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Intrinsic value

Posted Thursday, October 6, 2011, at 10:31 PM

Why have investments fallen so far so fast?

No doubt there are more reasons than any blow hard commentator like me can possibly give. However, I would like to offer a thought that kind of cuts to the heart of things.

As I previously mentioned, I am the kind of person who believes that objective reality is more important than people's perceptions or beliefs of reality. That is, in sum, the difference between people who follow the Austrian School of economics and those who follow the Keynes School of economics.

In my opinion, stocks are poised to decline from here by no less than 20 percent. Here's why.

One of the most important measures of a value of a stock is its "price to earnings ratio;" its P/E Ratio.

What that means is, how many years of earnings would a company have to have to be able to buy back all of its shares of stock at the current price.

For example, if a company's stock is selling at $20 per share and has a P/E Ratio of 15, it would take 15 years of corporate earnings to buy back all of the issued stock at $20 per share.

The current P/E Ratio of the combined top 500 companies in the stock market is presently 20. That is down from its high in the year 2000 of almost 45. Today, it takes 20 years of earnings for these companies to be able to buy back all of their stock.

Ten years ago, it would have taken 45 years. No wonder the market tumbled! There was no way that earnings justified prices.

The historical average P/E for the stock market, from 1880 to present, is 16 with a midpoint of 15. During times of economic boom, this ratio raises to an average of a shade under 20.

During recessionary times, it drops to a little above 10. In 1929, during the Big Crash, the market's P/E Ratio fell from 30 to 5. Today, we are still falling from the high of 45 and the economy is still under recessionary pressure. Only artificial manipulation from the government is keeping the stock market P/E Ratio hovering around 20.

Well then, why did gold drop? Why did you say it was going to continue to rise?

Since there is a relatively fixed supply of gold, its intrinsic value is based on the amount of gold in existence divided by the number of dollars available to buy it.

For more than half of American history, that value was fixed to $20 per ounce of gold by keeping the number of dollars in existence relatively small.

As the number of dollars goes up, the intrinsic value of gold goes up in exact proportion.

From about 2006 until about 2008, the price of gold fluctuated around $800 per ounce. That reflected a domestic supply of dollars of around $800 billion.

Since then, the domestic money supply has more than doubled to approximately $2 trillion. This should mean that the intrinsic value of gold is now somewhat above $1,600 per ounce.

But there is another objective factor that affects gold: Demand. Since the supply is basically stable, if demand rises, the price moves above its intrinsic value. If demand falls, the price drops below its intrinsic value.

Since August, demand by speculators trying to cash in on the natural movement of gold from $800 per ounce to $1,600 per ounce pushed the price up to $1,900 per ounce.

That was too high, too fast.

People lost confidence, demand fell and the prices fell with it.

However, the U.S. Federal Reserve is trying to quietly sneak another $400 billion into circulation. This will nudge the intrinsic value up yet again. Moreover, it is very likely that the Fed will significantly inflate the money supply again with another round of "Quantitative Easing," sometime in the next two years.

Additionally, the central banks in Europe and around the world are trading the money that they themselves print for gold to put into the vaults. They know that the money that they are printing is falling in value as they continue to print it.

This fundamentally reduces the supply of available gold to be purchased on the open market and increases the amount of demand to buy what is available.

Moreover, when Greece (and possibly others) defaults on its debt, the big banks (Like Societe Generale) which loan to governments, will go belly up without government bailouts to save them.

The "bailouts," will further inflate the money supply and cause institutions and people to flea to the security of gold, creating a spike in demand.

Incidentally, this will likely be the peak of the bull market like it was in 1980. Speculators will again be induced to chase the natural rise in price to again try to cash in on this movement and will again drive prices up well above gold's intrinsic value, leading likely well above $2,000 per ounce, to yet another tumble.

These are just my thoughts on these subjects and you follow them at your own risk.

It is always a bad idea to invest in what you do not understand.

People should do their own research before making investment decisions.

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I agree with your analysis. One note however: earnings are whatever an accountant says they are. Perhaps a better gauge might be dividend payout. The accountants can't fake that.

When people profess to not understand the allure of gold in this day and age (those who might refer to it as a barbaric relic), I ask the question, "What would you rather leave to your descendants 100 years from now, dollars or gold". The answer is almost always gold. That pretty much says it all.

-- Posted by Bob E on Sun, Oct 9, 2011, at 11:51 PM

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