“Understand that securities are not net economic wealth. They are a claim of one party in the economy - by virtue of past saving - on the future output produced by others. Fundamentally, it's the act of value-added production that ‘injects’ purchasing power into the economy (as well as the objects available to be purchased), because by that action the economy has goods and services that did not exist previously with the same value. True wealth is embodied in the capacity to produce (productive capital, stored resources, infrastructure, knowledge), and net income is created when that capacity is expressed in productive activity that adds value that didn't exist before.
“New securities are created in the economy each time some amount of purchasing power is transferred to others, rather than consuming it. Once issued, all of these pieces of paper can vary in price later, so the saving that someone did in a prior period, embodied in the form of some paper security, may be worth more or less consumption in the current period than it was initially. That’s really the main effect QE has - to encourage yield-seeking speculation that drives up the prices of risky securities, but without having any material effect on the real economy or the underlying cash flows that those securities will deliver over time.
“If one carefully accounts for what is spent, what is saved, and what form those savings take (securities that transfer the savings to others, or tangible real investment of output that is not consumed), one obtains a set of ‘stock-flow consistent’ accounting identities that must be true at each point in time:
1) Total real saving in the economy must equal total real investment in the economy;
2) For every investor who calls some security an ‘asset’ there is an issuer that calls that same security a ‘liability’;
3) The net acquisition of all securities in the economy is always precisely zero, even though the gross issuance of securities can be many times the amount of underlying saving; and perhaps most importantly,
4) When one nets out all the assets and liabilities in the economy, the only thing that is left - the true basis of a society’s net worth - is the stock of real investment that it has accumulated as a result of prior saving, and its unused endowment of resources. Everything else cancels out because every security represents an asset of the holder and a liability of the issuer.”
Stock-Flow Accounting and the Coming $10 Trillion Loss in Paper Wealth
John P. Hussman, April 6, 2015
Following the British referendum to exit the European Union, the paper value of global assets briefly fell by about $3 trillion. This decline in the market capitalization immediately garnered headlines, suggesting that some destruction of “value” had occurred. No. Thevalue of a security is embodied in the future stream of cash flows that will actually be delivered into the hands of investors over time. What occurred here was a paper loss. While the recent one was both shallow and temporary, get used to such headlines. In the U.S. alone I fully expect that $10 trillion of paper wealth will be erased from U.S. equity market capitalization over the completion of the current market cycle.
While any given holder can sell their securities here, somebody else has to buy those same securities. The fact that valuations are obscene doesn't mean that the economy hascreated more wealth. It just means that existing holders of stocks and long-term bonds have a temporary opportunity to obtain a wealth transfer from some unfortunate buyer. Whoever ends up holding that bag will likely earn total returns close to zero on their investment over the coming 10-12 year horizon, with profound interim losses on the way to zero returns.
Investors who fail to understand the difference between paper wealth and value are likely to learn that distinction the same way they did during the 2000-2002 and 2007-2009 collapses, both which we correctly anticipated, with a constructive shift in-between. So not to throw stones in our own glass house, see the “Box” in The Next Big Short for a narrative of the challenges we encountered in the speculative half-cycle since 2009, as the Federal Reserve intentionally encouraged yield-seeking speculation long after previously reliable warning signs appeared. This has created what is now the third financial bubble in 16 years, the third most offensive valuation extreme next to 2000 and 1929, and the single most extreme point of valuation in history for the median stock.
Part of the discussion below repeats portions of recent commentaries. While we may or may not observe further short-run speculative extremes, I can't think of a more important set of principles that a long-term, risk-conscious investor should understand at present.
The higher the price an investor pays for a given stream of future cash flows, the lower the long-term return the investor can expect to achieve over time. As the price of a security rises, what investors considered “expected future return” only a moment before is suddenly converted into “realized past return.” The higher the current price rises, the moreexpected future returns are converted into realized past returns, and the less expectedfuture return is left on the table. Because of this dynamic, the point where a security seems most enticing on the basis of realized past returns is also the point where the security is least promising on the basis of expected future returns. See Blowing Bubbles: QE and the Iron Laws for a straightforward demonstration of this idea.
This is why good valuation measures, such as the ratio of market capitalization to corporate gross value-added, are inversely related to actual subsequent market returns across history. Bubbles do not create wealth. They simply raise the current price of a security, lower the future expected long-term return, and, at best, leave long-term cash flows unchanged.
I say “at best” because there’s no evidence that yield-seeking speculation, encouraged by central banks, has any positive effect on long-term cash flows at all. Indeed, I don’t think there’s any real doubt that the crisis and disruption following the collapse of prior yield-seeking bubbles is precisely what has crippled the accumulation of productive capital at every level (real investment, work experience, infrastructure) in the real economy. Given that the accumulated stock of productive capital is the basis for the net worth of our nation (as detailed above), it follows that yield-seeking speculation, intentionally encouraged by the Federal Reserve, is perhaps the single most destructive force in the U.S. economy, and in the lives of the American people.
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