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Monday, September 13, 2010

Fundamentals are Not the Fundamentals

If it is, then, primarily newly printed money flowing into and pushing up the prices of stocks and other assets, what real importance do the so-called fundamentals — revenues, earnings, cash flow, etc. — have? In the case of the fundamentals, too, it is newly printed money from the central bank, for the most part, that impacts these variables in the aggregate: the financial fundamentals are determined to a large degree by economic changes.

For example, revenues and, particularly, profits, rise and fall with the ebb and flow of money and spending that arises from central-bank credit creation. When the government creates new money and inserts it into the economy, the new money increases sales revenues of companies before it increases their costs; when sales revenues rise faster than costs, profit margins increase.

Specifically, how this comes about is that new money, created electronically by the government and loaned out through banks, is spent by borrowing companies.[7] Their expenditures show up as new and additional sales revenues for businesses. But much of the corresponding costs associated with the new revenues lags behind in time because of technical accounting procedures, such as the spreading of asset costs across the useful life of the asset (depreciation) and the postponing of recognition of inventory costs until the product is sold (cost of goods sold). These practices delay the recognition of costs on the profit-and-nloss statements (i.e., income statements).

Since these costs are recognized on companies' income statements months or years after they are actually incurred, their monetary value is diminished by inflation by the time they are recognized. For example, if a company recognizes $1 million in costs for equipment purchased in 1999, that $1 million is worth less today than in 1999; but on the income statement the corresponding revenues recognized today are in today's purchasing power. Therefore, there is an equivalently greater amount of revenues spent today for the same items than there was ten years ago (since it takes more money to buy the same good, due to the devaluation of the currency).
"With more money being created through time, the amount of revenues is always greater than the amount of costs, since most costs are incurred when there is less money existing."

Another way of looking at it is that, with more money being created through time, the amount of revenues is always greater than the amount of costs, since most costs are incurred when there is less money existing. Thus, because of inflation, the total monetary value of business costs in a given time frame is smaller than the total monetary value of the corresponding business revenues. Were there no inflation, costs would more closely equal revenues, even if their recognition were delayed.

In summary, credit expansion increases the spreads between revenue and costs, increasing profit margins. The tremendous amount of money created in 2008 and 2009 is what is responsible for the fantastic profits companies are currently reporting (even though the amount of money loaned out was small, relative to the increase in the monetary base).

Since business sales revenues increase before business costs, with every round of new money printed, business profit margins stay widened; they also increase in line with an increased rate of inflation. This is one reason why countries with high rates of inflation have such high rates of profit.[8] During bad economic times, when the government has quit printing money at a high rate, profits shrink, and during times of deflation, sales revenues fall faster than do costs.

It is also new money flowing into industry from the central bank that is the primary cause behind positive changes in leading economic indicators such as industrial production, consumer durables spending, and retail sales. As new money is created, these variables rise based on the new monetary demand, not because of resumed real economic growth.

A final example of money affecting the fundamentals is interest rates. It is said that when interest rates fall, the common method of discounting future expected cash flows with market interest rates means that the stock market should rise, since future earnings should be valued more highly. This is true both logically and mathematically. But, in the aggregate, if there is no more money with which to bid up stock prices, it is difficult for prices to rise, unless the interest rate declined due to an increase in savings rates.

In reality, the help needed to lift the market comes from the fact that when interest rates are lowered, it is by way of the central bank creating new money that hits the loanable-funds markets. This increases the supply of loanable funds and thus lowers rates. It is this new money being inserted into the market that then helps propel it higher.

(I would personally argue that most of the discounting of future values [PV calculations] demonstrated in finance textbooks and undertaken on Wall Street are misconceived as well. In a world of a constant money supply and falling prices, the future monetary value of the income of the average company would be about the same as the present value. Future values would hardly need to be discounted for time preference [and mathematically, it would not make sense], since lower consumer prices in the future would address this. Though investment analysts believe they should discount future values, I believe that they should not. What they should instead be discounting is earnings inflation and asset inflation, each of which grows at different paces.)

Excerpt From Ludwig Von Mises Institute

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