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  • Writer's pictureMatthew Harms

Money and Financial Markets: Smoke and Mirrors

It seems like this has already gone off the rails from the opening statement, but nothing could be further from the truth when we take into account that those salaries and costs of living people are using for the benchmark of their spending ability are measured in the national currency of United States Dollars (USD). That seems like a very obvious statement, but there are implications behind it that virtually no one ever takes the time to understand. The money we use on a daily basis, that people lie, cheat and steal to obtain when necessary, is not just worth the amount printed on the face of the bill because our government said so.

From the beginning of time, societies used tangible assets to obtain the goods and services they needed. Oftentimes this was in the form of gold, silver or other precious metals. In some instances, it might have been livestock, lumber or other commodities that were needed by the other party. Prior to the United States easing off the “gold standard” in 1933 and Richard Nixon fully abandoning it in 1971, the value of every dollar bill in your pocket was somehow linked to the current price of gold and quantity of said gold on hand. There was a warm and fuzzy feeling to know that there was something backing or providing the value to that money that we now take for granted. The gold standard helped to maintain the value of money buy hedging control inflation and staving off deflation, two of the biggest thieves to the value of your bank balance.

So what is used to determine the value of money today and how does that have anything to do with it being fictitious? The value of the USD, and how it stacks up in comparison to other world currencies, or exchange rate, is calculated in three main ways. Before looking at each one it is important to realize that this is not a perfect science as it is subjective to the views and intentions of those who work behind the scenes to make the case for a value that the majority of the world can rely on.

One of the factors used to determine the value of any currency is the exchange rate that was mentioned earlier. An exchange rate is the value that someone from another country would pay to obtain the currency from another. If you have ever travelled internationally, or know people who have, you might have heard whisperings of not going to certain countries at certain times because their currency was too high. And on the contrary, when a country’s currency is weak, or undervalued in relation to the USD, that is a perfect time to get the most value out of your money. The issue with this valuation factor is that it is based on supply and demand, much like everything in life, and is set by currency traders who seemingly at times use arbitrary factors in evaluating the actual supply and demand of a currency.

If there was an actual physical formula at play here we would see drastic declines in the value of the USD every time the federal government prints more money, or in other terms, increases the deficit by borrowing more money. This is effectively increasing the supply of currency without ever changing the underlying demand on the global stage. As the supply of anything goes up but demand remains the same, the value by right should decline. The fact that it doesn’t in this equation illustrates that there may be less tangible and scientific factors at play like emotion and unfounded opinion. There is also the underlying premise of GDP (gross domestic product) that can be used as an argument for how our deficit is not as high as this example might imply, but that is a completely different topic that needs its own dedicated article.

The second factor impacting the value of the USD is the demand for US Treasury notes. Think about a note as a short-term loan to the American government where they will pay a fixed rate of return for a period of anywhere from 1 – 10 years. Historically, the United States has enjoyed the highest possible credit rating from all of the major ratings agencies, indicating that it was almost guaranteed any money lent to them would be repaid as promised. In 2011 the S&P cut that rating by one notch, which may not seem like a big deal. However, it was done for exactly the reasons mentioned in the prior paragraph, rising deficits and an increased obligation to pay out interest on their debts. So to think that a currency can be considered stronger based on how willing others are to lend that government more money can quickly become a recipe for disaster as debts keep growing and somewhere along the line the ability to repay gets blurred. Think about a college kid with a credit card who gets their limit increased every time the card is maxed out; at some point something has to give.

The third, and quite possibly most dangerous factor in the value of a currency, is the amount owned by other governments. The more USD a country like, let’s just say China, owns the higher the value of the currency. While the underlying principle that others seeing enough value to stockpile something makes it worthwhile is valid in general, there is also the concern of their ability to change their minds. China owns so much USD that the act of them simply slowing, or stopping the purchase of more currency could hurt the value if the USD and American economy. Should they then turn around and decide to sell off most or all of what they own it would result in a catastrophic devaluation of the USD that would cripple the economy.

There are reasons that countries don’t do things like this though, mainly because it would result in them now trying to sell a currency that they just made virtually worthless and losing money on their own investment. But countries like China are notorious for manipulating the value of their own currency so that it is difficult to tell at any given time what the Yuan is worth. If they are buying USD with a Yuan that is artificially valued at 5x what it is really worth and then turn around and sell off their USD holdings, China could easily win an asymmetric currency war by sustaining less damage to their own economy than what they inflicted on ours.

This concept has precedent in other factors of the global markets as well. OPEC, or Organization of Petroleum Exporting Countries, routinely manipulates the global price of oil by using their substantial control of the overall supply on the market. If OPEC wants to crush a competing country they simply increase the available supply until the price drops far enough to where their competition can no longer sustain production. Once the threat is eliminated they can scale back demand and push prices higher than ever before to recoup any money they may have lost in the process.

If the thought of all the ways the USD can be controlled by external factors isn’t scary enough and doesn’t give pause to consider if it really is worth what we think it is, then the possibility of everything valued in the USD being just as fleeting should be petrifying. One of the largest sources of wealth, or seemingly so, in this country and the world, is valued in almost identical ways to the value of currency. Yes, that is the stock market.

Most of the wealth in the stock market is controlled by the top 10% of investors, much like 10% of world powers control global currency. They own the bulk of the supply and therefore have the means to directly impact stock prices, and in turn, the perceived value of a company. Supply and demand directly impacts the cost of every single thing we encounter in life. The difference between the stock market and something like a precious metal though, is that technically the supply of the first is infinite whereas the value of the second is finite. We cannot manufacture any more gold or silver than what the earth has provided us, which provides some fact based rationale behind how prices are set. With the stock market, again like national currency, companies can issues additional shares or play creative games to manipulate the price through means such as stock splits, reverse splits and buybacks.

So what is a stock? Simply put, it is an ownership interest in a company. Let’s use Apple for example. Currently, their shares are selling for $275/each. We hear all the time that companies like Apple, Google and Amazon are trillion dollar businesses. The formula behind that valuation is merely the current price of 1 share of stock multiplied by the amount of shares outstanding, which for Apple is 4.375 billion.

$275 x 4,375,000,000 = $1,203,125,000,000 market capitalization

Yes, Apple is, on paper, worth over 1.2trillion dollars. But does that mean that everyone who owns a share of Apple today would get back their $275 if they were to go out of business? Absolutely not. As with the USD, the factors that determine on any given day what the price of Apple stock is, are subjective, manmade and subject to manipulation by both those who value the company and those at Apple who control the flow of data used to perform these calculations.

The first thing to understand about that 1.2trillion dollar value is that it in no way reflects the amount of money Apple has on hand (now in Apple’s case they may very well have it, but not usually the case). Every person who gave Apple money to buy their stock made an investment into that business and then Apple was free to turn around and use that money for whatever they wished. Maybe it was to fund a new factory or develop a new product. Or maybe it was to pay a CEO 100 million salary, fly top executives around the world on private jets and fund their opulent lifestyles. Shareholders have no control over where their money goes once it is invested, they just need to have faith that the company will operate responsibly.

Financial analysts are integral in helping the public determine the risks involved with investing in publicly traded companies. They use a host of ratios including: price to earnings, forward price to earnings, earnings per share, liquidity and free cash flow. Individual investors rely on this data to hedge against making poor decisions and possibly losing a life savings (based in USD). This analysis is all based on the information provided by the company, which can be pitfall number one, and does not take into account the supply and demand piece.

There was a time where markets reacted accordingly to good and bad news, in a timely fashion to when those announcements were made. So, a bad earnings report or falling short on a specific target would result in the stock price declining while conversely a great earnings report or the announcement of a new product would drive the price up. But in the current world of artificial values good news often results in price drops because it wasn’t good enough and bad news can buoy a stock since analysts expected it to be worse.

Why is that?

Much like with the USD, the supply of individual company stocks is controlled in bulk by large institutional investors. These institutions range from hedge funds and mutual funds to individual governments or private billionaire investors. Regardless of the name assigned to the party, they all have the ability to dictate the price in the market. Think back to the example of China selling all of its USD holdings overnight and crashing the value of the currency. If one party owns millions of shares of Apple and chooses to sell it off abruptly, that transaction is going to increase the supply of Apple shares on the market, thus creating a perceived declined in the demand. Most of their trade will likely be executed in the range of the $275 a share we spoke about earlier, but the sheer transaction size is going to cause the remaining shares to decline precipitously in value.

In the last example, that means that everyone else still holding their shares of Apple has less value than they did before. Now imagine if someone else holding millions of additional shares saw the sharp price decline and panicked, deciding they were okay selling for a reduced price (let’s call it $225 for easy numbers) that would then drive the price down even further for those still holding their shares. And generally, it is the smaller average investors who are left holding the bag when the big guys engage in market making, but that isn’t really the point. One of two things can happen at this point.

The first scenario, and the one that winds up happening more often than not, is another large investor, sometimes the original investor who drove the price the down in the first place, will now see Apple trading at a reduced price of ($175 again as an example) and decide to buy it back. If you have been following along then you should realize that this diminishes supplies, creating a perceived demand and the price will rise again. When certain players have the ability to virtually decide at will how to influence a stock price it becomes difficult to understand how there was ever any underlying value to begin with.

The second scenario, which, like that of China selling all of its USD overnight, is far less likely. But that does not mean it should not be considered as a possibility to understand just how fictitious the so-called wealth created by the stock market really is. Imagine now that after the price hit $175, the dominoes start to fall. Another investor dumps millions of shares, so on and so forth. Eventually, those who are still holding shares, or trying to sell their shares, are stuck with something that has become worthless. Knowing that is a possibility, it is insane to think that Apple is actually worth 1.2trillion dollars as not every person who owns shares will ever see the current trading value of $275 per share.

Even without looking at such extreme examples, although the mechanics behind them are incredibly important, the most obvious sign that stock value is as fictitious as the value of the underlying currency at any point in time is how quickly an interruption in their core business can cripple them. To understand this, one only needs to look at the banks, automakers and airlines. Each of the top players in these sectors is worth billions, if not hundreds of billions of dollars. Yet when times get rough, all of that market capitalization does nothing to prevent them from needing bailout money, funds that come out of the pockets of the honest tax paying citizens who also bear the brunt of their plummeting stock prices.

In conclusion, our entire economy is based on nothing more than blind faith that those who control monetary policy and create valuations are operating in the best interest of the general public and that they are competent in their fiduciary duties. When we take into account that our own government is rarely prepared to respond to any unforeseen financial disruption without borrowing obscene sums of money, and those CEOs who are paid millions upon millions of dollars to run companies into bankruptcy at the expense of their shareholders, it is hard to have any confidence that a dollar today will be worth anything tomorrow.

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