A Basic Accounting Equation Applied to Financial Markets Today

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 |  Includes: AGG, BIV, BND, BSV, CEF, DEM, DIA, EEM, EWX, GDX, GDXJ, GLD, IEF, IEI, IWM, IWN, PHYS, SHV, SHY, SLV, SPY, TBT, TLT, VWO, XLE, XLU
by: The ETF Authority

Assets = Liabilities + Equity

This "basic accounting equation" is spoon fed to Accounting 101 students around the world. But many investors appear to lose sight of its meaning when applied broadly to financial markets. Generally speaking, under the double-entry bookkeeping system, when an asset is created/increased (absent retained earnings or equity issuance), an offsetting liability is entered. For the U.S. government and governments around the developed world, the liability entry has grown hopelessly large. Accordingly, in response to the developing financial crisis in 2008, governments began printing money to boost the asset side of the equation with hopes of minimizing the relative significance of the liabilities over time. In other words, they are attempting to beat the system by papering over the liabilities, knowing they will be unable to generate net income sufficient to retire existing and future debt loads.

Advocates of fundamental analysis seek to value a firm's assets, net out the liabilities to determine the firm's intrinsic equity value, and compare the result to the current market value. Large liabilities relative to assets serve to reduce or even eliminate the intrinsic equity value of a firm. While the U.S. government may not have stockholders' equity in the conventional sense, it certainly has stakeholders in its more than 300 million citizens and billions around the world with direct or indirect exposure to its financial position. It is these stakeholders who stand to suffer as the "intrinsic value" of the U.S. collapses. The standard of living for many U.S. citizens will decline as their cash savings are rendered useless by currency debasement. It is for this reason, that the recent flight to safety into non-yielding cash and the paltry yields offered by Treasury securities will not preserve wealth or protect purchasing power long-term.

Investors seeking protection should direct their investments to specific equity sectors, excluding financials, real estate, and discretionary consumer goods. Also worthy of consideration are emerging nations, currently trading a deep discounts due to their struggles with inflation, because they ultimately have stronger growth prospects in light of manageable debt loads and untapped consumer bases with high personal savings rates. Precious metals offer valuable protection, though investors should be prepared to endure violent price declines in both bullion and mining stock positions.

Disclosure: I am long CEF.