Everything has its limit -- iron ore
cannot be educated into gold."-- Mark Twain
Several charts have been floating around
the Internet for some time, showing the historical Dow Jones Industrial Average, priced in terms of
gold. The simplest explanation entails thinking of the Dow divided by one
ounce of gold; if the Dow is at 5000, and gold is at 500, then Dow-to-gold is
10. But it's important to remember as you're considering this ratio that the
Dow is calculated in terms of dollars. So essentially, when we determine the
Dow-to-gold ratio, it's not just a simple ratio of gold to shares in the Dow,
but rather it is a three-part ratio -- Dow, expressed in dollars, to an ounce
of gold.
Wouldn't it just be easier to express
gold in terms of dollars, or the Dow in terms of dollars? Well, those are certainly
useful ratios -- and we use them all the time -- but what we're really going
after when we look at a historical Dow-to-gold chart is how well the Dow has
performed, relative to the dollar, and relative to gold. What have
inflationary pressures done to the Dow, in terms of gold and the
dollar, over the past century? How have the three components moved in the
various historical boom-bust scenarios? The results are interesting.
Let's shift gears for a moment. Just off
the top of your head, what would you expect stocks to do in periods of
inflation? The dollar loses value rapidly, right? And that means prices of
goods and services move higher, presumably with wages. So wouldn't it stand to
reason, intuitively, if corporations were making more money as prices
increased, profits would increase too? And if profits increase, shouldn't share
prices go higher in response?
It turns out that inflationary price
increases are bad for the stock market, and no period in history establishes
this more concretely than the late 1970s and the early 1980s. Interest rates
and prices soared, along with the price of gold, but stocks were flat. I want
you to think about what I'm saying here: prices in general were going up, and
yet the stock market was not. What this means is while stocks, in nominal
terms, looked to be relatively stagnant, in real terms they were getting
crushed. This is why the Dow-to-gold ratio is so significant as an indicator of
relative value.
There is an elegant, simple truism that
comprises every single transaction between buyers and sellers, and yet most
people don't even think about it: whenever you buy something, you are selling
something else. When you buy corn, you are selling dollars. When you buy a
Ford, you are selling dollars. If you are in Mexico and you buy a chicken, you
are selling pesos. Of course, if you came from the U.S., you first sold
dollars, bought pesos, and then sold pesos to buy the chicken. I know most of
you already understand this concept, but I'm trying to emphasize that even when
currency is used, every transaction is merely a trade; that is to say,
the transaction is nothing more than negotiation that results in the exchange
of two things -- whether goods, services, or currency.
With that in mind, consider this: when
prices rise because of inflation (printing of money), it isn't so much that
goods and services are getting more valuable -- rather it's much more
accurate to say the currency is simply getting less valuable relative
to everything else. If the dollar collapses, for instance, and the cost of a
loaf of bread goes from $1 to $20 at the same time a share of Microsoft (MSFT) goes from $20 to $30, then
Microsoft is severely under-performing -- in inflation-adjusted
dollars. A loaf of bread will cost you 20 times what it used to -- not because
it is more valuable, but because the dollar is less valuable.
Meanwhile Microsoft is worth only 50% more. Relative to the dollar, shares of
Microsoft are actually losing money -- in a big way.
If you look at a chart of inflation from 1978 to 1982, you'll notice a huge
spike. If you look at a chart of the Dow Jones Industrial average during the same
period, you'll see that stocks traded sideways in a fairly well-defined
range over the same period. But that doesn't tell the whole story; if you
adjust for the meteoric rise in prices during that five-year period, the stock
market actually performed much worse than the nominal dollar fluctuations
presented in the historical chart. In other words, the price of just about
everything was going up dramatically, but stocks were not. So if you adjust
prices back to "normal" levels, and adjust stocks accordingly, the
picture for equities would have been horrible.
Now for the pièce de résistance...
Here is a series of charts
of historical nominal gold prices (not adjusted for inflation), in several
different currencies -- the first of which is U.S. dollars. Take a look at the
spike in the price of gold from 1977 to 1981. Now, if we go back to our
original chart above, showing the Dow Jones Industrial Average, in direct relation to an ounce of
gold (Dow-to-gold), you can see that the ratio went roughly 1:1 in 1980 --
at the peak of the inflationary price surges. To clarify, the Dow was at about
750, as was gold.
But didn't we say that, relative to
rising prices, the Dow actually underperformed dramatically? So if you
bought gold in the mid-1970s, not only was your investment skyrocketing, but
the stock market -- which was flat in nominal dollars -- was actually doing
very poorly relative to rising prices. Bear in mind that both the Dow and gold
were priced in terms of nominal dollars at the time; they essentially
"cancel out" -- that is to say, relative to rising prices, gold also
failed to perform as well as the nominal dollar-price. Still, it did offer an
excellent hedge against rising prices, and even outperformed during the period.
What does all this mean? Well, for
starters the average Dow-to-gold ratio over the last century has been about
9.5, and we are currently at about 8.5. So you're probably thinking we're
oversold and due for a correction. In other words, the Dow-to-gold ratio is
probably going higher, right? Well that was my first conclusion too, but
actually on closer examination it turns out that's probably not right at all.
For much of the last century the dollar
was tied to gold, and while the relationship was never perfect -- and the U.S.
government betrayed the union many times, in many different ways -- there was
at least some relationship, which helped pull the ratio down.
Eventually, excessive inflationary printing caught up with the government in
the 1960s, and it became clear it wouldn't be able to honor redemptions against
the dollar at the price it had fixed. Nixon essentially defaulted on the U.S.
promise to redeem dollars for gold by taking the U.S. off the standard in the
1970s -- and this, more than anything else, allowed inflationary pressure to
drive general prices into the stratosphere. This was the moment the Dow-to-gold
ratio approached 1:1. To fight rising prices, Paul Volcker, the Fed Chairman at
the time, pushed the Fed's target interest rate past 20% and barely saved the
U.S. economy from collapse.
For most of the next 20 years, gold fell
and stock prices rose. Meanwhile, the U.S. government capitalized on the lie it
had created and printed more and more money. Who really cared? Everyone was
making money in the stock market, and prices remained relatively stable. In
fact, every time prices failed to act "correctly," the Fed simply
changed the rate at which it would lend to banks. But the illusion of the
monetary policy game couldn't last forever; people used easy money printed by
the government to buy assets they couldn't afford throughout the economy --
especially houses. Finally the pressure was just too much, and everything
started unraveling in 2007. But the gold market seemed to understand the game
couldn't last, and around 2000 it started a slow, steady rise.
Relative to everything, the number of
dollars in the system in early 2009 is almost incomprehensible. Once
de-leveraging reaches its nadir -- and it's coming soon -- those dollars are
going to hit the economy and drive prices much higher.
What have we learned about stocks in such
periods of rising prices? Not only do they fail to perform, but adjusted for
inflationary price pressures, they actually under perform. General
prices and unemployment will continue to rise. The consumer will continue to be
unable to consume. Corporate earnings and dividends will continue to
collapse as a result. Stocks are going lower -- probably much lower.
And what about the price of gold? It will
almost certainly continue to increase -- not only because people will flock to
its long historical stability and consistency, but also because there are
simply so many more dollars (and yen, and rubles, and euros) in the world.
Remember, the U.S. isn't the only country printing innumerable sheets of
currency. And in that context, remember also that inflationary price increases
have almost nothing to do with increased demand, but rather they are the result
of currency devaluation and destruction -- through printing.
I just want to share two more charts with
you. The first should give you a little perspective -- it is a historical
chart of gold, in both nominal and real dollars. Notice the real price of
gold in 1980 (in 2007 dollars) was $2272 per ounce. If I'm correct about
inflation and the fate of the dollar -- and I'm confident I am -- then we are
nowhere near the historical high in gold. But I don't think we're merely going
to re-test that high -- I think we're going to blow through it as the dollar
loses value.
In the 1930s, as corporate earnings and
dividends disintegrated, the Dow lost nearly 90% of its value from peak to
trough. The U.S. was a creditor nation with a huge manufacturing base. The
dollar was tied closely to gold. Since its peak in October 2007, the Dow has
lost less than 50% of its value. The U.S. is a debtor nation with a relatively
small manufacturing base. I can't say it enough: we borrow profusely, we
manufacture very little, and we consume gluttonously. Nonetheless, the consumer
has now lost almost all his purchasing power, and corporate earnings and
dividends are going to suffer massively as a result.
In 2007, the Dow peaked at about 14,150.
To give you some perspective, an 85% drop in the Dow from peak to trough would
put it at about 2100.
I know it's easy to imagine the Fed has
magical powers. I've fantasized about such things myself at times of extreme
weakness -- that maybe the Fed will "somehow" figure out a way to
fight and defeat the unprecedented evil specter of inflation it is foisting on
its unsuspecting children. Sometimes I do believe that our Lord and
Savior Barack Obama will wave his charmed "unicorn horn of change"
and all will be well again. Likewise, at times I feel like I could let Uncle
Ben Bernanke take me just about anywhere in his helicopter of
prosperity. My faith in the reverend John Maynard Keynes runs deep, as I hope,
and hope, and hope. I find myself gleefully clicking my heels together and
repeating, "the dollar is almighty, and the Stars and Stripes will
prevail." And when I am in this wonderful place, I have confidence
that someday soon, we'll all be buying houses with no money down, and with no
jobs. Our driveways and backyards will once again overflow with boats,
motorcycles, and sports cars.
Then I think about the 1930s. And
suddenly I am wide-awake.
Let me ask you a simple question, and I
want you to actually think about it. Do you really think we can't get
to the 1930s again? Do you really think that we're going to return to
the exuberant excess of the past few decades? If so, let me disabuse you of the
notion: the United States was in much better shape, economically, going into
the Great Depression than it is now. Prosperity is not coming back to
the U.S. as we know it. We are in a lot of trouble.
Is a Dow-to-gold ratio of 1:1 so
incomprehensible? Again, it has happened before -- several times. But I'll even
take it a step further: what about a Dow-to-gold ratio of .5? Or less? I
promise you, if the Fed fails to soak up all the dollars it's putting in the
system, that's exactly where we're going. And what, you may ask, does
the Fed use to "soak up dollars?"
I'll be glad to tell you that too. When
the Fed needs to take dollars out of the system, it sells Treasuries (which
means it buys dollars). The problem is, the U.S. debt-load is
astronomical. Who, exactly, is going to buy that debt from the Fed? And at what
interest rate? Remember, if the Fed is desperately trying to take dollars out
of the system, there can be only one reason: it is scared of rising prices
caused by inflation. But if the Fed floods the market with Treasuries, it will
achieve exactly the opposite effect it's looking for -- it will cause rates to
rise, probably dramatically. Do you really think the Chinese and the Japanese
are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to
buy dollars to stop an inflationary price explosion? If so, you're delusional.
Chinese and Japanese people are smart. They're not going to fund an
inflationary dollar at 2%. Ever.
In the past it might have worked. Of
course, in the past, the U.S. money supply was much smaller, and our ability to
borrow was much stronger. But those days are gone.
As if I haven't terrified you enough, the
last thing I'm going to leave you with is really scary. It is a link
to an excellent article by Mark
J. Lundeen, whose insight into this economic catastrophe has been
stupefying since long before all of this even started. Embedded in the article
is a chart that shows historical dollars-in-circulation, relative to U.S. gold.
With that, I think I'll let you do the
rest of the math. Sleep well.