Preface: Last month's article The Shrinking Dividend Difference prompted an email discussion with Edward Jaffe, a private investor in the process of starting a Registered Investment Advisor entity in Bennington, VT. The email dialog that followed resulted in this contribution from Edward.

While the subject is shrinking dividends, Brian is making the issue part of a "cost of capital" discussion, and I think that is valid. A corporation's cost of capital can be either debt or equity and there is likely to be some connection between the two. However I disagree with the basic premise that a reduction of risk is the cause for a lower cost of capital in any form — at least during the Greenspan/Bernanke regime — or that risk has been declining. This chart of total credit market debt (TCMD) as a percent of gross domestic product and the federal funds rate against a backdrop of the U.S. market suggests that, on the contrary, credit expansion and lower rates is the driving force behind higher asset prices — not lower risk.

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In a fiat money system, central bank policies are at the core of most "cost of capital" issues. Brian's comments imply an unfettered "efficient" market for capital sourced from savings, where interest rates and other key pegs are set by supply and demand between savers and borrowers. My rebuttal of the "Efficient Market Hypothesis" view is that lower returns do not indicate less risk — in such a system. On the contrary, they could indicate more risk as market participants often bid up the price of investment assets at the top of a bubble. In fact, at the end of 2007 toxic mortgage debt had no trouble attracting institutional investors, who were willing to take risks they did not even understand to get a few more basis points (mania).

In reality interest rates are not set by a market. Short term rates are set as follows: The Kommissar of Ka$h puts on his big fur hat, looks up from his 900 sq. ft. mahogany conference table at one of the various Masonic symbols on the wall. Then, after going into a trance and channeling the soul of John Law, the short term rates are announced to the other FOMC members, who get up from their knees and call CNBC.

The cost of capital for some has dropped because we print it — hardly a formula for lower risk. The Panic of 2008 clearly disproves the theory of general lowering of systemic risk. Moreover, central bank policies, notably the zero interest rate policy (ZIRP, see chart above) distort the cost of capital further. In reality, real earned and saved capital is DEAR. If I had a going business that needed to borrow for expansion, that money would not be inexpensive. Of course some bank prop-desk could borrow for zero and lend me some.

Long term rates have much input from market participants, but they can be drowned in a sea of new green paper. The Federal Reserve can buy 30 year treasuries or mortgage-backed securities, or backstop Fannie and Freddie — by creating Trillions in Symbolic Money.

When bubbles burst, both central banks and market participants lose control over these variables. Then we learn the true difference between "Boom Times" and "Good Times."

But back to dividends. In my view the primary cause of the shrinking dividends discussed in the original article is asset inflation and anticipated future asset inflation.

Let's create a quick asset inflation example in the real estate world. An apartment building is for sale with 10 apartments that each rent for $500 per month. The $5,000 per month is your dividend. So how does the price of the building work out?

The price of assets is more than a little connected to the cost of money. Because since few landlords pay cash, the selling price of the building will be different with different interest rates.

Example A:    $500,000 for the apartment building    $3,243 per month 30 year fixed mortgage @ 6.750%    Rent Roll = $60,000    Effective Dividend (not including other expenses) = 12%

Example B:    $700,000 for the apartment building    $3,242 per month 30 year fixed mortgage @ 3.750%    Rent Roll = $60,000    Effective Dividend (not including other expenses) = 8.5%

I think that is a good analogy, and one can see within it the seeds of the housing bubble. Keep in mind however that while some conventional wisdom about real estate investing has changed, conventional wisdom about financial assets has some catching up to do.

The period set highlighted in next chart is 1983 to present — a period that contained the almost two-decade long end of the century super bull market — a period that has elements of a bubble including asset price increases that outstrip any increase in U.S. economic performance.

Looking at the S&P related charts above and below, we can see that 1982-2000 has many "non-historic" components. Asset values took off and didn't look back.

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The primary cause of asset inflation is credit expansion, and it has been so since the Tulip Panic. The expansion of credit accompanied the structural decline in (many) interest rates with the ultimate result of credit exhaustion. Demographics and increasing numbers of investors are also an issue.

I believe that bubble dynamics create correlations between falling interest rates, TCMD, falling dividends and rising asset values. I am saying that, to a great degree, the central bank controls the overall cost of capital (by creating more capital out of thin air), with their primary tool being short term rates (and other policies). Thereafter market participants build the remainder of the bubble with all its typical symptoms, such as having a hard time earning income from dividends both from stocks and bonds.

As the TCMD chart suggests, it is hard not to consider the role played by cheap money in what is usually perceived as a secular Bull Market based on real economic growth, progress, technology and stability. On the other hand, maybe it's just another bubble. Think of the difference in systemic stability between the left and right extremes of the federal funds rate on the chart at the beginning. On the right extreme debt and asset values are heading for the moon while interest rates reach exhaustion (zero).

In the chart below, the dramatic advance in the cyclical P/E ratio from 1983 to 2000 provides additional evidence for bubble dynamics.

Bubble Dynamics 101:

1. Credit is expanded as/via the central bank's lowering interest rates and/or making credit expansion easier within the private credit system.
2. Expansion of credit and less competition from bonds starts to run up stock prices -- especially where there is leverage in the equity markets (hedge/prop desk).
3. Higher stock prices beget higher stock prices as the psychology changes, possibly accompanied by other economic expansion related to new, cheap, easy money.
4. Stock prices outstrip any possible economic expansion, so Price starts to pull away from Earnings, or things related to earnings — like dividends.
5. 5. Investors eventually start to invest for capital gains and not income.
6. All bubbles burst. No exceptions.

If one finds compelling the argument that the engine of rising stock prices in the past few decades was falling interest rates and expanding credit, what could one assume about the future with short term rates run up against the zero peg and credit no longer expanding?