Economics 101: It is all irrelevant
Today's Financial News - Posted October 21, 2008
Today’s stock market is drastically different than last month’s market. Imagine how much has changed in the past fifty years. By understanding the past, you will have a better grasp on the future.
By Andrew Snyder
Baltimore – (TFN): I have always believed the key to the future lies in the past. If we want to see where the markets are headed, we need to look at where we have been.
There is no better way to study the past than to look at the works of a couple of dead economists, especially if those economists were Nobel Prize winners.
Since the investing world is keenly focused on the phenomenon of leverage thanks to the current market crisis, I would not be able to sleep tonight if I did not tell you about two great American heroes, Franco Modigliani and Merton Miller. They are the two Carnegie Mellon professors noted for developing the Capital Structure Irrelevance Principle (CSIP).
Now hold on… Before you go clicking on some other site that looks far less boring than reading about some outdated, far-flung theory, please realize that understanding this theory and its monumental flaws will change the way you invest.
It is that important
In a nutshell, the CSIP proves, through mind-bending calculus, that a company should be valued by its earnings power and the risk of its underlying assets, not by the way its executives chose to finance its operations.
In the simplest words possible, Modigliani and Miller tell us to invest in companies with good products and moneymaking potential. Do not worry, they say, if the company funds those products through new stock offerings or additional debt.
Yes, Modigliani and Miller won a Nobel Prize for this theory. But did they deserve it?
They most certainly did.
Their theory shows how an efficient market – one not cluttered by taxes, derivatives, bankruptcy costs, and government intervention – cleanly and accurately sets prices for debt and equity positions.
But what happens when you destroy that efficient market with artificial influences like taxes, derivatives, bankruptcy costs, and a slew of government intervention.
Again, in the simplest of terms, you get what we have today: a complete mess.
No efficiency here
All you have to do is introduce the notion of taxes to the CSIP and its validity starts to go downhill. Add the increased costs of borrowing due to bankruptcy costs and the theory comes to a complete halt about halfway through the equation.
You can figure out on your own (if you haven’t already) what ignorant attempts at government intervention will do to the theory… Ka Boom.
According to fans of Modigliani and Miller, leverage should not be the dirty word it has become today. But these gentlemen lived in the world of academics. They had the ability to erase all the nasty little economic forces (like credit default swaps and mortgage-backed securities) that make investing a tough, often unpredictable game.
By learning the basics of their theory, however, you can get a firm understanding of the forces that drive the market. Best of all, you can use that knowledge to uncover better investments.
Back to the future
If we know that things like debt-to-equity ratios have less to do with investor profit than aspects like popular products and strong management than we can base our portfolios on companies that meet these standards.
Companies with high-demand products (food, beer, cigarettes, computers) have the rare ability to fight through the nasty headwinds created by taxes, borrowing costs, and a government that cares about itself before its people.
What it takes to win on Wall Street this week is totally different than what it took just eight weeks ago. It is no longer a point-and-shoot market. Now, it takes a firm understanding of economics on a level that we have not needed in some time.
Modigliani and Miller may be in that great place where economists go after they leave this world, but I cannot help but think they are looking down and smiling with intrigue as they watch us try to figure out how to get the heck out of this mess.
Next Article: Alternative Energy: The energy cycle does it again
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