Asset Price Deconstructionism: How Big is a Balloon?

French philosopher Jacque Derrida caused a plague revolution in literary circles that continues to inaffect academic circles to this day. Termed Deconstructionism, the theory proposed that in literature, and by extension painting and sculpture, there was no such thing as objective value. In short, the worth of a work of art could not be separated from the reader. If the audience determined that the poetry of William Blake, for example, had no relevance to their experience, then it was worthless no matter what anyone else thought. To the extent that deconstructionism led to a reassessment of the dominance of Dead White Males in history, it was entirely healthy. Its wholesale adoption in college English departments, on the other hand, is an ongoing disgrace. I have no problem believing that current IQ testing is inaccurate and unfair for inner city kids because of the context of the questions, but the second this thought leads to Hamlet being crap because a high school student “doesn’t get it”, I have to tap out.

A similar process of Deconstructionism is occurring in asset markets as most conceptions of objective equity and debt values are being tossed out the window.  The valuation of investment assets is, of course, a matter of debate. However, for the sake of argument let’s accept that most valuation techniques are variations on the primary theme that a “hard value” can be determined by the present value of future cash flows. This is a blog post and I’m not getting paid, so we’ll keep the discussion of correct discount rate simple, assuming  a blend of government rates.

This underlying assumption of this classical valuation technique was that the discount/interest rates were only peripherally related – the economy, as reflected by the discount rate, went a long way in determining the relative value of the cash flow stream of the investable asset. This is the relationship that’s been completely thrown on its head.  The Fed and the ECB are determining rate policy in response to credit, not economic conditions, arguably with the sole intention of boosting asset values. History will judge whether this is a good idea or not, but it is clear that rate policy is now largely disconnected from current economic activity. This in turn implies that the validity of current rate policy is arbitrary in the same way that Deconstructionists believe that the value of Shakespeare is arbitrary – dependent on the reaction of the audience or markets.

The preponderance of technical analysis in the current market is an important contributor to this phenomenon. Technicians eschew fundamental analysis in favor of careful measurement of short-term investor behavior. With reference to Graham’s belief that the market was (to paraphrase) “a voting machine in the short term and a weighing machine in the long term”, technicians are fully concentrated on the former. This is not to criticize technicians, far from it – during the past three years ignoring technicals has been a sure path to investor bankruptcy. But, the fact that the vast majority of current trading activity is determined by an investment philosophy that completely fades any concept of intrinsic or objective value, furthers the argument of this post – that the market is operating without the net of accurate asset price valuation.

To attempt to determine the “correct” value of an investable asset in the current market is to ask “how big is a balloon?”,  dependent on how much central bank air will be pumped into it.  The market today, in light of the ECB’s LTRO program is nuts – being in uncharted waters, I wouldn’t predict market disaster as any more probable than any other scenario. At some point though, equity and debt markets will have to settle into some form of homeostasis where future values are in some way predictable. Until then, we are just gambling on coin tosses and hoping for the best, living in a world where The Di Vinci Code can be considered our highest artistic achievement if enough people agree.

22 thoughts on “Asset Price Deconstructionism: How Big is a Balloon?

  1. Pacioli says:

    Some very thought-provoking remarks here.

    Nonetheless, I would strenuously disagree with your starting premise in relating Deconstructionism to the markets: “The Fed and the ECB are determining rate policy in response to credit, not economic conditions, arguably with the sole intention of boosting asset values. … but it is clear that rate policy is now largely disconnected from current economic activity. This in turn implies that the validity of current rate policy is arbitrary…”

    First of all, I’m not sure where you have been, but economic conditions are horrendous. We have ongoing debt deflationary dynamics in the US and Europe (and Japan, and perhaps soon in China), which have persisted for upwards of 4 years now. Thus, central banks have been correspondingly accommodative with rate policy. Thus, your concluding implication regarding rate policy (that its validity is arbitrary) seems erroneous, IMO.

    • Interloper says:

      Sure, thanks for commenting. I understand that there are severe structural issues, but thats Ki da my point. GDP growth will come in pretty good for q4 despite the unemployment misery. That GDP/unemployment/rate disconnect Is the type of thing that’s making discount rates, and thus classical valuation, impossible. I’m not saying rates shouldn’t be low, just that the GDP/corp profit connection is busted.

      • Pacioli says:

        “That GDP/unemployment/rate disconnect Is the type of thing that’s making discount rates, and thus classical valuation, impossible…”

        Again, I see where you’re coming from here, but I’d strongly disagree. Here’s why:

        If we take the Fed, its dual mandates concern price stability and employment. Nothing (directly) about GDP in there. Employment remains atrocious. Meanwhile, deflation remains at least a big a threat as inflation in the near term (call it, 3-4 years). Thus again, extremely low rates SHOULD be expected (as you concede in your comment).

        Your contention that “the GDP/corp profit connection is busted” implies that it is somehow valid to expect a “GDP/corp profit” direct connection in the first place. Yet, when economies are undergoing private sector debt deleveraging on massive scales, a smaller and smaller proportion of overall GDP is attributable to the private sector (as public sector fiscal initiatives must pick up the slack in order to stave off Depression-like deflationary dynamics).

        So, yes, GDP will look OK – but it will not be due to corp profits in the aggregate.

        All of this is to say that, amid this backdrop, global central banks’ rate policies appear both rational and consistent with the economic conditions. Importantly, monetary policy alone is nowhere near powerful enough to overcome these conditions in the long-term. Eventually, markets always win out, and debts that cannot be repaid, will not.

  2. Bwee's BaBa in Orange County California says:

    Interesting thoughts, but the logical problem is that Bernanke et al are in no way deconstructing existing values that conventional paradigms/algorithms assigned in the past. These central bankers are using mainstream economic thinking (monetarism as an economic policy tool) to perpetuate old values and abstract notions of worth, by manipulating the cost of money, just more aggressively now than they always have. They are not challenging previous attempts to establish an ultimate value or deconstructing the ideological biases that led to old (over)-valuations. And we’re not “living in a world where The Di Vinci Code can be considered our highest artistic achievement if enough people agree”, we’re living in a world in which worthless debt is still valuable because an elite group of old white men want it to be.

    • Interloper says:

      Yes, the politics are 180 degrees reversed. But the notion of abstraction from some concept of “intrinsic” is consistent. Im definitely not defending recent central bank action. This post would easily extend into some form of gold standard although gold, with no utility, is also only worth whatever we decide, scarcity or no.

      • Mario says:

        exactly. the value of gold is as arbitrary and random as the value of fiat money. The only difference for some being the “historical precedence” of gold. Yet the fact remains that its value is completely “made up” probably at first b/c it was shiny, hard to get, and “looks nice.”

        A gold standard is really just fiat money creation tied to some scarce resource. There is no real intrinsic value difference between gold versus paper/ink.

  3. Octavio Richetta says:

    I think in addition to the well-known arguments explaining money managers’ focus on short term results, I believe the Internet has played a big role in the overweight of short term news on stock prices. In theory, to the patient G&D/Buffet style investor this is actually an advantage but it involves stomaching volatility and, frequently, underperformance. No wonder, investment in private companies which are not valued minute by minute in equity markets is now in vogue.

  4. Interloper says:

    To Pacioli: I don’t disagree with any of that. I was hoping my “history will determine” phrase implied that. I’m saying the current situation makes classical valuation of assets near impossible, not that central banks are de facto wrong.

    • Pacioli says:

      Fair enough – you did not outright assert that central bank policy is ‘wrong’ currently. But you did assert that it has led to diminishing usefulness of classical asset valuation. Which I would also disagree with.

      I guess I did not really finish out my whole thought process.

      Which is to say, based on my earlier remarks, when I plug in the consequently weak top-line and profitability assumptions into my valuations of the companies I follow, their valuations seem pretty reasonable to me, on average.

  5. Pacioli says:

    I would also like to reiterate that, despite my disagreement, the discussion being provoked by this post (and most of your others) is far more productive and profound than that of the vast majority of the blogosphere. Keep up the good work – cheers.

  6. Mario says:

    It seems to me that the subjective valuation issues you bring up actually create competitive advantages for those of us who do know how to value assets and companies. This is a GREAT time for fundamental investors to come in….if you know how to predict fiscal policy initiatives at the federal level (which admittedly is no easy task these days). But you’re basically saying that there are a lot more people that are valuing assets incorrectly or with a very short-term vision than ever before. And I’d agree with you there….however I don’t see how that negates classical valuation techniques at all. Accounting and economic textbooks are still the same as ever in regards to valuation techniques so the idea that there is some equivalent of a Derrida-run academia that is pushing new valuation techniques does not seem to apply at all. We just have more “hack” investors in the mix. It should be noted that as far as I know technical analysis is not taught at all at any major university as far as I know. That is “real world” education not “book” education. So I think the real issue is that we have a larger cacauphony of “valuation voices” in the markets these days thanks to the internet, the emergence of self-direct IRA’s, and a vehemence for mutual funds and financial advisers etc. after the crash among “the people.” It’s amazing when I talk with acquaintances of mine to hear them bring up the markets and options and gold and technical patterns, etc., etc. Many people are taking their investments into “their own hands” these days…and of course doing all sorts of strange things (they probably don’t even know what a discount rate is either!)….this of course is a good thing for those that do….that is if you are willing to take bets on the government and be able to sit through some serious noise in the markets. I also think that since we are in what I view to be a secular bear market and a deflationary malaise, it’s not so much valuation techniques that need to change but the TYPES of assets that you need to gravitate towards to increase profitability and sustainability. This isn’t the 90’s anymore so you can’t exactly go for serious “growth” stocks if you will. That’s not so much a shift in valuations as it is a shift in sectors and growth models.

  7. mike says:

    I’m enjoying your stuff, Interloper. But a special shout-out to Mario, who (more deftly than I’ve been able to do) debunks the idea gold has “intrinsic” value. Gold is worth what it’s worth because two parties on either side of a transaction agree that that is what it’s worth.

    • Mario says:

      thanks mike! Yes Interloper is quite a good read indeed. If you are as unsatisfied with the gold standard as I am then I highly encourage you to check out MMT (stands for modern monetary theory). Warren Mosler, Bill Mitchell, Randy Wray, Hyman Minsky, Mike Norman, Wynne Godley, etc. You’ll probably see me around those sites from time to time as well. Cheers!

  8. Interloper says:

    Shhh. You’ll wake,up the gold bugs. I don’t like talking about gold the same way I’ll never mention abortion – both sides of the argument are clearly delineated and no one’s going to budge.

  9. Kris says:

    Interloper, you are FANTASTIC. This is a quite different perspective.
    I might side with Derrida on this one. I have a question for you, which I will present in a Jon Stewart way:
    – If the what the global warming lunatics claim comes true, there’s a super heat wave and everybody on earth dies, what is the “intrinsic” value of:
    – Stock market?
    – Hamlet
    – Van Gogh paintings? (I love Van Gogh).
    Let me know.

    • finnagain smith says:

      Global warming is already here, the pack ice in the Arctic has never behaved as it has in the last two or three years according to the Eskimos who have been studying it for centuries. As the methane gas frozen in the tundra is released due to the thawing it is currently experiencing, the warming will accelerate quickly. The value of Van Gogh will be the least of our worries.

  10. finnagain smith says:

    This isn’t the worst deconstruction of deconstruction that I have ever read, but it’s wholesale adoption by investors everywhere would leave them disgracefully ignorant of what it is really about, and that makes me question the value of the rest of your analysis in the financial realm. There are a ton of great and simple explanations of deconstruction, or you can just view the film “Derrida”, so don’t settle for this simplistic explanation of mine either, but Deconstructionism is actually an attempt to broaden understanding, not make it laissaiz

    • finnagain smith says:

      -faire as in, if enough people think “The Da Vinci Code” is anything then it is.

      The principle idea of deconsrtuctionism is a critique of the way western metaphysics historically creates meaning through opposites, as in “black is the absence of white”, or “females are the opposite of males.” It grew up in reaction to Marxist and existentialist thought, and it has no plot to replace Shakespeare with Dan what’s his name

      • kris says:

        The reason the post is outstanding is that brings up theory vs practice (reality) dichotomy. In my opinion, any theory that people do not practice is useless. Crude reality is what matters.
        (Let’s leave global warming out of the blog. Interloper clearly does not like on/off topics. It’s his blog ultimately).

    • Interloper says:

      It’s an over simplification for sure, and I would encourage those interested to watch the movie or read the central texts, as I did a long time ago, by Derrida and Foucault. I am comfortable with what I’ve written, however. It’s possible you are objecting to equivalences that I’m not actually making.

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