The Proper Approach to Market Fundamentals

There is little in the current literature on securities analysis that approaches the accurate method of forecasting stock prices based on the so-called "fundamentals." Although much ado is made of fundamental analysis in the financial realm, very few practitioners of the financial sciences have taken the right approach to market fundamentals.

While much can be written as to what actually constitutes the fundamentals of supply and demand, essentially it boils down to four major elements: time, price, volume and momentum. These four factors, when combined, produce the most powerful and accurate method for performing fundamental analysis of securities and commodities.

The basis of sound fundamental analysis does not consist merely in looking at a company's earnings, sales, debt-equity ratios, etc., but rather in comparing each of the basic measures of financial soundness over time, comparing it with previous time periods, and—most importantly—factoring current rates of inflation and taxation into the equation. Modern-day fundamental analysis, unfortunately, fails to adequately consider these measures.

Short-term technical considerations aside, the ultimate fundamental measure of equities prices is quite simple. From a long-term perspective (which we will define as anything over 3-6 months), the dominant factor that determines a company's stock price is the second derivative rate of change of net real earnings. This is merely a formal way of stating that the true measure of price and performance is how much a given company earns per quarter compared to previous quarters, factoring in the current rate of inflation. This and this alone is the comprehensive measure of long-term fluctuations in a given security's price.

The great failure of modern day financial analysis has been the total lack of accounting for inflation (i.e., the purchasing power of the dollar) when analyzing assets earnings. The great Austrian economic Ludwig von Mises lamented this shortcoming in his writings, and it is the most conspicuous failure of the modern-day Keynesian approach to economics, as well as the other major schools of economic thought. Only the Austrian School appears to have properly accounted for this basic and all-important factor.

Rate of change, which measures price momentum and internal strength simultaneously, must be employed in analyzing corporate earnings, irrespective of the timeframe under consideration. When we look at quarterly earnings, we need to know how those earnings compare with previous quarters, factoring in the rate of inflation on a continuous basis for each time period being analyzed.

The other important factor that must be analyzed when performing fundamental securities analysis is the real, or natural, rate of interest (von Mises calls this the "originary" rate of interest). It is this common failure to properly make interest rate calculations when conducting financial analysis (whether done by the investor or the producer) that has been responsible for great loss of capital.

In his seminal work "Human Action," Ludwig von Mises wrote concerning interest rate calculation: "A drop in the gross market rate of interest affects the entrepreneur's calculation concerning the chances of the profitability of projects considered. Along with the prices of the material factors of production, wage rates, and the anticipated future prices of the products, interest rates are items that enter the planning businessman's calculation. The result of this calculation shows the businessman whether or not a definite project will pay….It forces him to employ the available stock of capital goods in such a way as to satisfy best the most urgent wants of the consumers.

"But now the drop in interest rates falsifies the businessman's calculation. Although the amount of capital goods available did not increase, the calculation employs figures which would be utilizable only if such an increase had taken place. The result of such calculations is therefore misleading. They make some projects appear profitable and realizable which a correct calculation, based on an interest rate not manipulated by credit expansion, would have shown as unrealizable. Entrepreneurs embark upon the execution of such projects. Business activities are stimulated. A boom begins."

Further expanding upon the importance of the interest rate factor in the business equation, von Mises writes, "The entrepreneurs draws from the fact that demand and prices are rising the inference that it will pay to invest and to produce more. They go on and their intensified activities bring about a further rise in the prices of producers' goods, in wage rates, and thereby again the prices of consumers' goods. Business booms as long as the banks are expanding credit more and more." Thus, bank credit is another element that must be considered when performing fundamental analysis.

Yet another consideration when performing fundamental analysis is the debt/equity and capital savings ratio of the entities concerned. Writes von Mises, "A further expansion of production is possible only if the amount of capital goods is increased by additional saving, i.e., by surpluses produced and not consumed. The characteristic mark of the credit-expansion boom is that such additional capital goods have not been made available. The capital goods required for the expansion of business activities must be withdrawn from other lines of production."

What characterizes a financial bubble, according to von Mises, is not so much over-investment as mal-investment. Producers and investors, taking a bad cue from the government rate of interest, direct their activities through channels that do not adequately address the underlying market demand for products and services. A financial panic is the result of the mass realization that production and consumption during the boom was misdirected and that available capital is not sufficient to prolong the boom. The corresponding depression is merely a realignment of the factors of production and a proper adjustment of the supply/demand balance.

In analyzing the present state of financial and economic affairs, it becomes plainly evident that the very mistakes von Mises warned of concerning the financial boom and panic are coming to pass before us. Throughout the boom years of the 1990s, production has been misallocated, capital has become scarce, and savings practically non-existent. A broad-based corporate earnings slow-down has emerged and continues to worsen, especially when viewed from a rate of change perspective. Inflation on both the consumer and producer ends has increased, further eroding corporate profitability.

Meanwhile, the capital asset most heavily maligned during the boom period was gold. The fundamental factors surrounding its supply were improperly distorted, and market demand for it subsequently declined. The developing depression will readjust many things, including the supply/demand balance for gold. As gold becomes properly assessed in light of the massive mistakes and oversights of the previous boom, its true valuation will emerge. Needless to say, its value will only increase. In the final analysis, gold is the market fundamental that will matter most.