Making Sense of Inflation – Vega

I’d like to start a discussion about inflation; hopefully Alpha will join me in struggling with the myriad complexities of inflation and we can gain a deeper understanding. First, it’s important to define what we mean by “inflation.” Economists generally define inflation as a persistent and broad increase in prices. By this definition, an increase […]

Shortage of Dollars?

Less than a year ago, crude oil was $145 and everyone was wondering how fast the dollar would inflate into worthlessness. Could it be that today there’s a shortage of dollars? The usual discussion centers around the supply of money, defined as the quantity (M1 or M2) times the velocity (how quickly a dollar gets passed around the economy). Over the last year the fed has roughly doubled the supply of money while the velocity has roughly fallen in half, keeping the real supply stable. But what about the demand for dollars?

What makes stocks rally?

There’s a common belief that assets rise when there are more buyers than sellers. The truth is more subtle. Every time a stock (or any other asset) trades, there’s both a buyer and a seller; whenever the market is functioning there must always be an equal number of buyers and sellers. So what makes stocks move in a particular direction? The simple answer from economics is that there were more buyers than sellers at the old price, so the stock price must rise to entice new sellers into the market and dissuade the buyers. This is frequently true, but is far from the whole story. There are many momentum traders who are more likely to buy a stock as it rallies.

What is productivity? (or how far could GPD drop?)

The economist JK Galbraith introduced the idea that in an affluent society such as ours, demand must be invented. While we’re all willing to work to afford food and shelter, we’re not automatically willing to trade our leisure time for a nicer watch or an expensive painting. Once our basic needs are met, companies must convince us to continue working to buy designer clothing, a sleeker phone, or front-row seats to a concert.

The frightening thing about this is just how much of the production in the US is “unnecessary.” GDP is a measure of all the goods and services produced in this country. What if we’re no longer willing to pay much for the “unnecessary” consumables? Could GDP drop by 20%? 40%?

What are stocks worth? (or how I came to love the PE ratio)

Lots of analysts are shouting that stocks are undervalued because next year’s earnings are only down 25% while the stock prices are down 50%. They claim this means the equities are a buy. They’re ignoring the important question of how much we should pay for those earnings.

Here’s a graph of the historical PE (price to earnings) ratio of US equities over the last 100 years. The PE ratio is what investors were willing to pay for a company relative to the previous year’s earnings. A lot of things affect what investors are willing to pay including interest rates, the opportunity cost of their money, expected inflation, and their general tolerance for risk.

Will the Euro exist in 3 years?

Before scoffing at the question, consider these facts:

Italy and Greece have quickly growing public debt of about 100% of GDP and shrinking tax revenues. Without independent currencies, Italy and Greece can’t devalue and inflate away their debt. Investors are still willing to finance such high levels of borrowing at single digit interest rates under the assumption that as members of the EU, Italy and Greece are safe from both inflation and default. What happens when investors start questioning the long-term solvency of these governments? What happens if they face a sovereign “bank run” as investors flee to safer sovereign debt?

The “Anti-Consensus Rule” and Inflation

George Soros has long expounded on the topic of “reflexivity”, a way of looking at financial markets that is both common sense and academic heresy. Reflexivity includes the idea that market prices don’t just reflect economic reality, they actively shape it. Take the petroleum industry for example, where new investment frequently won’t pay dividends for 4+ years. If crude oil prices are stable at $70, oil companies will invest to maintain adequate production levels so we’re likely to have similar oil prices in 5 and 10 years. However, if oil prices plummet below $40, oil companies curtail investment leading to a production shortage in 5 years and potentially $200+ oil.

Managing Risk

As promised, here is a constructive approach to managing risk. I start with the least trustworthy (but still useful) metrics and move down to the most trustworthy.

4. Current market information – for most asset classes, we can look to the collective wisdom of the market for the short-term risks. For example, the current prices of options reveal the market’s consensus on the probability distribution of equities over the next few months. Most of the time the market is very accurate and does a fine job of predicting the day to day volatility of a portfolio.