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Stimulus, Savings, and Stocks

February 23, 2009

Tags Booms and BustsThe FedFree MarketsInterventionism

[An MP3 audio file of this article, read by Floy Lilley, is available for download.]

The Corner of Buy and Sell 

As the president signs the trillion-dollar stimulus package into law, financial networks are abuzz with investment pundits speculating on what companies will benefit, and thus what stocks should be purchased. Such analysis makes an error of causality commonly found in equities research. It assumes a direct correlation between business activity and stock prices.

The price of a stock is derived from a transaction involving the exchange of money for a piece of paper that denotes fractional ownership of a corporation. The profits of a business are a result of transactions where money is received, minus the cost, in exchange for a good. In addition, with the exception of initial public offerings and secondary offerings, the money in a stock purchase ends up in the pocket of another individual and not the coffers of the company.

Expenditures on goods are a function of income, while outlays for stock or any other investment requires savings — income that is set aside for future consumption.

Depending on one's lot in life, savings will be accumulated for a variety of reasons, which may include purchasing a house, funding a child's college tuition, or buying a new car. For most, the financing of a house or an automobile would consume a great portion of savings, and that savings would need to be safeguarded from the exposed risk found in stocks. Saving for a house, therefore, could mean temporarily less money invested in stocks or other asset classes.

The recent easy-money credit era helped solve such problems. With zero-down financing and low initial payments, individuals could have it all: a house, a new car, the latest in electronic equipment, and investments in the stock market. By all appearances, the rise in stock prices seemed perfectly correlated with increasing business revenues bolstered by debt-driven consumption. As the debt bubble imploded, individuals withdrew money from investments to service existing liabilities and reversed course on consumption. Again, spending at the cash register and the movement of stock prices seemed in harmony. Statistically driven models would conclude that stock prices shadow, or in some cases foreshadow, business activity.

But why do individuals buy stocks or mutual funds, which are managed pools of money usually allocated toward stocks or bonds? This question is a subset of the larger question of why individuals invest. The reason, of course, is to make money on existing savings.

The investing individual has numerous avenues to choose from when deciding where to make money work. The most common type of investment includes stocks, corporate bonds, municipal bonds, government bonds, real estate, precious metals, and cash accounts. The allocation of money among the different choices boils down to which investment instrument offers the best reward for the assessed risk. In an effort to diversify risk, most will choose several investment vehicles.

Stocks, therefore, compete in a figurative sense against all other investment classes. Choosing the stocks to put in one's portfolio from thousands of securities takes an almost identical path of risk-reward assessment. The benefits from owning stock come in two forms: dividends and price appreciation. Dividends are money flows coming directly from the company, while price appreciation happens when another individual bids more than what one paid for the stock.

Analysis based on stock yields, the dividend divided by the price paid per share, is fairly simple. Buyers will bid up stocks with compelling yields to the point where such advantage disappears; money will flow from low yielding instruments to higher ones. Such analysis, however, must take into account the safety of the dividend and company balance sheets.

The price-appreciation analysis used by many today, especially for stocks that offer little or no yield, is somewhat convoluted in its logic. In simple terms, the model uses a calculation of revenue growth, earnings, and price-earnings ratio to derive a hypothetical valuation of the stock and to decide whether the current price is cheap or expensive. This sort of analysis is the basis for the question of what stocks will benefit from the stimulus package.

This type of mathematical analysis places the emphasis for stock-price movement in the wrong place. It leads one to believe that stock prices are a function of transactions at the cash register.

Stock transactions depends on one party having sufficient savings to participate. In an environment of deleveraging, where individuals are either retiring outstanding debt or unable to acquire additional credit that would free up resources for other uses, the amount of savings to power higher stock prices probably does not exist.

Even in the cases of merger and acquisition, where stock holders are entirely bought out of their ownership by a corporate takeover or private equity, debt plays a major role. Fueled by the easy credit that marked the bubble, corporate buyouts exploded in a two-year period from 2005 through 2007. In 2006, private equity bought 654 US companies for a total of $375 billion or 18 times the transactions witnessed three years before. Additionally the total money that private equity raised during the same period surpassed the previous year's totals by 33%. The previous record for buyout activity, not coincidentally, occurred at the peak of the tech bubble in 2000. Today, the buyout calendar is barely a trickle, compared to years past.

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The good news today is that individuals have started the process of retiring debt and increasing savings, which is the first step toward recovery in the financial markets. Unfortunately, the government continues to pursue a policy of ripping any accumulated savings away from them in the form of taxation or inflation.

The net effect of inflation is that it devalues the worth of paper assets. Stocks, therefore, provide little in real wealth building during times of soaring prices for goods. The inflationary environment causes savers to divert savings from paper assets to the safer harbor of hard assets such as precious metals, commodities, or even goods used for daily use.

Until the government and the Federal Reserve stop their interventionist policies and stop robbing individuals of their savings, those searching for a meaningful rally in equities may be looking for a long time.

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An MP3 audio file of this article, read by Floy Lilley, is available for download.

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