Using financial and real estate valuation principles, I have to conclude that the US equity markets must lose some $10 Trillion in capitalized value during the period in which the balance of payments reverts to back into balance and debt creation reverts to a condition of balance with income. The symptoms in the economy correspond to detecting an abnormal build up of stain on the San Andreas Fault. It does not foretell doom, but it does show an increase in risk of a temblor. Both the temblor and the mere existence of increased risk cause damage. A common sense response to increased risk of a temblor would be to secure fragile items and keep earthquake insurance current. But, the whole situation could be resolved by a slow release of the built up strains. So, simply knowing about risk is insufficient. We need to know more.

Cash Flow Paradigm.

Our current paradigm of valuation leaves determination of value to the market place. The market is people interacting to establish a price. Ok, but how exactly do people arrive at a price they are willing to pay for a physical product? How they give a value to something physical is a complex interaction of psychology, perception, personal beliefs, what others in the market think, and many other elements. But, but when one tries to put a value on a security (stock), that adds several additional orders of difficulty.

A security is a quantum leap in the number of unknowns. A security exists in a marketplace characterized as a vast numbers of transactions ongoing continuously in a never ending auction. The information media publishes a value determined by whatever the price was in the last transaction. Because the value exists entirely in the mind of the market participants the combined minds set the price that is appropriate for the participants.

To find flaws in current valuation ideas, one can look at the assumptions that underpin whatever is the current paradigm for assignment of monetary value. In the ethereal world of securities, value is not based upon desirability of a physical object, or ability of the asset to produce needed products. In the world of securities value is dominated by promises and perception.

How a Security is Valued

A security supposedly represents both a claim on assets, and also on present and future cash flows. In reality, the claim on present assets is impossible exercise1. So, this leaves only cash flow as a source of value. We accept that situation without a second thought. So, how does value come from cash flow? By comparing with other cash flows, such as interest on bonds, our minds register that the ‘market’ sets the value of a cash flow.

This has serious implications. For one, securities then represent a claim on cash flows and virtually nothing else. Certainly various considerations attenuate the value given by the market, but the raw value is found within the cash flow to the holder of the claim. The mathematical formulae used to deduce present value from cash flow requires the cash flow being valued to have a reasonable history and reasonable expectation to continue in the future. On this basis (really an assumption), the total benefits accruing to the claimant can be calculated as an irregular cash flow. Applying certain considerations it is given a present value relative to other income sources.

All cash flows can be capitalized. Here is the mathematical reasoning. Lets start with simple one: the value of bond paying periodic interest. Assuming the face value of the bond will be paid at the end of the term, the formula: Value = Interest/Rate or Rate = Interest/Value can be reduced to simply cash flow that accrues to the claimant multiplied by another number that varies over time. (The formula would look like this Value = Interest x 1/interest rate). Interest or dividend is the usual term for this cash flow. Value of this cash flow is determined by what others will pay for right to claim the cash flow. This is a circular definition, but cash flow does end up with a value. The value is called capitalization. Bottom line: any cash flow can have a value. By our current paradigm, the value of any security is capitalization of the cash flow. (Again; it is a world of promises, promises, promises).

In the case of shares, the dividend is a diversion of corporate cash flows from all business operations to the shareholder. In this case, value equals a very complex group of cash flow. But again, the value is in the size of the cash flow going to the holder of the claim. So all cash flows can be capitalized. The next implication is that that if cash flow it has a value, it can be securitized and, it can be further leveraged. For example, stocks and bonds can serve as collateral or security for more borrowed assets.

Other Cash Flows

What I am getting at is that the balance of trade, the balance of payments, and Federal Deficit are all cash flows. All of them have a history and a future. Both are fundamental economic activities. Because all cash flows have value and can be securitized, these cash flows have probably been securitized by the financial establishment and now count as capital. Indeed they most likely have been integrated into what we see as the prices of stocks and bonds on the various stock exchanges. The capitalized value has been leveraged upward by the artificially low interest rates engineered by the Federal Reserve Board and further leverage can be added through borrowing against the securities the cash flow underwrites. . .

The balance of payments (BP) deficit gives a claim on American property. Federal currency laws back these claims. The BP deficit represents claims only on private property. Because government is sovereign, the claims do not apply to property owned by the government. Like the Federal fiscal deficit, and cash flows that are associated with capitalization of credit, the BP is not just a measure, it is also a cash flow. It too, has most likely has been securitized. Like other cash flows, the underlying assumption is that the cash flows are predictable and result in an irregular cash flow that can be measured relative to other cash flows and given a value. If one takes each of these cash flows and capitalizes them at a particular rate, they result in a multi trillion dollar value. When the cash flows peter out, as they must, what happens to the capitalized value?

Seed Corn or Investment Corn.

In lay terms, here is the nub. Are we bartering next year’s corn production or are we really selling our seed corn? Which is it? To the extent that borrowing does not increase future production to cover the interest payments due, borrowing such as the Federal fiscal deficit is eating into our capital equivalent of seed corn. Because it is a deficit/credit cash flow it has probably been capitalized. So, when the seed corn-cashflow peters out (cannot increase borrowing), the capitalization of all this cash flow will collapse. Because the balance of payments deficit is a savings deficit, this cash flow is entirely the equivalent of using our seed corn capital. Our leaders say we have enough seed corn to trade until spring and spring may come early, etc. Therefore, they say that we have no immediate crisis. But if we are using seed corn for something other than spring planting we are in the process of creating a crisis. It certainly seems absurd that the sale of seed corn could precipitate a value in the shares of companies engaged in selling our ‘capital’ seed corn. But, in the world of “beliefs,” we see this source of value is considered perfectly rational. At a capitalization rate of 10% the capitalized value of these cash flows that will come to an end when capital seed corn capital is no longer available, is something on the order of $10 Trillion.

Unwinding $10 Trillion.

The lost capitalization due to colossal changes in cash flow will impoverish one group of investors while development of the new cash flows will enrich others. Mr. Greenspan calls this ‘creative destruction’. But, the byproduct of creative destruction is instability. American pre-eminence in the world economy is a product of stability. With the competition between low cost and high cost regions of the world, stability is what draws capital to high cost labor markets. Stability is not just key to running a business in a high cost environment, it is essential. The scale of this impending constructive destruction is so colossal the word ‘stability’ will cease to apply.

Working in and around the housing market, as I do, I see very serious dislocations of cash flows. And of course, cash flows mean value. Like all other markets, a principle exists that states people will “substitute” a lower cost item for a higher cost item provided the differences can be ameliorated (an idea that underwrites the carry trade). The increase in housing prices is dragging upward all other prices as people seek to ameliorate the high cost of housing and use “substitution.” Materials prices are rising, as is the cost of labor per unit that is built. After a time, those prices lose the aura of being an aberration and become part of business models and consumer expectations. They become a multitude of cash flows that can and are capitalized. The way homebuilder shares have gone up is an example of capitalized these cash flows. This runs through all sorts of other industries from natural resources to medical bills. Are doctors going to keep their medical service bills down when their patients have so much loose change in their pockets thanks to new equity in their houses? Using equity drawn out of higher housing prices increases demand for cars. Are car prices going to stay put? While some will benefit, others will lose in this ‘creative destruction’. Today, the prices have made home ownership impossible for a whole segment of the American population. The situation has brought a virtual halt to development of apartment rental units. It has produced a surplus of condominiums owned by people who would normally rent. The net economic effect is to reduce the number of renters looking for rental units. This loss of renters is what has held rents steady while residential prices have soared. This condition has a name: overbuilding.

Playing with inflation statistics.

A little known fact is that prices of substitutable items, in the same use category, vary dramatically in relative price. Those at the high end vary most while those at the low end vary least. Hamburger price varies less than fillet mignon. Over any given period of the business cycle (or housing cycle), low priced houses vary less in price than high-end houses. Using low priced goods to determine inflation will give a much lower rate of inflation than if it is gauged by the increase in price of higher priced goods of the same use category. Perhaps the same holds true for securities with high P/E multiples, I do not know.

The disassociation between home prices and what people earn as income has left people ‘house poor’. The implication is that people have a much smaller portion of their income to allocate to other needs. It also means very little flexibility to respond to economic circumstances. Too much of people’s income is going into paying off a mortgage on a house. This has serious implications about where the income is going to come from to buy goods and services that make up the rest of the economy. It changes the way America spends money. Until high priced American made goods come down from being ‘high end’, more of us will be shopping in the China surrogate known as Wal-Mart. China will become our ‘company store’ and eventually own us.

Swinging of the Pendulum

The only way out of this situation is for incomes to grow relative to residential prices. Housing is a consumption, and Americans produce virtually no savings. The capital needed to invest in the productivity that will increase real incomes relative to the rest of the is woefully insufficient to the task before us.

Coming into Balance

Because the value of all things are inseparably tied to one anther by a medium of exchange and relative value that we mentally apply, the relative value must return to balance. Doctor bills are tied to home prices just as food is tied to doctor bills and the price of cars and how much you pay a handyman to repair a door. The only hope is that the rebalancing will occur slowly, over time. $10 Trillion in destroyed capital can be accommodated with some pain over 10 years. But to lose $10 Trillion in capitalization in one year would be a disaster.

Insurance

For those entering critical pre-retirement and retirement, this situation has particular gravity. We know the risks. We know the extent of the economic strain. During this time of increased risk, will we be able to control ourselves, our greed, our ego and all the other character flaws that are the source of our truly bad decisions? The answer is a resounding NO! The conditions for severe economic earthquake have reached high levels and any resulting quake could produce an economic tsunami. This does not mean one will happen today. But it means one should not simply be cautious about risk taking. Instead, one should reduce exposure to risk. If disaster happens, it won’t happen to us, will it? Of Course not!!

Foot Notes:

1 Actual value includes a value of the on-going business (such things as contacts, good will, brand name, etc), personnel and internal organization, plus physical assets, etc. At its zenith of value, the stock/shares are usually at a premium to any liquidation value. Synergism makes 1+1=3. Book value exceeds capitalized value only when the stock is off its zenith. So, financial systems and economics prevents liquidation of a company at its zenith of value.