Wednesday, March 18, 2020

Where are the Reference Points?

[What follows is rather raw reaction and thoughts scribed in an effort to focus my own thinking. The reader may wish to read the section written March 16 (which follows the March 18 text) first.]

As I write (1:22 PM, March 18, 2020) chaos does indeed seem to be occurring. Congress just passed a $1.3T? relief package and there's panic talk on CNBC (Bill Ackerman). Of course the solution is more money from government.

Or is it?

We need to ask ourselves why we have stockholders? It is not so the people can make money, as if money making was the only thing that could happen. No, the real reason for stockholders to exist (as a class) is to absorb risk when the venture fails. Yes, stockholders do expect to make money as a result of owning stock and taking risk but success is not assured. Certainly we can see that today as the market craters.

After some 70 years (more or less) of declining interest rates and the increasing use of debt to increase return on capital, interest rates have reached zero and the coronovirus has arrived. It seems that every company I looked at (and certainly every one I own stock in) has a large debt overhang that now threatens to become an iron collar on all swimmers. A very ugly picture.

I think we are likely to move into a new world financial order. I have no idea of where the reference points might be. Of course, interest rates are basically zero. Oil (which reached into the low $20's today) is a very disconcerning reference point. Gold, long the reference point in times of trouble, has also lost value but by a modest amount. (Apparently people are buying gold just about as fast as it it sold.) Virus related shutdowns have thrown profit expectations into a tizzy for nearly all business entities.

We are living through a learning opportunity--especially when viewed from a macroeconomic perspective. My natural inclination is to look for evidence that interest rates matter (should not be zero) and stock owners provide capital for firms (avoiding banks in normal times).

What will tomorrow bring?

[from earlier in the collapse event]

As I write (6 AM, March 16, 2020) the U.S. market is a half-hour away from opening. The first open with zero interest rates a present reality. Futures are locked down limits. What to do?

Not only are the futures locked down, the national economy is nearing lock-down with coronovirus fears.

On top of that, a prolonged period of declining interest rates has preceded this day. In fact, we could say that ever since the beginning of WW2, the history of interest rates is a story of decline. Lower interest rates predict increased economic activity with increased wages--inflation.

Inflation has been built into asset prices everywhere but especially into the prices of fixed assets such as land and housing. Mathematically, we could predict the future value of assets by discounting the future earning power by the expected interest return. An asset earning a free cash flow of $512 facing an asset (such as savings) earning 3% interest would have a present value of $512 / 0.03 = $17066. (A quick but perhaps controversial method of establishing value.)

What is the value of $512 if interest rates are zero? $512 / 0 is infinity. Obviously a ridiculous answer. Pick your own acceptable interest rate if you expect a sensible answer.

So what has the Fed done when it sets interest rates at zero? It has removed the economic reference point called 'interest rates'. Now it it up to every decision maker to set his own interest rate. Chaos!

(c) Roger Sparks 2020

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