November 29, 2004
From the desk of Jane Galt:Future shock
The idea that current price of an asset should equal the future price, discounted appropriately in order to represent the cost of tying up one's cash, seems to be one of the least intuitive out there. I had a conversation the other day with a hedge fund manager of my acquaintance, who knows his way around a balance sheet about eight zillion times better than me, and is cleverer in myriad other ways to boot. Said hedge fund manager offered the hoariest excuse known to man for doing a merger: because you want to gain control of an asset whose owner is (or might threaten to be) charging outlandishly high rents.
I myself offered such rationales for fashionable mergers, such as the AOL/Time Warner megadeal, when I was in business school. Then one of my favourite professors, a fellow by the name of Austan Goolsbee, disabused me of this notion by asking a simple question: What price will the owner be willing to sell the asset at?
The answer, of course, is that he will be willing to sell the asset for the present value of all the future exorbitant fees he's planning to charge you, less a discount because it's nicer to get all the money now in a big pile, rather than in dribs and drabs over the years.
Assuming that your discount rate is approximately the same as that of the asset's owner, you can easily see that it is impossible to make money off the transaction; you'll just be giving him the money now, rather than later. The discount you receive for your troubles will probably be about equal to your borrowing costs, plus the lower liquidity you get from owning, rather than renting, an asset.
In the real world, of course, it is not quite as clear-cut as in an economics class, since mergers often happen when the acquiring party has some overvalued asset, such as AOL stock in 2000, that it can pay with. But even such mergers don't really work as advertised: AOL didn't benefit from getting control over Time Warner's distribution network and content, which it has barely used, but from trading stock in a hideously overvalued business for stock in a more fairly valued one; the deal would have worked out quite as well for AOL shareholders had they traded their stock for shares in ConAgra (probably better, in fact, since little time would have been wasted on consultants trying to wring out "synergies" from the deal.)
But I digress. Back to future price = current price - discount. As in stock markets, so in money markets. Theoretically, we shouldn't have such a unanimous chorus of economists and financiers proclaiming that the dollar still has farther to fall; if the information which makes the dollar likely to fall is out there, traders should already have beaten the price down to where it is a good current and future bet. So why haven't they?
Brad DeLong hazards a guess:
I think I understand why the foreign exchange markets are not yet pricing the big dollar decline to come. As long as central banks are large actors in the market, the big foreign-exchange bets against the dollar undertaken by private businesses that are needed to drive the dollar down to medium-run equilibrium are very risky indeed. It's better for large private players (or they think it's better) to wait until it's clear that central banks are about to start dumping their dollar reserves for euros, yen, and renminbi before dumping their own dollar-denominated assets for euros, yen, and renminbi. Central banks are, after all, governments--and so private businesses think that it will be easy to anticipate what they are about to do and to front-run them when it's about to happen. Prematurely betting against the dollar takes on lots of risk for no real significant gain. That, at least, is how I think the big private players in foreign exchange are thinking.
He also has an interesting theory about the bond market:
I don't, however, understand the bond market. Do they expect the wage share to stay this low forever, and corporate profits are retained earnings to be abundant? Do they expect the capital inflow to continue forever? Do they expect the Bush administration to get serious about balancing the budget? None of these seem plausible as expectations, as modal scenarios, as central cases. But then why isn't the long bond market already pricing the supply-and-demand for loanable funds imbalance that seems inevitable in medium-run equilibrium? It's a mystery.Perhaps it's as simple as this: in the 23 years since 1981, Ten-Year Treasury positions have yielded capital gains in 17 out of the 23 years averaging more than six percent per year. Those who are by nature likely to be short the long bond have presumably lost heavily over the past quarter century, and are no longer a significant part of the market. We may have selected for a group of long-bond traders and speculators who are powerfully overoptimistic, because optimism has been powerfully rewarded over the past quarter century.
That could also explain the stock market, which continues to be valued rather outlandishly, in my opinion.
Posted by Jane Galt at November 29, 2004 11:19 AM | TrackBack | Technorati inbound linksPerhaps the end result of the current decline in the dollar will be a floating (or, more likely, revalued Chinese currency). What would the loss on a short dollar position be in those circumstances?
It seems there is a gamble of sorts dependent upon the Chinese gov't actions regarding revaluation. The uncertainties include:
1)timing of revaluation
2)extent of revaluation
because of the gov't enforced, artificial exchange rate, currencies such as the yen, euro, pound, etc. can only appreciate so far in advance of this anticipated move because they must, necessarily, also appreciate against the yuan.
therefore - I expect that the dollar will fall further relative to euro, etc. currencies following the dollar:yuan revaluation.... unless the % revaluation is less than current punters are betting on regarding current dollar:euro, etc. rates.
Question: how will these dollar moves affect the U.S. housing market? ... maybe a '70s experience of values rising, but slower than general inflation.
I'd be interested in your thoughts in the graph that appeared in today's Investors Business Daily. They define something called "internal finance gap" as corporate cash flow less plant & equipment spending...which seems like aggregate free cash flow. This number has been positive for the last few quarters, for the first time in recorded history (which goes back to 1970.) To the extent that this is sustainable, it would seem to imply a reduced demand for both debt and equity financing, which, of course, would tend to keep interest rates relatively low.
Because the market can stay irrational longer than an individual can stay solvent betting against it?
I think Jason may have a legitimate point here as do you and Brad DeLong. It's not only generals who fight the last war. Everyone has a lag factor between what's happening and what they perceive happening to some extent. "A *lot* of the money on the market is placed there by institutions such as banks, pension funds, investment firms, the Fnord Foundation type "nonprofits", etc and institutions are slower to react to events than individuals are.
That said, I'm not sure the optimism is necessarily wrong. No investment would be possible if it didn't pay off in some form or the other. Civilization is always fragile enough that you can always point at things that could go wrong in the first place. That too can be a source of profit if you keep your nerve at a time when everybody else is losing theirs. (As Baron Rothschild once said, "The time to buy is when blood is in the streets").
And it's an ill wind that blows no good if you tack accordingly when it actually happens. In the case of stocks a weak dollar *if it happens* means that our exports are more competitive and that our debts are easier to repay (Which should be a boon. So it's not necessarily the end of the world from an investor's viewpoint but rather a matter of shifting away from import firms and lending firms towards firms that export when it happens.
Meh! Maybe it's just that I'm too jaded. I remember the 1970s when morons like Paul Erlich, Richard Heilbrenner, Lester Thurow, the Club of Rome and Jimmy "the National Malaise" Carter roamed the Earth (Or at least "The Futurist" magazine). Compared to them this current crop of "the prophets of doom" are nothing. In the end it all comes down to Machiavelli's "Fox and Lion" metaphors. The Fox by being cautious is better at discerning and avoiding traps, but the Lion by being bold is better at seizing opportunity and making things happen the way he would want them too. Either approach works if pursued intelligently, so the path to select is the one most suited to your temperament. ^_~
- S.P.M.
Isn't the fundamental problem of pricing the dollar in others' currency on a forward looking basis an innability to forcast future public policy events?
Among many other things, it is impossible to know policy moves such as:
-fiscal policies including possible revisions to Social Security but also vis-a-vis discr spending
-potential Federal Reserve actions on either interest rates, reserve requirements, etc etc
-USTreasury or Fed Res action to bolster the value of the dollar in light of exaggerated weakness
-transmition effects from a weaker dollar into higher inflation and interest rates here but also into weaker growth abroad sparking policy changes there to mitigate effects
-outright changes in FX policies elsewhere such as the aforementioned China
-the willingness of foreign central banks to continue holding dollars as I opined here: http://americasoutback.typepad.com/blog/2004/08/china_mercantil.html
And finally the simple fact that traders and portfolio managers and all the rest operate with rather short-term horizons: it is too expensive and difficult to hedge against long-term trends. If one could, then it is likely that the trend would be advanced, but the reality is that trading and hedging are, typically, focused on the near-term which has a dampening effect on directional volatility.
Jason McCullough is on to something, but there is always more than one way to play the market. I.E. you do not have to go short not to be long. You can always sell your long position in a given market and take another long position in a negatively corelated instrument. If you really think the US is going to hell you can sell your dollar securities and buy Euro or Yen securities long.
I am however, seriously unconvinced by the Bush is a Chimp school of analysis. Europe and Japan are the places with the zero growth rates and high unemployment. It strikes me that it is entirely possible that the weakness of the dollar is the execesive strength of the Euro.
My best evidence for this is that there has been no dramatic jumb in dollar bond yields, which is what we should expect if everyone were fleeing the dollar because Bush is a Chimp.
DeLong's first point can aptly be summarized by a dictum every economist should remember: wherever there is irrational behavior, look for the influence of government. It will not be hard to find.
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