Myths of discounted cash flow

Discounted cash flow (DCF) is the adjustable wrench of modern financial mechanics. Essentially, the analyst forecasts the revenue and costs for several years out and applies an appropriate discount, or interest rate, to calculate what those future dollars are worth today. The process is supposed to provide a hard number for the current worth of the company.

But as many of us recognized in college, there is a lot of room for wiggle in the process. Forecasting revenues and costs is tricky and always based on assumptions. An optimistic analyst might generate a rosy forecast while a pessimist may predict gloom and doom. Usually, analysts just assume the future will look like the past, which is always a dangerous assumption. How many oil analysts saw the recent collapse in oil prices as a result of projecting the past into the future?

New York manufacturing stumbles

In the Ricardo Effect, Hayek’s chief contribution to the Austrian business-cycle theory (ABCT), the turning point in the cycle from expansion to recession happens when the makers of consumer goods and services employee more workers and buy less equipment. Equipment makers face plummeting sales and rising costs for materials and labor, and therefore a profits squeeze. So they cut back on production.

Signs of that may have appeared in New York. The New York Federal Reserve released its August 2015 Empire State Manufacturing Survey reporting that the index fell to -14.9, its lowest level since 2009 in the depths of the latest recession. Naturally, economists had expected the number to be +3.86. A positive number suggests growth ahead and you can guess what negative numbers mean.

Don’t drink the Schwab Kool-Aid

The Schwab Center for Financial Research recently published an article intended to tranquilize investor nerves after the latest volatility and keep them shoveling funds into the stock market. “Schwab’s Perspective on Recent Market Volatility” begins with “Global markets may have swung wildly in recent days, but we think the recent selloff in stocks and commodities is not a sign of imminent global recession.”

I’m picking on Schwab because they are big and can take it, but they have said nothing that almost all mainstream financial service firms aren’t saying. Also, Schwab put their piece in nice bullet points that are easy to address. I’ll take them on one at a time:

1. The basics of investing have not changed.

They should change because the received wisdom is to always buy, never sell and just swallow the bitter pill of a major market decline. Instead, investors should try to time the market by getting out of stocks before a recession hits.

Stock market forecasts better economists

After the stock market stumbling through the past two weeks, you will hear top mainstream economists repeat the old joke that the market has predicted ten of the last eight recessions. The point of the joke is to belittle the idea that the market can predict recessions and to convince investors to remain fully invested. Austan Goolsbee echoed the joke on National Public Radio recently then insisted the economy was fine and he saw no recession in the near future. When asked if now was a good time to panic, he said it’s never a good time to panic and people should just ignore what the market does.

It is true that the market has predicted more recessions than actually happened, but if anyone will examine the data they will find that growth slowed dramatically after major declines in the market even though the fall wasn’t deep enough for the National Bureau of Economic Research to declare an official recession. But even with its false positives, the market has done a better job of predicting recessions than have any mainstream economists.

Training the Chinese dragon in economics

The story of China’s great leap forward to slightly freer markets is well known. Around 30 million people starved to death in the 1960s and the West fed the Chinese in the 1970s. Deng Xiaoping took over after Mao died and began looking for some way to make Communism work well enough to at least feed the people.

About the same time, a small group of farmers in a remote village rebelled against socialist farming by dividing up the land among them and selling their excess produce on the black market. They signed a contract binding each farmer to take care of the families of any farmers whom the state discovered and executed. After a couple of years, they couldn’t keep their success a secret any longer and Deng found out. But instead of executing the farmers, Deng made them national heroes and encouraged other farmers to do the same.

Watch out for falling productivity

The government reported recently that productivity in the US rose 1.3% from the last quarter, but that was little comfort to the Maestro, Alan Greenspan, who is worried about the collapse in productivity. Investors should be worried as well. StreetInsider.com reported Greenspan saying:

I think it's the most serious problem that confronts not only the United States but the world at large and more exactly the developed world especially. American productivity is not significantly different from zero growth in the last 6 or 8 quarters. And the cause of that, if you work backwards through the causative chain is capital investment has been inadequate to fund the amount of assets that you need.

The interviewer, Tom Keene responded with “There was a moment when we were bewildered by why nation's productivity was so good and America running on all cylinders. It is a distant memory.”

Why has productivity fallen and what does it mean? The answer lies in Hayek’s Ricardo Effect. Profits in consumer goods sectors will peak near the end of the expansion phase of a business cycle. Profits rise because investment in capital goods sectors has increased employment, and therefore demand for consumer goods before new consumer goods arrive on the market. Prices and profits rise in step.

Mainstream economists predict the past

Mark Twain once said,"Prophesy is a good line of business, but it is full of risks," and "It is difficult to make predictions, especially about the future." In the Bureau of Economic Analysis’ (BEA) recent statement that the GDP of the US grew by 2.3% in the second quarter of this year, it isn’t predicting the future, but the past. And Twain was right, even that is hard.

Initial GDP growth numbers are not actual data; they are the output of statistical models. That’s why the BEA has to revise them in a month and again years later. Most people pay attention to the first estimate, but the real interesting information comes from the direction of the miss. Most math models will miss on the high side as the economy heads into a recession and the gnomes will revise the numbers downward. In an expansion, they will miss on the low side and be revised upward.