Benson's Economic & Market Trends Pricing and Valuing Financial Assets... It's a great time to sell! Richard Benson December 1, 2003 Determining the price of financial assets is far easier than determining their value. However, knowing there is a difference between price and value and having the wisdom to see the difference, is a pre-condition for making the right investment decisions. Over time, it is certainly wise to buy financial assets at a price below their long term value, and to sell them at a price above their long term value. Examining the price and value of financial assets is critical for the US economy. The current market price of stocks is about $10 Trillion. While this is down from a 2000 peak of $17 Trillion, it is still a considerable number. Credit market borrowings are approaching a pay-off balance of $34 Trillion. With the US Treasury running $500 billion deficits a year and the single family mortgage market still growing at a rate of over $600 billion a year, the total debt owed is continuing to grow quite rapidly. In our economy, the vast majority of financial assets are nothing more than the ownership of someone else's liabilities. The current total market price of financial assets (liabilities) is certainly over $47 Trillion, or four times GDP. (The cash flows from our $11.8 Trillion economy will not support payments on this level of liabilities. Something has to give, and it will most likely be the real value of the assets). Credit market financial instruments are the easiest instruments to price and value. The prices of notes and bonds can be mechanically calculated by a simple mathematical formula for Present Value, based on the current interest rate. One clear and profound observation is the longer the maturity of the note or bond, the greater the decrease in market price given an increase in interest rates. The usual reason to hold on to the shorter maturity credit market instruments is the need for liquidity, or the inability to find another attractive investment. On the other hand, the reasons investors hold on to the longer credit market instruments are to earn a higher yield, to engage in the "carry trade" borrowing at lower short-term interest rates, or to buy the longer term bonds because the owner anticipates interest rates will go even lower, causing the bond to appreciate in price. Since these financial instruments are priced at an inverse of interest rates and the Federal Reserve has cut rates to a 45-year low, it is logical to assume the market prices of these instruments are about as high as they could ever be. This, of course, raises the question of "value." If you knew interest rates were going to rise, you would know that the future price of these credit market financial instruments would fall. A wise man would not consider that the current price of these financial instruments is their true value. More importantly, what would you think about the value of financial instruments if you knew that: 1) the US had no savings and was running massive government deficits; 2) the Fed was holding short-term interest rates down below the level of inflation; 3) foreign central banks were manipulating US long-term interest rates down by buying our treasury debt; and, 4) the Fed has to come out every day to promise the speculative community in the carry trade that this interest rate manipulation can go on forever. Given this is the state of affairs, we believe the current price of credit market instruments in the US has been artificially "pumped-up" by the Fed and Asian Central banks to a record unsustainable level. Pricing stocks is easy while valuing them has a strong element of art and psychology. The current price of marketable stocks is about $10 Trillion as measured by the Wilshire 5000. The Federal Reserve has made holding cash painful by dropping interest rates to 1% or less. This has propelled stock prices to inflate to extraordinary levels given all logical means of measuring value. With interest rates artificially pushed down, stock prices have "no anchor." Current liquidity-driven P/E multiples on stocks are at 1929 levels. While investors may hold short-term financial instruments for liquidity and longer term for carry profits or capital gain, almost all stock holders hold stocks for capital gain. While the Federal Reserve is working overtime to keep easy money available to push up corporate revenues, and a declining dollar helps corporate profits, there is no question that a rise in interest rates would likely smash current stock prices. Rising interest rates would return stock P/E ratios to more normal levels, just as they would return the price of credit market instruments to normal levels. On a current price and normal term value basis, it looks like current stock prices give an investor a wonderful opportunity to sell stocks. From a value perspective, financial assets are riskier than the average investor can imagine. Our government operates on the assumption that most Americans rarely go overseas. Therefore, the only currency they are familiar with or relevant to them is the dollar. US financial assets are dollar denominated. They are sold and traded for the dollars that the average person will need to buy real goods and services. Now that the average American buys more goods produced outside of the US, it is time to think of other options besides the dollar. In the foreign countries that make the goods we buy, only the Central Banks take dollars. The private foreign sector knows all about currencies and devaluations and is aware the US is running trade and budget deficits without any savings. They realize the only reason the dollar hasn't crashed is because the Foreign Central banks are allowing speculators to take massive dollar short positions, while the dollar is "eased down" in value. Even if interest rates in the US can be held down keeping the price of US financial instruments artificially inflated in dollars, the average American holding these dollar assets will lose another 30% in addition to the 20% they already lost from a falling dollar. The average investor has also forgotten how much at risk financial assets are to inflation. Our Central Bank under Greenspan is dedicated to getting significant inflation underway. His propaganda campaign on fighting deflation and disinflation ignores the rapid rise in commodity prices and services, the fall in the dollar, and, the way the CPI is biased against inflation. Beef prices are at a 24-year high and insurance, education, health care, property taxes, and many other day to day expenses make the CPI a joke. The CPI assumes every one rents even though 65% of households actually own their homes. Rising home prices are not in the CPI but the declining cost of renting a home is. (Rents are weak and many people are opting to buy, rather than rent.) Housing is 22% of the CPI. Another 8% is the cost of buying new and used cars which are temporarily subsidized. The Federal Reserve wants inflation because only the rising prices of goods will help companies service their massive debt loads, and only rapidly rising wages and salaries will allow individuals to service their record debt loads as interest rates rise and inflation kicks in. For instance, Ford Motor is only one of a long list of companies that requires higher prices of their products to remain solvent. Ford has a debt of $180 billion that is just above junk and a massively under-funded pension fund. Inflation is needed to melt down our country's massive mountain of corporate, government, mortgage and consumer debt. Needless to say, what inflation does to the value of financial assets is like taking a pile of paper and dumping it into a bonfire! In summary, the outlook for the price and value of US financial assets does not look very good. A rise in interest rates to normal levels would give us Fed Funds of 3% to 4% (or 1% more than the CPI) instead of current Fed policy of 1% less than the CPI. This would put the 10-year Treasury at 6% and the 30-year mortgage rate at 7.5%. A normal level of interest rates would knock down financial asset prices by an easy 20%. The drop in the value of the dollar will certainly wipe out 30% of the value of US financial assets. While the average investor in the US is not familiar with this risk, the average investor overseas is. The smart investors will sell their US financial assets as long as Foreign Central Banks are buying. Foreign Central Bank buying, to slow the dollar decline, is a gift at the expense of foreign taxpayers. This gift should be taken by private citizens from every country. World Central banks are printing money out of thin air to finance the US deficit. Indeed, so much new money is being created that it is only a matter of time before real inflation shows up in America. Inflation eats up the value of financial assets and helps push up interest rates. A falling dollar eats up the value of financial assets and helps push up inflation. This is not a virtuous cycle! The average investor has not grasped the concept that most assets are financial assets. However, one man's financial assets are another man's financial liabilities. In the US economy, the mountain of financial liability is so big it can stand in the way of economic growth. The only way to melt down the mountain of debt into a hill that can be climbed is to devalue and depreciate it, effectively inflating it away. For the holders of financial assets, the outlook is clear: Sell before Foreign Central Banks stop buying! Then, if you have to own financial assets, buy financial assets of those countries that will do well as the dollar devalues. If you don't have to buy financial assets, favor real assets (they aren't someone else's liability). Great candidates are marketable commodities and precious metals. We believe that as long as the Federal Reserve is dedicated to "trashing the dollar" and eroding the value of financial liabilities (which destroys the value of financial assets), the average investor will discover gold and other real assets as more viable alternatives for the preservation of capital. Richard Benson December 1, 2003 President Specialty Finance Group, LLC Member NASD/SIPC 2505 S. Ocean Boulevard - Suite 212 Palm Beach, Florida 33480 1 800-860-2907 eMail: rbenson@sfgroup.org ______________ 321gold Inc ref: 02747