Sunday, April 01, 2012

Placebo Effects of Earnings Drives Stock Prices

Here is an excerpt to my note to a special client

Corporate "Fundamentals" serve as placebo to most of the momentum chasers. People look for psychological refuge mostly on what is popular rather than what really works.

A sample of my previous argument in this link.

It is very important to understand that since half of every transactions made by everyone in the marketplace have been based on money or credit—money financed by a financial intermediary that will be paid for with future money or income of the debtor—then policies that tampers with money and interest rates (price of time) affects practically ALL economic and financial activities.

But the impact will not be the same for everyone. Inflationist policies eventually work through a spillover or a trickle down effect.

The first beneficiaries are the wards of the state, the state itself, and the industries or sectors connected to or targeted by the state.

Those affiliated to the first beneficiaries represents as the secondary layer of the inflation multiplier and so on. This is the Cantillon Effect on Money as earlier discussed here

This also extrapolates that people’s incentives, through value scales and time preferences channels, will change in response to these policies. Again the changes will differ from individual to individual.

For instance, today’s negative real rates regime have been prompting many banks to call on me (weekly) to offer credit, which is evidently an offshoot to the current policies which encourages banks to profit from the yield curve through maturity transformation (loans or spread arbitrages) activities.

Those who don’t understand the nature of business cycles may be tempted to add leverage which may induce them to engage in extravagant spending.

If many respond to such policies by taking up loads of debt, then the growth in credit may become systemic in that it reaches levels that may not be adequately financed by aggregate debtor’s income, (perhaps to be pricked by higher interest rates) then the balance sheets of creditor institutions have reached bubble conditions that is bound to burst.

Yet in order to delay the day of reckoning requires sustained credit growth which will likely be facilitated through central banking policies. And this is why central banks exists--to provide backstop to the banking system and to provide finance to the state.

In effect, a financial system that thrives on bubble policies will require sustained credit injections. So many of the company’s business models may transition towards a Hyman Minsky’s Ponzi finance paradigm that only worsens or exacerbate the unsustainable bubble conditions. Remember major US investment banks vanished in 2008.

And there is the social signaling effect. Policies that promote consumption fosters the Keeping up with the Jones’ mentality that tries to lift one’s relative social standings through accumulation of positional material goods. These behavioral changes are partly conditioned, but mainly fueled by monetary policies, promotes what is known as 'consumerism'.

Thus, the subsequent effect of inflationist policies has been to reconfigure social and economic activities through people's incentives.

Consumption, savings and investment patterns, or the effective allocations of resources, has substantially been altered as compared to the non-existence of such policies. The policy induced distortion of the economic coordination process eventually leads to malinvestments and to an eventual discoordination.

Therefore sales, earnings, operating costs, investments, or leverage (gearing) or what in finance nomenclature known as ‘corporate fundamentals’ will be substantially affected, but again on varying degrees.

Of course every markets have individual characteristics too. They are shaped by idiosyncratic culture, unique legal framework, distinct political institutions, individual tax and regulatory regimes, varying depth of the market economy and many many many other variables.

This also means that the earnings principle is NOT a one-size-fits all dynamic. The earnings of the corporations in the US can’t be seen in the same lens as the from earnings of the companies listed on the Philippine Stock Exchange, where many of the latter’s companies have been shielded from competitions or are de facto political concessions. It is important to note that the business environment in the Philippines has been vastly more unfriendly and significantly less competitive than the US, principally due to politically related factors.

The bottom line is that the mainstream’s mathematical or financial construct of earnings DOES NOT accurately describe how policies shape or affect them. That said, earnings hardly will function as a reliable metric for the ascertainment of stock values.

So like the Heisenberg uncertainty principle, the entrenched orthodox belief in earnings is like trying to pin down an elusive target that never really is, or signifies as vain attempts to get hold of the Holy Grail--especially when markets have been vastly distorted or artificially boosted by rampant interventionism and inflationism. This is based more on faith or groupthink than of functionality.

Effects must not be read as the cause.

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