Quote:
Originally posted by legion
A comment on the RE thread got me thinking...
When one can buy an asset with leverage, does that allow the price of the asset to become detached from its intrinsic value?
Some examples:
Stocks. The intrinsic value of a stock is the net present value of future dividend payments. Based on a quick scan of PE ratios, most stocks trade for many times their intrinsic value.
Homes. The intrinsic value of a home, adjusted for inflation, and barring some change in circumstances (like a toxic dump is built next door), should never change. Yet on the coasts, home values have doubled, tripled, quadrupled or more in the last ten years.
Education. The cost of college should be less than the net present value of future earnings to be worthwhile. I don't think this is true of all colleges anymore.
Does the fact that these are commonly financed with someone else's money mean that people are more likely to speculate with their purchase? The are more tolerant of price increases that depart from intrinsic value because they anticipate future gains will go up even more?
In all three examples, I think if financing the purchase of these assets was impossible, then prices would be both stable and lower. If people had to spend real money (and not borrowed money) on them, then their costs would be more closely weighed against their intrinsic value.
|
This is a really interesting question.
I think more leverage would tend to mean higher prices. For a couple of reasons.
First, think about how prices are determined. For most assets, the "value" is a matter of opinion, and among reasonable people there will be a range of opinions. The people who think the value is higher (call them the optimists) will buy from the people who think the value is lower (call them the pessimists), until the price reaches some equilibrium. But some of the optimists don't have enough money, so they can't act on their opinions, i.e. can't buy. If the optimists have easier access to money, more of them can buy, so there's more upwards pressure on the price.
Second, just looking at history, rising asset prices and price bubbles often tend to be associated with easier access to money. In the stock market, one thing people look at is how much margin buying is going on.
Third, in finance theory, the "intrinsic value" of an asset is the net present value of the future cash flows - discounted cash flow (DCF) valuation. The discount rate is determined by the riskiness of the future cash flows and the current risk-free interest rate. So when interest rates are low, discount rates tend to be low, and NPVs tend to be high. (Look at a long-term chart comparing the PE of the SP500 to the 10-year interest rate, the inverse correlation is obvious.) Well, periods of low interest rates also are often associated with easier access to money.
There might be other reasons too. More leverage means more ability for speculators to buy (since they can borrow). More leverage can also mean the reward-risk looks asymmetrical (house price goes up, your profit is magnified by leverage; house price goes down, you hand the bank the keys and walk).
So basically I agree w/ you.
I might disagree on a couple of details.
On stocks, I would not say prices are many times intrinsic values. Curious how you are calculating this. If you do DCF valuation on the market, you won't find a 2X over-valuation.
On houses, you have to look at the long-term price trend. Over the past 40 years (as far back as the OFHEO data goes), the increase of home prices in California have roughly matched the stock market, roughly 8%/yr. Home prices boom and bust, so trough to peak (boom) looks like a huge increase but don't forget the peak to trough (bust). If you consider the growth in incomes, wealth, and rents in the coastal cities of California over the past 40 years, 8%/yr doesn't seem unreasonable to me. (If you go far back enough in this thread, I think I've posted on this.)
On education, I dunno. I know a Harvard MBA opens te door to a hell of a lot in future income (assuming the diploma-holder does his part), but I doubt a Harvard Masters in Medieval French Literature is worth much (financially speaking). No idea how to do the valuation.