Porc,
Thanks for noticing.
>>One of Wayne's premises is that the cost of capital (interest rates) and the market price of capital (stock prices in relation to earnings) perforce must tend toward convergence in a free market.<<
I'm not sure I understand the question you posed in your post. But I am sure I don't know the answer to it.
The above may be a slight misunderstanding of my view. My view is essentially that there are many interrelated things going on in the economy at all times that effect the return on capital investment, the return on equity, stock prices, leverage levels, interest rates, saving levels, wages, inflation, whether money is easy or tight, asset values etc...
I am not sure that anyone can predict the course of events that the economy will take with a high degree of precision. I certainly can't. But I strongly suspect that certain combinations produce certain results and others are very difficult to sustain over the long haul.
One of those might be "aggregate" (I stress aggregate) stock prices trading at a substantial premium to the underlying asset values. You could just sort of think that if everyone could get 2 or 3 times as much for their businesses as they invested, there would be some sort of leveling process that would bring things more in line. Perhaps a lot more investment and declining returns on those assets or perhaps a lot more IPOs. Perhaps rising real interest rates as investment explodes. Certainly many companies are worth more than their assets. That is goodwill. But goodwill implies above average returns meaning that some companies get average returns and other may have ill-will or below average returns.
I think the same might be said for interest rates and return on equity. If I can borrow at one rate and earn a higher rate, I will do so as long as I am rewarded properly on a risk adjusted basis. If rates fall and ROE rises the rewards become super terrific. That's where we are now. Return on Equity is very high and nominal rates are low. There may be all sorts of reasons for that situation, but again, you could just sort of think this will invite investment decisions that look to take advantage of the present terrific rewards. I suspect this will result in a return to a more average relationship. The exact way I am not sure. There are so many things going on and human behavior and central bank intervention play a part. But intuition, many decades of economic experience, and some economic theory I am aware of suggests it will.
That's why I am so uncomfortable with the current environment. We have a set of conditions on which someone could come to the conclusion
that prices are high but not that far out of line. It's the assumption that these conditions are sustainable that stresses me so. Because if average relationships return, we are in the twilight zone and that could be very dangerous based on experience at home and in other countries whenever assumptions like these were made.
My gut, 125 years of history, my intuition, a lot of overlooked facts, and economics suggests that this is not sustainable.
Wayne
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