Asset bubbles and valuation. (Part I)

Part I discusses the current US asset bubble and its effects

The selloff in the equity market should be expected. None of us should be surprised...and why you ask? Here are few reasons why:

1. Interest rates (and the fed funds rate in particular) were so low, for so long that it made money "cheap" and induced a borrowing frenzy of epic proportions. The effective fed funds rate dipped below 2% for the first time in almost 40 years. (For those unfamiliar with the fed funds rate, it is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions, usually overnight.)

From a "macro" standpoint, promoting low interest rates will give corporations the incentive to borrow which in turn creates an expansionary environment thus higher economic growth. And, as you will see later, higher cash flows and earnings growth will lead to higher asset prices.

2. Inflation rates never forced the Fed to "moderate" growth as they have in the past. Under the premise of higher economic growth, it was usually expected that higher inflation would follow. However, due to better Fed policy management, inflationary pressures never really set in this decade. As a result, the Feds kept rates for longer than it should've.

3. Revenue growth and unsustainable profit margins also played an important role. With the advent of global demand and the US consumer, firms prospered from unprecedented economic growth. Demand kept profit margins at a healthy clip this decade.

With all of that said, let examine how these factors quantitatively transformed into higher asset valuations and, in some case, bubbles:

Typically, asset valuations can be measured in the form of a perpetuity. The equation takes the following form:

Asset Value = (cash flow) / (discount rate)

Asset value [the left side of the equation] will increase in the following scenarios:

a. Increase Cash Flow, Hold Discount Rate Constant
b. Hold Cash Flow Constant, Decrease Discount Rate
OR
c. Increase Cash Flow, Decrease Discount Rate

In our case, this decade we have seen scenario "c."

Reasons #1 and #2 (as listed above) led to us having a decreasing "discount rate." Low interest rates coupled with lower inflation figures promoted the decreasing discount rate. With no real gains in inflation and rates sitting at all time lows, we were destined to see a lowering of discount rates. Unfortunately, as history would have it, it appears now that our policymakers probably waited too long to raise rates to moderate levels. The "cheap money trap" induced many financial players. While consumers tapped out home equity loans, maxed out credit cards, and engaged into overspending, the "smart money" (or LBO financiers) overspent on buying and leveraging firms at extraordinarily high multiples.

Reason #3 is why our cash flows increased. The US consumer and global demand provided for the infusion of unprecedented cash flows. Will the demand dry up in the next 12 months? Maybe a bit but with China and Latin America growing, I still expect a healthy "worldwide" demand. We are entering an era where the "emerging markets" have just about now "emerged".

As we would have it, these factors have led to highly inflated asset values across the economy and at the moment we are experiencing a decompression of those assets. Does it hurt? Yes. Is this normal? Absolutely.

In my next entry, I will discuss what's next....stay tuned.