Benson's Economic & Market Trends
Pricing and Valuing Financial Assets -
It's a great time to sell!
November 25, 2003
Determining the price of financial assets is far easier than determining their value. However, knowing there is a difference between price and value and having the wisdom to see the difference, is a pre-condition for making the right investment decisions. Over time, it is certainly wise to buy financial assets at a price below their long term value, and to sell them at a price above their long term value.
Examining the price and value of financial assets is critical for the US economy. The current market price of stocks is about $10 Trillion. While this is down from a 2000 peak of $17 Trillion, it is still a considerable number. Credit market borrowings are approaching a pay-off balance of $34 Trillion. With the US Treasury running $500 billion deficits a year and the single family mortgage market still growing at a rate of over $600 billion a year, the total debt owed is continuing to grow quite rapidly. In our economy, the vast majority of financial assets are nothing more than the ownership of someone else's liabilities. The current total market price of financial assets (liabilities) is certainly over $47 Trillion, or four times GDP. (The cash flows from our $11.8 Trillion economy will not support payments on this level of liabilities. Something has to give, and it will most likely be the real value of the assets.)
Credit market financial instruments are the easiest instruments to price and value. The prices of notes and bonds can be mechanically calculated by a simple mathematical formula for Present Value, based on the current interest rate. One clear and profound observation is the longer the maturity of the note or bond, the greater the decrease in market price given an increase in interest rates.
The usual reason to hold on to the shorter maturity credit market instruments is the need for liquidity, or the inability to find another attractive investment. On the other hand, the reasons investors hold on to the longer credit market instruments are to earn a higher yield, to engage in the "carry trade" borrowing at lower short-term interest rates, or to buy the longer term bonds because the owner anticipates interest rates will go even lower, causing the bond to appreciate in price.
Since these financial instruments are priced at an inverse of interest rates and the Federal Reserve has cut rates to a 45-year low, it is logical to assume the market prices of these instruments are about as high as they could ever be. This, of course, raises the question of "value". If you knew interest rates were going to rise, you would know that the future price of these credit market financial instruments would fall. A wise man would not consider that the current price of these financial instruments is their true value.