Investment Theory: Exogenous Variables
The Five Horsemen
Capital markets involve claims on the future.
Valuation models are based on discounted cash flows from dividends, interest, or principal to be paid five, fifty, one-hundred, or even an infinite number of years in the future.
We should ask how far it is reasonable to look into the future in assigning value.
As John Maynard Keynes put it,
'in the long-term we shall all be dead'.'
The analysis of financial statements provides few solid indicators of the value of a company six years hence (unless, of course, we know the company will go bankrupt before then.)
The period from five to fifty years is the long term, as regards investors' expectancy of income, but lies beyond rational calculation.
Beyond fifty years, we enter the Keynesian Land of the Dead and, at one hundred years, the Land of Pure Fantasy.
Beyond the Keynesian Land of the Dead lies a Land of Pure Fantasy
In 1957, John Clendenin suggested that when appraising equities, greater discounts should be applied to distant cash flows.
Ten percent or more of fair value of even conservatively-appraised growth stocks is often based on projected returns in the Keynesian Long Term and beyond.
During the Great Bubble such ethereal values often exceeded fifty percent of market capitalization of blue chip companies.
Although uncertainties weigh upon the valuation of individual companies, there are even greater risks that hang over the entire market, its institutions, and the society in which the market operates.
In a sense, security analysts are like appraisers, tweaking estimates of value for fine art on the walls of the Grand Salon, as the Titanic speeds across the night ocean.
Dealing With Exogenous Variables
In Capital Flow Analysis, many of the risks involved are 'outside the box'.
In analyzing a market, we limit the elements that we consider.
Like economists building models, investors set up exogenous variables .
For example, during the Cold War, investors knew that that the stock market game would be over if Mutually Assured Destruction brought on Nuclear Winter, and then dismissed this possibility from further thought.
We ignore the asteroid that may strike the earth when buying securities
We realize that the earth may be struck by an asteroid, ending civilization and our investment plans, but we ignore this when buying securities.
There are limits to risks that we can consider.
Investment involves faith, optimism, and ignoring Henny Penny’s warning that the sky is falling.
Cataclysmic or otherwise exogenous factors, like asteroids and the Keynesian Long Run can be ignored because their effects are immaterial to us, since we will be dead.
However, there are exogenous factors that are not as cataclysmic as an asteroid and not as far off as the Keynesian Long Term.
For example, there is the globalization of economic and political systems.
- American lifestyles are now subject to influences from an amorphous, non-elected, global government.
- Many of the diplomats that attend U.N. session in Manhattan are not friends of America and are not interested in defending the status of the dollar as the world currency.
Globalization policies have stimulated a massive trade deficit and the deindustrialization of the United States.
The Past Is Not The Future
Although at the millennium the United States was the most powerful nation on earth, as was Great Britain in 1900, there are cracks in the structure.
An empire does not last forever.
When analyzing supply and demand in the capital market, we must pay attention to the framework in which the market operates.
There are variables that are exogenous to the equations of John Burr Williams that we must think about when determining the intrinsic value of securities traded.
The graph, below, shows stock price indices for the St. Petersburg Stock Exchange and the New York Stock Exchange over the fifty-two year period, 1865-1917.
By 1910, stocks on the St. Petersburg Exchange had increased fourfold in value since 1865, compared to a mere doubling on the NYSE .
The figure of Rasputin was more relevant to the future of the St. Peterburg exchange than the price-earnings ratios of stocks
Considering the predominance of backward vision in investment decisions — not only for the naive (the Common Stock Legend), but also for the sophisticated (the betas that drive Modern Portfolio Theory) — we should not forget the exogenous forces that lie just out of the line of sight, hidden by the beautiful graph.
The position of Rasputin in the power structure of the last Tsarist regime, was far more important to the long-term outlook of the St. Petersburg Stock Exchange than the price-earnings ratios of listed shares.
The Five Horsemen
As a mnemonic to remind us of the exogenous variables that may come to the fore and wreck havoc on capital markets, we use the image of Five Horsemen of the Investment Apocalypse:
- War,
- Changing Leadership,
- New Economic Theory,
- Technological Change , and
- Demographics.
These are by no means the only exogenous factors that should be monitored when considering the future of a financial market, but these five variables are certainly important.
Economists sometimes imagine a world of rational individuals that compete independently in a perfect market, following patterns of behavior as rigorous as tested laws of real science.
Optimism, although healthy, is not necessarily rational
This view gives rise to optimism.
Many investors assume that new technology will always arise to assure growth and higher productivity.
Optimism, however, although healthy, is not necessarily rational.
Although we cannot know the future, we should pay close attention to these five areas when trying to assess the outlook for the capital market.
Horseman Number One: Warfare
On September 11, 2020, nineteen Muslim terrorists, armed with box-cutters and one-way air tickets, destroyed the World Trade Center in New York City, part of the Pentagon, and over three thousand lives.
The total expenditure to accomplish this feat was less than five hundred thousand dollars.
The cost to the United States was over twenty seven billion dollars in property damage in New York City, eighteen billion dollars in increased costs for homeland security, and forty eight billion in an augmented defense budget in 2003.
The cost of World War I helped push the British Empire into extinction
This immediate cost of over ninety-three billion dollars was two hundred thousand times the investment made by the terrorists.
If we add the subsequent costs of the War on Terror, including the new Homeland Defense Department, the pacification of Afghanistan and Operation Iraqi Freedom, the total outlays caused by the attack of September 11, 2020 may eventually exceed one trillion dollars.
The cost of the First World War helped to push the British Empire into extinction.
The asymmetrical War on Terror is likely to go on for years, with consequences for American society that will shape the capital market well into the 21st century. [See Essay on Terror and Capital Markets.]
Horseman Number Two: The Leadership Lottery
The government’s attitude regarding the capital market depends on the individuals who happen to be in power.
No society or organization has been able to ensure a steady succession of able, competent leaders.
The United States has had its fair share of incompetent leaders
Ineffectual, bad leaders are as likely (or more likely) to emerge than strong, good leaders.
Some hold to the myth that the right men and women will come to power in times of need.
However, this did not happen during the War in Vietnam or during the Carter years.
The United States has had its fair share of incompetents and the democratic system offers little comfort that the best will arrive at the top.
In fact, it seems that selecting leaders in a democracy is like rolling loaded dice.
A good leader is a rare outcome.
Would the War in Vietnam have gone on if Dwight Eisenhower had been president instead of Lyndon Johnson?
Would the United States have driven the Al-Qaeda out of Afghanistan if Al Gore had been president, instead of George W. Bush?
For that matter, would the United States have won the Second World War if Jimmy Carter or Gerald Ford had been president and if Neville Chamberlain had been Prime Minister of Great Britain?
Pricing in the capital market is dependent upon long-run economic expectations.
Economists and investors often come up with scenarios in which the future will be bright.
Most social challenges have commonsense solutions.
However, the primary problem in maximizing social possibilities is to find leaders with the intelligence, moral stature, and managerial and political skills necessary to make the changes that are always required.
No society has successfully solved this problem.
Consequently, just as the War on Terror makes the course of American history uncertain, so does the murky succession of future American leaders.
Horseman Number Three: New Technology
The Common Stock Legend is partly based on the assumption that new inventions will constantly emerge to ensure the growth of corporate sales and profits.
However, history shows that great technological achievements have not occurred at a steady pace over the decades.
Technological achievement has not occurred at a steady pace over the decades
In some periods, such as the Golden Decade (1876-1886), there have been concentrations of inventions that radically improved the lives of people throughout the world.
In other decades, inventions have had less impact.
Productivity Flim-Flam
In recent years, Federal Reserve economists have placed emphasis on improved productivity, but their reasoning is open to question. [See Essay: Productivity Flim-Flam].
In a service economy, productivity increases are not only harder to measure but also harder to come by.
Illusionary productivity gains are no defense against the inflationary pressures of fiat money and Big Government.
Population Growth and Profits
In order for technology to result in an increase the supply of equities, new inventions must boost overall corporate profits faster than growth of the population.
Historically, this has not happened.
Progress may make our lives easier and more enjoyable, but total corporate profits cannot, in the long run, increase faster than Gross Domestic Product, which in turn is linked to the number of people working in the money economy.
Technology Is Not Profitable For Everyone
An individual inventor may become a billionaire, while others go out of business.
Competition eventually reduces the profits of invention to ordinary levels.
The Internet is a wonderful technological achievement that has had, so far, less effect on corporate profits than the electric light, the internal combustion engine, or the electric motor.
Amazon.com, Inc., now a Fortune 500 company, founded in 1994, had negative net worth of more than one billion dollars after a decade of growth and two billion dollars of investment.
Thomas Edison or Jimmy Hendrix?
The motivation of a population to engage in certain kinds of activity is important in driving human progress.
The Brazilians have won the World Cup in soccer five times because millions of poor Brazilian children are strongly motivated to seek fame and fortune by increasing their skills with a soccer ball.
The Ancient Egyptians directed their efforts towards building elaborate structures for the dead.
In the American past, some of the greatest inventions were made by people with little formal education, growing up in the moral, ethical, and social climate of the nineteenth century — an environment that was favorable to mass participation in the task of inventing things.
Millions of Americans were driven by dreams of striking it rich by patenting an invention developed on their kitchen tables.
From Benjamin Franklin to Henry Ford, the legendary Yankee tinker was a figure to be emulated in traditional American society.
It makes a difference whether Thomas Edison or Jimi Hendrix is the role model for American youth
In the United States today, the young are more likely to spend time learning to play the electric guitar or writing scatological lyrics to loud music, than in making technological inventions.
It makes a difference whether Thomas Edison or Jimi Hendrix is the role model for American youth.
America’s idols have steadily crumbled in intellectual merit from the highs of George Eastman and the Wright Brothers, to Bing Crosby and John Wayne, and to Janis Joplin and Snoop Doggy Dogg.
The delivery of the American public school system into the hands of teachers' unions and the politically correct, does not augur well for the future of American science and invention.
Technological Progress Is Sometimes Negative
Technological progress, while usually neutral, may have a negative effect on the capital market.
Gene therapy and new miracle drugs, if available at reasonable cost, may prolong lives, thereby raising the burden of retirement and putting stress on capital markets.
Miracle drugs that extend life may raise the burden of retirement and stress capital markets
On the other hand, the artificial heart, although a medical marvel, is an expensive technique that seems likely to bring benefits to less people than the invention of plastics.
Forecasts of future invention and scientific progress have often proved wrong, while surprising new advances have arisen seemingly out of nowhere.
Current economic projections for an ever-increasing GDP and productivity are based on faith and hope rather than sound indications of assured progress.
Furthermore, with the Internet, weak security, and easy travel, it is unlikely that any nation will long maintain economic advantage based on innovation and technology, unless society provides strong emotional reasons and role models for millions of young people to dream of making inventions that will benefit mankind.
Before proceeding, check your progress:
Self-Test
A stock investor in St. Petersburg in 1916 might have avoided loss by focusing attention on:
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The term 'Five Horsemen' refers to:
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New technology and scientific advances can be counted on to:
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Investment Theory: Exogenous Variables : continued >
