Super-Duper-Irrational Exuberance, Report 11 Mar 2018
Kitco Commentaries | Opinions, Ideas and Markets Talk
Featuring views and opinions written by market professionals, not staff journalists.
Think back to the halcyon days of the dot com boom. This was a time after Greenspan declared “irrational exuberance”. Long Term Capital Management collapsed in 1998, and Greenspan decided to risk propelling exuberance to a level beyond irrational. Super-duper-irrational exuberance?
Anyway, Greenspan cut interest rates a few times in late 1998. Technology companies were able to raise $5 million or more with just a sketch on a napkin (“serviette” for those outside the US). Companies at a “later stage”, though without revenues, could raise $30 million. A company called “Webvan” was able to raise nearly a billion dollars without ever becoming profitable.
These companies should not have been able to raise so much capital. At any given point in the development of a company, there are only so many things that need spending. Not to mention can be justified to investors.
It is obvious in retrospect that those particular companies wasted investor money (if not the broader principles), after investors booked the losses, but it was anything but clear at the time. Keith recalls debating the so called hypothesis of efficient markets with some people who believed that all market prices are correct. That all changes in price are random, unpredictable.
We have written a lot about how falling interest rates cause capital consumption. It drives speculation, which is a process of conversion of one speculator’s wealth into another’s income. No one wants to spend his wealth, but people are happy to spend their income.
Greenspan’s super-duper-irrational exuberance shows another mechanism. An equity market boom force-feeds companies more capital than is good for them. Consider the AOL acquisition of Time Warner. By any rational measure, the latter was a much bigger company. Take your pick of assets, revenues, profits, etc. However, by one irrational measureâ€”which is the one measure that matteredâ€”AOL was bigger.
It had a larger market capitalization.
Whereas Time Warner was merely an old media company, AOL was everything hip and new-economy-ish. And technology. Tech was going to change the world, don’t’cha’know? So the latter acquired the former. The super-duper-irrationally exuberant stock market had given AOL the currency with which to buy anything it wanted to buy. In a normal world, AOL could not have acquired Time Warner. But a stock market boom fueled by falling interest rates under central bank socialism is not a normal world.
At the end of the day, the AOL Time Warner merger was a failure. So was Webvan. So were the companies who raised millions before they had a business. And so many others. Keith recalls a statistic that something like 2.5% of GDP was invested in technology startups in 1999. We will get back to this point in a moment.
There has got to be a principle, an iron law of investing, that for each enterprise there is an appropriate amount of investment. By lowering yields, which causes share prices to rise, the central banks are injecting more capital than businesses can rationally use. Therefore they use it irrationally. This is inevitable because the very metric to measure rationality and irrationality is collateral damage of the central bank’s monetary policy.
Interest emerges in the market as a function of time preference and productivity. When a central bank distorts the interest rate, it does not change the human condition and its consequent preference for cash over a long-term promise to pay. It changes only the means of measuring these things. It gives business managers false signals. Imagine hacking a traffic light to turn the light facing your car green as you approach. You are bound to crash.
There is a positive feedback between mal-investment and GDP. We note above the absurd level of investment in technology startups, far greater than the opportunities these companies really had. Too-low and falling interest are the cause. Let’s now focus on the effect.
Every penny of that malinvestment was spent. It was spent on things that add to GDP. GDP was increased as the effect of malinvestment. The capital of investors was converted into income, to be spent. Everyone is poorer for this process (well except for a few who earn fees on the transactions).
Much of this spending was on other technology products. For example, every tech startup had to buy computers with Intel chips inside, routers from Cisco, and software from Microsoft. So revenues at these companies was artificially elevated. We say artificial, being that it was merely the accumulated wealth of investors going up in digital smoke.
The artificial, temporary revenue increase was not exclusively at major technology vendors. It was boosted at office furniture companies, office remodeling contractors, even quarries in Italy where they cut the stone slabs for sexy new conference room tables. And of course all of the employees at the tech startups got salaries and bought groceries, cars, vacations to Las Vegas, etc.
This rising revenue caused rising profits at these vendors. That in itself could cause their share prices to rise. And in addition to rising earnings, was rising price to earnings ratio. The net effect is that these companies were over-overvalued. If earnings doubled, then share price could have doubled. But the P/E also rose, so the share price went up by even more than that. This stock price surge was temporarily fueled by someone else’s capital.
We are sure glad that no such super-duper-irrational exuberance or false signals is going on today. Good thing that investors learned their lessonsâ€¦
This is one reason why we argue that GDP is no measure of the health of an economy. It adds capital destruction in as a positive term. Many readers will be familiar with the Keynesian rubbish that paying a thousand men to dig a hole adds to GDP. It’s trueâ€”it does add. This is not an argument in favor of paying for useless holesâ€”it is an argument against misleading macroeconomic statistics!
Many people assume that such waste comes only from government spending. They might say “yes, there’s a problem with this formulation, Government should not be added:”
GDP = Consumption + Government + Investment + Exports â€“ Imports
That’s correct, government should not be added. However, we are arguing that a part of Consumption and a part of Investment are also capital destruction. Eating the seed corn employs people, generates revenues, and attracts investment, etc. During Greenspan’s super-duper-irrational exuberance period, a lot of seed corn was eaten.
A falling interest rate causes capital destruction in a myriad of ways. We have not even covered all of them yet in this ongoing series. So far, under the post-Nixon-default regime of pure irredeemable currency, we have had 37 years of falling rates (notwithstanding the present premature pronouncements of the passing of this trend).
Forget about rising consumer prices. Thisâ€”the falling interest rate and destruction it wreaksâ€”is a compelling argument for why we need to move to the gold standard. We need a stable interest rate, which is not possible nor desirable under central bank socialism.
We need a free market in goods and services, but most of all in money. Socialism is killing us.
Supply and Demand Fundamentals
We were reminded by a hail of tweets this week of a popular view of the gold futures market. It is: futures exist to siphon off demand that would otherwise go into physical. We have a few things to say about this.
First, be aware that many institutional investors are barred by either charter or regulation from owning a commodity. They may own securities and other financial products. These institutions can bring their demand to the gold market today, whereas if the market was physical bars and coins only, they would have to sit on the sidelines. Futures reduce the friction in gold trading. There is an old rule for sophisticated investors “if I can’t get out easily when I need to, then I don’t want to get in.”
Second, the implicit theme of our Supply and Demand Report every week (and the explicit topic of pieces such as Thoughtful Disagreement with Ted Butler) is to look at the interactions between the physical and futures market.
WHEN YOU BUY A GOLD FUTURE, THE MARKET MAKER IS BUYING PHYSICAL, SELLING YOU THE FUTURE, AND CARRYING THE GOLD FOR THE DURATION. During this time the market maker may or may not lease the metal.
It cannot be overemphasized, or stated too often. Please tell your conspiracy-believing friends. Futures do not take demand away from physical metal. They pass the demand right through.
Beyond merely siphoning demand, some go farther and call futures a simple fraud to get away with selling each bar of gold 100 times over. This is a hypothesis that, if it were true, would cause certain effects in the world. We can identify what those effects would be. We can study the data to see if these effects occur. We provide that data and analysis in our Ted Butler piece. We proved this fraudulent multiple selling allegation is false.
Finally, these tweets asserted that the central banks have to suppress the price of gold. They gave many reasons, but we want to focus on just one. They need to prop up the value of their currencies. We want to note the absolute irony of this.
Who in the world measures the value of the dollar (or any currency) in gold terms?! Other than Monetary Metalsâ€”we say the dollar is currently 23.6mg goldâ€”who else thinks like this? The central bankers, their academic enablers, and their most harsh critics alike all agree to measure the dollar either in terms of its so called purchasing power or in terms of its derivatives euro, pound, yen, etc.
Either the dollar is 1/P (where P is consumer prices), or it is the dollar index, a basket of currencies.
Aside from this, central bankers do not think about gold.
Granted, they once did. In the 1960’s, there was the now-infamous London Gold Pool to keep the price of gold at $35. This is endlessly cited as evidence of current central bank price suppression, without bothering to mention that until 1971 the official US policy was to maintain the dollar to gold exchange rate of $35 to the ounce. Alan Greenspan wrote an essay that Ayn Rand published in 1966, in Capitalism: The Unknown Ideal that showed he understood gold. At least then. During his tenure as Chairman of the Federal Reserve, not so much.
But today? We see no sign that central bankers care about the price of gold. They, and the gold bugs, think of gold as a volatile asset that one can buy just like a 1955 Testarossa or a 1983 Chateau de Rothschilds. One buys to diversify one’s portfolio, hedge risk, or bet on its price. And the central banks care about the gold price about as much as they do the price of antique Ferraris.
This week, the price of gold was basically unchanged with the price of silver moving up a few pennies.
Let’s take a look at the only true picture of the supply and demand fundamentals for the metals. But first, here is the chart of the prices of gold and silver.
Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio (see here for an explanation of bid and offer prices for the ratio).
Here is the gold graph showing gold basis, cobasis and the price of the dollar in terms of gold price.
We see a small rise in the April cobasis, but this is more due to the selling ahead of the impending contract expiryâ€”the contract roll.
The Monetary Metals Gold Fundamental Price rose $20 this week, to $1,401. Now let’s look at silver.
Our scarcity indicator for silver moved sideways this week.
The Monetary Metals Silver Fundamental Price rose 4 cents to $17.25.
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