Following up on my last post concerning the relationship of the availability of financing and prices, I thought it would be a good idea to quickly review what finance is in the first place.

From my perspective all of finance, from the simple mortgage loan to the complex derivative, can be summarized in one simple sentence: Finance is the creation of capital today based upon the expectation of some future event(s).

In essence, in both personal and business situations, certain purchases are not currently affordable. Finance, however, makes these purchases possible by creating new capital out of nothing simply by reference to a future event. So for example, if the new factory can’t be paid for today, it’s not a problem. We will still create capital for it, on the assumption that future profits from the factory will cover today’s expense. The actual form of the capital, i.e. equity or debt, is not so important, and it could consist of any currency that has value in the eyes of the economic players.

The crucial discovery of modern-day financial capitalism is simply that this financial alchemy can be further enhanced by securitization, which simply means that the entity which originally creates the capital can sell it to another party, and that party to another, ad infinitum. Moreover, the original capital can even be split up between various parties. It is obvious that securities also must derive their current prices from future events, since the original contract which created the capital is completely based upon future expectations, so that any new buyer of this contract, must also have some future expectation if they are to pay to assume ownership of the contract.

Once one accepts the vital role that future expectations play in finance, two key ideas become evident.

Finance is Fantasy
Since future expectations are vital to finance, there is a fantasy aspect to finance. Finance does not deal in realities. It can’t because the future is unknown and virtually anything can and does happen in the future. As such, finance is completely reliant on creating believeable stories of the future. Basically whatever you can imagine and convincingly present as possible can be financed. Finance is infinite! This is why the Fed can create capital endlessly. If I owe $1 trillion, I just need to convincingly present a future scenario that justifies borrowing another $1 trillion. By simply hiring a bunch of clever bankers, it shouldn’t be too difficult. Bankers excel at creating new fantasies about the future. They are dreamers.

Finance Always Exaggerates the Future
Since the amount of capital that can be created is entirely based on the future, and since bankers/traders etc. are compensated based on the amount of capital they create today, finance incentivizes everyone in society to exaggerate the future to secure the largest amount of capital today. The bigger the story, the more money can be raised. It is not important whether the future is sufficiently probable or not, as long as it is believable.

Just in case, you didn’t think the above had anything to do with investing in the stock market, I’ll just throw this one idea out.

Companies that currently Lose Money are no less valuable, all things considered, than Those that Make Money.
Since Finance is about the future and consists in fantasies about the future, the present money-making capacity of a company remains irrelevant. It’s always the future profits of the business that determine the present value. Whether a company is making or losing money at the present time is completely meaningless. What is important is simply: What will the company do in the future? So a company losing $500 million a year, can in theory be worth more than a company than is earning $500 million a year, if future expectations of the money-losing business are such that it will generate larger profits in the future than the company that is already massively profitable.

Given the above, the game of investing in stocks is actually quite simple: Determine a believable story about future profits, and bet whether that story will gain traction with other investors. The extent of your profit in investing is simply based upon the credibility of your fantasy of future profits coupled with the amount of believers you are able to convert. In other words, investing profit is always a function of hype and timing.