Is a rights issue good for shareholders / Should I participate in a rights issue?

One way that companies raise capital is by issuing shares through a rights offering. Some shareholders see rights issues as a "gift" from the company, because the exercise price is usually below the market price of the shares in the market. They view a rights issue as the company giving them a special "by invitation only" opportunity to buy shares a discount to its market price. Others see a rights issue as a sign that the company's investment merits are deteriorating because the company is either being forced to adopt a lower-debt funding structure that reduces the shareholder's return on equity, and/or is becoming more capital intensive.

This post explains how both perspectives can be valid depending on the conditions surrounding the way the market views the company.

Case Study: an example of a rights issue and how it affects shareholders

Here's a simple, but representative, example that illustrates the mechanics behind a rights issue:

You buy one (1) share of a company with the following financial structure:

Total shares issued: 1,000

Shareholder's equity: $2,000 ($2 per share)

Earnings: $1,000 ($1 per share; ROE=50%)

Market price: $10 per share (PE ratio of 10; PB ratio of 5)

The next day, the company makes a 1:1 rights offer with an exercise price of $5 per new share. This gives the company the following financial structure immediately after the offer is exercised:

Total shares issued: 2,000

Shareholder's equity: $7,000 ($3.50 per share)

Earnings: $1,000 ($0.50 per share; ROE=14.3%)

Does it make sense for you as a shareholder to participate in the rights offer? If your primary concern is in maintaining your voting power, then you need to subscribe to the rights issue in order not to have your stake diluted. Otherwise you will end up owning a smaller percentage of the company.

However if your primary concern is the value of your stock holdings, then it depends on how the market values the company: whether the market values the company as a multiple of its earnings, or as a multiple of its book value.

• If the market values the company as a multiple of its book value, then a rights issues is beneficial to an existing shareholder only if the exercise price of the rights shares are above the Shareholder's equity per share of the original shares.
  
  
• If the market values the company as a multiple of its earnings, then a rights issue is beneficial to an existing shareholder only if the company can employ the additional capital at an ROE similar or greater than the ROE enjoyed on the company's existing shareholder's equity.

Here's why:

(A) Companies that are valued by their PE ratio.

In the best case scenario, the capital raised can be used with a ROE of 50% (the original ROE achieved by the company), then the company will end up earning $3,500 or $1.75 a share, and can be valued at $17.50 if the PE ratio remains at 10. If the company cannot put the new capital to such productive use, then the price of the shares should be lower because the earnings are lower.

Assuming this best case scenario, how then would a shareholder fare? A shareholder which bought 1 share originally at $10 (which he could have sold for $10), would have put in an additional $5 to subscribe to the second share. By contributing $5 out of his/her pocket, he now has 2 shares each worth $17.50, for a total of $35. The additional $5 contributed has resulted in a gain of $25. What has effectively happened is that the company has offered the opportunity to (1) invest $5 in a venture that has a ROE of 50%, and (2) benefit from the market's propensity to capitalize those additional earnings at a certain PE ratio. The shareholder has gain of $35-$10 - $5 = $20 ($35 of shares after the issue, $10 for the initial share purchase, and $5 for the rights exercise price)

Businesses that are lumpy step functions (like property developers) where there is a need for huge amounts of funds for each "project" can end up raising rights issues often. While they can try to keep retained earnings until they reach the critical mass needed for a project, many avoid doing this because during the interim years, the retained earnings just sitting there will be a drag on ROE and result in unhappy shareholders.

However in the worst case scenario, the company needs the additional funds just to continue operating as it is. Then the rights issue would be extremely bad for all shareholders. In this scenario, the company would continue earing $1,000, or $0.50 per share (since there are now 2,000 shares after the rights issue, instead of the the original 1,000 shares). The fair value price of the share would then be $5, assuming the PE ratio of 10 is maintained.

An investor would then be worse off. He originally paid $10 for one share. Then had to to pay $5 for the rights issue. In effect, he paid $15 for 2 shares, and the 2 shares are now worth $10 in total. A loss of $5 for the shareholder. In reality, if the ROE of the business dropped, the fair value of the company in PE ratio terms would also drop, which would further reduce the value of the shares. This is a simple mathematical relationship in the Discounted (Extractable) Future Earnings model for valuing any asset.

So in summary, whether or not you are financially better off depends on the ROE at which the company can employ the new capital being raised:

• (a) if the company is raising funds for a new venture, then the funds raised had better earn returns that justify the current share price.
  
  
• (b) if the company is raising funds to continue operations, because it cannot access debt, then your ROE is dropping and the fundamental investment merits of the company have changed.

(B) Companies that are valued based on their book value.

The amount of gain for a non-participating shareholder depends largely on how much higher the rights exercise price is to the book value per share of the original shares.

In the best case scenario where shares are issued at a price higher than current book value per share, you would have benefited even if you had not participated in the rights offering. Let's see how this works: your original share would now be worth $17.50 each and you would have a gain of $7.50. What has effectively happened is that you've gotten a free ride, because the rights shares buyers are effectively subsidizing you. Buying the shares on the open market, you paid $10 each share which had $2 of underlying shareholder equity, without actually injecting any equity into the company. Whereas the "buyers of the new rights shares" are injecting $5 for every new rights share they are being given. This $5 they have injected will increase the value of your "original shares". In other words, there is new additional shareholder's equity for your shares, that is being paid for by the new buyers.

But if the company has issued the rights at an exercise price of $2 (the book value of the original shares prior to the rights issue), the company would have $4,000 in shareholder's equity. There would be no gain for you in book value per share terms. So the market value of your stock holdings would be unchanged.

In the worst case scenario, the company has issued the rights at an exercise price of $1 (below the book value of the original shares prior to the rights issue), the company would have $3,000 in shareholders' equity. The book value per share would have dropped to $1.50 per share, and the market value of your existing shares would be diminished. In this case, it pays to subscribe to the rights, since the premium of the market value of your new shares over their exercise price would counter the loss in market value of your current shares. Whether or not this completely compensates for the drop in value of your existing shares depends on how far below the book value the new shares are issued at.

So in summary, whether you benefit depends on whether the shares are issued at an exercise price equals to the book value of the current shares, or if it is greater/less than it. If it is greater, than you may benefit even if you don't subscribe to the shares. If it is less, then you may need to subscribe to the shares just to minimize the losses in the market value of your existing shares.

Short-term trading opportunities when a rights issue occurs and trades on the secondary market

In the short term after a rights issue is announced, the immediate question that strikes many investors is: is there money being left on the table, when a company is selling new rights shares at less than its market price? Strictly speaking the answer is no, because the current share price is simply a reflection of the returns on the capital /book value already in the company. The rights issue will have changed this calculus, because the key question going forward is what is the ROE on the new capital / the new book value per share after the rights issue.

However this line of thought is sometimes the reason why the existing/new shares may continue trading at their prevailing prices. (In other words, the market can't figure out the "correct share price" after the rights-issue) This can create a short-term windfall for existing shareholders, because the rights may trade at over-valued prices. When this occurs, shareholders who subscribe to the rights can sell the rights. Likewise, the market may clear at a a too-low "post-rights-issue" price, and the rights trade at a unfairly low price. This creates a buying opportunity for new investors to take an ownership stake in the company at a discounted price to the market.

The key in both situations is that you must have a clear idea of how the market values the company over the long run, and whether the rights exercise price creates a beneficial or detrimental situation for you as an existing shareholder (see our earlier analysis). That will allow you to figure out the price that the shares would likely trade over the longer term after the rights-issue, and allow you to see if a mispricing has occurred which you can take advantage of. Of course, be aware that the mispricing may continue for quite a while, even after the rights issue exercies, because it takes a while for the company to actually deploy the capital and earn the return which you think it should be earning.

Analysis of First Ship Lease Trust (Singapore)

At it's current price (SGD0.60), FSLT's attractiveness as an investment boils down to 2 questions:

1. Is a price of SGD 362m (the market cap) a good price to pay for (a) ownership of the 23 ships that the trust owns, and (b) assuming responsibility for SGD 650m of bank debt.
   
   
2. Will the trust management be able to manage well (ride the cyclical shipping demand / manage capital) to the benefit of unit holders.

Here's the thought process behind this:

First, assuming the management does not buy more vessels, and just continues running the existing ships until they are obsolete. Typically ships have a lifespan of 20-25 years, and the average age of the ships in the trust is about 5 years. So the question is: is SGD 362m a good price to pay for 23 ships with 20 years of life left, and taking on SGD 650m of debt that was originally taken on to buy the ships.

The answer probably depends on two things: (1) were the ships purchased at rock bottom prices? and (2) what's the probable lease income from the ships after the current lease term expires in 5-7 years time.

Ships are a commodity, and shipping rates are cyclical. Ships lessees tend to lease ships mainly by price, so having the cheapest ships is key. When the industry is in a funk and excess capacity abounds, ships that were purchased at high prices are effectively money losers for owners, as the lease rates may be even less than the cost of the loan taken to buy the ship. So the future level of distributions ("dividends") from this trust depends on whether the ships were purchased at a rock bottom price and/or the amount of loans outstanding.

The other thing is that because the ships will become obsolete after 20 years, the intrinsic value of the trust drops every year. So having a high dividend/distribution yield is critical for investors to counter this. At the end of 20 years, the intrinsic value of the trust is the scrap value of the ships minus any outstanding loans.

Of course, if the ships were purchased at a rock-bottom price, then the trust can sell the ships even during a down cycle and make some money to return to unit holders. The ships are carried on the books at SGD 1.18b, so a key variable is whether this is considered cheap in the maritime industry.

So the next question is, can the management counter this inherent drop in value by buying new ships? The answer is yes, and this leads us to the second angle.

Because of the legal-financial structure of this type of trust, they generally do not retain their earnings. They more or less have to distribute all the cash coming in from leases/income streams. From an accounting standpoint, this means that the distribution is typically more than the accrued income shown on the income statement. This is because the reduction in equity caused by the depreciation expense can be distributed, unlike in normal companies where dividends are generally not to be distributed if there are no more retained earnings in the shareholder's equity. (In other words, the trust is a self-liquidating vehicle)

The implication is that anytime they want to buy new ships, they will need to either take on more loans or raise equity by issuing more units. Whether this is beneficial or detrimental to existing unit holders depends on (a) the price at which the new units were raised, relative to the Net Asset Value per unit of existing units, and (b) the returns on the capital raised - ie. whether they are able to buy good ships at cheap prices using the money raised. Both of these factors are very much determined by the decisions made by the trust management. (This is broadly true for companies too, any time new shares are issued, it can either be good or bad for existing shareholders, depending on the management's business acumen and decisions)

This variable depends entirely on the business acumen of the management team.

How Demographics affects Equity Investors (and people saving/investing for retirement)

Some investment theses rely in part, on making a broad bet on the economic prospects of a country. (For example: buying an equity index fund) The economic prospects of a country are determined by two key factors: its resources and scheme of organization (its legal, cultural, financial and political framework), and its demographics. The former is understood and often acknowledged; the rule of law, respect for private property, and so on, are seen as essential to unleashing the economic instincts of human beings. However, the impact that a country's demographics have on its economic prospects is sometimes overlooked. Why? Because much of recent economic history has unfolded over an era when populations were growing in almost all the major countries. But this is now changing as many countries have crossed the tipping point and are now starting to age.

To see how demographics affects economics, we can examine the 2 extremes that population demographics can take: a growing population that is predominantly young and growing, and a shrinking population that is predominantly old and aging. (You can check up the population pyramid of most countries at this U.S. Census Site)

Growing Population

All things being equal, a country with a growing population will generally report positive economic growth. As the population grows, the population will create and consume more products and services to sustain itself as a given standard of living. So even if the economy does not grow on a per capita basis, investors betting on general economic growth will have the bet work out in their favor. Within the economy itself, we can expect to see real estate values grow in real terms, as the growing population has more productive output that it can cede to land owners to secure rights to the land. (This is assuming constrained land resources - if there's huge tracts of usable land adjacent to major cities that are already zoned for development, then its a different calculus). Investors in such an economy can protect the value of their savings by using it to either (a) buy a share of the profits of economic production (via equities) or (b) buying land. Since the dawn of the industrial age around 200 years ago, this has been the demographic pattern of most countries in the world.

However, we are now at a turning point in many countries, and populations are beginning to shrink. This portends a very different economic reality for investors. Countries like Japan, whose populations have peaked and are beginning to shrink, are giving us a preview of what is to come in Europe and other soon-to-be aging countries.

Inflection point between Growing and Declining Population

At the point when the population begins to turn from growth to decline, the economy will begin to have excess productive capacity because the capacity was built by a larger population to sustain itself. As the population declines, we can expect the productive capacity of the economy to exceed the needs of its shrinking population. There will literally be too many houses, machines, car, and equipment for the shrinking number of people. Because capital equipment tends to increase and decrease in step-function jumps, we can expect that the excess productive capacity will remain for a while. During this time, it is probable that businesses will try to cut prices in order to retain the nominal amount of business in a shrinking pie. The implication for shareholders is that they face a declining ROCE. The shrinking consumer needs will ultimately lead to reduced production needs, and reduce the number of workers needed, hence preventing wage inflation from pushing prices up. Deflation is the likely result during this inflection point period. This would suggest that investors would do best simply to hold on to cash during this time, since cash would increase in real value as prices continue to drop.

This deflationary trend will probably be hard to reverse using monetary policy:

1. The first monetary tool that central banks can use to induce inflation is to grow the money supply through credit growth. Unfortunately this is unlikely to cause inflation because credit is predominantly extended for capital stock creation, of which there is already too much of it relative to the shrinking consumption. If anything, it will probably exacerbate the deflationary trend for the reasons we've seen. (This monetary tool to induce inflation is probably more effective with a growing population, because the increased capital stock will eventually be utilized as the increasing population requires more products and services. The increasing population may temporarily freeze their consumption, thus making this monetary tool ineffective in the short run as the extra capital stock sits idle. But over time, the growing population will eventually start demanding more soap, food, electricity and other products which are produced by the capital stock. Once this kicks-in, the deflationary trend will probably be reversed.)

2. The second monetary tool is for the government to turn on the printing presses and grow the money stock through the government spending of printed money. This too is unlikely to induce inflation, because the surplus productive capacity of the economy would easily create the goods and services for the government to buy with its freshly printed money, without increasing the price level because supply capacity is abundant. If the economy has a high savings rate, then this extra money will probably go back into investments in capital stock, further reinforcing the deflationary trend.

Unfortunately, the tendency to over-invest in capital stock can be expected during the period when population gradually shifts from growth to decline, because people tend to extrapolate from the past when making decisions. In the past the population was growing, which required (and rewarded) a continuing increase capital stock. So businesses will likely persist in this behavior and over-invest in capital stock, until it finally sinks in over time that what worked in the past no longer applies because of the shift in demographic trends.

In such an environment, deflation will be sustained, and investors would do well to simply hold on to cash.

Declining Population

However once the country's economic participants adjust to the new reality of a shrinking population, and reduces its investment in capital stock as a proportion of GDP (i.e. reduces its savings), then a different set of economic forces come into play. The more normal level of capital stock relative to consumption will remove the incentive for businesses to cut prices because they are no longer operating under high fixed overheads. The systemic deflationary forces will then disappear.

Over time, the total overall economic production will continue to decline in line with the shrinking population's reduced need for material goods and services. Unless exports are an overwhelming proportion of the economy, the economy can be expected to shrink in line with the decline in population. (Technically speaking under today's economic terminology, such an economy would be considered to be in a prolonged recession.)

Investors would not profit by buying a share of the profits of economic output (by buying equities), since overall production and productive capacity will keep shrinking. In practice, equity investors will see this happening though shrinking corporate profits. (With the shrinking population, businesses will also have to get used to shrinking revenues as overall sales volume goes down.)

Investors would also do well not to buy land, since the shrinking population will have less economic production to cede for the finite land, and indeed, on a per capita basis, the increased available land per capita would also increase and further reduce the real value of land.

How about cash? Would investors (or people planning for retirement) in such an economy do well to hold cash over the long run? In all probability, no. In a declining population economy, both savers will likely earn negative real returns. The savings (either held as cash or in equities) generated by an earlier generation when the population was larger, will have less real value as the population declines. Why? There are 2 reasons:

1. Because society requires less and less capital over time, and hence owners of capital (savers and equity owners) will find that their returns will drop. Conceptually what's happening is that at the earlier time, and forgone consumption of the larger population (i.e. savings) was basically work spent to build up capital stock in the form of buildings and machinery. As time passes and the population declines, the smaller population requires less buildings and machinery than what was built (through savings) of the larger population. So the capital stock built by the earlier generation will now be used to produce fewer products(profits) than what the earlier generation would have been able to get if the population stabilized at the earlier generation's level. In effect, the earlier generation will experience low nominal returns (negative real returns) on its savings.
   
   
2. Inflation will also likely set in, as the total economic production drops and the money supply chases fewer and fewer goods. The central bank may forstall this effect over the short run by absorbing excess money through bond issuances, but over the long run, the inflationary trend is likely to persist.

NOTE: In a steady state economy, capital stock investments as a % of GDP should increase or decrease in line with population growth or decline. (This implies the same for savings, since in a clearing economy, Savings = Investment). The capital investments should be to get ready for the increasing or decreasing needs of a increasing or decreasing population.

Rule of Thumb for Equity Investors (wrt to Demographics)

On balance, investors would in general, do well to avoid investing in economies with declining populations. It is difficult to profit from holding scare resources like land, because as the population declines, the amount of production that the population can use to purchase the resources also declines. In such economies, the reducing need for capital also means that returns for capital owners will be poor. Persons in such economies who are saving for retirement will probably fare best if they hold on to inflation protected bonds. Unlike persons in growing population economies, their prospects for increasing real wealth through passive investing is lower, because there isn't a future generation of more people and more consumption which requires the capital they provide as investors.

This is an important realization, because recent economic history has been one founded on continuous population growth. A declining population presents a different economic environment.


Image by TerriersFan, via Wikimedia Commons, released under the GNU Free Documentation License Version 1.2

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.