Now suppose that the local mining firm announces a refurbishing of
the mine to begin one year from now that will result in a temporary
influx of workers which will raise the rent on your house to $2000
per month for five years. What will happen to its value?
The market value of your house will equal its present value.
That will consist of the present value of the permanent income
stream from the property ($120,000) plus the present value of the
temporary income stream that will arise from the influx of workers
working on the refurbishment of the mine. The latter will equal
($1300)(12)/1.052 + ($1300)(12)/1.053
+ ($1300)(12)/1.054 + ($1300)(12)/1.055
+ ($1300)(12)/1.056 = $64,326
which brings the market value of the property up to $184,326.
This increase in the market value of your house will occur the
moment the new work on the mine is announced, even though the
additional rental income will not occur until next year.
The increase in the value of an asset resulting from a previously
unanticipated increase in the asset's earnings is called a
capital gain. Notice that the capital gain arose from
new information about the future earnings from the asset. Notice
also that changes in information about the future earnings from an
asset---or market participants' perception of the future earnings--will
lead to changes in asset values quite apart from any changes in current
earnings. This is the reason why the prices of many assets tend to be
quite volatile.
Information about the future earnings of an asset will be
evaluated in different ways by different market participants.
You might doubt, for example, that the effect on house rents of
the influx of workers will be as large as stated above and, as
a result, choose to sell your house to someone else who thinks
that house rents will rise by more than predicted and invest the
funds somewhere else.
Alternatively, you might know very well that rental income
will not increase by the amount others expect but choose not only
to keep your house but buy another in anticipation that as rumor
feeds upon rumor investors will bid up house prices far beyond
the sustainable level. You would anticipate selling both houses
just before other market participants realize they are wrong.
A situation where investors know that an asset is overpriced but
buy it anyway and bid its price up on the anticipation that other
investors are doing the same, hoping to sell just before the market
collapses, is called a speculative bubble. The factors affecting
the future earnings of the asset are referred to in market jargon as
the fundamentals. The market price of the asset will be constrained
in the long run by these fundamental factors. In the short run, however,
asset prices can stray from their long-run equilibrium values on account
of misinformation and strategic speculative behavior on the part of
investors. An increase in the price of an asset not warranted
by a change in the fundamentals is also a capital gain.
Speculation can be defined as the attempt to obtain capital
gains by acquiring information that other market participants do
not have about the future earnings on particular assets or second-guessing
what other market participants believe about future asset
values. Everyone who owns assets is in a sense a speculator in
that capital gains or losses on those assets may be forthcoming.
Most of us take the long view, however, and allow our capital
gains and losses to remain "on paper". One reason is that our
assets are connected to our lifestyle (our homes, for example) and
lifestyle changes are costly. Another is that most of us recognize
our lack of expertise in ferreting out new information about asset
returns and understanding market psychology. We choose to diversify by
permanently holding a mix of assets in the expectation that capital losses
on some will be more than offset in the longrun by capital gains on others.
One often hears statements that this or that asset is overpriced or that
the observed movements in the market prices of particular assets represent
speculative bubbles rather than market fundamentals. Such statements
never have scientific content---they merely reflect opinion about
unobservables. We have seen in the Lesson entitled Interest Rates
and Asset Values how market interest rates and realized real
interest rates are observable, but the expected inflation rate and contracted
real interest rates are not. Similarly, market values of assets and the
current income from those assets are observable, but the fundamental factors
determining future earnings are not. Since these fundamentals are not
observed, we can never be sure whether a particular movement in the market
value of an asset is due to a shift in the fundamentals or a speculative
bubble.
Any statement that an asset is overpriced carries with it an (often implicit)
theory of the fundamentals. Such theories can rarely be verified on the basis
of currently available information and techniques of analysis. Where they
can, there is no room for speculation---there is only one
"supportable" opinion about what will determine the future earnings
of the asset.
Capital gains and losses can arise not only on assets like houses, cars,
machinery, equity shares in corporations, etc., but on fixed assets such as
government and private bonds, loans, and deposit accounts in commercial banks
and credit unions. As we saw in the lesson entitled Interest
Rates and Asset Values, unanticipated inflation changes the real
value of both the principal and the earnings of these assets. Moreover,
a change in market interest rates, due either to a change in the return
from investing in real capital or a change in people's expectations of future
inflation, will lead to an opposite change in the present value of the
earnings on this type of asset.
Consider, for example, a perpetuity yielding coupon interest of $1000 per year.
At a market interest rate of 10 percent, this asset will have a market value of
$10,000. Suppose that the market interest rate falls to 5 percent. The
market value of the asset will double.
Since there is room for differences of opinion about the
expected future inflation rate there is ample room for speculative
activity in bond markets and the markets for other nominally fixed
assets. If one can forecast the future movements in market interest
rates better than other investors can, one can increase one's
bond holdings just before interest rates fall, and shift out of
bonds just before market interest rates rise. The issue here
is the same as before. Any statement that bonds are overpriced
carries with it a theory of the fundamental factors determining
future interest rates.
It is time for a test. Make sure you think up your own answers before looking
at the ones provided.
Suppose that you own a house that you rent for $700 per
month. After paying $100 in taxes and an average of $100 per
month for repairs and maintenance, you expect to receive $500 per
month income (in perpetuity) from your asset. At a real interest
rate of, say, 5 percent (which includes an appropriate allowance
for risk) this perpetual income stream is worth ($500)(12)/.05
or $120,000.