Bubble-mania (Econo-speak)

Essay. We don’t like talking about economics because it doesn’t help us and the field itself – in our view – is best left as a branch of statistics and provably dangerous if it tries to draw fast or glib conclusions of a causal nature, and there is a lot of evidence for that in the C.D. Howe Institute article quoted below, and written by Mr. Paul Masson, who is a distinguished Canadian economist at the Rotman School of Management in Toronto, Canada.

Mr. Masson has suggested that the Bank of Canada should think about “raising the interest rates” which have been held at about 1% per year since September of 2010, in order to prevent the emergence of “asset bubbles” that could lead to higher inflation in the distant future, and therefore, presumably – a perhaps unintended subtext, as often happens in economics – further erode the wealth of “rent” seekers, who aren’t affected by employment or unemployment, or a burgeoning economy marked by at least some inflation, because they already have what they need, but can’t get by on a negative (-1%) real rate of return forever, or much longer (whichever comes first).

He also reminds us, stoking “fear” but not logic, of the “asset bubbles” ending with an “investment surprise” such as the market meltdown of 2008 following a sustained rise between 2003 and 2007, and asset bubbles “ending in tears” which is a more apt metaphor for the “housing market” and “consumer bankruptcies” than it is for the investment market which recovered rather grandly in 2009 and 2010.

The Bank of Canada raises the rate by raising the “Overnight Rate” which is a rate range at which all the commercial banks borrow and lend money to each other overnight in order to assure that all transactions of the day will be cleared by the end of tomorrow; and it is a system in which the Bank of Canada is the lender of last resort, and its rate is the highest rate and a lending rate that ripples through all the other rates at which banks lend and borrow money to consumers. If a bank, or the banks, has to go to the Bank of Canada for cash, then there really isn’t enough cash around to clear all of the debits and credits that must be cleared today. But, if there is enough cash, then the banks don’t have to go the Bank of Canada, no matter what its lending rate, although it still sets the mandatory range for overnight lending.

If the Overnight Rate goes up or down, then all the other rates, such as the prime lending rate, GIC rates, mortgage rates, et cetera, will follow which is one of the few certainties in all of economics and it is effected by arbitrage. (Please visit the Bank of Canada website for an extraordinarily kind introduction to these concepts, far removed from “econo-speak” which tends to be confusing.)

Mr. Masson’s evidence for the alleged “asset bubble” are house prices and rising consumer debt, and that seems to be all that he offers because there is certainly not an “asset bubble” in the Canadian investment market (please see our Post, The S&P TSX “Hangdog” Market, May 2013):

In this Commentary, I argue that short-term rates are therefore too low in Canada, a situation that is starting to build in pervasive problems for the economy. Below-equilibrium interest rates for an extended period distort investment decisions, leading to excessive risk taking and inefficient and ultimately unprofitable investments. They also encourage the formation of asset bubbles whose collapse could lead to a recurrence of the recent financial crisis.

Some of the symptoms of inefficient investment and asset price bubbles are already evident in Canada, in the housing sector for instance. The cumulative effect of artificially low interest rates also risks fuelling an underlying inflationary process. Therefore, I recommend that the Bank of Canada start now to reverse some of the monetary stimulus and begin raising interest rates. – C.D. HOWE Institute Commentary NO. 381, May 15, 2013, Paul R. Masson, “The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now”

So, how can we help this?

We can relax a little bit because most Canadian economists and market “players” regard Mr. Masson’s view as “hawkish” (Reuters, May 15, 2013, Bank of Canada should hike rates to pop bubble: former BoC aide), meaning, we suppose, that the view excites the pigeons but doesn’t really scare them, and is, therefore, unlikely to change the behavior of consumers or investors; and, of course, it is also at odds with the current policy of the Bank of Canada, as will be further revealed on May 29 when the Bank is scheduled to next set the Overnight Rate.

Secondly, there is no such thing as an “equilibrium interest rate” so we have no idea what a “below-equilibrium” or “artificially low” interest rate would be. In view of the tepid Canadian investment market in equities, we would have to conclude that capital and investors are content to receive a negative real rate of return, or just don’t know what to do about it (please see our Posts, The Pensionnaires, May 2013, and A New Key in Economics, March 2013).

And, since there is no evidence of “excessive risk-taking” (other than paying too much for our houses and spending too much money), we would have to conclude that if there were an “equilibrium interest rate”, then we are currently already above it, and although the prevailing rates are “low”, in almost everybody’s opinion, they must not be “artificially low” so that it would seem to be disingenuous to “artificially raise” them, one would think.

Finally, there is no distinction between “investment” and “risk”. An investment is just and only the purchase of risk, with money, and the risk is that we might not get our money back or that we might not get a hopeful return above the rate of inflation; or, in other words, that we might not get a non-negative real rate of return, and that’s all that matters, no matter what the bank rate is. And that’s really up to us, as consumers and investors.

Please see our Posts, The New Wave Markets, May 2013, and Proactive Risk Management For Everybody & The One Rule, May 2013, for more information.

The Price of Risk

The calculated Risk Price (SF) is a provably effective estimate of the “price of risk” which is “the least stock price at which the company is likeable” (Goetze 2009) and “likeability” is determined by the demonstrated factors of “risk aversion” – we want to keep our money and obtain a hopeful return above the rate of inflation – and the properties of portfolios of such stocks.

Stock prices that are less than the price of risk can be said to be “bargain prices” but with the risk attached that the company might never get a higher price other than that due to ambient volatility or “surprise”; on the other hand, investors who are willing to pay the “full price” above the price of risk, and buy and hold the stock at those prices, must also be confident, and have reason to believe, that the company will produce those values, absent new information.

Please see our Posts, The Price of Risk, August 2012 and The Nash Equilibrium & Its Stock Price, October 2012, for more information on the theory.

To see what else “risk averse” investing can do for us, please see our recent Posts, The Wall Street Put, April 2013, and earlier Posts such as The Dow Transports, March 2013, or The Risk Adjusted Dow, March 2013, or The Canada Pension Bond, February 2013, and for a more colorful description of investment risk and the application of the “price of risk” to mergers & acquisitions, please see our Post, Bystanders & Collateral Damage, April 2013.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond™
“Alpha-smart with 100% Capital Safety and 100% Liquidity”
Guaranteed
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For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to RiskWerk@gmail.com.

Disclaimer

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*.