“Davidson” took a stab at having an influence with the Dallas Fed using their own published data and their statement that Wicksell is the “Father of Modern Monetary Policy”. The following letter was sent..
To whom this may concern:
Below you will find a comparison of what I call the Wicksell Rate based on Knut Wicksell’s observation that the cost of capital is arbitraged on the Return of GDP vs. comparable fixed alternatives, namely the 10yr Treasury Note. I took the Dallas Fed trimmed mean12mo PCE values and added these to the long term trend line of the Real US GDP(2nd Chart) to produce the Wicksell Rate(1st Chart). The reason for using longer term trends is that business investors typically make capital commitments with 10yr time horizons and ignore year to year fluctuations.
I think this comparison helps to differentiate the enormous short term effect of market psychology which can be observed in the multiple deviations reflecting both periods of enthusiasm and gloom. Net/net the proper relative return relationship holds over long periods. Perhaps, one will find a better fit with changes in tax treatment of capital gains, but I am a lone practitioner and have neither the resources nor the time for extensive analysis.
I note that a better alternative for making the same point which would strip out the economic swings of earnings (because the market does look ahead on the expected returns on assets) is to use a 5yr MovAvg ROE for the SP500 and its P/BV multiple thus producing a ROE/(P/BV) = hypothetical Asset Based Return Yield.
Not all returns come from earnings. For instance, oil companies and real estate companies have asset gains due to inflation which are eventually converted to earnings at some point in the future in the form of higher rents or asset sales. This is less true of companies like GE and PG which have finished products with rising cost inputs but do not have the ability to convert the rising cost of production (rising value of factory equipment) into higher margins during inflation periods as do oil and real estate based businesses. The problem with this approach is that SP500 has to my knowledge stopped issuing BV information as it is deemed unreliable as a financial indicator. However, I think that as a gross measure of the asset base of the economy, I have seen from Ned Davis Research an avg 14% ROE and ~6.1% BV growth rate which is much smoother than the ~6.1% earnings trend you see below for the SP500(3rd Chart).
The point to be made is that Knut Wicksell had the correct observation in 1898 even though the tools for proving it were not available till much later. By using his observation a less volatile monetary policy should produce a less volatile economy, less volatile inflation, fewer economic headaches and Federal Reserve decisions with substantial genius.
It is clear to me that the activities of the Federal Reserve have proven to have been since the US Real GDP trend from 1930 very beneficial as a shock absorber. However, under the Greenspan years the availability of cheap money followed by comparable contractions has resulted in higher corporate earnings volatility(see 3rd Chart Earnings Trend Line)
I ask that you consider using the Wicksell Rate. I ask that you publish this for all to see so that corporate and investment decisions can be made with greater long term clarity. My suggestion is that in the current environment an immediate implementation would be disruptive, BUT, if you were to announce that you were going to work towards implementing Wicksell Rate as a policy over the next 5yrs-10yrs, I believe you would bring great clarity to many financial decisions as well as give all a period in which to make adjustments that would not be unduly disruptive. Importantly this would result in far less speculation as returns would have to breach the Wicksell Rate and all would realize that the cost to doing this would be considerably higher than with funds much lower. Perhaps it would also be helpful to dampen rampant speculation that the Federal Reserve promote the concept of “matching maturities” when investment commitments occur and recourse as opposed to non-recourse financing.
I think some of these suggestions would result in higher levels of individual discipline and common sense.
Humbly submitted,
“Davidson”
Disclosure (“none” means no position):
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