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Money, Inflation, the Market & Risk - 10/14/2009 12:32:45 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		A little while ago in another thread Kirata asked me to talk about equities and the value of the dollar - specifically focusing on how when the dollar is devaluing it affects the equities markets. I had a lot of time recently as I was on a plane to San Francisco and back so I took a shot at it. The problem is, it turned out to be seventeen pages long.

I don't think anyone really wants to read a thesis explaining the basics of the economics behind currency valuation and the stock market, but since I wrote the damn thing I might as well get some use out of it. I'll break it up into sections and post them. For those curious but not that curious, I'll put a little summary at the end of each section in bold - like Cliff Notes. If the Cliff Notes don't make any sense, then all the detail will be there to read through.

A lot of what I'm going to say is streamlined or simplified and by no means covers all aspects of economics. I was just trying to address the basics of currency valuation and the equities markets - there are all sorts of other factors that can come into play - I'm just trying to cover the basics.

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.
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RE: Money, Inflation, the Market & Risk - 10/14/2009 12:33:50 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		MONEY


There’s a lot of jabber about what exactly money is and how money works but, for most purposes, you can simply view money as a bunch of tokens that you can exchange for stuff. That number of tokens that you need to get any particular piece of stuff is what we call prices. As I said previously, you can view money as the lubricant that keeps the axle of the economy turning. Since everyone will accept money in lieu of stuff, money is universally used and removes the difficulties that arise in trying to barter for stuff or determine the exact value of an obscure group of assets.

Classically money, in and of itself, has no value. Its only value is in the amount of stuff it can be used to obtain. Hang onto this thought.

Things get a little fuzzier if you have a fixed exchange system or a metal-backed currency but we don’t and currently almost nobody does so we can safely skip that. We have what is called a “fiat money” system. The word fiat is Latin and is most commonly used in the term “fiat lux” or “let there be light” which is supposedly what God said when creating light from nothing in the Book of Genesis. Therefore, “fiat money” would mean “let there be money” or imply the creation of money from nothing. This should not reassure you.

The amount of money in the system is never really “fixed” at a certain rate. The central authority that creates money (say the U. S. Mint) can always make more. You, yourself, can influence the amount of money in the system by simply taking some and burying it in your back yard. Banks can raise their reserves (withdrawing money from the system) or lower their reserves (adding money to the system).

Okay. So. How do you value money? Well, the axiom in economics is that the amount of money in the system is equal in value to the amount of goods and services (stuff) produced by the system. Money is a batch of tokens chasing goods and services (stuff).

At a given point in time, the amount of stuff in the system is fixed. You cannot run out and instantly make ten cars if you decide you need more stuff. You can print up a batch more money if you need it. Therefore, in a short term period – the amount of goods and services in the economy is a constant and the amount of money in the system is a partially controllable variable.

Key Points:
Money, in and of itself, has no value.
Money is a batch of tokens chasing goods and services (stuff).
The amount of good and services in the economy is fixed.
The amount of money in the economy is variable.


< Message edited by InvisibleBlack -- 10/14/2009 12:35:22 PM >

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

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RE: Money, Inflation, the Market & Risk - 10/14/2009 12:42:27 PM   
ThatDamnedPanda


Posts: 6060
Joined: 1/26/2009
Status: offline 		Now this is going to be very interesting. Thanks! I'm looking forward to it.

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Panda, panda, burning bright
In the forest of the night
What immortal hand or eye
Made you all black and white and roly-poly like that?


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RE: Money, Inflation, the Market & Risk - 10/14/2009 12:47:21 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		INFLATION & DEFLATION

In the classic school of thought, inflation or deflation was viewed as a result temporary imbalance between supply and demand. The most widely accepted theory currently is that put forward by Henry Hazlitt, Milton Friedman and other “Monetarist School” economists that 'inflation is always and everywhere a monetary phenomenon'.

The underlying idea works like this:

Since the amount of stuff in the economy at any single moment in time is fixed, if you add more tokens then each token is worth less (inflation). If you remove tokens, then each individual token is worth more (deflation).

So if all we have in our economic system is 100 tokens and 100 pizzas (can you tell it’s lunchtime?) and the only way you can get pizza is by redeeming tokens for pizzas, then each token is worth 1 pizza.

100x = 100 Pizzas where x is the value of tokens so x = 1 pizza

Deflation: If we destroy 50 tokens but don’t eat any pizzas, then since there are fewer tokens, and the only way to get pizza is by using tokens, then each token is worth 2 pizzas.

50x = 100 Pizzas where x is the value of tokens so x=2 pizzas.

Inflation: If we eat 50 pizzas but don’t remove any tokens so we still have 100 then 2 tokens are worth 1 pizza.

100x = 50 Pizzas where x is the value of tokens so x=.5 pizzas (four slices!).

This is inflation, deflation and the value of money in a nutshell.

In modern parlance:

“Nominal” value is the face value of your currency. So if you have a hundred dollar bill, its nominal value is $100.

“Real” value is the actual purchasing power of your money (usually given in relation to some fixed reference point). So if you have a hundred dollar bill but it will only buy you what $50 would have in 1980, then the “real” value of your hundred dollar bill is only $50 in 1980 dollars - even though the "nominal" value of that bill is $100.

Am I making sense here? Ask if I’m not clear.


Key Points:
Inflation is too much money chasing too few goods & services.
Deflation is too little money chasing too many goods & services.
“Nominal” value is the “face value” of your currency.
“Real” value is the effective purchasing power of your currency.


_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

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RE: Money, Inflation, the Market & Risk - 10/14/2009 12:55:32 PM   
snappykappy


Posts: 616
Joined: 3/5/2005
Status: offline 		easily put what the market will bear and what one will pay for it
supply v demand

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believe-it-actually-happened
super duper fantabulous awesome day
thomas michael
just a simple wish

i have sarcoidosis it does not have me
i will kick its ass
i refuse to lose

thomas michael kappler

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RE: Money, Inflation, the Market & Risk - 10/14/2009 1:03:05 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		WHAT HAPPENS DURING INFLATION/DEFLATION


In classic economics (this is pre-Keynes now so we’re taking turn of the century… er, the 19th century) inflation and deflation were viewed as being pure pass-throughs and having no effect on economic activity. If you doubled the supply of money, they thought, wages and salaries would double and if you halved the supply of money, wages and prices would be halved but everything would just steam along otherwise unchanged.

This turned out to be untrue.

There’s a lot of discussion as for the reasons for this but a lot of the underlying premise is that, quite simply - people don’t understand what’s going on and so refuse to act “rationally” or that they try and game the system in their own favor and therefore distort the results.


A simple example:

If we have an inflation of 50% and so your salary increases 50%, (say you’re making $50,000 per year and no suddenly you’re making $75,000 per year) most people do not realize that they are actually making the *same* amount as before – that their new “higher” salary will only buy them the same amount of stuff since prices are rising by 50% as well (or to put it differently, the nominal value of your salary has increased but the real value has not). The rational thing to do would be to maintain your existing spending habits since in “real” terms nothing has changed. This is not what happens. If an inflation of 50% occurs and salaries increase 50%, most people view this as a raise and go out and spend more money. In time, as their savings decrease and they can’t pay their higher bills, their spending habits return to normal but initially there is a “pop” to consumption following an inflation.

Therefore, if a government can run an inflation without most people being actively aware of it, there will be an increase in consumption of goods & services as people will think they are earning more income than they actually are.


The deflation example:

In the event of a deflation of 20%, where prices are falling 20%, people will refuse to take a 20% pay cut – even though their actual “real” salary would remain the same. Instead businesses are forced to maintain existing “nominal salaries” – which results in effectively giving employees a raise. What happens instead is companies lay people off. Those laid off people are unable to find jobs at their previous salaries and so end up working in new positions for less money – thus wages “adjust” to 20% lower not by salary reductions but by rotating unemployment.

Periods of deflation are quite rare these days, so there aren’t many modern examples of sustained deflation.


Milton Friedman’s thesis – which came to be called the “Monetarist School” of economics – was that changes in the supply of money have large and often unpredictable effects on the economy.

If you listen to the news and to what the people at the Federal Reserve say, they are always terrified of deflation. Deflation would mean that there was less money in the system. This would mean that each dollar you had would buy more and that prices would fall (which is actually saying the same thing, capiche?). This would seem like a good thing, wouldn’t it? Why is everyone scared of it?

To use an extreme example – let’s say we have a hundred tokens in the system and 100 pizzas and you want a pizza. No big deal. Get yourself a token and buy a pizza. What if we only have 5 tokens and 100 pizzas? Then one token will buy you 20 pizzas. If you have a token, you can buy 20 pizzas and eat your pizza but you then have 19 pizzas that you need to find something to do with and odds are that no one else has a token and if they do, you don’t have 20 pizzas to give them, you only have 19 so you need to find another pizza. If you don’t have a token, you need to find someone who does and convince them to buy you a pizza or get 20 people together to obtain a token and get 20 pizzas which you then divvy up. The lack of available tokens limits the range of possible economic activity.

This is what Friedman said happened after the Crash of 1929. Right when people were scrabbling for money and trying to get all their cash out of the banks, the Federal Reserve reduced the money supply. Suddenly there wasn’t enough cash to go around. Banks couldn’t get currency, businesses couldn’t get loans, companies went insolvent and people ended up out of work and the whole system slagged down.

Why did the Federal Reserve do this? Were they insane? Were they evil?

Well … the theory was that if they caused a deflation, then prices would go down. The money people had on hand would be worth more – so they could buy more with it. This would increase demand. Falling prices means people buy more. People buying more means inventory drops. Inventory dropping means business produce more. Producing more means hiring people. Voila!

Only since there was no money in the system, business couldn’t get the cash to produce more and so went out of business. This means people are out of work. This means they spend less. Oops.

Prices DID go down. Way down. Only nobody had any money to spend and the people who did have money to spend were afraid to. Beyond that, once it became apparent that the economy was in an ongoing deflation – that prices kept dropping – the savvy investor realized that if he didn’t spend a dollar today, the same dollar would buy him more next month. So there was a strong incentive to hoard dollars and wait for prices to drop even more. To spend as little as possible today since with your cash you could obtain even more tomorrow. Once this phase hit, even when Roosevelt started pouring money into the system, people were just hoarding it, taking it right out of the system, waiting for prices to fall more. You see the trap there?

What about inflation? Everyone worries about inflation. Why?

Well, if you have $1000 and in Year One a toaster costs $50 and the government runs a 10% inflation every year:

Year Cash Toaster Price Real Value
1 $1000 $50 20 toasters
2 $1000 $55 18.2 toasters
3 $1000 $60.5 16.5 toasters
4 $1000 $66.55 15 toasters

So in four years of 10% annual inflation, if you just sat on a pile of cash, your purchasing power would have fallen by 25%. That means that your real wealth would be only 75% of what it was four years ago, even though you still had the same amount of cash.


Key Points:
Sustained inflation will cause consumption to be higher than it normally would.
Sustained deflation will cause consumption to be lower than it normally would.
Inflation gradually reduces the value of your currency-related wealth.

< Message edited by InvisibleBlack -- 10/14/2009 1:04:12 PM >

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

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RE: Money, Inflation, the Market & Risk - 10/14/2009 1:13:04 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		INFLATION & WEALTH TRANSFER


Inflation is really a stealth tax. It moves purchasing power from the person holding money to the government. How does this work?

Back to my lunchtime economy. Let’s say that there are 10 people in the system and there are 100 tokens each worth 1 pizza because there are exactly 100 pizzas. If we assume total equality at the start, each person has 10 tokens and can buy 10 pizzas. So every individual in our lunch economy has a personal savings equal to 10 pizzas.

Let’s say we pick one person. We’ll call him Person A. Person A is the one who gets to make the tokens. Let’s say one day out of the blue, Person A makes 100 more tokens. So now there are 200 tokens in the system, only Person A has 110 and everyone else has 10 each. There are still only 100 pizzas out there to buy, though. So if everyone wants to buy pizzas, we have 200 tokens chasing 100 pizzas, so each pizza becomes more expensive and costs 2 tokens.

Person A’s personal wealth has increased to the equivalent of 55 pizzas. Everyone else only has 10 tokens each, so now their personal wealth has decreased to where they can only afford 5 pizzas.

Understand, nothing else happened except the guy who makes the tokens made 100 more tokens. So by creating 100% inflation, Person A has leeched wealth from everyone else who had any tokens – reducing their wealth by 50% and increasing his own.

Changing Person A’s name to “the government” and tokens to “dollars” and you can see how inflation functions as a stealth tax. By printing more money, the government reduces the value of the dollar. Anyone who has dollars can buy less with theirs. The government, however, has more dollars, and so now has more purchasing power than it did previously.

This is not actually new with our government nor with "fiat" money. In the old days, when the king didn't have enough gold in his treasury, he would mix other metals in with the gold and mint new coinage that contained less gold than before. Therefore the same amount of gold could be used to make more coins - each of which contained less gold. Currency devaluation is along the same lines as this.

The sad part about this “stealth tax” is that it is a regressive tax. This means it affects the poor more than the wealthy. Why?

If you’re rich, you have easy access to other markets and currencies and can shift your dollar-denominated wealth into precious metals, real estate, foreign currencies or whatever – thus you can avoid some or most of the burdens of inflation.

If you’re poor you have your paycheck and possibly a checking or savings account. These are all denominated in dollars. You don’t have ready access to foreign markets, obscure investment vehicles, the ability to stockpile gold, or whatever the method du jour is for avoiding inflation, so you get hit with the full brunt of whatever the effect of inflation is.

I could discuss the effectiveness of taxing the poor versus taxing the rich, but that’s a huge (and controversial) topic in and of itself.

Since, as stated earlier, inflation favors the debtor and it functions as a stealth tax, you can see why governments with an excess of debt (like say, the Weimar Repbulic in Germany) ran a constant high rate of inflation. This reduces the real value of what they owed and pulled more wealth to the central government to help them pay off these debts.

To recap:

During inflation it is bad to be holding cash. During deflation it is bad to be heavily invested in stuff.

During the hyperinflation of the Weimar Republic in Germany, people would bring a wheelbarrow full of money to buy a loaf of bread. If you had a loaf of bread, you could pretty much command anything you wanted for it. Money was used as wallpaper.

During the depths of the Great Depression, people would be thrown out of their homes due to their inability to pay the rent, but be unable to sell any of their possessions because no one had any money to buy them. If you had money, you could pretty much get anything you wanted.

That’s the basics of money, inflation and deflation. Before we get to equities we need to discuss interest rates. You still with me?


Key points:
Inflation functions as a tax.
As a tax, inflation affects the poor more than the rich.

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

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RE: Money, Inflation, the Market & Risk - 10/14/2009 1:18:28 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		INTEREST RATES


Money has what is called a “time value”. What does that mean? Well, if I tell you I can give you a thousand dollars today or a thousand dollars next year, which would you rather have? Obviously, a thousand dollars today! (Show me the money!) What if I told you that you could have a thousand dollars today or more than a thousand dollars a year from now? Which would you want? Well … that would depend on how much more. The number which would make you unable to decide which is better (they call this being indifferent and throw that word around a lot) is the “time value” associated with the money.

So if a $1000 now or $1050 a year from now would make you indifferent, then that $50 is the value you put on not having access to a thousand dollars for a year – which would make the “interest rate” you would charge to loan someone a thousand dollars for a year and have them pay you back $1050 next year be 5%.

$1000 x 1.05 = $1050

If you go to a bank and put $1000 into a 12-month CD paying 5% then in 12 months the bank will give you $1050. The bank takes that $1000 and loans it someone else (say as part of a mortgage). If the bank charges them 8% a year, then at the end of the year the bank gets $1080, gives you $1050 and keeps $30 for themselves. In the classic model, this is how banks make money.

However, not all loans are equal. What if there was a chance you might not get the thousand dollars back at the end of the year? That you might lose it all? How much more would you have to be offered to give someone that thousand dollars? Well … that would depend on how big a chance there was you might not get the money back. This is called risk and risk analysis is a huge industry.

Prior to the current financial imbroglio, United States Treasury Bonds were regarded as effectively risk-free. So if a T-Bill paid you 5% and Fly-By-Night-Investing paid you 5% there is absolutely no reason to entrust your money to Fly-By-Night-Investing. They would have to offer you a higher interest rate to gain your money. How much higher? It depends on the risk. Just how fly by night are they?

IBM corporate bonds might have to pay you 5.5% or 6% to entice you away from secure Treasury bonds. Tiny start up companies with dubious chances of survival might have to offer you 10% or more to get you to contribute your money (this, btw, was the start up of ‘junk bonds’ – if you had someone very sharp picking your high-risk bond investments (say Michael Milken putting your money into Apple or MCI in the early 1980s) you could make substantially higher profits with little real risk – if you had someone not as savvy investing in high-yield high-risk bonds, you could lose everything and people did).

So now you have what is called the “risk spectrum”, with highly secure investments paying low interest rates on one end and highly risky investments paying very high interest rates on the other end. Taken to the extreme, if you are a bankrupt gambling junkie, a loan shark might loan you $1000 at 40% interest with the understanding that the leg-breakers will come by and bust you up if you don’t pay back in a week. The loan shark is able to charge the bankrupt gambling junkie such a high rate of interest because of the extreme risk of the loan (coupled with the added expense of having to pay some guys to be available to break his legs if the gambler tries to skip town).

So the breakdown is, interest is what you get paid to give someone else access to your money for a given period of time (typically yearly). The more risky the loan is, the higher the rate of interest – basically you are paid more to take on more risk.

Key Points:
Money has a "time value".
This "time value" is the interest rate that would be charged to loan money for a set period of time.
The greater the risk associated with the loan, the higher the interest rate will be.

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

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RE: Money, Inflation, the Market & Risk - 10/14/2009 1:23:47 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		INFLATION & INTEREST RATES


Okay. Now comes the tricky part. We’re going to combine inflation and the time-value of money.

Let’s say I convince you to loan me $1000 with the promise that I’ll give you back $1100 in a year. That’s a 10% interest rate. Pretty good – assuming you think I won’t ditch you. But hey, trust me, I’m rock solid. There’s no chance I’ll default. Let’s talk purchasing power. If a toaster costs $50 then you are sacrificing 20 toasters now for the ability to have 22 next year.

So I get the $1000 and go and buy 20 toasters.

What if during that year the government creates 100% inflation? Then the dollar is only worth half as much (twice as many tokens chasing the same fixed amount of goods) so all prices double.

So I borrowed $1000 and bought 20 toasters. Those same toasters I can now sell for $2000 since their price has doubled. I then give you back $1100 and keep $900 for myself. Wow. Good deal for me and I didn’t even have to do very much.

You get the $1100 but since toasters now cost $100 you can now only buy 11 toasters instead of the 20 you could have bought a year ago. You were paid a “nominal” (or face-value) interest rate of 10% but in actuality, due to inflation you *lost* purchasing power from the transaction or had a “real” interest rate of -45%. That’s pretty harsh.

Deflation works the other way. Using the above example, if the government reduces the money supply by 50%, then all prices will fall to half. So:

I borrowed $1000 and bought 20 toasters. I can now sell those toasters for only $500. I owe you $1100 at the end of the year, so I have to use my savings (or rob someone or sell an organ or whatever) to pay you back your $1100. I lost $600 on the deal. Bummer.

You could have bought 20 toasters at the start, but you get $1100 back and the price of toasters has dropped to $25, meaning that when all is said and done, you can buy 44 toasters. Your return on that loan wasn’t really the “nominal” 10% but was in reality 120%. Wow. You’re a financial genius.

Inflation favors the debtor. Deflation favors the lender.

So what if I don’t loan any money, don’t carry any debt and just hang onto my cash?

Then your cash just keeps losing purchasing power for as long as there’s an inflation as I mentioned before.

Key Points:
Inflation favors the debtor by reducing the effective real interest rate being paid.
Deflation favors the lender by increasing the effective real interest rate being paid.

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

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RE: Money, Inflation, the Market & Risk - 10/14/2009 1:35:14 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		EQUITIES MARKETS


Stocks, bonds, commodities, currencies, precious metals and pretty much all investment vehicles can be lumped together in something called the “equities market”. Equity is loosely defined as the value of a property or business, so bluntly an equity is something that you own that has value and generates income or revenue.

In the old days, back when the sky was blue and the sun shone all the time and everyone was happy, the way you determined the value of an equity was that you totaled up its innate value, figured out what the “time value” of its future earnings might be, added these together and then subtracted out whatever risk might be entailed with owning this equity (companies go out of business, crops might get a blight, etc.) and that was your “price”.

If you and I disagreed on these figures – I for example might think that this Jobs character is a drug-addled loony toon and will never amount to anything and you might think that he and the Woz have hit on something big with their new computer named after a piece of fruit – we would arrive at different estimates of the price of a share of Apple Computer. In this case you would be willing to pay more for a share than I would, and so if I had some shares I would be willing to sell them to you.

The place where I would sell these shares and you would buy them is called an Exchange because that is where we exchange goods. So you have the stock exchange and the bond exchange and metals exchanges and so on and so on.

The type and nature of the various instruments of investment have become so obscure and abstruse that explaining them all could take weeks. Months. Hell, it would be never. I don’t understand how some of these things work anymore. The basic ones are fairly simple in their operation and will serve to illustrate the points that need to be made.

A bond operates like this:

You give me a thousand dollars for a set period of time. Say ten years. I pay you a fixed amount every year for the use of your money (say 5% or $50) and then at the end of the ten years I give you your money back. So for nine years I have a thousand dollars and you get $50 a year, and then in the tenth year I give you $1050 (the original sum plus the last interest payment).

Calculating how much money you’re going to receive from buying a bond is a pretty easy exercise.

Stocks are a little more complex. If we’re starting up a company, we might issue stock to raise money. Let’s say you find a gold mine. Great! You’re rich, you say. But wait … yes, you have land where the gold is – but mining, tools, workers, machinery, equipment, EPA variances, smelting facilities – those cost money. Millions of dollars of money. Do you have millions to set up your gold mining operation? No? What to do!?

You could issue a bond for millions of dollars, but at 5% per year you'd have to pay out tens or hundreds of thousands of dollars a year in interest payments and you don't have that kind of cash and the stupid smelter isn't going to be even built until two years down the road! That won't work!

Start GoldMine Inc! Form a corporation and issue shares!

What does this mean?

Basically, you are selling ownership or part ownership of the mine in return for cash. Each share of the company gets a vote in what to do and who should run the company. Profits are divided evenly amongst the shares – these are called dividends.

So if you issue 100 shares of GoldMine Inc you have created 100 votes. If you sell 40 of those votes for money and keep 60 votes, you still control the company. If you raise enough money and mine some gold, after you pay the workers and the leasing fees on the equipment and whatever other expenses you have in mining your gold – whatever is left is profit. Let’s say in the first year after expenses and taxes, there's nothing left because they haven't finished that stupid smelter. Hey! No profits! You pay no dividends! Let's say that in the second year, the smelter goes online and after expenses and taxes, you have a million dollars left. This is the “profit” and would be evenly distributed amongst the shareholders. So every share would pay $10,000 to whoever owned it. Your 60 shares would mean you get $600,000 – not bad. The 40 shares would pay whoever owned them a total of $400,000 – the remainder of the million dollars in profits. These payments are called “dividends” and they are typically paid quarterly.

So the value of a share of stock is the total value of the assets of the company, plus the value of the expected dividends (discounted for their “time value” since they come in the future) minus whatever risks we view the company might have (the mine might flood, gold might crash in value, you might be a crook and embezzle all the funds, whatever).

Stocks are viewed as innately riskier than bonds. Why?

Well, bonds pay a fixed monthly rate. You know what money you will receive.

Stock dividends are based on profits and profits are not guaranteed. They might be high. They might be low. There might be none. What’s the total value of all the assets of the company? It could be huge. It might be low. Buildings burn down. Stuff breaks.

If the company had a tough year, it still has to pay out the value of its bonds. It can choose to pay no dividends.

Following the logic that riskier investments have to pay more to justify taking on the increased risk (i.e. if your gold mine will only pay me 5% per year and Treasury bonds will pay me 5% per year – I’ll put my money in T-bills – they’re safer and guaranteed by the U.S. government) to get me to give you money you have to pay me more, or give me the expectation that I’ll receive more.

Let’s say that I own 1 share of your gold mine and it pays me $10,000 a year. Great deal. But let’s say that I think the price of gold is going to collapse and that I won’t be seeing that kind of payout in the future. Someone else, Mister Goldbug, thinks gold is only going to go up up up up! He wants to buy and buy now before the coming rush!

I would then likely be willing to sell my share of stock to Mister Goldbug. Since I think its future earnings will be low and he thinks they will be high, the price he views as fair and the price I view as fair will be different and his will be higher than mine, so he’ll be willing to pay me what I want for it and probably more than that.

If I paid a million dollars for that share of your gold mine and he gives me two million for it (good deal for me!) then I made a million dollars in profits. This profit is called a “capital gain” because I bought capital (a share in your gold mining company) and made money on it (a gain)). Another way to say this is that the price of a share of your company went up from 1 million dollars to 2 million dollars.

Important to note here is that the increase in the stock price of one million dollars, doesn’t mean that you or your company got any money out of the deal. *I*, the former stock owner, made a million dollars. If IBM shares double in price, it doesn’t mean that IBM made any more money.

It means that people think that IBM is going to be making more money in the future and so are willing to pay more to own some of IBM now.

Sometimes people are right. Sometimes people are wrong. Sometimes they are horribly wrong.


Key Points:
An equity is something that you own that generates income or revenue.
Equities are traded on various exchanges.
Riskier equities promise higher income or revenue streams.
The value of an equity at any given time is based on what investors think the equity is actually worth - not on its "real" worth.

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

(in reply to InvisibleBlack)
Profile   Post #: 10
RE: Money, Inflation, the Market & Risk - 10/14/2009 1:45:18 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		MARKET INDEXES


In order to provide some sort of overview or barometer of how the whole country or a particular industry is doing – people group certain companies that they view as representative of an industry or an economy together and track the prices of their stocks. These are called indexes and the major three I can think of are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the NASDAQ Composite.

Each of these is supposed to represent how the American economy is doing. None of them is perfectly accurate. Why?

We’ll use the Dow as an example. The Dow Jones Industrial Average is composed of the stocks of 30 companies. Those 30 are:

3M
Alcoa
American Express
AT&T
Bank of America
Boeing
Caterpillar
Chevron Corporation
Cisco Systems
Coca-Cola
DuPont
ExxonMobil
General Electric
Hewlett-Packard
The Home Depot
Intel
IBM
Johnson & Johnson
JPMorgan Chase
Kraft Foods
McDonald's
Merck
Microsoft
Pfizer
Procter & Gamble
Travelers
United Technologies Corporation
Verizon Communications
Wal-Mart
Walt Disney

Why those thirty? It’s felt that the industries they represent make up an accurate composite of American industry. Why any particular company? Why Wal-Mart and not Target? Why American Express and not Visa? The people who make the Index feel those companies are more accurate indicators.

The Dow Jones is not perfect and it’s difficult to use it to accurately track things historically. Why?

Well … you see any car companies in that list? Back in June, they took Citigroup and GM out of the Index and replaced them with Travelers and Cisco. Was this the correct thing to do to properly represent the American economy? I’m not sure. You might want to argue over this industry or that industry and its representation in the Index but I would argue that an auto manufacturer (either GM or Ford) should still be in the Index given their share of the U.S. economy. It has been argued that the composition of the indexes is deliberately manipulated to make things look better than they are. Is this true? Well ... I'll just say that I'll leave this as an exercise for the reader.

Anyway – my point is that the Indexes aren’t perfect.

Now – if the price of a stock is based on what investors think a company is actually worth and the index is composed of a batch of stocks, then the Index is actually an indicator of what a group of investors in certain stocks think those stocks are worth.

It doesn’t really tell you about the U. S. economy. It tells you what investors in the stock market think about the prospects of certain companies in certain industries.

You following me?

Obviously there’s a correlation between how the economy and how 30 big companies are going to do or even how investors think 30 big companies will do, but that correlation is not one to one.

The United States economy did not suddenly take a nose dive on September 15th 2008 – what happened was that investors realized that their estimates of how the economy was doing were way off and way too high and tried to get out of the stocks they owned. Since they all were trying to sell and nobody wanted to buy, the price of the stocks went down (too much supply and too little demand means prices fall) and so the Dow crashed.

The stock market and the indexes (by which I mean investors’ opinions about the value of companies and bundles of companies) are accurate on average, in the long run.

At any given particular moment, they are probably wrong.

Wait a minute, here! How could that be?

Okay. Let’s say that at the start of the year IBM is valued at $150 per share. You decide to conduct an audit of IBM to see if that’s right. Because you’re a thorough person, you conduct a massive audit. You interrogate the directors and executives with truth serum. You track down every vendor, every customer and every contractor and assess their books. You triple audit IBM’s books while putting guns to the heads of their accountants and smiling at them.

You determine that the accurate price of IBM is probably $100 per share.

In June, as you’re in the middle of your [strike]reign of terror[/strike] audit, word leaks that IBM is being audited and that maybe their value isn’t as high as people thinks it is and on July 1st the stock price crashes to $50 per share and stays that way until close of business December 31st when you release the details of your audit.

The average price of IBM for the year would be $100, exactly equal to its actual worth, but at no time was the price of the stock ever actually $100 per share.

Hold it! What about efficient markets!? What about the “Invisible Hand”!?

Don’t believe everything you read.

Market forces tend to move the value of a stock towards its actual value. If you look at a trend chart of a stock you’ll see it kind of dances around what a company is actually worth, sometimes too high, sometimes too low. It’s rarely exactly steady on a price for even a few minutes. This is because people tend to be emotional and either too optimistic or too pessimistic. It’s also because people lack perfect information and often make irrational purchasing decisions based on impulse, rumor, herd behavior, fear, greed or any of a hundred other causes that have nothing to do with their valuation of a company.

This movement of the price, this fluctuation around the real value, is what allows people to make (or lose) money in the stock market. If your information, or ability to assess value, is better than the average person’s then you can make money trading stocks. On average. In the long run.

Sometimes, however, the valuation and the actual value get out of whack. Way out of whack. Eventually reality assets itself and the market corrects itself.

Why does this happen?

Well, there’s a lot of speculation on this. Herd behavior. The “greater fool” theory. People have a lot of theories. There isn’t a hard and fast answer that I’m aware of. People become vested in a wrong belief and blindly follow that wrong belief off a cliff. It happens all the time – only in the stock market we call that cliff a crash.

Key Points:
An index (such as the Dow Jones Industrial Average) is a group of companies whose stock prices are felt to mirror the performance of the economy.
The price of an index is based on what investors feel the future earnings of the indexes component companies are worth.
These valuations are accurate only on average over the long run, at any given moment they are likely to be incorrect.
Incorrect valuations will correct as accurate information becomes available and investors' opinions change.
When an index's valuation is way off on the high side, this correction is called a crash.
The exact reason for wildly inaccurate valuations is a matter of great debate.

< Message edited by InvisibleBlack -- 10/14/2009 2:17:41 PM >

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

(in reply to InvisibleBlack)
Profile   Post #: 11
RE: Money, Inflation, the Market & Risk - 10/14/2009 1:53:40 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		EQUITY MARKETS & INFLATION (or ... the whole damn point)


Okay, now it’s time to put the Dow and inflation together. Hang on.

So. In 1920 the Dow was at 100. It’s now at 10,000. Does that mean that the United States economy is 100 times larger than it was in 1920!?

Not really.

Stocks are valued in dollars. Dollars can be inflated or deflated. If you adjust for inflation (using the consumer price index as your benchmark) the Dow peaked around 1000 in 2007. So the economy is really 10 times as large as it was in 1920 and we have had an inflation of about 1000% since 1920.

Oh my.

So, looking at it, 900 points of gain in the Dow since 1920 is due to expansion, productivity increases or something that added value and 9,000 points of gain is due to inflation or basically does not reflect any increase in productivity or value but rather a loss of purchasing value of the dollar.

Is this really accurate!? Really!?

Well … yes and no.

Yes, the inflation rate since 1920 is probably around that high. I mean, if it’s 900% rather than 1000% does that change your overall opinion? It’s not 20% or 40% or something.

No, all of the non-productive increase in the Dow is not due to inflation. Some of it is due to the side effects of inflation.

Lemme think of a good example. What can you buy for $5 these days? Aha! Lunch time again, I can get two hot dogs and a soda from a street vendor in New York for about $5.

Let’s say our prospective investor has $1000. That’s his entire life’s savings, and he spends and plans on spending all of his income for the rest of his life so he will never have any more. He wants to be able to afford a few luxuries in life (for him a meal at a hot dog vendor is a luxury) so he wants to invest his $1000 and use the earnings to buy these special lunches.

If he buys a Treasury bill paying 5% a year in interest, his $1000 will earn him $50 per year. That’s 10 hot dog lunches. He’s good with this – too many hot dogs give him heartburn – so he buys a 30-year Treasury bill with his money.

This assumes, however, that there is no inflation.

What if the government starts a 1% inflation?

Well, if there’s a 1% inflation and a bond is paying him 5%, then the “real” value of his interest payment, its purchasing power, is reduced to 4%. This means that instead of 10 hot dog lunches he can now only buy 8 a year.

If inflation goes to 2%, then 5% - 2% = 3%, he can now only buy 6 hot dog lunches a year. This is getting serious!

If inflation goes to 4%, then he’s left with 1% of purchasing power and can only buy 2 hot dog lunches.

If inflation goes to 5%, then he isn’t making any “real” money off of his investment, the interest is merely enabling him to break even, so he doesn’t dare take any money out of his account or he’ll be feeding on his life savings. He can afford no hot dog lunches.

I could do all the math about the prices of hot dogs rising and put up a chart but take my word for it.

But… but… what if inflation goes to 6%?

Then his 30-year fixed Treasury bill is only paying him 5%, so he’s LOSING purchasing power every year. Admittedly, less than if he’s been keeping it all in cash, but his life savings is slowly going down.

What if it goes to 10%? Then his wealth is shrinking at 5% a year.

What if you need that 5% interest you were earning. What if that extra $50 a year was important to you?

Well … you remember when we were talking about risk? You get more interest when you take on risk. If inflation goes to 5% and IBM is paying 6% for their corporate bonds, he could sell his Treasury bill and buy an IBM bond paying 6%. Now he’s got a little extra money each year. It’s not really that much more risk.

What if inflation goes to 6%? Now he’s only breaking even again.

You remember Fly-By-Night Investments? Their “junk bonds” pay 10%. He could sell his IBM bond and buy a junk bond.

What if inflation goes to 10%?

Well … there are these guys see. They’re really sharp and they say they have these new investment vehicles, they’re far too complex to explain, but they’re called derivatives and they pay better than 10%.

As inflation rises, it forces assets further out onto the risk spectrum, into riskier investments as people seek to maintain their current level of wealth. This is not desirable. Why?

Risky investments are just that … risky. They fail. They go under. Wealth is destroyed. Money is lost. In a classic Adam Smith explanation, it forces the markets out of their equilibrium and distorts investments into areas that people would not have made under ideal circumstances. Too much risk is taken and too little stable investment is made.

Is this starting to come together?

(As an aside, this is not to say that greed doesn't play a part in what happens. Obviously as people are more willing to invest in greater risk and are looking for investments that pay a higher rate, the criminally minded and the morally bankrupt have much greater opportunities to take advantage of them.)


Key points:
Inflation forces people to invest in riskier investments than they usually would.
People do this to prevent inflation from reducing the value of their savings.

< Message edited by InvisibleBlack -- 10/14/2009 1:54:04 PM >

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

(in reply to InvisibleBlack)
Profile   Post #: 12
RE: Money, Inflation, the Market & Risk - 10/14/2009 2:03:07 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline 		CONCLUSION (or, y'know - you could've skipped all the rest and just read this):


Let’s recap:

During inflation, people tend to view themselves as having more real wealth than they actually do and so tend to consume more than they realistically can. Check.

During inflation it is bad to be holding cash and better to be buying or invested in stuff. People tend to either buy more stuff or put their money into non-dollar investments. Check.

Inflation favors the debtor. During inflationary periods, people tend to borrow more money and take on more debt. Check.

Inflation makes the nominal value of the stock market appear greater than its real value, making stocks look like an attractive investment even if they’re only staying even. Check.

People tend to be either too optimistic or too pessimistic about the values of stocks. Check.

During an inflationary period, people tend to move their assets out of cash and into riskier assets in order to preserve both their existing savings and their expected level of income. Check.

So what are we looking at here? Continuing ongoing inflation should result in people spending more and consuming more than they realistically can, taking on more debt than they normally would, being unrealistically optimistic about the stock market and the equity markets, and being willing to make investments that are riskier than they normally would.

That’s the current theory. Make any sense?

(I hope I answered your question, Kirata.)


(Great Scott, I do go on and on, don't I? Anyways, if you made it all the way down here, kudos to you. If you have any questions or want to throw brickbats or whatever, I probably won't be around tonight as I'm going to go out and get drunk but I'll take a shot at answering them and/or defending myself when I get the chance).

Key Points: I talk too much.

< Message edited by InvisibleBlack -- 10/14/2009 2:04:09 PM >

_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

(in reply to InvisibleBlack)
Profile   Post #: 13
RE: Money, Inflation, the Market & Risk - 10/14/2009 2:35:33 PM   
MrRodgers


Posts: 10542
Joined: 7/30/2005
Status: offline 		Two things:
One is that an economics professor at a nearby univ. once told me that M1,2,3, through M5 is a different description of capital designed to fit his particular thesis. Take what economists say with a big grain of salt.

Two, Friedman and too many others referred to today are post Keynesians and post Fed and believe in a monetary system as the ultimate market determiner or 'self-regulator' and combined with Friedman's postulation that 'capitalism IS freedom' fiasco, renders there advice specious at best.

Much of your examples are taken in a vacumm as if there are no other mitigating factors. Because pizza is not a rare or in-demand commodity, its price is meaningless as with any 'stuff' that has little or no universal demand say for example like gas, oil, coal. It is the inconsistency of the demand or supply due to weather...that is whole rationale for farm subsidies and would only have a very minuscule effect on pizza dough prices.

Currency...i.e., paper money has only a perception of value individually and an assessment of the value of what labor or added value (any finished goods) that one will obtain in exchange for it. Otherwise the value of any currency is ONLY in reference to...another currency.

Yes, you print up more dollars, later, one causes inflation and usually of the creeping kind and that's because every newly printed dollar isn't immediately sent into the marketplace. If one prints up money and saves it ALL, the cost of capital comes down...higher supply and it isn't until after most of that hits the market at large representing demand in all goods...do we see any uptick in inflation.

Inflation has been defined as the increase in hours worked to purchase the same thing and has almost no relationship to wages. Wages are a by-product of the supply and demand in the labor market...NOT the capital markets and are only has high as what that marketplace demands and in no ways follows or leads prices. Investors are never forced by either the laws of man or the marketplace to pay anymore than the minimum necessary to fill any given position.

Let's be realistic now and thus pizza is not in ANY of our measurements of inflation as we report that number. Most inflation is caused by two main vehicles...low interest rates which increases debt, increasing demand. This is what happens in bubbles like oil (speculation through futures) and real estate (and printing more money) two different things. AND speculation in commodities or things.

Capital gains and its immoral tax benefit leads the way to inflation in oil, gold etc. (see oil futures 2008) and is almost never because any structural change in supply or demand. Capital gains and the buying of selling paper and things takes only a year and may be the largest single influence on inflation as measured in the CPI and other govt. figures on commodities.

(in reply to InvisibleBlack)
Profile   Post #: 14
RE: Money, Inflation, the Market & Risk - 10/14/2009 4:58:38 PM   
Kirata


Posts: 15477
Joined: 2/11/2006
From: USA
Status: offline
quote:

ORIGINAL: InvisibleBlack

(I hope I answered your question, Kirata.)

Nicely, thanks.

K.

(in reply to InvisibleBlack)
Profile   Post #: 15
RE: Money, Inflation, the Market & Risk - 10/14/2009 9:22:47 PM   
Termyn8or


Posts: 18681
Joined: 11/12/2005
Status: offline 		A couple of key points for you IB.

You have surpassed me in the realm of verbosity, and thoroughness as well.

I will have to look for my original copy of Silent Weapons for Quiet Wars, something like that. It is not available on the internet, only some excerpts here and there. You might have to learn just a bit of electronics, but calc will do as well because the methods of control used on this type of economy to make money is discussed thoroughly and expressed with formulae (hand written I might add). In other words it is sort of the nuts and bolts part of exactly what you're talking about. It is very thick and will take a long time to scan, once I find it. I think you are one of the few who may actually understand quite a bit of it. I do not understand it fully but I found it very enlightening.

Incidentally I learned a thing or two in your series, and I appreciate that.

I think that was quite well written, but if you publish it more for general consumption, remember that the plural of index is indeces. I won't dwell on it though, because not everybody even knows that data are plural and license is singular.

A better analogy than pizza might be some sort of fuel, or water or something because if the pizza doesn't sell at all, it or it's indredients go bad. I grasped what you meant, but I think you pulled pizza out of your hat, when you may have actually meant to use something non-perishable. Perhaps you should have lunch first next time :-)

What's more, I never thought of the DJIA like that. I'm sure I knew, but it had slipped my mind that the companies selected for inclusion do change. What has occurred to me now is - just who decides and what are their motives ?

Once I find it, I think you'll find silent weapons to be a very interesting read. If you don't know what capacitance and inductance are, if you know higher math, the equivalent references are readily available. Interesting that the author, who was an electronic engineer as well as a financial genius equated the different influences on the economy as components of an eletronic circuit. Most of my understanding of it's content is based on my electronics knowledge, I am a bit weak on higher math.

At this time I yield the floor.

T

(in reply to InvisibleBlack)
Profile   Post #: 16
RE: Money, Inflation, the Market & Risk - 10/15/2009 2:36:45 AM   
Alphascendant


Posts: 285
Status: offline 		Perhaps if the importance of math was stressed to a greater degree in our public school system
the general public would have an easier time grasping the concepts outlined in the previous thesis.
Understanding how the fundamentals of addition, subtraction, division, and multiplication are intertwined
as they randomly bear on each other could give one the impression that this entire financial mess
is indeed the desired result of those that most influence the direction of our economy.
Can anybody name one Federally funded program that has ever been managed properly and adds up correctly?

Our socialite, camera mugging "conservatives" all talk big talk, stirring emotions about preventing illegal immigration
and how the masses of illegals drain our economy, when in fact the Republicans benefit from the illegal immigration as
much as their twin sibling "liberal"-ites do, which is probably why they haven't done much to slow it,
other than for the sake of photo-ops.
The reasons why are explained in the previous thesis, more hands to distribute the fiat , funny money, further draining the system dry.
The general population then blames the illegal immigrants for the dwindling resources
when it is the politicians and bankers who are making off with the loot.

I grew up in Maine, and I remember when Olympia Snowe first made her political platform public.
She was elected to the State Senate in 1976, three years before the end of James B. Longley's second term
as the state's first Independent Governor, who only ran as an Independent because he had missed the deadline to run as a Democrat.
"Think about it," was his platform slogan.
She held such promise and hope for the people of Maine, where nearly 20% of the economy is gathered from cleaning up after the summer tourists.

I guarantee that if half the people in Maine could read the health bill, let alone have access to it, they would boot her ass out of the state for signing on to it.
The only reason she got elected in the first place is because, by Maine standards, her opponents always camped out at the far left of Maine politics
while she stood just a bit to the right to create the mirage of her being a Republican. Today she has betrayed her state.


Sure, Maine might have a slightly higher graduation rate than the overall average of all the states, but most of the people I went to school with, that graduated , did so while not being able to read or write much better than many second graders.



"Unacceptably low graduation rates, particularly among poor and minority students, have been obscured for far too long by inaccurate data, calculations, reporting, and inadequate accountability systems at the state and federal levels."

http://www.all4ed.org/files/National_wc.pdf

The only other place in this article where the word "federal" appears is in the paragraph, "Problematic Calculations." Gee, I wonder why?
It is my opinion that anybody who believes that the Federal Government is willing to do anything that serves the best public interests
isn't much smarter than those same second graders. Being more educated does not make one smarter.

Printing all that extra money to throw at the problems, not intending to solve them, but gift wrapped and handed to the problems
as a reward for such a cleverly devised heist of America's wealth does not make good business sense, as explained in the previous thesis, except for the politicians and bankers of course.

There is a problem with the education system. The government said they would fix it, yet the general public seems to be getting stupider and continues to elect enemies of the U.S.Constitution to office.
Now the American public appears to be willing to let the government run health care. That should be an indication of where our health is going.


So keep worshipping that little green piece of paper.

www.toiletpaperworld.com

Stock up on toilet paper, it will not ever decrease in value. When the economy takes a shit, a single square of Scott toilet paper
will be worth more than a dollar, how many squares in a roll?


< Message edited by Alphascendant -- 10/15/2009 2:44:48 AM >

(in reply to Termyn8or)
Profile   Post #: 17
RE: Money, Inflation, the Market & Risk - 10/15/2009 6:27:59 PM   
InvisibleBlack


Posts: 865
Joined: 7/24/2009
Status: offline
quote:

ORIGINAL: Termyn8or

A couple of key points for you IB.

You have surpassed me in the realm of verbosity, and thoroughness as well.


Yeah, I can really get going once I get started.

quote:

ORIGINAL: Termyn8or

I think that was quite well written, but if you publish it more for general consumption, remember that the plural of index is indeces.


I think that current vernacular accepts both indices and indexes as the plural - although I agree with you that indices should be the valid plural. I just wasn't thinking when I typed everything out and my spellcheck didn't catch it.

quote:

ORIGINAL: Termyn8or

What's more, I never thought of the DJIA like that. I'm sure I knew, but it had slipped my mind that the companies selected for inclusion do change. What has occurred to me now is - just who decides and what are their motives ?


For better than a century the Dow Jones Industrial Average was compiled by Dow Jones & Company, a financial reporting firm that also published the Wall Street Journal and Barron's. Dow Jones & Company was bought out by News Corp a couple of years ago, so they're now run by Rupert Murdoch.



_____________________________

Consider the daffodil. And while you're doing that, I'll be over here, looking through your stuff.

(in reply to Termyn8or)
Profile   Post #: 18
RE: Money, Inflation, the Market & Risk - 10/15/2009 8:11:19 PM   
Termyn8or


Posts: 18681
Joined: 11/12/2005
Status: offline 		"so they're now run by Rupert Murdoch"

That does NOT instill any confidence in the system.

T

(in reply to InvisibleBlack)
Profile   Post #: 19
RE: Money, Inflation, the Market & Risk - 10/15/2009 8:27:47 PM   
pahunkboy


Posts: 33061
Joined: 2/26/2006
From: Central Pennsylvania
Status: offline 		Oddly enough you do not even own the currency in your wallet.  

it is owned by the federal reserve.

the whole game is so that 13 banking offshore families can collect interest.

you really dont own anything.....  not with the liens on it.   federal reserve notes.

(in reply to Termyn8or)
Profile   Post #: 20
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