We’re still not over the 2008 financial crises

A big proportion of wealth is a fiction.

Before your natural instincts kick in, take a look at how much of finance works.

Let’s use the example of Bitcoin, which until January 2009 did not exist. As of today, the total market capitalisation is over half a trillion US$^[1]Bitcoin. And yet it’s nothing. It all exists digitally. No assets backing it up. The only return you can get is the appreciation in value. That’s driven by supply and demand. If the demand disappears, so does the value. You’re left with nothing.

The same is true for other assets too.

Let’s take companies. There, at least you have some tangible value – the difference between the assets and the liabilities, which is the nett asset value (NAV). But there is often a big difference between the market capitalisation and the NAV. The market capitalisation is the number of listed share multiplied by the share price. 

Let’s take Tesla. The NAV is $46 billion. The Market cap is $514 billion^[2]Tesla, Inc.. The difference is $468 billion. Where does that difference come from?

Now a company is different from Bitcoin in a very important way: a company has earnings. The difference between the Market cap and the NAV is the value of future earnings at an expected rate of return. This is where the magic in the numbers starts to happen.

The expected rate of return is based on the risk free rate plus the risk differential. If the company has a triple A rating the risk differential is virtually zero. With more risk, the rate goes up.

The important part of this is the risk free rate, which after quantitative easing (QE) was introduced to deal with the financial crises in 2008 was reduced to almost zero. And with that company values increased. 

In its simplest form, a company’s value is calculated as the earnings (E) divided by the expected rate of return(i): E/i. If earnings are $100,000 and i = !0% the value = $1,000,000. If the expected rate of return drops to 5%, the value is now $2,000,000. So when QE was introduced, the value of companies increased proportionately.

QE creating a massive fictional value.

Now, as they wind down QE, and expected return increases, values will go down. All that magic money will disappear.

We’ve already had a couple of bank crises. Governments will try and convince us that they have a tight handle on things.

Once the rabbit is out of the hat, it’s not going back.