Below is a modified extract from a commentary originally posted at www.speculative-investor.com on 17th May 2007.

In our opinion is it unreasonable to hinge a long-term bullish view on any investment on positive changes in NOMINAL prices because it's the REAL performance of an investment, not its nominal performance that matters. After all, if the central bank sponsors sufficient money-supply growth (inflation) then the resultant fall in the relative value of money may very well lead to large gains in the nominal prices of most investments. However, an investment that consistently rises in price by less than the rate at which the money supply is expanding will, over the long-term, lose real value (by holding this investment you will suffer a reduction in wealth even though the price of the investment may be rising). Is it reasonable to say that an investment is in a long-term bull market when its real value is in a long-term downward trend? We think not.

An extreme example of how inflation can create massive gains in the nominal prices of equities at the same time as equities are losing substantial value in real terms was provided by the German stock market during the years following the end of World War 1. Here is an excerpt from the November-2006 edition of Franklin Sanders' The Moneychanger newsletter (http://www.the-moneychanger.com/) outlining what happened during that period:

"Would you want to invest in a share index that in less than six years went from 126 to 23,680,000 million (that' s 23 quadrillion)? Sure, sign me up, you say. Not so fast! That's what the German share index did under the hyperinflation from January 1918 through November 1923.

Let's measure that record from another standpoint, in terms of (at that time) goldbacked US dollars. The German stock market index equalled $100 in 1913 and by January 1918 it had reached $101.55. In October 1922 was at $2.72 [sic], and in November, 1923 at $39.36. So the gain of 187,936 million times in Reichsmarks amounted to a 60% loss in US dollars."

Now, we certainly aren't predicting that the US will go through a Weimar-style hyperinflation over the next few years. Our points are simply that inflation distorts price signals and that the only gain worth having is a real (inflation-adjusted) gain. The central bank can make prices go to extraordinary heights by creating money out of thin air; for example, by depreciating the dollar through inflation the Fed could bring about a doubling of the Dow. But so what? Any investment that doesn't provide positive returns after the depreciation of the currency is properly accounted for is unattractive and should not be considered bull market material.

If there were no need to adjust nominal prices to account for the effects of inflation then the people who invested in German equities during the early-1920s would have been the richest people in the world, and the people who invested in the Zimbabwe stock market a few years ago would now be amongst the richest in the world. Clearly, there is a need to adjust for the effects of inflation; but figuring out how a market is performing in real terms is not a straightforward matter. You can't, for example, convert nominal price changes to real price changes using any of the popular price indices because these price indices are, in effect, made-up numbers that bear little resemblance to reality.

Over the short- or intermediate-term there is probably no way to accurately quantify the real performance of an investment; at least, none that we know of. Over the long-term, however, expressing prices in terms of gold works well. Therefore, IF an investment is in a secular bull market then it should be in a long-term upward trend relative to gold*.

The following chart of the Dow/gold ratio (the Dow Industrials Index in gold terms) shows that the October-2002 low was NOT a major bottom in real terms. Thanks largely to the effects of inflation the Dow's nominal price is now comfortably above its Q1-2000 peak, but in gold terms the Dow is still well below its October-2002 LOW. Rather than a new bull market or a resumption of the 1980s-90s bull market in equities, what we've had since the October-2002 nominal bottom in the Dow is a bear market in the currency in which US equity prices are quoted.

But isn't it possible that both the Dow and gold are in long-term bull markets, in which case the on-going slide in the Dow/gold ratio would just be a reflection of gold's bull market being bigger/better than the Dow's bull market?

The answer is no. Being long-term bullish on both gold and the US stock market is a logical inconsistency of immense proportions because for hundreds of years gold's primary trend has moved opposite to the primary trend of the world's senior stock market. The relationship between the two markets is the way it is because the investment demand for gold -- the most important driver of the gold price by a country mile -- rises and falls in response to changes in the REAL returns being provided by financial assets. In particular, during long periods when the stock market generates good real returns the investment demand for gold tapers-off, whereas the investment demand for gold ramps-up during long periods when the stock market's real returns are sub-par. Therefore, if gold commenced a secular bull market during 2000-2001 then the US stock market commenced a secular bear market at around the same time, and vice versa.

So, here's what we know:

1. Oct-2002 may have provided the ultimate low for the US stock market in terms of depreciating dollars, but in real terms the Oct-2002 bottom was just a 'pit stop' on the way to much lower levels.

2. In real (gold) terms the US stock market trended lower from the first quarter of 2000 through to the second quarter of 2006, losing more the 50% of its value in the process.

Our interpretation of these facts is that a secular BEAR market in US equities commenced in 2000 and continues to this day. This is just a theory and cannot be proved, but in addition to being consistent with the performance of the Dow/gold ratio it is consistent with a) the long-term valuation trend (secular bear markets are about falling valuations, not necessarily falling prices), b) our view that gold commenced a secular bull market at roughly the same time, and c) the fact that it has taken a huge amount of monetary expansion over the past 6 years just to get the Dow and the S&P500 back to near their 2000 highs.

The most bullish forecast that we can come up with for the US stock market is that the Dow/gold ratio commenced a cyclical bull market -- a 1-2 year counter-trend rebound within the context of a long-term decline -- in May of 2006. We currently don't consider this to be the most likely scenario, but it will move to centre-stage if the Dow/gold and S&P500/gold ratios exceed their October-2006 highs.

*Prior to 1971 gold was either the official money or the official money was linked to gold at a fixed rate. As a result, prior to 1971 the stock market's nominal price trend and its real price trend were effectively one and the same. However, from 1971 onward there has been no official link between gold and the dollar and, therefore, no restriction on the amount of new money that can be printed or borrowed into existence. This has created some huge differences between the Dow's nominal trend and its inflation-adjusted trend. For example, in nominal dollar terms the Dow essentially traded sideways between 1966 and 1980, but in real terms it collapsed.