Investment Outlook 2011

2010 in review

The US stock market spent the better part of 2010 in mildly overvalued territory. As of December 2010, the S&P is hovering around 1200, and the overall market capitalization is around USD 14.2 trillion. The market capitalization ratio is around 100%. As we've seen in our post in October 2008, the fair value of the US market is around 70-80% of GDP, which in todays terms corresponds to the S&P at 960. (A good place to get an update of the market valuation is here at GuruFocus: http://www.gurufocus.com/stock-market-valuations.php)

History also suggests that market values will correct towards fair value, often overshooting in the process. But there is no guarantee that the past will repeat itself, and we must be careful not to drive forwards while using only the rear view mirror to guide us. The nature of the market and investor participation prior to the 1960s is different in some fundamental ways from today's market. Nonetheless, my bet is that the market is still overwhelmingly driven by human mob psychology, and that is something that has not changed throughout human history.

Market mob psychology has historically demonstrated the ability to allow:

- the market to fall to 50% of GDP. This would imply the probable lowest the S&P may fall to is approx 600. That's a 50% drop from here.

- the market to rise to 150% of GDP; this occurred very briefly during the 1999 dot com mania, and was an unprecedented all-time valuation high for the market. This would imply the S&P at being 1800, which is a 50% rise from here.

Wildly overvalued markets are often challenging for value investors, because almost all stocks can be overpriced. Similarly undervalued markets present a feast for value investors as the majority of stocks drop to fire-sale prices. Mildly overvalued or undervalued markets would typically present fewer investing opportunities, as individual stocks and assets become cheap because of poor investor sentiment arising from events such as bad press and unexpected (transient) earnings surprises.

However the market in 2010 did not manifest many such opportunities, because it demonstrated an interesting characteristic: a very high level of correlation across all stocks. This has commonly been referred to as the "risk-on, risk-off" behavior of investors. All stocks move up and down in unison, and individual stock picking thus becomes a very challenging task as every stock pick becomes a bet on the overall market movement. There are fewer opportunities to practice investing, the art of buying undervalued stocks whose prices then go up as their value gets realized in the market. One of the few opportunities that came up were the few times when high quality blue chip companies were trading at fair value.

Looking forward : 2011

The economic environment is 2011 is likely to continue to be subdued as we continue working through the mis-allocation of resources during the bubbles between 2000 and 2008. The high levels of obligations to retirees and government employees (manifested as debt and unfunded obligations) will likely be a drag on the economy, as either (1) working people adjust to reduce their standard of living to make good on these promises made by the government to other sectors of society by transferring the results of their production to these other sectors, or (2) society adjusts to inflation which comes from monetizing the debt to break those promises made. The drag on the economy comes from the psychological effect on people who discover that their plans based on past promises or projections now have to be changed. As they feel poorer and/or find less rewards in production, they may reduce their level of economic activity (production and consumption).

But does the underlying economy really matter for investors? Stock prices will go up if everyone gets whipped up into a frenzy, whether or not the underlying economy is sound. How it matters is that the degree of activity in the underlying political economy can increase or decrease the probability that investor psychology will be triggered in one direction or the other.

What is 2011 likely to present to us: what are the known risks this coming year?

1. The risk of people recognizing that massive central bank money printing will lead to inflation.
   
   
2. The risk of people recognizing that private and sovereign debt will default explicitly or implicitly via inflation, either way leading to inflation or increasing yields; because of the large amounts of debt.
   
   
3. The likelihood that economic growth continues to be slow, as we work through the continuing economic readjustment from the housing and financial asset bubble.
   

The underlying longer term trends, that we have observed earlier, continue to play out:

1. reduction in availability of low cost resources (energy, commodities)
   
   
2. demographic trends: aging in the vast majority of developed countries, and China

How investor and mass psychology plays out over the coming year is uncertain, though the triggers for a market correction seem to be there.

Investing Playbook

Given the underlying economic landscape, and what seems to be latent triggers for a change in investor psychology leading to a fall in equity prices, we look towards investing in companies which have strong business positions and growth ahead of them. Their downturn resistant earnings streams should support their stock prices to some degree, and even driving a growth in prices once correction-psychology stabilizes. The key is to buy at fair prices, as it is highly unlikely that companies seen as low-risk, durable and world-leading will sell for cheap prices for too long, irrespective of how much the market corrects. It is unlikely for example, that WMT would go for less than 10 times earnings for any prolonged period of time. A study of the bear market in the 1970s would suggest this belief.

Other more transient, or in-the-moment approaches are likely to be tricky this year. The recent erratic risk-on risk-off nature of market psychology makes it difficult to make money by playing transient shifts in changing asset preferences. It also makes it difficult to make the traditional value investing play of buying assets below their fair prices, in the hope of markets recognizing their true value.

The one shift in preference that seems a possibly good bet is the shift away from debt instruments. Rising recognition of sovereign default would likely trigger a shift away from bonds and resulting in rising yields. This has been expected for several years, and it is still anybody's guess whether this will happen this year. But when it does, it is likely the shift will be swift and decisive, providing an opportunity to place a bet on the continuance of this shift after it has started.

Investment Outlook 2010 - Inflation Resistant Stocks

2009 was an eventful year as the financial crisis played itself out, and the stock market plunged in March as panic set in. Investors who bought during panic are now enjoying a nice lift as the S&P 500 looks set to close the year at about 1100, a large rebound from its March lows of around 700.

However what is remarkable is that even during the lows in March, stocks were never truly cheap by historical standards, nor were they really cheap from a Discounted Earnings perspective. (See the October 2008 post for my view of stock valuation). Value fund managers like John Hussman have alluded to this, and investment managers like Jeremy Grantham have placed the S&P 500's fair value at around 900. Whichever the case, today's 1,100 level puts stock squarely in over-priced territory.

I believe the odds are that the overall market will become cheaper over the next few years, simply because history suggests that after bouts of overvaluation, investors tend to allow markets to spend many years in undervalued territory. Assets prices are determined by what people are willing to pay for them, and human psychology has not changed over the last thousand years. There is no reason to believe that this time is any different. But this doesn't mean that prices will fall to once a century lows, because the democratization of investing and the raised awareness of stocks since the 1960s.

There are many ways the market can revert to cheaper levels, for example: (a) the market trades sideways over the next few years between 700 and 1000 while earnings continue to grow, or (b) another correction occurs in 2010, possibly triggered by a financial panic or the realization that slow economic growth is here to stay.


The future is inherently unpredictable

Of course one knows for sure if these outcomes are going to play out. Both markets and the economy are complex systems which are hard to predict. They also rely on individual decisions made by human beings that are driven by their own psychology and life experience, and reactions to each other. This makes it difficult (or some would say impossible) to use economic data points to predict the behavior of the economy.

For example, the huge increase in the quantity of money engineered by the Fed over the last year should be cause for inflation in the near future. But if individuals simply choose not to spend, then inflation isn't going to appear. Likewise, the large unfunded government obligations (Medicare, Social Security etc) suggest that either US interest rates should rise or inflation should kick in as government runs the printing presses. But this may not happen if individual investors continue to have faith in the ability of the US government to meet its obligations and continue funding the government's debt. While some would consider this living on borrowed time, the reality is that this "borrowed time" can last for decades and span the bulk of an investor's investing life. In the long run the fundamentals reassert themselves, but the long run could be a meaningless abstraction for an individual's investment lifespan. An investor whose analysis is fundamentally correct could suffer poor returns over his life, while someone riding momentum (or the popular thinking) could ride to riches.

Of course we can't abandon all hope and take a fatalistic view of things. It would be impossible to make any investment decisions if that were to happen. We need to make bets that will play out over the next 5-10 years. Some bets will go wrong and some will work out, and the name of the investing game is simply to have more bets go right than wrong over an investment lifetime. We need to form investment views based on the best data we have, and long term historical averages are one data point in any viewpoint.



The Investing Environment in 2010 and beyond

So what does this mean for us in 2010? It means we must be cognizant that today's investment landscape is marked by 4 key parameters that are likely to define our investing horizon:

(1) The probability that inflation is going to accelerate is high. The key drivers are the large unfunded government liabilities, and the large amount of money injected into the financial system by the Fed. The former will tempt the government to run the printing presses and inflate its way out of its debt hole, while the latter is a huge reservoir of money held back only by people's unwillingness to spend, much like Hoover Dam holds back the Colorado River. When the mood changes, the money will flood out into the economy.

(2) Economic growth is probably going to be low for a few years. The following suggest this:

• (a) Realignment of economic structure. It is going to take some time to work through the mis-allocation of resources caused by the credit bubble. The structure of economic activity has to be realigned to stop the production of un-needed goods (like excess housing). People need to be re-skilled, and the debts taken on to purchase unproductive assets need to be cleared.
  
  
• (b) Reduction in credit. Banks need to work through their bad assets which will reduce the amount of lending. Credit is the grease that keeps the economic engine running, and its reduction will probably reduce the quantity of economic activity.
  
  
• (c) Demographic changes. Many economically significant countries (the US, China and large parts of Europe) have gone into full scale demographic decline. The aging of baby boomers and China's one child policy mean that going forward, the ratio of retired people to working adults is going to increase. This means both that (1) the structure of economic production will need to change to meet the needs of more older folks, and (2) the amount of production that can take place is going to grow slower or shrink, as there are fewer people of working age to carry out economic activity.
  
  
• (d) Oil and energy. The probability is increasing that real energy costs are going to rise. Fewer easy to extract energy sources means that our EROEI is going to go up. More economic activity has to be generated to produce the same amount of output. The structure of the economy has to change to meet this challenge, either by restructuring our chain of production (which can be analyzed from a biophysical economics / thermoeconomics standpoint) and/or new technologies are going to be invented and the energy architecture of our economy changed.

In short, the probability is that we are headed into a world of low economic growth accompanied by inflation, much like the 1970s. Back then, equities performed terribly, while commodity prices and interest rates rose (i.e. bond prices declined). The question is will history repeat itself in the coming years?

All things considered, increased inflation and slower economic growth is likely to reduce the real earnings of companies and their valuation multiples. Warren Buffett's 1977 article on inflation explains this mechanism very clearly. The gist is that in most cases, companies have not been able to increase their ROEs in times of inflation. This means that they are rarely able to increase earnings beyond their historical average ROE of 12%. This reduces real earnings if inflation increases beyond a dormant 2-4%, and investors penalize company valuations accordingly.

The general remedy for investors is to own companies that have high ROEs. Such companies have room to increase their earnings during inflationary periods by retaining more earnings. However it is important to realize that this ability to increase their earnings in the face of inflation will, all things being equal, not increase their PE valuations. The higher earnings growth rate will likely be countered by the increased discount rate investors require on the future earnings stream.


How investors can profit in this environment

Fundamentally investors profit in three distinct ways:

1. Capital / Asset preferences. Investors can profit by riding the price rise wave as other investors start converting their capital into a particular asset class. For example, from the early 80s up to 2000, people converted their capital into equities, driving a secular rise in market PE ratios. Investors who caught this wave made a good amount of money. The challenge is to see which assets investors might want to convert their capital into, and then jump in front of that train and ride the asset revaluation uptrend. It is important to distinguish between fundamental price revaluations and asset price bubbles. The difference between the two is the price relative to the underlying economic value generated by the asset. (i.e. the "pe ratio")
   
   
2. Assets that grow economic value add. Investors can also profit by owning assets that continue to increase the amount of real economic value generated over the years. In other words, owning profitable businesses that have a growth path ahead of them.
   
   
3. Betting on events. Another way investors profit is by spotting mis-priced bets. This does require a fair degree of understanding of the environment and parameters underlying the bet, and an appreciation for managing bets. Example of such bets include betting on the weather (which is what P&C insurance underwriters do), and betting on the direction of interest rates.
   

In the environment that we have for 2010 and beyond, we are likely the face the following parameters for each of these categories of profit-making opportunities:

(A) Capital / Asset preferences
Although there are similarities in the economic backdrop between now and the 1970s, the key difference is that in the 1970s, government was perceived to be functioning better than businesses. Businesses could not keep up with inflation and in some cases were seen as the cause of inflation, whereas the government was seen as an entity that had heft and was attempting to fix problems. It is debatable whether government fixed or created more problems, but the key is that the perception was that government was more a positive force relative to businesses. The backdrop of the cold war and the competing economic philosophies probably had a big influence on this perception. In contrast, the government today is thought of as being in trouble. There is pervasive awareness of the government's debt and under-funded obligations. In contrast, businesses are perceived in a better light, influenced in large part by the positive view of business and capitalism in general from the 1980s onwards, especially after the cold war ended. This makes it probable that investors will not abandon equities en-masse in exchange for government bonds or cash. Their attractiveness is likely to be muted as the people grow more wary of the risk of government default (explicit or implicit via inflation).

Real estate, which would ordinarily be a good inflation hedge, is unlikely to reclaim its role as a store of value because there is a dramatic oversupply of housing stock / commercial space built during the bubble years.

Commodities, another traditional inflation hedge, also face demand softness as the major economies slow down. Unless there is a supply constriction or intensive speculative activity, it is probable that commodity prices will not rise dramatically. (Though it should be noted that prior to 2005, commodities were hitting their lowest prices in decades. So some upwards movement in price, as has happened recently, is to be expected to get back in line with economic fundamentals.)

On the whole, it is probably that no asset class is going to be fundamentally more attractive than the others. Hence it it probable that we will not see a dramatic reallocation of capital between asset classes. (There may be a dramatic reallocation of capital between geographies, but that is a separate discussion.) The soft economy, oversupply of real estate, and "not-cheap" equities also makes it likely that the returns on capital will mediocre for investors in the coming years.


(B) Businesses with growing real economic value add.
One of the perennial investing opportunities is to buy companies whose real economic value add continues to grow over the long term. In other words, companies with sustainable competitive advantages that are taking business away from their competitors and/or riding a mega-trend brought about by changes in fashion, demographics or technology. There are a few key mega-trends that will continue into the next decade or so, which we should pay attention to:

1. Globalization and Economic Development through the adoption of capitalism:
   
   (a) Developing countries are improving their incomes and standard of living, potentially benefiting consumer goods companies and infrastructure companies.
   
   (b) Countries across the world continue to mature their financial systems to allow savings to be channeled into investments in a rule based manner. In most developing countries, large conglomerates thrive at the expense of free competition from smaller/upstart players. In some cases this is due to political connections, but often also because it is difficult for small companies to raise capital to compete. This tends to allow established companies to continue dominating simply because they have access to capital. Maturing financial systems removes the opacity and fund raising obstacles in these countries, and provides growth opportunities for financial services companies.
   
   
2. Electronification of payments; Payments are increasingly becoming electronic, benefiting credit card companies, to the detriment of check and cash handling companies.
   
   
3. The Internet; The information revolution continues unabated, and is continuing to remake the landscape for media companies. It also continues to allow e-commerce companies like Amazon, and information companies like Google to thrive and grow.
   
   
4. Globalization and uniformity of lifestyles. The living experience of people across the globe is becoming increasingly uniform. The information revolution and the way our lives are shaped by universal technologies account for this. A successful concept in one country stands a much better chance of working across the globe today: witness the pervasiveness of Starbucks, mall culture, supermarkets, FMCG products, and so on. Travel to any country in the world today, and you will find a stunning similarity in the consumer experience. Of course local differences have not disappeared completely. Tastes in food and fashion still differ from country to country. For example, Cadbury type chocolate has carried less well in United States, and Hershey type chocolates have found it tough going in many foreign markets. In today's world, a middle class professional in one country is likely to have more in common with a middle class professional in another country, than with his fellow citizens in a different socio-economic strata.
   
   
5. Demographic wave of change - Many countries are aging. This demographic change is made worse in countries like the US by the government's crushing debt and under funded pension and medical benefits plans.
   

For investors, the key is to invest in companies with sustainable competitive advantages and to find companies with growth possibilities (by riding megatrends or by taking share from competitors).



(C) Betting on Events.

In many areas, the way a large number of events work out is predictable once a sample size is large enough. The insurance industry is founded on this basis. Underwriters make bets on the number of bank robberies in a country, the mortality rate of the population, and so on. P&C insurers even make bets on the weather, for example whether a hurricane is likely to strike an area in a given year.

Sometimes the odds on such bets are good relative to the price of the bet. These mis-priced bets afford an investor the chance to make some money, provided a large enough number of these events can be bet on. The trick is usually finding a large number of mis-priced bets. If you only have one or two instances of the event to bet on, then the law of large numbers that makes the outcome predictable isn't working for you, and you'd be taking a gamble more than an qualified bet.

Another opportunity for betting is when a single event is so extreme that it is an outlier event. In such cases, you only need one event to bet on, because the probability of the bet working out your way is relatively high. Betting on an outlier event is like betting on the movement of a basketball player when he is at the edge of the court. It's a reasonably good bet that he is going to move away from the edge. The number of movement possibilities is reduced, making a bet easier to set up. In contrast, betting on the basketball player's movements when he is in the middle of the court is more like betting on the basis of large numbers. You may know that over a season he is statistically going to move to the right 53% of the time. But it's much less predictable where he is going to go when he is in the middle of the court at a particular time in a particular game.

One key type of outlier event is asset prices, because asset prices tend to revert to a certain mean PE ratio over time. However it is important to be aware that asset price outliers can persist for a very long time. Stocks were at generational lows for more than two decades around the 40s and 50s. Similarly. between 1980 and today, stock prices have generally been raising their average PE value beyond what people in earlier generations would have considered sensible. Asset prices are determined by what other people are willing to pay for it, and people can keep prices up or down for much longer than an individual's investment horizon. So sometimes, it can pay to play outlier event as it continues its way up or down.

The only gradients which as a rule of thumb are better avoided are those that rise incredibly quickly. It is the fact that a collective mania has taken place that drives the speed of the ascent, and it is because the human condition makes collective manias tend to dissipate as quickly as they come, that makes these outliers revert to mean quickly. In other words, they are bubbles waiting to pop. Slowly growing bubbles are more like a cultural conscious that both inflates and deflates slowly, sometimes almost imperceptibly.

Unfortunately there are not many outliers in today's environment. Stock prices are neither cheap nor excessively expensive. The economy's direction is likely to go either way. The huge worldwide government intervention in economies has dampened the natural correction that should have taken place. Instead of a near certain shrinking of economic activity and recessionary consumer psychology, we now have an middle of the road situation where future economic growth or contraction become equally likely possibilities. This makes it difficult to find outlier bets in asset prices.

The only data point that I have seen that is now approaching outlier status is the interest rate. Interest rates are near zero, and they cannot go below that. Though as Japan has shown in practice, they can remain at zero for a very long time.

However, we must beware of "false outliers". A very good example is the government debt, which by all accounts is at a record percentage of the GDP in many developed countries. Government debt is not at an outlier, contrary to common belief. The debt can continue to grow as long as there are people willing to fund it (buy government bonds). New debt can be issued to pay off old debt, and the merry go round goes on as long as people allow it to. As long as people believe the borrower's best days are ahead of it, the circus can continue. The takeaway is that we need to carefully distinguish a true outlier (which has mean reverting tendencies) to record breaking feats, whose records can continue to be broken in successive years.

Investment Themes for 2010

Given this backdrop, what are our investment themes for 2010?
They are:

(1) Look for inflation beating companies. Returns on all asset classes are likely to be muted in the coming years. We will be looking for inflation hedges, with inflation beating companies being prime candidates.

(2) Prepare for asset price declines. The probability is that the equity markets will become cheaper in the near to medium term. So avoid chasing market momentum, and be especially careful of panic buying.

(3) Take outlier bets when the opportunity arises. We can opportunistically bet on outliers when the odds are in our favor. The closest one that is visible on the horizon is interest rates.

The Nature of Money (How money works) in the Economy

The role of money and its impact on the economy is often misunderstood. Many ideas about money today are based on a pre-1960s world-view where money was gold-based. They treat money as a secondary variable to underlying economic forces, equating it to the motor oil that lubricates the economic engine. This view is no longer accurate in today's fiat-money capitalist economies where free flowing capital takes on a life of its own and can drive changes in the underlying economy. This is a reality that a dogmatic Monetarist or Keynesian approach to looking at the economy would miss.

In this post, I describe (my view of) the interrelationship between money, capital and the underlying economy, and how it investors can use this to form a macro-framework for their investment theses.

What is Money / How does something become money

Money is any item that can be offered to induce another person to do work for you, or give you something that he has worked for. In other words, money is the means by which we induce each other to economic activity. It does this in two ways: (1) It functions as a medium of exchange, as a means to induce each other to economic activity, and (2) as a store of value - when stored aside, it represents the ability to induce future economic activity when desired.

In other words, anything that has the following properties can become money: (a) it can be owned, (b) it can be exchanged, and (c) is desired by at least some group of people, is a form of money. In other words, money is more than just the paper currency which we are familiar with. Government issued currency is universal money because it is accepted by everyone, because everyone is willing to work (i.e. carry out economic activity) to get it. Other money, such as rewards points and physical assets like houses, are only accepted by smaller groups because not everyone is willing to be induced to work for it.

The types of items that can be used as money largely depends on society's legal and financial framework. A framework that allows assets such as houses, to have its ownership rights passed between individuals, to be subdivided, and to have agreements on the asset enforced, allow those items to take on the role of money among people who value the item. In countries without reliable property rights and contract enforcement, money tends to be restricted to physical things that can be carried around.

It is important to realize that money is not just the currency. In today's economy, there are broadly 2 types of money:

1. Central bank issued currency - what we colloquially refer to as money or currency.
   
   
2. Tangible items that are manufactured or extracted from nature - gold, silver, diamonds, seashells, land, houses, cars, antique art, companies etc.

In any economy, people will choose between different types of money to use to store wealth and for buying and selling. The choice of which type of money to convert a person's wealth to depends on a myriad of factors: the expectation that a money type will increase or decrease in its ability to induce others to work, the acceptability of the money to people whose work is required by the holder of the money, and the durability of that money.

The value of a unit of money is the amount of work that it can induce others to perform to get it. In other words, the value of a unit of money depends on the value your intended counterpart places on the money, which depends on what utility he can get out of the money. This utility typically falls into two categories: (1) the amount of work he can induce others to do in exchange for it, and (2) the natural utility produced by the item serving as money. Currency money's value is entirely dependent on the former, except in the case of collectors who may value paper currency strictly for its physical design. For most types of assets (tangible item money), both come into play. Though the utility of the item usually imposes a "floor" on the value of the money. For example, a house has as a minimum utility, the shelter and living condition it provides.

Money is created and destroyed in two ways:

1. It is manufactured. Tangible item money, such as gold or houses, is created when the items are extracted from the ground or manufactured. Fiat currency money can be created simply by the Federal Reserve creating money out of thin air and depositing into the accounts that banks maintain with the Federal Reserve (In practice, it usually does this in exchange for some non-monetary collateral, such as securities, that the bank pledges to the federal reserve). Alternatively the Federal Reserve can simply buy up Treasury issued bonds. Similarly, the Federal Reserve can create money by giving foreigners dollars in exchange for foreign currency.
   
   
2. IOUs of the money that arise from borrowing/lending are treated like the underlying money. Money is created when the borrower issues IOUs which can function the same way as the underlying money, meaning it can (a) be exchanged for goods and services (i.e. to directly induce others to work) and/or (b) if it can be used as a store of value. This relies on people trusting that they can call in the IOU anytime. For example, if the IOUs can be exchanged for goods and services, then it is effectively a form of money. The total amount of money that is circulating in the economy then becomes the money that was borrowed (and presumably spent, inducing others to work for it), and the IOUs which are being passed around in exchange for economic activity. If a borrower's IOUs cannot be traded for goods and services, then money is not created because the IOU is unable to induce economic activity. The amount of currency that can induce economic activity will not have changed. The money that used to be in the hands of the lender has been transfered to the hands of the borrower.
   
   For example, if I borrow 20 apples from you and give you an IOU, and you can trade this IOU to another person for some services, then there are 40"apples" running around in the economy that can induce work. (The 20 physical apples I borrowed, and the IOU for 20 apples which you are using). This is the primary mechanism by which fiat money is created, and is also known as the money multiplier effect. The fiat money case is special because fractional reserve banking allows the IOUs (e.g. loan agreements by borrowers) to be treated exactly like cash, allowing the deposits to appear to still be there. (In effect, the IOUs are the deposits in the bank, and accounting rules allow them to be treated as cash, not IOUs). Changes in bank reserve requirements also create or destroy money by affecting the amount of lending/borrowing that can be done.

It is important to understand the nature of money

because it affects the underlying economy

It is important to understand the characteristics of money, because changes in people's preference for storing wealth, or in using one money over another can affect the underlying economy. Interest rates, asset yields, capital appreciation expectations are not just a reflection of the state of the economy; they can actually drive changes in the underlying economy.

(1) Central Bank Currency Money

By virtue of its universal acceptance, central bank issued currency is backed not by the productiveness of one asset (e.g. a house can induce people to work for it only insofar as the living condition it provides) but rather its value is backed by the productive capacity of the entire population / economy.

Because it is universally accepted, it has the special role of being the form of money that we use to measure the value of economic activity. For example, it is difficult to measure the value of a house in Vermont in terms of bottles of apple cider, simply because the people who love apple cider may not be interested in that Vermont house. But it is easier to say a house in Vermont is worth 1 million dollars, which is perhaps equivalent to the services of a doctor to perform 10 surgical operations, or 5 years of legal services, because everyone is willing to be induced by central bank currency because it is ultimately acceptable to the government for tax payments. Without universal currency, we would be back tot he world of barter trade, where the value of a good has to be expressed in the form of another good.

Because central bank currency is universal currency, and because we measure value with it, it alone serves as the measure by which economic decisions are made. Hence things that affect currency money can affect the underlying function of the economy. It affects how we decide to allocate society's resources, and affects decisions on if and how to create productive capacity in the economy.

The value of currency money is preserved if new dollars are created only when new productive capacity is created in the economy, and destroyed when productive capacity is reduced. Changes in the ambient velocity of money, arising from habits and economic structure, need to be factored into the overall money supply estimation. This means that the value of currency money depends on how its creation is handled:

1. Currency Money created through borrowing/lending. The value of money depends on the ability of economic actors to use borrowed money to create productive capacity. When money is lent to finance the creation of productive capacity, if the productive capacity is successfully created, then the loan can be repaid using the income from the productive capacity. This is also why the banking system should only lend money on the basis of income of the borrowers, or the income that the asset being financed can generate. The banking system should never lend money on the basis of the market value of the asset being financed. The guardians of this are (1) the lending decisions of the banking system and (2) any borrower who can issue tradeable IOUs which can be used as a store of value and medium of exchange. Money has the primary functions of being a store of value, and a derived function as a medium of exchange. Money is created through: debt borrowing / credit extension, provided the borrower's debt is tradeable and hence can be both a store of value and a medium of exchange. The corollary is that the monetary base at all times is seen both as savings and as debt, which means that debt will grow in line with the economy. What is important is that it does not grow as a % of the economy.
   
   Money is destroyed when borrowers cannot repay their loans, because the loans are written off and shareholder's equity is lost (effectively shareholder's funds are transferred to depositors to keep them whole). The money in shareholder's equity is destroyed to compensate for the money that was given to the borrower, which the borrower was not able to use to create productive capacity. (Had productive capacity been created, income would have been generated to repay the loan). However, at the banking system level, this has the effect of reducing the banking system's ability to lend, because of reserve requirements. Hence to a certain extent, bad lending decisions affect the economy as a whole. Premium based federal deposit insurance (such as the one run by the FDIC) makes this mechanism work by transferring equity from sound banks to those that have made bad lending decisions. However, deposit insurance in the form of government guarantees and actions to prop up a banking system that made bad lending decisions by printing money and putting money onto the banking system's balance sheets (i.e. "investing in them") will debase the currency, because it prevents the money destruction needed to reflect the fact that the earlier lending (money supply increase) did not increase productive capacity.
   
   Sidebar: Non-fractional reserve deposit taking institutions generally do not create money. They may offer loans (funded by shareholder equity) which allow an asset owner to monetize an asset for a short while. This does no result in the direct creation of money in a big way. Take a pawnshop as an example. The pawnshop is essentially providing a "sell first with option to buy back later" arrangement for the borrower. The borrower "sells the item" to the pawnshop, with the option to buy it back within a certain time frame, failing which the pawnshop can sell the item to cover a non-redemption. The entire flow of money is simply a set of transfer payments (transfer of ownership of currency money) in the economy. This doesn't mean such loans are not helpful to the economy. They can increase the ability of economic actors to increase production, by allowing asset owners to more easily borrow money to invest in new business ventures (i.e. another channel for savers to get their money into the hands of people who can create productive capacity).
   
   
2. Currency Money created by Central Bank domestically. The value of the money depends on the ability of the Federal Reserve to exercise good judgment, and only create new money when economic productive capacity has increased (and vice versa). This is why qualitative judgement, the interpretation of economic statistics to discern the true productive capacity of the economy, and political independence are necessary for central banks.
   
   The biggest threat to preserving currency value in modern political economy is the issuance of debt by the government which is funded by the central bank printing money (i.e. the central bank buys the government's debt). If this borrowing is used to fund productive capacity in the economy, then the value of the currency will be preserved. However if the borrowing is used to fund consumption, wars, or other activities that do not increase productive capacity, then the money will be debased. If the central bank sterilizes the borrowed amount by destroying an equivalent amount of money, then the value of the currency can be preserved. Likewise, there is no problem if the government repays the loan from the central bank through taxation, because the process will transfer money out of the economy and back into the central bank to offset the initial issue. In other words, money is taken off the market and destroyed. The problem is when the government does not repay, and the central bank does not sterilize (possibly because it wants to avoid reducing the money supply available to the economy).
   
   
3. Currency Money created by Central Bank through foreign currency operations. The value of money also depends on the judgment of the Central Bank to manage the money supply when it accepts foreign currencies from foreign companies and creates new dollars to give to them. Foreign companies then use it to buy goods and services from the domestic economy. (i.e. a net basis, more foreigners want to buy the country's products, leading to a trade surplus). When there is a trade surplus, new domestic currency has been created out of thin air, and foreign currency reserves have increased. Hence trade surplus countries by definition, have a glut of currency money in their economy which the financial system needs to channel into productive capacity creation. For the trade surplus country's currency to hold its value, either the private sector needs to be using it to induce the creation of productive capacity, or the central bank needs to sterilize the additional money (for example through reserve ratio adjustments, or by issuing bonds and borrowing money from citizens in exchange for non-tradeable IOUs).
   
   In contrast, the country with the trade deficit now has fewer dollars in its domestic economy. There is no actual change in the quantity of domestic currency (provided it was private companies that sold domestic currency to the foreign central bank). The only that has changed is the ownership of some domestic currency has changed from being locally owner to being owned by foreigners.
   By virtue of the fact that the trade between the two countries took place, it means that the trade surplus country's central bank (or private sector) was willing to take foreign currency in exchange for products produced domestically. In other words, the trade surplus country has demand for the trade deficit's country's currency money as a means of storing value. When there is a net trade deficit/surplus between two countries, what has happened is that on a net basis, the one whose products are in demand is trading with the one whose currency is in demand as a store of wealth.
   
   A corollary of this is that there is no self-correcting mechanism for trade surpluses/trade deficits in a fiat money economic systems. Trade deficits and surpluses were self correcting in a gold-standard monetary system, but are not self correcting with production backed country-level fiat-money systems. The demand for a nation's currency money can allow trade deficits to run continuously, until the demand for the currency tapers off. Hence, there is also no "natural equilibrium" exchange rate for currencies. The only trading bands that currency exchange rates will stay within are the the rates which cause Purchasing Power Parity disparities to become untenable. For example, the exchange rate at which foreigners can buy your products so much cheaper than elsewhere, is likely a rate below which the currency will not fall. Because if it did (and assuming you had the capacity to produce the products, and the product value add is largely domestic), the flood of exports from the domestic economy would create a much larger demand for your products than your currency, and reverse the direction of currency movement (and net trade flows).

(2) Tangible Items used as Money

What underlies the value of tangible item money

There are two components to the value of a tangible item that has monetary characteristics:

1. Utility Value. If the tangible item produces some tangible value, then the value of the item can be thought of as a multiple of the tangible value. For example, a house provides living space and its location and condition contributes to a certain lifestyle. This "living value" places a lower bound on the amount of work that a person is willing to do in exchange for the house.
   
   The value of course also depends on the supply of the tangible item relative to the people's demand for it. For example, if there are more good houses than there are people in the population, then it is conceivable that many houses will be worth near nothing.
   
   
2. What other people (whose work you want to induce) think of it value. The fundamental value of tangible item money lies in the minds of people. It depends on how much work a person is willing to do in exchange for getting the item. In other words, the value of the money lies simply in what other people think it's worth. If the item produces no tangible value, then it's value solely lies in what people think other people will give up for it. Sometimes what people think other people think the item is worth (how much work they will do for it) depends on the perceived scarcity of the item.

Most items have value from both counts. For example, antique art is largely "what other people will pay for it"value, but it also has enjoyment value. In most cases, the are outbound markers that mark the outer limits of how people will think of its worth, are based on the utility value, relative the supply and demand situation.

How Monetary Preferences (Asset inflation / Asset deflation) affect the economy

In a modern economy with specialization of labor, people make economic activity and resource allocation decisions with the objective of creating economic value, which is represented as money, so that they can use this wealth to induce a host of other people to perform economic activity that in combination will improve their lives. When people's perception of the value of a money changes, or when people's expectation of its future value changes, it affects their economic decisions. This is how monetary phenomena affects the economy's structure and the amount of economic activity on the existing economic structure.

1. People switch from preferring to hold currency money to preferring to hold asset money (Asset price inflation) - causing resource misallocation, and long term devaluation of currency money. Capital and asset markets make its easy for people to trade one type of money for the other. People generally choose the type of money to hold based on their expectations of the value of that money over time. This comes from both inflation/deflation expectations, and also market psychology. A market where asset prices are constantly rising can induce market mob psychology, and build in asset price growth expectations. An economy where faith in currency money or government has deteriorated can build expectations that currency money will not be able to hold its value over time. Often these decisions are expressed in daily parlance as the need to invest for capital preservation, of to invest for capital growth and returns, or simply a place to squirrel away one's retirement savings.
   
   When more people start preferring to hold asset money, the price of asset money in terms of currency money rises. People holding currency money are more and more willing to give up more of their currency money for smaller and smaller amounts of asset money. People trade money with one another, exchanging ownership of money. In the short run, the total amount of currency money and asset money in the economy stays constant. But there are more and larger transfers of ownership of currency money between parties reflecting the increasing prices of asset money being traded for. In the medium term, our propensity to make economic decisions based on currency money indications of value means that economic decisions will be made to create more the assets being used as money (for example houses or gold). This can create a misallocation of resources if the economy fundamentally does not need so much of those items. For example, the rising housing prices may suggest strong demand for houses, which could cause overbuilding because the underlying population may not be big enough to need all the newly built houses. (If you think houses are always useful, have a look at cities like Buffalo, Detroit or parts of Germany where the population is thinning out). This misallocation of resources fundamentally means the loans taken out to build the houses (money created) did not go to creating productive capacity (living space) that was actually needed by the people in the economy. This means the currency money has the potential to be devalued, if money is created to "write-off" the bad loans. It also presents the likelihood that economic activity will be constrained as the banking sector reduces its lending owing to capital destruction caused by loan writeoffs.
   
   Rising asset prices can also affect individuals' perceived financial savings. They perceive they have more wealth, and so save less income each month. The result is that economic savings (actual saving of monthly income) declines, which reduces the economy's capital formation and future productive capacity.
   
   A key force that tends to prick asset price bubbles is that as prices and trading volume go up, there comes a point where the transfers of ownership of currency money between asset buyers and sellers becomes so large that there are simply not enough people who own enough currency money left to trade at the prices being asked for. In other words, as asset prices go up, the herd of people who can buy and sell starts to thin out. Market crashes occur when everyone tries to sell at once - there simply isn't enough underlying money to transfer between parties to match the volume of all the shares, even if there are willing buyers in theory. For example, if market capitalization is 15 trillion, and money supply in cash accounts is only 5 trillion, then if all stock holders want to sell at one shot, there simply isn't enough money to transfer to them to buy it. So a price crash occurs. Corollary: The corollary is that as asset prices increase and trading volume increases, the velocity of money increases while the quantity stays constant, until there simply isn't enough money anymore. The duration of this phase can be extended if buyers start taking out loans (debt=credit) to buy the assets, then overall money supply increases. But this only lasts until the maximum debt-to-income ratio is reached, then the bubble will also pop. Unless it kicks into 3rd gear, when people start lending on the basis of asset prices instead of income. This can last a long time. But fundamentally is inflationary because the dollars are now not backed by productive capacity.
   
   This is one reason why it is useful to watch trading volume in market, once the market capitalization starts getting close to or exceeds the M1/M2 money supply, to see if an asset price bubble is running out of steam. Naturally bubbles can be given a boost if banks start lending to buyers on the basis of expected prices of assets instead of the income of borrowers. This boosts the asset price bubble, and also makes its aftermath worse, as the amount of misallocation of resources becomes much higher and a much larger amount of money destruction is needed to preserve the value of the currency money.
   
   
   
2. People switch from preferring to hold asset currency money to preferring to hold currency money (Asset price deflation) - causing asset price deflation and reduction in gross capital formation in the economy. Conversely, when people have expectations that asset prices (measured in currency money) are falling, they may start preferring to hold currency money instead of asset money. As more people are willing to give up their ownership of asset money in exchange for currency money that the other way around, the prices of assets will drop. The ownership of both currency and asset money changes hands, with transfers of currency money ownership becoming smaller and smaller in quantity.There is no natural stop to this downward cycle, as eventually the ownership transfers of currency money drops to a negligible level. In the short run, no currency money or assets are destroyed, unless the asset price bubble also involved banks lending on the basis of rising asset prices, and the inability of borrowers to repay loans leads to a destruction of currency money.
   However, in the long run, continuing expectations that asset prices will continue dropping will lead to a reduction in investments in creating assets. People can continue to save their income whilst the economy as a whole reduces its borrowing. In economic terms, economic savings still equals economic investment. However, the economic investment can take place out of the country owing to financial flows. It manifests as monetary savings that continue to increase, but not translate into monetary borrowing. Instead, monetary savings is held in currency money of foreign countries. (This is a probably what is happening in Japan today)
   
   This can reduce the economy's productive capacity, insofar as these assets are capital goods. People may also stop borrowing money to create capital assets, thus preventing money supply growth, which could induce consumption good price deflation. The only natural force that can stop this cycle is if the population is fundamentally growing and the legal and financial framework allows these people to demand and work for more consumption goods. This can manifest itself in rising consumption goods prices, which in turn, will make the return on assets higher and induce economic investment in capital assets, breaking the asset deflation. (Japan's difficulty is that its population is in decline)

This misallocation of resources caused by changing monetary preferences is probably a part of the economic tempo, caused by the way people relate to money (as a store of value and medium of exchange) and the nature of the way human psychology responds to markets. The way the human mind works in a market environment has not changed over the last 5,000 years. This makes it probable that this economic misallocation behavior occurs like a harmonic wave, with peaks and troughs that occur in each generation whose lives are shaped by large shared experiences.

The takeaway for investors

The takeaway for investors is that economic statistics can mean very little when making macro level analysis of foreign country investments. Trade deficits or negative net international investment positions can persist for extended periods of time. Asset price levels in each country can also change beyond what appears to be levels that can be supported by national income.

The underlying zeitgeist and expectations of people play a large role in sustaining asset price directions, which can in turn affect the underlying economy in ways that support the nominal price increases. To a certain extent, profiting from "secular" changes general asset price levels depends on the ability to identify turning points in the zeitgeist and the expectations harmonic wave.

The key idea is that Money is alive. Changing expectations of its value and changing preferences for different types of money, will drive economic activity in different directions. This is especially relevant in today's world of free capital markets, and improving legal frameworks that allow more and more assets to become capitalized and take on the role of money. In scientific parlance, money is no longer just the dependent variable in the economy. It is often the independent variable in the economic system.

How General Inflation and Deflation affect the economy

General inflation and deflation are monetary phenomena caused by changes in money supply relative to underlying production. They affect both consumption good prices and asset prices, and tend to have different effects in the economy.

1. General inflation. Inflation happens when there is a general increase in prices of all goods and services across the board. (This is different from spikes in prices for certain goods caused by supply and demand imbalances). Orthodox economic thought says that this happens when
   
   (a) the quantity of money increases - caused by animal spirits driving people to borrow to the full extent, thus increasing money supply through the money multiplier effect and through central bank printing money into the banking system, and/or
   
   (b) the velocity of money increases - this happens when animal spirits drives people to trade more frequently, increasing the number of times a dollar changes hands. This could also be because people expect inflation to accelerate, and so opt to use their currency money as a medium of exchange to buy assets instead of as a store of value.
   
   
2. General Deflation. Deflation happens when the reverse occurs.

Inflation and deflation, especially when they are unpredictable, cause damage to the economic system because it makes it difficult for people to make economic decisions. Inflation makes it difficult to invest in creating productive capacity, since the cost of production and the prices which produce can fetch over the life of the production (factory etc) become hard to predict. Inflation also makes it better to be a borrower than a lender, since debts are denominated in nominal sums, and inflation makes it cheaper to pay back future dollars. This can accelerate the borrowing in the economy, which further increases money supply. This can lead to spiraling inflation. It should be pointed out though, that countries like Brazil have managed to grow their economies even with sustained levels of inflation. The key though is that inflation rates while high, they were felt to be predictable.

The takeaway for investors in cases of inflation is that a company's financials need to be examined relative to the general inflation level. Through the early 2000's for example, many Brazilian companies showed 10-20% annual growth in revenue. This was considerably less impressive than it appeared, because much of the gain was purely inflation driven.

Deflation on the other hand, damages the economy by inducing consumption hold-backs, which reduces economic activity. It also increases the burden of borrowers over time, and can lead to social instability because of the stresses it creates in society. For investors, the impact is that deflation can reduce overall economic activity, and affect the general business climate.

Analyzing oil companies - The economics of the energy, commodity and materials business, and valuation traps

One school of thought is that investing in commodity-processing/resource-owning companies, such as oil majors like XOM, RDS, BP and CVX, and pulp and paper companies like Votorantim Celulose e Papel (NYSE ADR: VCP), is a good way to preserve wealth during periods of elevated inflation. The underlying hypothesis is that the price of commodities will rise in line with the general price level, allowing them to grow their profits in line with inflation.

However as with all investments, it is crucial not to overpay for a stream of earnings or you will end up with negative real returns. We'll look at one way of analyzing and valuing a commodity-processor/resource-owning company's earnings quality. We'll also see why in some cases we are better off buying commodities directly.

The economics of Commodity producing businesses

- they are price takers

Because their products are seen as commodities, customers have no particular reason to pay significantly more for a product from one company over another. In many cases, it is also relatively easy for customers to switch suppliers. This means that commodity sellers are price takers who cannot sell their product for more than the market-clearing price. The implication is that:

1. The strongest company is the one with the lowest cost of production and cash reserves. One of the worst things that can happen to a commodity company is if the market price for the commodity drops below its cost of production, making it lose money every day it stays in business. (While hedging can ameliorate this, it is only a short term solution) So well-funded companies with the lowest cost of production will have the most sustainable competitive position; if prices drop, the lowest cost company will be able to run with the lowest losses until all other competitors go broke and withdraw capacity from the market, allowing prices to rise to a profitable level.
   
   
2. They are vulnerable to price-irrational competitors. A competitor that decides to sell product below cost could drive the company out of business. This is a particular risk in "essential commodity industries, as governments may run loss-making state-owned competitors for political reasons. This is also a risk if the industry requires large amounts of fixed capital to operate, because ailing competitors may resort to flooding the market with product just to cover some part of their fixed costs (ie. manufacture as much as possible, as long as variable production costs are covered).

Durability of competitive position

- Factors affecting Earnings stream quality

Because they are price takers with an undifferentiated product, they have a durable earnings stream only when (a) the environment minimizes chances of prices falling below their operating costs, and (b) in the event that occurs, they are the best positioned to weather the down period until prices recover.

Industry reports and published financial statements can give you an indication of which companies are the most competitive, and have low production costs. The leading companies typically achieve their competitive position by (1) having economies of scale, (2) acquiring commodity reserves with lowest costs of production, and (3) applying operational efficiency and technology to minimize production and overhead costs. Unless there are disruptive events, it is likely that the leading companies will retain their competitive positions over the short term. However, the long-term durability of their earnings stream depends on 2 principal factors:

(1) The probability of price-irrational competitors emerging (such as government funded competitors). This depends on:

1. the geo-political environment: For commodities that are considered strategic assets, there is always the possibility that interventionist governments may setup state-funded not-for-profit competitiors. States with resource reserves are especially good candidates for this. The probability of this happening is balanced by the existance of trade barriers and trade agreements which can prevent dumping of commodities into foreign markets.
   
   
2. the cost structure of existing competitors. Competitors that are heavily in-debt and/or have high overheads may flood the market with product, just to cover some part of their fixed overhead costs/debt servicing. They can price product below true (fixed+variable) costs over the short run, just to meet cash flow needs.

(2) the probability that an upstart competitor can achieve lower costs of production. This depends on:

1. The components of the cost of production. For example, the bulk of the cost of steel production lies in the cost of energy needed to run furnaces. So a competitor could achieve lower costs of production if it managed to find a cheaper source of power, for example by erecting a new dam for cheap hydroelectric power. You would need to analyze the probability of this happening to estimate the earnings quality of a commodity company. Likewise a pulp and paper company's costs could predominatly be in forestry costs, so a competitor who could open up cheap forestry landbanks (because of climate change or changes in government rules) could gain a competitive edge.
   
   
2. Commodity re-cyclablity. Recyclable commodities like gold present the possiblity of a recycler finding a way (through technology, or finding an untapped source or cheap recycled gold) to produce re-cycled commodity at a lower price than extracting it out of the ground. For example in the gold market, it is conceivable that gold prices can fall below the cost of production of even the lowest cost miner, because there is a huge supply of gold which is already in the hands of consumers. Because gold is indestructible, there is always the possiblity that existing consumers may flood the market with their gold, and depress the market price of gold below it cost of extraction from the ground.
   
   
3. Probability of changes in the company's competitive sphere. The "competitive sphere" is the range of competitors who can serve the customers that the company is serving, and it varies according to the nature of the commodity. For example, a perishable commodity like fresh milk has a local competitive sphere (as long as customers aren't open to ESL milk or UHT milk which can be supplied from thousands of miles away e.g. by Fonterra in New Zealand). Competitive spheres can change with technology. For example, natural gas used to be a local product which could only be transported along a pipeline to nearby consumers. However, with technology advances and the build up of LNG processing facilities worldwide, natural gas can now be converted into LNG and shipped anywhere across the world, making its competitive sphere a global one. The lowest cost producer in a particular region might find itself displaced from the lowest cost position when compared with producers across the globe.
   
   
4. The Company's ability to keep acquiring lowest cost reserves. Resource owning companies constantly need to find new resource reserves to replenish reserves depleted by production. Otherwise the company will be operating in run-off mode, and will cease operations once its existing resource reserves are depleted. If the company is unable to find reserves with low extraction costs, or a competitor finds a motherlode of easy to extract reserves, then its future competitive position and earnings quality will deteriorate.
   

Valuing commodity/resource companies

- buying commodities, instead of resource companies, may be a lower risk way for investors to preserve wealth

To a long term owner looking at a company as an income producing asset, the valuation of any company is based on the present value of the expected stream of earnings which the owners can take out of the company. (We exclude earnings which need to be retained in the company, since they are needed to keep the goose alive to continue laying its golden eggs)

To arrive at a risk-weighted estimate for the future earnings stream, we need to combine all of the following:

1. the earnings that will flow from its current commodity reserves
   
   
2. the risks to those earnings, arising from changes to its competitive position (costs relative to its competitors) and the likelihood of non-economic competitors
   
   
3. the ability of the company to continue adding to its resource reserves without changing its costs of production relative to its competitors

In the short run the company's earnings will likely grow in line with inflation (assuming it also drives commodity price rises), because the company's costs of production (reserve extraction costs and reserve acquisition costs) are based on yesterday's prices while revenue is based on today's inflated commodity prices.

However over the long run, the ability of resource companies to grow earnings in line with inflation is not a sure thing. In fact, their earnings behavior over the long term is likely to be no different from the average of a basket of companies across industries. Why? Because (a) as inflation sets in, their cost of acquiring reserves and the costs of extraction will also likely go up, and (b) like all companies, they face competitive risks to their earnings. And as we have seen, as commodity producers they can face more earnings risks than non-commodity producers.

So if you are looking to preserve the value of your wealth during inflationary periods, you may be better off investing directly in commodities, if you hold the view that commodity prices will rise in line with inflation. (which is the same premise in the "invest in resource companies" hypothesis)

Valuation traps and mistakes

- particular to commodity/resource companies

One mistake is to value a company by extrapolating its future earning stream from its recent earnings history. Commodity prices tend to be cyclical in nature, because of the oscillating boom-bust feedback loop that develops; increasing production causes prices to drop, which causes production capacity to be withdrawn, which causes prices to go up, and so on. These cycles can span many years, so you need to look at the 10-year earnings history (or longer) to get a feel for the company's earning power.

For resource-owning companies, this approach also ignores the fact that the company's reserves are not infinite and will run out at some point. Management will continue acquiring new resource reserves to keep the company viable as a going concern, and the new reserves' cost of production will determine the company's earnings quality down the road. For example, an oil company with low-cost reserves may have a high quality earnings stream today. But if it cannot replenish its reserves with equally low cost resources, it will gradually slip into a weaker competitive position and become more vulnerable to losses in future. This should reduce the valuation placed on the company.

Another valuation mistake is to take the enterprise value of a commodity company as = the amount of commodity reserves they have, multipled by the prevailing commodity price. (i.e. valuing the company in run-off mode, where the company will cease operations once its existing reserves are depleted). The problem with this approach is that it assumes that it is possible to extract and sell the entire reserves all at once. In practice annual production capacity is limited, so if you want to value the company as a run-off company, you need to base your value calculation on the NPV of each year's production, until all reserves are depleted. (It is not uncommon for resource companies to have only 10-20 years of resource reserves if production rates are maintained.) You may be surprised that the NPV value expressed as a PE ratio can be in the low single digits.

Preserving the International Purchasing Power of your Savings

There are 3 levels of investment success that investors can achieve:
1 - Preserving the real value of their savings (2-3% pa growth)
2 - Grow the value of their savings in real terms (4-7% pa growth)
3 - Become rich through investing (achieving 8+% pa growth)

Many investors are fixated on becoming Level 3 investors, but the reality is that a large number of investors fail to even achieve Level 1 outcomes. They take on risks and leverage subscribing to the "no risk no gain" mantra. Some succeed (sometimes by luck, sometimes through skill), but others end up sustaining losses which set them back permanently.

Investors should figure out how to achieve Level 1 returns before thinking of higher level outcomes. Then when they decide to go for Level 2 and Level 3 outcomes, they will be able to only undertake "risks" that even if things don't work out, will allow them to achieve a minimum of a Level 1 outcome. This is essential, because inflation is here to stay, and is the enemy that every saver faces. There is nothing more tragic than watching the value of your savings slowly disappear before your very eyes.


Inflation, the enemy of savers, is inherent in contemporary political-economy

Why? Because:

1. In an economy where money supply is free to grow (e.g. in a fiat money economy, or even in a gold back monetary system if it is in a period where new gold is constantly being discovered and dug out of the ground), it is practically impossible for cash savings (stored work) to maintain or grow its purchasing power. Why? Because in contemporary economic systems, there are always new claim checks (credit) being created for which work has not yet been done. The fractional reserve banking system always extends credit (i.e. creates money via the money multiplier effect) before the underlying productive capacity is created to back this new money that has been created. In such a system, purchasing power is highest for people creating economic value in the here and now. The purchasing power of unclaimed stored work done in the past (i.e. cash savings) is bound to deteriorate over time.
   
   
2. Further, in fiat money economies with societies where the interests of all sectors of society are represented by politicians facing periodic re-election, political forces and human nature tend to create inflation over the long run. Money creation will like be invoked repeatedly to hide the true cost of government deficits, and smooth over financial losses incurred at various times by different segments of society.
   

This of course, does not mean that deflation will never occur. It can occur over short term periods of monetary destruction, for example when a large number of banks fail because they made bad loans, or when people withdraw their deposits out from the banking system and convert it into cash which they stuff into their mattresses. Deflation can also happen during periods of major changes in the structure of economic production. For example, the adoption of new technologies like the steam engine which cause the cost of individual items to drop and overall productivity to increase, which general keeps wages constant so that people end up consuming a larger overall basket of goods (in a sense, this isn't “true deflation” - rather it is a failure of measurement - i.e. it only looks like deflation because the price level is the only thing we are measuring).


2 Strategies to Preserve purchasing power of Savings
under two types of Inflationary environments

Because inflation is inherent, the challenge for savers is that they need to become investors in order to preserve the purchasing power of their savings. The way to do it is conceptually simple but difficult in practice: hold cash during deflationary periods, and hold assets (whose nominal value grows in-line with the inflation rate) during inflationary periods.

The former is simpler to do: simply convert all assets to cash during deflationary periods. This requires us to identify inflection points between periods of deflation and inflation, which requires us to apply qualitative judgment.

The latter is more challenging: we need to figure out what kinds of assets will hold their real value in inflationary periods. Inflation occurs when the money supply changes are not in line with changes in underlying economic production, by exceeding the amount needed for the upcoming amount of production. (I subscribe to the theory that inflation is a monetary phenomenon. Inflation occurs where there is a sustained rise in the general price level. We are not talking about changes in relative prices which are caused by localized supply/demand changes, or changes in the demand/supply chains arising from technological or structural changes; for example the advent of containerization made it cheaper to import tropical fruits, and reduced the price of exotic produce in supermarkets.)

Investors need to respond differently depending on the environment in which inflation occurs:

1. Money supply increases in excess of increasing population/economic production. In this type of inflationary environment, one of the safest things to do is to hold a share of the profits accruing to the economy's underlying productive capacity. We can do this either by owning a share of all the companies in the economy, or own the land which is required to house the population and capital assets in the economy. This of course, assumes that the land in the economy is limited, and that you are not in a wild-west frontier town where available land is in abundance. (This refers to actual land on which we can create value; not an apartment or some strata-titled portion of a building whose earning power depends on factors beyond its control)
   
   A passive index tracking fund is the easiest way to buy a representative share of all companies in the economy. It saves you the trouble of having to buy shares in individual companies in the economy. (If you did this, you would have an additional problem: some of the companies would inevitably go bust as their products become obsolete. New companies with new products would come up. You would have to constantly rebalance to get the money from your existing investments to buy shares in these new companies. A stock index, by periodically dropping off declining companies and adding in new up-and-coming companies, solves this problem for you. It is roughly equivalent to only holding companies that are in their middle age. Dying companies are sold off as they shrink, but before they go bust, and the proceeds are used to buy shares in up and coming companies which are past their youthful growth and maturing into middle-aged big company status.)
   
   As the economic pie grows bigger, your assets will not just maintain their purchasing power, their purchasing power will actually grow in real terms. The only thing that will destroy this real return is if you either (a) buy the stock index at an unreasonably high a price, or (b) the economy structurally changes and permanently reduces the corporate sector's profits as a percentage of GDP.
   
   
2. Declining population/economic production; with money supply not declining in line with declining production: Investors in such economies face an insurmountable barrier. Holding cash is futile because inflation diminishes its value, while holding a share of the economy's productive capacity would be futile, since economic production continually declines. To see how this works, imagine that the economy is that of an isolated island. If the people on the island are slowing dying out, then the amount of goods that are being produced will also slowly drop. You could hold 100% of all the profits accruing from economic production, and it wouldn’t mean much over time. Likewise, holding a factor of production like land is also futile, unless you can sell it to foreigners looking for a second home. Investors would do best to move their savings to a country where the population is not shrinking.
   
   Even if deflation were occurring in this dying-out island, investors holding cash would only be delaying their day of reckoning. While their cash holdings would enable them to buy more and more of the local produce, the amount of local produce would eventually drop to a level where it falls below the critical mass needed to support the specialization of labor required for many of the complex products in modern living. Unfortunately, this isn't just an academic exercise - there are many countries in the world where the population is already declining (e.g. Japan) or are soon to decline.
   

The corollary of this analysis is that investing in a passive index-tracking fund, often touted as a simple and safe way to invest over the long run, is actually a bet on macro-economic outcomes. Long term investors of such funds are making macro-economic bets, and it is wise to keep in mind that predicting macro-economic trends is a difficult task.


Investors in small countries need to preserve the
International Purchasing Power of their Savings
by Investing Internationally

Investors living in small economies, where the economy is not broad enough to provide all the goods and services desired for modern living, need to invest internationally to preserve the purchasing power of their savings. (For example, if you are living in a small economy which only produces widgets, it's not a good idea to only buy a share of the profits of local productive capacity, unless you're very sure that widgets will continue to be in demand for the next 100 years. Instead, you'll also need to buy a share of the farming capacity of other parts of the world, a share of the economic production of countries which make bricks, computers etc.)

But investing internationally presents another challenge: foreign exchange exposure. How should we think about this?

Currencies will undergo bouts of over and undervaluation, and in practice, it is incredibly difficult to know whether a currency is over or undervalued, and when this will change. There are a lot of variables involved, and over/undervaluation can persist for decades. For example, growing current account deficits in themselves do not necessarily indicate that a currency is overvalued, since in the world of free flowing capital, the desire for a currency as a safe haven can cause this over valuation which in turn causes a current account deficit by making imports "too cheap". A mercantile explanation for currency movements and current account deficits doesn’t capture the reality of the present economic and financial architecture. With free flowing capital, it's difficult to tell if the tail is wagging the dog or vice versa. (Some would even say that it's hard to know which is the dog and which is the tail!)

There are 2 broad strategies that can be employed to preserve the international purchasing power of savings:

1. Buy the profits of every economy. You can buy a share of the profits of the productive capacity of all countries at the same time, so that over time, overvalued and undervalued currencies cancel each other out. This works as long as long as global production continues to grow (i.e. the global economy continues to grow).
   
   
2. Buy the profits of international products/commodities. You can also buy a share of profits of the productive capacity of an internationally used (and internationally traded/shipped) product or commodity. It is important that the product or commodity chosen be one that will continue to be in greater demand over time. For example, you can buy a share of oil production, but you wouldn't buy a share of natural gas production because natural gas tends to be difficult to transport and is often used locally where it is found (at least until the global infrastructure for handling LNG is built up). For internationally transported products and commodities, the price level is constant across the globe, and real (not nominal) producer profits will generally be unaffected by changes in the value of individual currencies.

There will also be situations where a company operating within a foreign country looks undervalued (or an entire corporate sector, e.g. the S&P 500, looks undervalued). The question then is: is the currency of the country of the intended company undervalued or overvalued? If it is overvalued, then any investment there may be a Sisyphean one - when the foreign currency drops from its overvalued position, any gains in foreign currency terms could be negated in international currency terms. For example, buying a share of the electricity production of an island nation that only exports bananas won't help you if bananas experience a permanent drop in value in the global market (perhaps because scientists discover that eating bananas causes premature aging). You'd be a prominent “tycoon” on that little island and the villagers would fete you like a king to keep their electricity supply on, but it wouldn't give you the means to buy cars from Japan, wine from France, a trip to San Francisco, and so on.

Making investments in a foreign country requires a qualitative assessment of the country: its social, legal and economic structure, and its long term economic relevance to the world. You'll also need to determine the probability that the currency is over or undervalued, the forces driving the apparent over/under valuation of its currency, and what will probably cause this to change.

No country is truly self sufficient, so Investors in big countries should also think about preserving International Purchasing Power

There is a case to be made that no country in the world today is truly self sufficient. Given the extensive specialization and division of labor, and large scale of production needed to support the complex products and technologies that we use in daily life, it is entirely possible that our modern standard of living can only be accomplished if all of humanity is involved in its production (so that we can achieve the needed scale of size and specialization). So preserving the international purchasing power of savings may be a concern of all investors, not just those living in seemingly small economies.

When buying assets (to preserve purchasing power of your savings), only buy at a fair/cheap price

This entire discussion presupposes that investors only buy those assets we've discussed when their prices are at fair-value or lower. No matter how intrinsically good an investment is at preserving real purchasing power, buying it at an overpriced level can make it an unprofitable venture. Buying at a fair price is an essential rule for successful investing.

Image by Martin Kingsley, via Wikimedia Commons, licensed under the Creative Commons Attribution 2.0 License

The 2008 Credit Crisis: Causes and Consequences

What is this Credit Crisis about; What's actually happening to the real economy, and how does it affect investors? The roots of the credit crisis have been in the making for several decades.

What's been happening over the last four decades: Credit has been growing as % of GDP

In a fiat-money fractional reserve-banking economy, the supply of money in the banking system broadly correlates with the amount of credit (loans) that have been extended to companies and consumers.  As you can see from the following data, the money supply in the economy relative to GDP has been growing:

1970: M3 USD 0.6 t; Nominal GDP: USD 1.1 t; M3 to GDP: 54.5%
1975: M3 USD 1.0 t; Nominal GDP: USD 1.7 t; M3 to GDP: 58.8%
1980: M3 USD 1.8 t; Nominal GDP: USD 2.9 t; M3 to GDP: 62.1%
1985: M3 USD 3.0 t; Nominal GDP: USD 4.3 t; M3 to GDP: 69.8%
1990: M3 USD 4.0 t; Nominal GDP: USD 5.8 t; M3 to GDP: 69.0%
1995: M3 USD 4.3 t; Nominal GDP: USD 7.5 t; M3 to GDP: 57.3%
2000: M3 USD 6.7 t; Nominal GDP: USD 9.9 t; M3 to GDP: 67.7%
2005: M3 USD 10.1 t; Nominal GDP: USD 12.7 t; M3 to GDP: 79.5%

An increasing amount of credit has been extended by the banking system to economic participants. In a closed system, the credit can represent three things at a systemic level: (1) increased consumption using the credit, which in turn causes increased capital investment to support the increased consumption; (2) increased funding of capital investments by credit to support increasing consumption; or (3) increased prices of real assets and financial assets as the credit is used to purchase assets. 

Leading to Unsustainable trends: (1) building white elephants;  and (2) increasing financial savings while depleting economic savings

The first two in themselves would not be a problem, since increased economic productive capacity provides the basis for economic growth. However, the fact that the proportion of credit to GDP is increasing means that either (a) the structure of the economy is changing to become more capital intensive, where higher levels of capital are required to produce a unit amount of goods, or (b) that the increase in consumption and productive capacity is increasing at an accelerated rate. Unfortunately I believe that hasn't been the case, which means that society has been  building more capital goods than required - or in other words, we've been building white elephants. (I use the term "capital goods" loosely - it can also refer to housing, which produces "living space" which is captured in GDP as rental income)

The third is a problem if it is sustained for too long, because it drains the economy of real savings. As the price of homes and financial assets go up, individuals believe they have built up savings for retirement and emergencies. However, on a systemic basis, no economic savings are being built up to sustain capital goods creation. What appears to individuals as savings is actually financial savings, which is different from economic savings. In the economy, savings that fund capital goods creation (real productive capacity) can only come about from foregone consumption. Capital goods are created when people work on building machinery and houses instead of making consumption goods. This means that the aggregate amount of consumption goods created (and consumed) is less than the amount of things they have created (income). If the income from work is not forgone to fund the creation of capital goods, then there is no economic savings. If the growth in asset prices goes on for too long, it will cause the nation to appear wealthy as the financial savings and financial wealth appears to be high. But in reality, the economy's underlying productive capacity is deteriorating because no income has been forgone to fund it. At some point, asset prices will collapse for psychological reasons, or because the underlying economic productive capacity cannot produce enough income to sustain the high prices (e.g. when rents cost more than what jobs pay).

The consequence of which is this Credit Crisis

- What's happening in this crisis

The current credit crisis seems to be a confluence of these forces: (a) the build up of white elephants funded by income forgone in other countries (imported capital), (b) the sudden fall in value of financial assets after their prices rose to unsustainable levels, and (c) the diminished productive capacity of the economy.

The result is that people who have borrowed (financially) to invest in white elephants are going to lose their money and default on their debt. This means that there will be significant destruction of money in the banking system, which would lead to banks reducing lending as they work through the losses. This reduced lending is going to crimp economic activity and capital investments for a while, and lead to a recessionary bias. (In the past, before deposit insurance, this might have led to runs on the banking system, which would be enormously destabilizing and could change the psychology of the population to the point where people reduce their living standards by lowering their consumption of goods and services, leading to a deflation and depression as the population demands a lower economic output than what the productive capacity of the economy is structured to produce.)

At a societal level, it also means that the economy does not have the productive capacity to pay back (in terms of goods and services) the people who have spent time building the white elephants. They may not realize this, because they could have already received payment from the people who borrowed money to create the the white elephants. But the reality is that there are more of these dollars, which are claim checks on future economic output, than there are goods and services that the economy can produce in future. (If they had been building needed productive machinery on the other hand, the claim checks could be used to claim the future products produced by those machines). In effect, all economic participants are being shortchanged as their dollars are devalued (through inflation).

This is leading to:

(1) inflation, causing everyone to suffer;

In a society without representative government, this devaluation of claim checks wouldn't be so severe, because the money supply would contract as bad debts are taken onto the banks' balance sheets. This reduction in money supply (manifested as destruction of shareholder's equity and deposits) would reduce the number of claim checks in the economy, to match the actual productive capacity of the economy.

But it would of course, be manifestly unfair to certain segments of the population. The trades people (labor) who invested their time in building the white elephants would be made whole, while persons who have saved their income would be wiped out thanks to the misjudgment of the people who borrowed to create the white elephants.

Politically, this has been hidden through the government's deposit insurance schemes and capital injections. These have the effect of protecting the savings of the savers, and preventing the monetary base from contracting. But the effect of this is inflation, as there are now more claim checks than the economy is able to produce goods and services for in future. Savers are still harmed through inflation - but the inflation creeps up slowly, and is politically more acceptable.

Societal over-investment in white elephants is fraught with moral hazard. Whichever way you look at it, the bad judgment (or reckless attempts at making a profit from creating too many capital assets) of one group causes everyone to suffer. The negative externalities of misinvesting capital into white elephants is simply not priced in when investors borrow money to build capital assets. This is why credit/debt extension needs to be regulated. 

And also leading to:
(2) a Recession; (how is the recession going to play out?)

The economy is going to be recessionary in nature as the reduction in credit squeezes economic activity. The credit squeeze is also going to be difficult for companies that rely heavily on debt financing - they are going to face tough times as their cost of capital goes up, and some businesses that are economically viable in the long-term may go bankrupt. The extent of the recession depends on the amount of mis-allocation of capital (i.e. credit/savings) that has happened. There is also going to be an impact from job losses and company closures in industries that were geared to building white elephants, and servicing the people building white elephants.

A cursory glance suggests that M3 as a % of GDP has at most peaked at 69% of GDP prior to past recessions. Considering that today's (2008) M3 as a % of GDP is probably around 80%-90% (this is a guesstimate, because the Fed stopped publishing M3 data after 2005), it suggests we are going to face a economic recession worse than any since the Great Depression. Conceptually, this is going to happen as society as a whole realigns itself to "forget the debt owed for work done in building white elephants (this debt will never be repaid), readjusts, and gets back to its normal course of living" (unfortunately as we have described earlier, the fallout and impact to different segments of society is unequal). Society as a whole will adjust to lower economic activity than what the previous high level of capital investments suggested the economy was capable of. Practically, this is going to happen through two mechanisms:

(1) The banking system is going to reduce outstanding credit as debts go bad, and this will crimp economic activity. In the short term, this may even lead to deflation.

(2) Because of the Fed's injections into the banking system, and because of the existence of deposit insurance, inflation is going to kick in as the money supply stays constant while the economy's productive capacity contracts, or grows slower than what the prevailing money supply was "intended" for.


This will be a deep recession,
but it's probably not another Great Depression

This is going to be deep recession, probably worse than anything we've seen so far. But I think the odds of a depression (with regular people starving and living off soup kitchens) are low, because:

(a) Deposit insurance now exists, preventing money supply destruction, and preventing systemic bank runs which would send people into a psychological state that would get them to reduce their standard of living and consumption of goods and services, below what the productive capacity of the economy can produce, hence leading to severe economic contraction.

(b) the injections of liquidity by the Fed and Treasury, which help to prevent money supply destruction by keeping banks solvent and allowing them to keep their credit facilities open to economic actors.

(c) as long as free-trade continues to be viewed positively in the political agenda, the United States has products which it can export to countries holding lots of dollars in reserve, of which there are many (countries which the U.S. has trade deficits with). When these countries increase their purchases of U.S. exports, paid for with the U.S. dollars their central banks are holding in reserve, it will stimulate economic production and follow-on economic activity. In a sense, these are an untapped group of consumers which can kick-start economic activity should the domestic mood be so dour that people reduce their economic needs way below economic productive capacity.

(d) the U.S. population is still growing. People getting married will need new houses, consumption goods etc. While some segment of society, especially those got into excessive debt over the last decade, are going to reduce their standard of living, the introduction of new young people into the economic system should bode well for overall production and consumption. (Simply adding young people into a non-functioning/fragile economic base would be useless - look at many countries stuck in 3rd world conditions because the political-economy isn't set up for its young people to participate and create a better life. In the case of the U.S., a growing population helps because the political-economic framework exists to allow everyone to create a better life for themselves.)

We are in uncharted territory;
Living in a Grand Economic Experiment

Nonetheless, it's important to realize that we are in uncharted territory with the 2008 credit crisis, because society now has two tools that weren't present in previous credit-crisis led economic contractions: fiat money, and central banks.

There is a case to be made that many of the depressions since the 1800s were caused by a contracting money supply following a credit boom. Prior to the 1900s there was no central bank in the United States who could manage the money supply in a coordinated fashion. And broadly speaking prior to the 1960s, most countries were operating on the gold standard, which constrained the degree of freedom that central banks had.

We are living in the midst of a grand experiment which will tell us if credit-crisis led depressions can indeed be prevented through inflationary monetary policy, without adversely preventing the economic from making the structural changes needed to compensate for the excessive investments in white elephants. But make no mistake, this recession is probably going to be deep.

Sidebar Observation: Credit crises are a normal part of the human-economic cycle (Long-term investors should expect them)

How should long term investors think about the cycle of oscillating between bouts of "Euphoria Phase", with high valuations of capital goods like houses and companies/equities because of overinvestment / overextension of credit, and the subsequent "Subdued Phase" where the real price of capital goods drop as excess investment/debt is unwound?

My hunch is that the cycles run a duration of one human lifetime or so. The first ended in 1929-33, and the current one is ending in 2000-2008. If you look further back in history, credit led booms were also probably the reason for Panic of 1837, and the Panic of 1873 which led to the Long Depression. In other words, credit-bubble led cycles are likely to be an inherent feature of fiat money economies, and co-exist with the regular business cycles caused by inventory fluctuations. Investors and savers should expect these cycles. 

Investors living today in their 20s and 30s need to work within the framework of a subdued phase. This will probably last for some time, and the implication is that investors today should not rely on the broad conventional investment wisdom built up over the last 2-3 decades during the euphoria phase (such as the rule of thumb that stocks as an asset class will always outperform other asset classes, and the feeling that general stock prices always go up over time)

Post script (14 Mar 2009): For an explanation of the financial crisis from a financial perspective, have a look at this excellent infographic. 

Image by i ♥ happy!! from Wikimedia Commons, licensed under the Creative Commons Attribution 2.0 License.