Jon