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The End is Near! (The End of Free Money, That Is)

Friday, March 6, 2015

It used to be that a strong jobs report would be welcome news by the stock market.  More people with disposable income would mean more profits to be distributed as dividends per share of stock.  But as the era of supposedly 'free' money comes to an end, we are seeing its real costs.

Today's strong jobs report is being met with the expectation that the Federal Reserve will remove the word "patient" from its guidance with respect to interest rates.  As of this writing the Dow is off a little less than 300 points, or almost two percent.  The past few years have seen these swings become more frequent.  This should be telling us more and more clearly that we do not have a 'free' market.  We have the banker's version of central planning - where the bankers' sentiments (as expressed by the Federal Reserve) are the real market movers rather than the underlying fundamentals of the companies that actually make up the market.

But leaving that complaint aside...

There are two reasons for these swings: The first is where the market is today against its historic mean.  The Shiller Price to Eanings Ratio is at 27.5.  This means that on average, a share of stock in today's market is worth 27.5 times the annual earnings for which that share represents ownership.  The historic mean is 16.59.  Of particular interest is the fact that this measure of market value last peaked on May 1, 2007 at 27.55.  You'll recall that the Fall of 2007 was the beginning of the last financial crisis.  (It will be interesting to see if the market follows its dictum this year: "Sell in May and go away.")

There is simply no way to miss the fact that the market is inflated against its historic mean.  What goes up must come down.  The only question is how fast and how far.

This leads us to the second reason: Back when money wasn't free businesses would have to actually think first before borrowing to make payroll and acquire raw materials.  Prices would have to be set to accomplish two distinct objectives: 1) recover the costs of production; and 2) ensure there was enough left over after paying those costs to keep their people employed, acquire the next batch of raw materials, and pay dividends to shareholders.

But with free money that second part of 'price discovery' can be allowed to slide.  Businesses begin to depend more and more on credit to make payroll and acquire raw materials.  This is the hidden lesson of the last financial crisis, which played out roughly like this:

1) People began to default on their sub-prime mortgages in large numbers.

2) Investors began to realize that the investments which were based on those loan payments were likely worthless and started racing to sell them.

3) When everyone is selling something and no one is buying it - that something becomes, by definition, worthless.

4) The banks who owned these investments now had no idea what their balance sheet actually looked like (since no one knew what these investments were actually worth, if anything at all) and thus started hoarding what money they did have.

5) And businesses who depended on credit from these banks to make payroll and acquire raw materials saw those credit lines dry up overnight.  They thus couldn't make payroll and started laying people off in the millions.

It is this over-dependence on credit, and how it distorts price discovery, that is going to be the real story once money is no longer free.  The businesses that get back to remembering what a truly free market actually looks like are the ones which will survive.  The ones that don't - or likely never knew to start with - will have no idea how to set their prices, the loss of that information having been one of the hidden costs of supposedly 'free' money.

The uncertainty as to how this all flushes out will be the source of the market swings when money is not 'free' anymore.  The question is whether or not we will learn the needed lessons and get back to having a sound dollar that cannot be manipulated by the Bishops of the Temple of the Free Market (otherwise known as the Board of Governors of the Federal Reserve) who have transformed the Temple into a den of thieves.

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