Stocks Up and Yields Down - Keith Weiner

by Keith Weiner, Sprott Money:

Many gold bugs make an implicit assumption. Gold is good, therefore it will go up. This is tempting but wrong (ignoring that gold does not go anywhere, it’s the dollar that goes down). One error is in thinking that now you have discovered a truth, everyone else will see it quickly. And there is a subtler error. The error is to think good things must go up. Sometimes they do, but why?

First, we think it’s a cop-out to say, “well it’s all subjective.” If it were all subjective, then there would be no way to say that gold is good, and no way to say that it “should” go up. It would be sufficient to say, “gold is $1,276.” Indeed that is all that one could say, if everything were subjective.

Why is gold trading at that price? Subjective preference, nothing more. Will it trade at $12,760? Maybe. If subjective preference changes. One might as well say “if God wills it.”

But it is not all subjective. There is something objectively wrong with the dollar and all of its derivatives such as euro, pound, yuan, etc. They are all slowly failing. Gold is the alternative to holding the dollar.

It is important to keep in mind that most people do not like to buy on speculation. This may be particularly difficult to understand if you are someone who bought gold as a bet on its price. Most people buy, not because they expect a discontinuous change, but simply because they have goals to achieve.

For example, a consumer buys food because he needs to eat. A business buys copper because it manufactures wire, or circuit boards, or chemicals to pressure-treat wood. That’s what businesses do—buy inputs, combine them into a product, and sell it for a profit.

Will copper go from $3.02 to $4.02? Maybe. But that is not why copper-using businesses buy it (at least not in the falling interest cycle—see part IV of Keith’s Theory of Interest and Prices ).

Suppose Acme Piping Inc. buys copper at $3.02. It adds $1.98 worth of labor, and turns the metal into pipes. It sells a pound of pipes for $6.00. It spends $5.00 ($3.02 + $1.98). We can say that this $1 of profit is an incentive to produce plumbing.

And there is another incentive. If Acme has a debt of $1,000,000, with a monthly payment of $15,000, then it must sell at least 15,000 pounds of pipes. If not, then its creditors will seize the business. It would like to sell at least 20,000, so it makes the payment, and has a profit of $5,000 left over.

If you wonder why the “worthless paper dollar” can buy so many great products, it’s because every debtor is exchanging whatever it can produce and sell to get enough dollars to service their debts.

When the interest rate falls, several things change. First, the incentive to borrow increases. If Acme had decided not to borrow to buy a new pipe-making machine when the rate was 6%, the company may be more tempted at 3%. Total debt goes up as more businesses take this greater incentive.

The monthly payment per dollar of debt is lower (total debt may be a lot higher). However, it becomes harder to generate the profits to service the debt. When every pipe manufacturer borrows more to add more machines to make more pipes, the price of pipe tends to fall. Taxes and regulations might slow or prevent the drop in price, but not the drop in profit margins.

So let’s look at a chart of the price of the S&P stocks overlaid with nonfinancial corporate debt (not the same as S&P 500 debt, but we use it as a proxy for data we don’t have). We started the graph in January 2008, so you can see the big plunge from 1400 in May 2008 to 734 in February 2009.

Source: Nonfinancial Corporate Debt, St. Louis Fed

Source: Nonfinancial Corporate Debt, St. Louis Fed

Acme Piping, Acme Banking, Acme Pharma, and 497 other Acmes are steadily adding to their debt. According to this data series, borrowing did not miss a beat, even in the worst of the financial crisis. This debt is quoted in millions, so total nonfinancial corporate debt nearly doubled from $3.4 trillion to over $6 trillion.

Aside from buying more machines, companies use some of this borrowing to buy back their shares. There is a reasonable argument for this, as debt and equity are alternative ways to finance the enterprise. And the lower the interest rate, the more attractive debt becomes.

Many companies are also paying dividends. Management has a tougher case, to argue that borrowing is used for other purposes, and dividends are paid of out of cash flow. However, cash is fungible. If a company is adding debt at the same time, it raises the question if it is borrowing to pay the dividend. The fact is that cash comes in from borrowing, and goes out for dividends.

Stocks have been rising relentlessly since 2009. We don’t know how much of the rise is due to borrowing for so called “shareholder friendly” actions. The graph certainly shows a strong correlation. We can say that these moves may seem “friendly”, but actually create a problem for long-term shareholders. Debt is rising. As the expression goes, “it’s not a problem until it’s a problem.”

Until it’s a problem, speculators keep buying stocks to front-run relentless “shareholder friendly” actions by the public companies.

Most have been trained not to think about yield, but to think about capital gains. Preferably big capital gains. They don’t see the engine of capital destruction, as each buyer in turn, turns over his capital to the previous owner of the asset. The buyer would never consume his own wealth, or want to be the Prodigal Son. However, to the previous owner who is now selling, it comes as income. Which he happily spends. This is a process that must inevitably end, when it depletes all capital that people are willing to put into it.

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