From recent US Federal Reserve Board meeting minutes, it would appear that monetary policies will move from a tightening bias to a neutral or easing mode within the next six months or so. In the past, I have maintained that the US, with a debt-to-GDP ratio of over 300%, has no other option but to print money (see figure 1).
Figure 1: Total Credit Market Debt as % of US GDP, 1916 - 2005
Source: Bridgewater Associates
Tight money policies, which would depress asset prices such as stocks and home prices is simply not an option the Fed will consider. As a result, inflation will continue, whereby I am using here inflation as defined by a loss of the purchasing power of paper money. At times, such as in the 1970s, this loss of purchasing power of money is brought about by rapidly rising consumer prices, while at other times, such as in recent years, the purchasing power of money diminishes because real estate, stock, art and bond prices increase significantly. In both cases, under consumer price or asset price inflation, your dollar today can only buy a fraction of what it bought ten or twenty years ago (see figure 2).
Figure 2: Purchasing Power of US Dollar, 1800 - 2005
What is remarkable about figure 2 is that for as long as there was no Federal Reserve Board - that is between 1800 and 1913, the purchasing power of the dollar was more or less constant. However, as soon as the Fed was formed in 1913, the purchasing power began to decline - in fact by 92% over the last 100 years or so.
Now, considering that Household Net Worth is at an all time high and that rising home, and equity prices in the last twenty years or so drove the US economy up and the household saving rate down (now negative), Mr. Bernanke will under no circumstance allow asset prices to decline much (see figure 3)
Figure 3: Household Net Worth, 1950 - 2004
Source: Merrill Lynch
Just imagine what the Fed's reaction would be if both the Dow Jones and housing prices dropped by 10%! Money printing would be back in earnest Just imagine what the Fed's reaction would be if both the Dow Jones and housing prices dropped by 10%! Money printing would be back in earnest because the Fed believes (erroneously, I may add) that it has the power to indefinitely postpone recessionary periods.
Now, if the Fed prints money, all asset prices will rise in nominal terms whereby some prices will rise more than others, while the currency of the money printing country - the US - will weaken. The only problem for us investors is to recognize and forecast, which prices will increase the most, consumer prices or asset prices, and if asset price inflation continues, as occurred in the past twenty years, specifically which asset prices will move up the most. Moreover, if the US dollar weakens it is important to define against what the dollar will depreciate.
The importance of being invested in the "right asset class" is evident from the diverging performance of the Hang Seng Index or of Hong Kong property prices and oil since 1997. So, whereas the Hang Seng Index and Hong Kong property prices have not risen, since 1997, crude oil is up by more than four times! I would expect similar diverging performances among different asset classes to emerge in future as well. In particular, I am a believer that at some point in future, investors will lose faith in the value of US dollar denominated bonds and in the US dollar. At such time, investors will drive US interest rates much higher resulting in tumbling bond prices and rush into anything but US assets such as equities and bonds. This does not mean that all US dollar assets will collapse in nominal terms, but they could collapse against a "hard currency" such as gold or possibly against non-US dollar currencies, provided foreign central banks pursue tighter monetary policies than the US. This, however, is an issue about which we cannot really be certain, as all central bankers have a propensity "to print money". Therefore, I feel that asset prices will tend to depreciate against the only currencies for which the supply is limited - gold, silver, and platinum.
I have shown the Dow/Gold ratio in the past but would like to expand on this theme. As can be seen from figure 5, the Dow/Gold ration has fluctuated over time between 1 and almost 45. When the Dow/Gold ratio was under five, gold was expensive and equities were cheap. Conversely, when the Dow/Gold ratio was over 20, stocks were expensive and gold relatively cheap (see figure 4).
Figure 4: Dow/Gold Ratio, 1900 - 2005
Now, it is interesting to observe what has happened since 2000. At the peak of the stock market in March 2000 the Dow/Gold ratio stood at close to 45. In other words, it was for a "gold money" holder very expensive to buy one Dow Jones Industrial Average since it took 45 ounces of gold to buy the Dow. Thereafter, stocks collapsed into October 2002 and, therefore, the Dow/Gold ratio also declined. What is, however, interesting is that despite the stock market's rebound since October 2002, the Dow/Gold ratio has continued to decline. Simply put for the holder of gold - the world's only honest currency, since it cannot be printed by some dishonest central banker - the Dow, although it increased in value in dollar terms, has continued to decline in gold terms with the result that, today, it "only" takes 20 ounces of gold to buy one Dow Jones Industrial Average. Simply put, since 2000, gold has risen at a much faster clip than the Dow Jones and I would expect this out-performance to continue for the next few years until "gold currency" holders will be able to buy one Dow Jones with just one ounce of gold.
So, if Mr. Bernanke does what he believes in - namely that asset deflation has to be avoided at all cost and, therefore, massively prints money, no matter where the Dow will be in future, at 36,000, 40,000, or at 100,000, as some pundits predicted in their in 1999 published books (of course shortly before the market tumbled), you will be able to buy the Dow with ounce of gold worth either $36,000, $40,000 or $100,000. Now, you may think that I have become insane. That is partially true because I am convinced that the US Fed's monetary policies will lead to exponentially widening wealth inequity and impoverish the majority of US households, which will then lead to social strive, protectionism, war, and the breakdown of the capitalistic system. However, if one considers that in 1932 and in 1980 (see figure 5) one could indeed buy one Dow Jones Industrial Average with just one ounce of gold, then maybe my views are rather conservative. Possibly one will be able to buy, sometime in future, one Dow Jones with just half an ounce of gold!
Therefore, rather than to buy US stocks, I suggest to invest in gold, whereby right now, both the Dow and gold, as well as most other investment markets are significantly over-bought and could easily correct by about 5% to 10% on the downside.
There are some more issues we need to address. What about if the "deflationists" such as my friend Robert Prechter, whose arguments I highly respect, are correct and deflation brings down the Dow Jones, home prices, and all other assets by 50% or 90% in value? In such a scenario, I would expect that there would be serious debt defaults, a collapse of the derivatives market, and an imaginable banking crisis leading investors to rush into an asset that is not a liability of somebody else. Therefore, I believe that if the Dow Jones declined to say 5,000, gold might actually rally further.
What about the US dollar's value against other currencies? This year the US dollar has been strong, but I would expect other currencies to strengthen against the US dollar once the market realizes that the Fed will print again money. At the end of 2004, investors bet heavily against the US dollar and sentiment about the dollar was extremely negative. Today, however, we have the opposite situation with speculators being extremely positive about the dollar and negative about non-US dollar currencies. In fact, the speculative positions on the dollar stand at a record high (see figure 5).
Figure 5: Net Speculative Positions on the US Dollar, 2002 - 2005
Source: The Bank Credit Analyst
So, I would gradually move some funds out of dollar assets into the Euro, Swiss franc and Yen and even better continue to accumulate gold, silver and platinum.