Sunday, April 27, 2014

Why one has to become a speculator

It is an unfortunate part of Americas continued decline that words and there definitions become muddled over time. It can be argued that if someone cannot define the words one uses than that person probably does not know what he or she is talking about. A case in point is the word investor. The dictionary definition of an investor is someone "who allocates capital with the expectation of a financial return." Examples would include buying a stock because it has a nice dividend yield or buying a duplex and renting it out to tenants. However if one lives in a hyper politicized economy like the US where laws, regulations, and political considerations cause distortions in the market place it makes it difficult to allocate capital efficiently and safely.

One of the biggest distortions in the market caused by statists, among many, is allowing the Federal Reserve and its unelected minions to arbitrarily set interest rates. If you were to ask the average person if it was a good idea to allow some government bureau of academics and wonks to set the price of smartphones, toilet paper, or canned peaches in heavy syrup I would venture to say that most people would agree that this would not be a good idea. However almost no one argues with allowing the Federal Reserve to have the power to set the price of money which are interest rates. In fact the power of the Fed and the people who run it has been raised to the level of demi-god status.

Interest rates are very important for many reasons. One of the main reasons is that it is a major consideration for managers in corporations and business as to whether a project should move forward or not. If I am considering building a factory and I will be using debt to finance the factory I have to figure in the cost of debt which is the interest rate. If rates are to high the debt incurred may make my anticipated costs to high and not allow enough of a return to make the project worthwhile. Obviously interest rates are not the only determining factor that a manager would take into account when analyzing the economics of a proposed project but they are a major factor nonetheless. So what happens when the Federal Reserve artificially lowers interest rates or the cost of debt. In the case of our manager who is analyzing a proposed project the lower cost of capital would help to make his anticipated return on investment look better than it would if one was operating in an environment where normal rates prevailed. This might mean that the project is not really economic but looks good in the suppressed rate environment. It is my contention that this is how bubbles are formed in the economy.

The Federal Reserve reacts to a weakening economy or financial crisis by lowering rates well below the market rate and floods the economy with liquidity. These actions by the Fed are price signals and economic actors react by borrowing money and doing things with that money which leads to much uneconomic activity taking place ie the tech bubble in the early 2000's and the real estate bubble in 2007 which led to the financial crisis. These bubbles which will always collapse as they are dependent on cheap credit from the Fed collapse when the Fed pulls back from its lower rate policy. It has been suggested that the recent stock market gains over the last few years are nothing but the result of Fed cheap money policies. John Hussman had a recent article that talks about this issue and its previous results. Two quotes from economists Hayek and Von Mises in Mr. Hussman's article are relevant:

To quote a decades-old passage by economist Ludwig von Mises, and as a reminder of what we should have learned after Fed-induced yield-seeking led to a reckless expansion of mortgage debt, a bubble in housing, and the worst economic collapse in modern times: “The recurrence of periods of boom which are followed by periods of depression is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. True, governments can reduce the rate of interest in the short run. They can issue additional paper money. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse soon or late and to bring about a depression.”

Friedrich Hayek concurred “To combat depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection or production, we want to create further misdirection - a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end.”

If we accept Professors Von Mises and Hayek along with Dr, Hussman at their word than one cannot allocate capital in the current environment as an investor. As prices have been distorted by the Fed's actions in the market it is impossible for a person to make accurate decisions regarding whether a business and it current earnings, cashflows, dividend, etc are real or dependent on the actions of the Fed. One must therefore become a speculator if one is going to operate in the markets. The dictionary definition of a speculator "is a trader who approaches the financial markets with the intention to make a profit by buying low and selling high (or higher), not necessarily in that order." The speculator is distinguished from the investor, who approaches the financial markets with the intention of making a return on his capital. Of course it is actually worse than just the Federal Reserve as the government causes even more distortions with their laws, rules, regulations, and interventions into the market. The fact that any average investor is able to make any money is just luck.

The definition of a speculator that I like is one given by one of the most famous speculators of our time, Doug Casey. He says, and I am paraphrasing, that a speculator is a person who takes advantage of price changes in the markets caused by government intervention in the free market and the subsequent distortions those interventions cause. I think that describes a speculator to a tee. I will be writing in the future about various opportunities open to speculation in subsequent articles.

This a dated interview (2011) but in it Doug Casey describes what a speculator is and some examples of speculations.

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