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The Problem With Modern Monetary Theory

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Return of the Risk Premium

The Equity Risk Premium represents the additional return demanded by an investor to own equity over and above what is considered to be a risk free interest rate. It is used in valuation models as a discount rate to determine the current (present) value of a future stream of earnings.

Wall Street Rediscovers Gravity
Although the ERP is a scientific concept, there are many subjective assumptions that go into its calculation1. Consequently, the debate has centered on whether to use a historical perspective in order to minimize human error in these assumptions or whether to try and achieve the impossible - a forward-looking model. Mr. Greenspan himself discussed the issue in a speech at Jackson Hole Wyoming last year, in which he questioned bullish conclusions that the theoretical ERP has been permanently lowered as a result of a number of factors relating to our technological revolution.

The issue is important because much of the bullish argument underpinning this pricey market (a low ERP), for many years has revolved around the bullish conclusion that various technological advances have contributed to the systematic elimination of the traditional risk associated with equity ownership… believe it or not. So it is perhaps timely to reconsider these assumptions in light of the severity with which Newton's Apples have recently been falling from their tree… If memory serves correct, wasn't Isaac Newton also a renowned speculator? For conceivably, he too was re-thinking his views on the ERP when he discovered gravity?

Looking forward is easy while everyone is mostly right (a typical bull market condition), but it is hard to resist that rearview mirror, I suppose, if all of this is changing and the party was just too much more fun back there. Yet, the brutally painful adjustments in some of the "blue chip" stocks recently has got to attract the attention of even the most bullish of observers. And it is not that new a development. In October 1999, when IBM shares fell by less than 20% in one morning, on an earnings warning I believe, commentators were convinced that it hasn't been in their lifetime, the last time that they have seen blue chip stocks behave like this.

That was 12 months ago and these adjustments have been arising with mounting frequency and degree since then. Of course, one might argue that the market has just begun to adjust the risk premium to account for an oil shock perhaps even starting as early as with IBM, which never did make it to new highs. Well if that is so, the invisible hand (of the free market price mechanism) is not quite finished yet. Indeed, we may soon find that it has a severe case of arthritis for there is nearly an entire market of stocks, which systematically must adjust their equity risk premiums, permanently higher. The reason, it seems, is that earnings aren't all that predictable as was once thought. Apparently, prices of essentials such as oil and gas, as well as those darned confusing floating exchange rates, are volatile.

Who would have thought? The government has worked hard to exclude these volatile influences from most economic data releases, only to have them unexpectedly show up in the bottom line of real businesses. And it gets funnier. Apparently, it has come to our attention that the US has not had any kind of coherent energy policy for over 20 years now... what have they been doing?

I suspect that most of us have been preoccupied with the casino action at Wall Street's virtual slot machines. Duh! So let's get back to reality shall we? And for heaven's sake, please do not take analyst's sudden focus on real fundamentals such as earnings too seriously. If they didn't really matter on the way up, why should they matter on the way down? Especially when we are still sitting in nosebleed territory and even bullishly biased consensus forecasts are for slower profit growth? As we said last week, the trouble is that these stocks, until now at least, have been priced for absolute earnings predictability not for disappointment, last week's GIC.

Therefore, current assumptions about any such eternally lower Equity Risk Premiums ought to be reconsidered… quickly, for it appears that the "invisible hand" is anxious to readjust the ERP all on its own, with or without your help.

Men who make potions in a traveling show2

Commentators on Friday were quick to dismiss the Bad Apple news as company specific. The aim of such a comment is obviously to quell concern over the rest of the stock market (or at least his or her other stock picks) since it conveniently misses the whole point. As I have pointed out, many bullish analysts have been defending these valuations for the better part of the past five years on the basis of their confidence in a few temporary macro assumptions.

Rising productivity, low inflation, and a structural reduction in the equity risk premium, all apparently owing mainly to the US information technology age, have been the basis of the goldilocks economic theme that has been at the driver's seat of this bull market for most of the past decade. Through the better flow of information and a closing gap between the knowledge of both buyers and sellers, the amplitude of the business cycle should not only moderate but the entire spectrum of commerce (including valuation methodologies) was supposed to become increasingly predictable and efficient. Notwithstanding that the quality of information flow has perhaps been overcome by the quantity of information overload, markets are still subjugated to emotions such as greed and fear. I doubt this will change in your or my lifetime.

Another fact that is unlikely to change is that few of these rearview mirror analysts, in particular, may ever understand the influence of any of their assumptions on these topics, I am sorry to say. I won't even bother with productivity because we beat that topic up enough in "A Nation of Storytellers". Moreover, both the OECD and the Deutsche Bank have recently questioned the validity of the US productivity calculation, publicly. I will only say here that the truth on productivity ultimately will not be known until the next downturn ends. Only when we can compare the current cycle peaks and troughs to future ones will we have washed out all of the multi factor variables, which cloud the data at the moment. Only then will the conclusions, including my own, be somewhat scientific. Until then it is every man for him self, I presume.

As for any kind of spin on equity risk premiums, have a look the following charts:

Apple Computer, Inc.
Apple Computer
Intel Corporation
Intel Corporation

Obviously, there were no warnings provided by this supposed efficiency in either of these cases (except perhaps the obvious cheating in Intel's case, but that has nothing to do with technology - see the chart). It is way past the time to question Wall Street's valuation models.

With so much spin, what then is the explanation for this long bull market and historic economic expansion? That is easy - historic consumption excess, an inflationary monetary policy, and a voraciously greedy appetite for an increasingly speculative lending business in the US banking system. So voracious in fact, that it may have put the entire dollar based monetary system in jeopardy. What isn't easy… is for people to accept this truth while the external exchange rate of the dollar continues to rise.

M3 Money Stock NSA; Billions of Dollars
M3Money Stock
Consumer Credit Outstanding; Millions of Dollars
Consumer Credit Outstanding

Please note the approximate date in the above charts where the expansions in money and credit accelerated, and compare this to the chart of the S&P 500 below, over the same time period:

10 Year S&P 500 Index
SPX Weekly

What does that tell you? The big downward trending red line is the advance/decline line, which proves that for almost the past two years more stocks have been declining than advancing.

This one is gonna hurt...
That was my thought after Apple Computer's news was released on Thursday evening, because that morning the bulls came into the market with some confidence as the week was shaping up without any bad news. They were all over the drug stocks and a few other oversold blue chips, pushing the Dow up some 200 points, and even got some momentum going while charging at the 10,900 barrier. The buying was broad and it was good... good enough to raise my temperature slightly, but then after the market closed Apple delivered its blow to the vulnerable tech sector... the bear has arrived.

After all, does not that kind of thing happen in a bear market? It sure feels like it to me... as if the bear has suddenly become more difficult to slay. By Friday morning, it seemed that currency players had already discounted the Danish no vote for the Euro and with nothing much else surprising equity markets, traders were surprisingly able to keep their cool. It wasn't until the last two hours of Friday's session that it all started to unravel again, when fresh selling pressure appeared and started slamming almost everything in sight.

Technically, the narrow Nasdaq 100's 50day moving average crossed down and over the 200day MA last week for the first time in nearly two years, having lagged the broader composite index in this endeavor by about five weeks. The relentlessly declining breadth and liquidity in speculative issues is beginning to drag down the more liquid blue chips, as is typical at the early stages of a credit contraction. Since many, many more stocks have been declining than rising over the past 12 months, this bearish resolution in the narrow leadership may be seen as an ominous sign, since most blue chip indexes are still near their all time highs. We have been telling people for the better part of the past 18 months that this market has been technically deteriorating from the inside out. Proof? If you have made money over this period of time, and I do not mean by that one profitable trade, you are the exception because most investors (excluding promoters, bankers, and brokers) have not:

Gross Private US Savings; Billions $$
Gross Private Savings
Annual Personal Saving in Billions $$
Personal Savings

Notice the decline in the nation's savings pool (chart on the left) throughout 1999. Wasn't that the year that the Nasdaq 100 was up some 80%? It was also the year in which the advance decline line collapsed the broad bull market (see the 10 year chart of the S&P500 above). From there on in, fewer and fewer investors were to make any money.

By the end of the week, bullish analysts were pointing to the productivity implications of the GDP report, while the increasingly confident bears were not budging from their conviction that those numbers are less meaningful (if at all) than data on savings rates as well as a number of other colossal macro imbalances building against this great economic expansion, which are, to be polite, less lagging than they are leading indications of what is likely to come. All in all, the week ended pretty much as expected except for the fact that gold prices gave back their early week rally.

The reason that is odd is that I was looking through my usual list of US industry charts and I noticed that the indexes that ended the week as if there were more selling to be done, were most everything except for most of the commodity (or hard asset) related equity indexes, although the financials and the health care related indexes also put on a little bit of a show. The only other exceptions being the few more extremely oversold numbers. I am placing the utilities index in the hard/commodity asset class because as I said in Wall Street Kisses Goldilocks Goodbye, without an energy crisis there is no play on utilities. Recall,

The Potentially Perfect Negative Correlation

The Dow Transports
Dow Jones Transportation Average
The Dow Utilities
Dow Jones Utility Average

Since we have made this observation, a number of things have developed. The US government has declared (for the record) that we have got an energy crisis on our hands, the Dollar/Euro exchange rate destabilized and then stabilized, it has been raining apples and chips on Wall Street, and it seems that the US government has been tossing around all sorts of incentives that might benefit both consumers and these power (utility) companies.

There were plenty of other indexes in this hard asset category that showed some life last week, from the REIT index to the Chemicals index to the Oil/Gas related indexes, and even Paper stocks began to show some life by Friday. As if to confirm our case, the top three performers (out of the only ten that closed up) in the Dow on Friday were Alcoa, Du Pont, and Merck. AT&T came in fourth and McDonalds came in fifth. Still, all four other than Merck have been badly beaten up lately.

All in all, the action has been encouraging to our hypothesis, but the one anomaly that remains is the dollar/gold rate. Even agricultural prices have been making higher lows and higher highs over the past 12 months.

How the world works today
"Leading U.S. drug companies and their trade organizations have spent at least $46 million on political advertising and donations to influence this year's election, according to figures compiled by organizations that track campaign fund-raising..." Bloomberg news, Friday Sept 29.

Here is the rest of it,
"George W. Bush proposed that the National Institutes of Health budget be doubled over five years... to about $67 Billion over ten years... In addition to doubling the NIH budget, Bush said he would push to double by 2003 the budget for the National Cancer Institute, increasing spending for that agency to $5.1 billion... Gore has also made health care a major focus of his race. His campaign said the vice president already has proposed doubling medical research funds; his plan would take effect over a three- year time frame and would boost funding to $29.2 billion in 2003 from $14.6 billion now... Bush said that if he is elected, he would ask Congress to make permanent the Research and Development Tax Credit, at a cost of $24 billion over five years... Gore has proposed a $250 billion, 10-year plan to help all 40 million Medicare recipients pay for prescription drugs, and he has also proposed setting aside $300 billion of the projected $4.6 trillion federal budget surplus over the coming decade as an emergency fund for Medicare... Bush, by contrast, has proposed a prescription drug coverage plan that would cost just $160 billion over the same time period."

These excerpts were taken from Bloomberg news on Sept 23, a week earlier.

Now, I haven't added all of that up, but I have a feeling that it works out to a lot more than the $46 million it cost the drug companies to persuade this platform. Furthermore, I am also certain that anyone with Merck stock options did not spend any of their own money on these unrelated events. So there is where the source of activity in Pharmaceuticals really is, because at 22+ times earnings, already representing a low risk premium in a volatile industry always vulnerable to potential liabilities, there is no other reason to own these things. That is because current multiples have roughly already priced up to 20% growth rates for the entire drug sector.

Amex Biotechnology Index
Biotechnology Index

Dollar Recycling and Inflation
Since inflation is beginning to show up in the dollar, then perhaps it is worth our while to consider what inflation really means, especially since a consensus is developing quickly that the dollar is overvalued. I think that there are fewer people who understand what inflation really is, than you might think at first glance. Mostly, we are taught that it means rising prices. If we get to an intermediate level of economic understanding, we know that inflation is too much money chasing to few goods. But even this might imply that inflation is somehow a function of demand. I beat this topic up in grave detail in Inflation versus Deflation. I will try to sum up my conviction on the topic.

It is simply the loss of purchasing power in a currency. According to Austrian economic thought, this can only happen when you expand the money supply, period. In other words, inflation is just too much money. Once this condition begins, history has shown that it will eventually end the day in currency ruin, and it will result in a permanent loss of purchasing power. Although the prognosis might have been different at each point in history the ultimate diagnosis is as correct today as it was at any other point, with retrospect of course.

Indeed it has little to do with demand. Generally, two factors, the changing relationships between supply and demand, and changes in the general purchasing power of the currency determine prices.

The latter may be viewed as either inflation or deflation. The former, however, is not inflation if the demand for something suddenly outgrows supply and prices rise. In this case, the price mechanism is working properly as it signals producers to produce more products. When I talk of inflation, I talk of the latter factor, the one that causes distortions in the ability of the price mechanism to function properly. Although we have not seen the inflation in the way that we presently understand it to exist, we may observe its existence in the highly visible degree of malinvestment and general credit excess.

As with prices, there are also many variables that influence purchasing power. For instance, historically it has happened with currencies whose marginal utility is too low - most non-luxurious goods fall into this category, which is why Gold is a favorite for currency theorists. In today's global economy where currencies float against one another, purchasing power may rise or fall against the goods priced in another fiat currency. Hence, trade deficits and oil crises. Let me try to explain the concept of purchasing power through the eyes of Ludwig von Mises, the preeminent Austrian economic scholar.

Specifically, Mises showed that, just as the price of any other good was determined by its quantity available and the intensity of consumer demands for that good (based on its marginal utility to the consumers), so the "price" or purchasing power of the money-unit is determined on the market in the very same way.

In the case of money, its demand is a demand for holding in one's cash balance (in one's wallet or in the bank so as to spend it sooner or later on useful goods and services). The marginal utility of the money unit (the dollar, franc, or gold-ounce) determines the intensity of the demand for cash balances; and the interaction between the quantity of money available and the demand for it determines the "price" of the dollar (i.e., how much of other goods the dollar can buy in exchange). Mises agreed with the classical "quantity theory" that an increase in the supply of dollars or gold ounces will lead to a fall in its value or "price" (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis.

For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances. Furthermore, Mises showed that the "quantity of money" does not increase in a lump sum: the increase is injected at one point in the economic system and prices will only rise as the new money spreads in ripples throughout the economy. If the government prints new money and spends it, say, on paper clips, what happens is not a simple increase in the "price level," as non-Austrian economists would say; what happens is that first the incomes of paperclip producers and prices of paper clips increase, and then the prices of the suppliers of the paper clip industry, and so on. So that an increase in the supply of money changes relative prices at least temporarily, and may result in a permanent change in relative incomes as well.

Mises was also able to show that an early and long forgotten insight of Ricardo and his immediate followers was eminently correct: that, apart from the industrial or consumption uses of gold, an increase in the supply of money confers no social benefit whatsoever. For in contrast to such factors of production as land, labor and capital, the increase of which will bring about greater production and a higher standard of living, an increase in the supply of money can only dilute its purchasing power; it will not increase production.

If everyone's supply of money in his wallet or bank account were magically tripled overnight, society would not improve. But Mises showed that the great attraction of "inflation" (an increase in the quantity of money) is precisely that not everyone gets the new money at once and in the same degree; instead the government and its favored recipients of purchases or subsidies are the first to receive the new money. Their income increases before many prices have gone up; while those unfortunate members of society who receive the new money at the end of the chain (or, as pensioners, receive none of the new money at all) lose because the price of the things they buy go up before they can enjoy an increased income. In short, the attraction of inflation is that the government and other groups in the economy can silently but effectively benefit at the expense of groups of the population lacking political power.

Inflation-an expansion of the money supply-Mises showed, is a process of taxation and redistribution of wealth. In a developing free-market economy unhampered by government-induced increases in the money supply, prices will generally fall as the supply of goods and services expands. And falling prices and costs were indeed the welcome hallmark of industrial expansion during most of the nineteenth century.

-- From the Essential von Mises by Murray N. Rothbard, Libertarian Press, 1980.

Understanding it in this way the diagnosis becomes easy. But it is…

The prognosis, which is difficult

By "persuading" foreign interests to buy new dollars, particularly in enormous quantity since 1995, the US financial sector has been successful at bullying its way to the top of the global financial system by creating all sorts of innovative uses for the rapidly printed dollar, as well as the fueling the delusion that rising fiat exchange rates indicate a true rise in purchasing power. Though this may be more accurately referred to as "Dollar Recycling."

And since inflation is most likely to occur where there is already some price pressure, it is understandable as to why it has shown up in US asset markets as the baby boomer promotion geared up earlier this decade, and why it has suddenly shown up in oil prices.

Putting aside the issue of why most commodities are priced in dollars in the first place, it is important to understand that were it not for the relative size and liquidity of US capital markets (growing in sync with money supply), the condition of so many excess dollars would manifest in many other kinds of more detectable inflation. A collapse in capital markets then, could undermine global confidence in the dollar as the preferred global investment medium of exchange.

Iraq has already threatened to price its oil in Euros or whatever. The day that the dollar ceases to function well as a global medium of exchange, the problem of too many dollars will suddenly surface everywhere as (what many people understand to be) inflation. That will be the day when its ability to function as a store of value is compromised. Demand will have little to do with it, just the same as it had little to do with the inflation of the seventies. And it will again be called stagflation, for most analysts will be unable to explain the combination of rising prices and falling demand through their modern (mis) understanding of what inflation is.

It has been shown that the perceptible loss of purchasing power may be delayed until the day that the prevailing use for that currency no longer exists, at least relative to its supply. So far, the US consumer's propensity to spend dollars in foreign countries has made it useful for our foreign interests to invest in, or recycle, those dollars in wonderland. But as I mentioned in the Politics of the Dollar, the consumer is the Achilles Heel for this whole dollar buying cycle.

Without trying to figure out which came first, the chicken or the egg, consider how this process works. Consumer A buys a PC in Country B with dollars. Country B has the option to both exchange those dollars for its own currency B, and therefore keep the profits, or to keep those profits invested in dollars. If country B keeps those profits in dollars, central bank A promises to never allow its money (dollar) supply to grow faster than credit demand so that the external exchange rate (which is simply a price for dollars, not a value by the way) of the dollar continues to inflate consumer A's global purchasing power. Consumer A thinks that this is wonderful, and private bank A has learned how to recycle those foreign profits and spin them into not only a further credit expansion, but an asset price spiral, adding to consumer A's purchasing power and encouraging consumers in country A to compete for who has more toys.

As long as this goes on, our foreign interests have a use for the dollar. It enables US consumers to buy their goods and services, historically a process by which they (the countries generating a trade surplus) would accumulate US gold. So what is the price? None in the short run because private banking system A has helped create as many speculative uses for the currency at home as it has created currency, none of which has anything to do with its reserve role as a store of wealth, however.

The Strong Dollar Policy at Work
Let me define the strong dollar policy for you. It is a policy where the US seduces foreign countries to export their excess capital to them or to inflate their own money supply faster than them, in exchange for a national agenda that promotes consumption and maintains the international reserve currency. It seems, however, that consumption has been pushed to the edge, and the nation has abused its privilege as keeper of the international reserve currency.

his is what this bull market has been all about. It is not about productivity gains, which are really still many years away. It is not about a more sophisticated financial community that has been able to apply its technological know-how to create a risk free speculative environment. That will never come. It is not about the success of a central banking system that has cured the world of its inflationary ills… it really hasn't. It is about the success of a global banking system in creating a monetary delusion on a scale heretofore never seen… perhaps unwittingly, but nonetheless certainly. Let us not delude ourselves as to what is at stake here.

1. Ibbotson Associates discusses this in depth in an article by Michael Annin and Dominic Falaschetti; published in the January/February 1998 issue of Valuation Strategies.
2. This is your song… Elton John

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