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The Price of Money (Econo-speak)

November 19, 2012

Economists come up with some real howlers that are not “accidental” or “mis-statements” because having said “that” they then go on to get “those” conclusions that seem to be totally bereft of “common sense” or “meaning” – so much so that it seems as if they are speaking in tongues. Today’s howler comes to us from Buttonwood

The Economist, October 20, 2012, “Interest rates are the price of money, balancing the demand of citizens to save with business’s desire to invest.  So a low real rate may simply be a sign that both consumers and businesses are feeling cautious.”

Their conclusion is that low real interest rates discourage stock market investing and that, therefore, we (as investment consumers) do not expect good returns on capital gains or dividends this year WHEREAS OUR EVIDENCE is that most of the major North American stock markets are UP in the double digits and about a third of the market can we worked to provide entirely safe double digit returns and typical above the rate of inflation dividends this year. Please see our Post, Investor Angst, November 2012.

How can we not help but to be confused and possibly punish ourselves even further by not participating in the investment market and, in the case of companies, by not investing in our businesses and just sequestering our cash as a buffer against the alleged and possibly self-inflicted “bad times” and the possibly worse times to come? Which, if we don’t invest in ourselves and others, will surely come.

Buttonwood’s conclusion is a discouragement and a bane to investment and a back hand to monetary policy that is allegedly making available gobs of low cost money that they say is likely to be paid for by higher inflation later. And, at that time, higher inflation and possibly higher real rates of interest above inflation will be necessary and sufficient for “good markets” in which there is a high demand for money at a higher price that we will be anxious to pay in order not to miss it, they say.

The fundamental error in Buttonwood (in our opinion) is to think and then say that “interest rates are the price of money” notwithstanding the fact that economists, in general and certainly in econo-speak, freely admit that they have no idea what money is (as a definition, perhaps only defined by its properties, and that would be a step up in terms of the intelligence communicated. Please see our Post, Stock Prices Are The New Pink, June 2012.) and to skip over that difficulty by simply claiming that whatever “it” is, it has a price that is demonstrated by what people are willing to pay for it.

We are certainly comfortable with the latter, that the “price” of a thing as a property is demonstrated by what people, one, some or all, are willing to pay for it but in the case of investments, what we are buying and willing to pay for is “investment risk” – all investment is just and only the purchase of risk (Goetze 2009) as is the purchase of any “thing” else with our cash now which is the real thing until told otherwise by our government – and, as we have often said, the “Price of Risk” is “the least price at which the “thing” is likeable” (Goetze 2009) and the property of  “likeability” is something (or some “thing”) that can be usefully defined and tested in the real markets, now. Please see our Post, The Price of Risk, August 2012.

Is it then the case that if real interest rates are high there is a high demand for money to spend either as consumers (who could also be investors with their money) or businesses which are investing to expand (not necessarily wisely). We can reasonably assume that consumers or businesses which are desperate for money won’t be able to get any at any price and that the “high demand” for money is “high” relative to the supply of it even though there might be a lot of money available. And there is. Please see our Post, Numbers 20:12, August 2012.

First of all, in our view, consumers and businesses are always cautious regardless of the interest rates – we invest (or buy things) not to have a better chance to lose (or waste) our money but to keep it and obtain a hopeful return above the rate of inflation (even if it’s just better goods or services now rather than later). The opposite of that is “recklessness” or “gambling” notwithstanding that too is a market factor and can sometimes dominate a market for long periods of time.

However, the interest rate is not the “price of money”. The “price of money” is the “price of risk” which is the exact opposite or inversely related to the rate of interest. We could, of course, have a field day of confusion in econo-speak on What is price? and What is money, anyway? but there is no point beyond trying to understand exactly what Buttonwood is saying about “interest rates balancing the demand of citizens to save with business’s desire to invest“.

For example, if the interest rate is 5%, let’s say, then Buttonwood says that 5% or $5 per year “buys” $100 – the price of money $100 now is $5 per year or $105 a year from now if we pay off the debt – and if the rate of inflation is 3% (say) then the low real rate of interest is 2% and both consumers and businesses are feeling cautious – meaning what?

It could mean that there’s no demand for money but lots of it is available relative to the demand and the lenders are having to shop it out at low rates in order to not actually lose (or attenuate) their money, as cash, simply due to inflation. If there’s no demand for money (relative to what’s available) then borrowers already have lots of money or they don’t have much use for it or they fear (“feeling cautious”) that if they did borrow it and spent it then they might not be able to pay it back or service the loan and thereby lose their assets in real properties as well as their money in cash.

However, the rate of interest is generally not determined in the back rooms of certain restaurants in New York or London. It’s determined by the discount rate on T-bills that are regularly (every two weeks) auctioned off to bankers who are willing to pay something more (but not less) than $95 now to receive almost surely $100 a year from now if they are willing and able to lend it ($100) now to us at 5%. If, for example, they only had to pay $93, why would they lend $100 to us at 5% when the government will give them 7%?

That is, the interest rate is the price of risk in a “shrivelled up form” and low real interest rates signify that the price of risk is high – that is, for example, we have to pay $95 or $98 now in order to get $100 later rather that $93 or $90 signifying that the expectation is that $100 will be re-paid, no problem, even if just by inflation. It could be even higher such as $102 now for $100 later signifying a deflationary expectation or much lower such as $50 or less now for $100 later signifying a “hyperinflation” expectation.

The bottom line is that one cannot generalize an inference from a high or low price of risk, or, inversely, from a low or high real rate of  interest to say anything about the economy. Prudent investors are always cautious. It is the lenders who might be desperate (desperate borrowers don’t get any money unless they are too big to fail, right) and it could be either a warning or an opportunity to investors and savers.

In order to derive a benefit from this observation one simply has to know the difference and that is amply illustrated in the (B)(N) Company Posts of these Letters.

For example, the price of risk was high for HPQ Hewlett-Packard Limited for a long time before its price collapse in 2010 and remained high thereafter (please see our Post, Belts, Braces and Scaffolds, November 2012), whereas the price of risk for AAPL Apple Incorporated has always been high and gone higher even as the stock price ballooned from $200 or less in 2009 to over $600 now (please see our recent Post, (B)(N) AAPL Apple Incorporated ).

The difference is not forecast but demonstrated simply by what people – investors – are willing to buy. If the ambient Stock Price (SP) tends to be above the Price of Risk or Risk Price (SF) then the company is said to be “liked” and is given a (B) designation whereas if the ambient Stock Price (SP) tends to be below the Risk Price (SF) and might be deemed to be “cheap” and a “bargain”, it is “not liked” (N) because there is a demonstrated investor anxiety towards the stock which we describe as a volatility driven price and uncertainty as to whether the purchase price and dividends can be maintained in the future.

For example, MSFT Microsoft Corporation (please see Exhibit 1 below) has traded below the price of risk (Risk Price (SF) Black Line which is a step-function) since mid-2010 and although there was/is opportunity for volatility- and index-based investors, we have not owned it since that time simply because – and only because – the ambient Stock Price (SP) or “stock price” tended to be a “low price” and below the price of risk.

Exhibit 1: MSFT Microsoft Corporation – Risk Price

Microsoft Corporation is engaged in developing, manufacturing, licensing and supporting a range of software products and services for different types of computing devices.

(Please Click on the Chart to make it larger if required.)

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Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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