muses of the moment

August 9, 2010

Present Value vs. Future Value and P/E Ratio are flawed formulas in the winter cycle

A currency collapse will negate any investment formula that the industry has been using in the last 30 years. It will shatter the underlying assumption, the currency. These formulas need to be reworked to account for a currency collapse.

PV vs. FV

There is a post over at oftwominds.com about present value and future value. Click here.

This post addresses PV and FV in light of deflation or inflation. The article has a good conclusion…we don’t know which one we will face in the next 30 years so it is hard to use these formulas to figure out the value of a proposed investment. Yes, yes it is.

But groovygirl has some other comments:

PV and FV are no long valuable formulas especially for real estate. 

The currency will collapse (that is different from deflation), making these formulas null and void. Do not use them for long-term investments. They could be valuable after the currency collapse and/or for short-term investments where the inflation or deflation percent is a known factor (or at least within +/- 5%).

The housing example is not a good one in this economic environment. Housing is in a 26-year decline, not because of deflation but because credit is unavailable for housing (banking crisis) and the asset bubble in housing has burst (mortgage crisis). These are 2 sides of the same coin and they feed each other, keeping the housing industry in a 26-year decline.

No credit equals no rise in the real value of asset prices, period. The government can throw all the money they want at the housing market, but if there are no jobs to serve a mortgage, there will be continued defaults. Defaults means no new mortgages from the banks. The banks will continue to use government money to cover their mortgage losses, not create new credit. If the government should stop flooding the banks with money, they would collapse from the current losses in the housing and commercial real estate sectors. It will take years for this to unwind, if the government does not restructure debt. I will not even address the further tangle of derivatives and securities based off these mortgages. That just makes the whole house of cards more vulnerable to collapse.

Regarding the real estate market, it doesn’t matter how over-priced or under-priced a house is if the buyer can not get a mortgage and make payments on that mortgage. Period. Real estate is stuck. You can see from the linked post that one percent difference can cause a host of problems. Government and banks and financial houses have been using these formulas for years to value the buying and selling of assets. That is why “no one saw this coming”. Their assumption of the rate of default was crap incorrect.

In the autumn cycle, these formulas have value; but in the winter cycle, in a currency collapse and frozen credit, the formulas are flawed. Currency collaspes negate all the investing formulas. As far as I can see the government is still using these formulas in part to gauge their polices, especially regarding the collapsed mortgage/banking industry. This is a huge mistake.

The United States will cause a wave of global currency collapses that will start or end with the collapse of the US dollar, the world’s reserve currency. The collapse of the dollar, a complete loss of confidence in not only the US government and its debt and bonds but its very currency. This collaspe will be a hyperinflationary event that causes a depression (or the deepening of the depression we are all ready in). The US Government has too choices to deal with the mountain of debt it has…default or super-inflate (print more money). They are choosing, and will continue to choose, inflation until the currency collapses. 

A hyperinflationary depression is an increase in expenses, not necessarily asset prices, and a deflation in debt. Any dollar increase in asset prices is really a decline in the purchasing power of the dollar, not added value of the asset. It has been that way since 2001, if you look at inflation-adjusted charts.

So, the two problems (currency collapse and frozen credit) in the winter cycle will prevent the PV and FV formulas from working properly long-term.

If you listened to Jim Rickards’ latest interview on kingworldnews.com you know that a hyperinflationary event happens suddenly. We can go along with low or no “core” inflation and then, suddenly, we are in hyperinflation. We are talking months. This will not give you enough time to recalculate the future value of an asset and change your investment path.

P/E Ratio

Click here  for an excellent article from Generational Dynamics entitled Updating the Real Value of the Stock Market. The article explains how investing formulas like the P/E Ratio should be used in this economic environment and how they have been distorted in the last 20 years.

This is a must read. It shows that we are in for a major, sustained stock market decline….in value. Keep in mind that during hyperinflation the dollar amount may go up, but the value will go down. These formulas, used correctly, will show you the real value of a stock in a deflation or inflationary environment.

The easiest way to make formulas and charts work in the winter cycle is to convert the USDollars to the current gold price. It clears up real inflation and the real decline in the dollar and shows you information you can actually use to judge the pros and cons of an investment or investment class.

Side musing: Matt Simmons found dead of drowning or heart attack?. Click here. I will investigate some of the reports and compile in a future post. The timing of his death raises some red flags.

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