The Inflation / Deflation Debate

This is not a topic we wanted to get into yet, but it seems that the market has forced our hand. It can be complex and so simple it's mind boggling. Work through this slowly. Make sure you understand it. Direct people that you think need to understand it to read it. Without understanding these concepts, you will be fooled and fooled very soon.

The Value of the Dollar and Floating Exchange Rates
As we've commented on numerous times before, the US stock markets and global commodity markets are not trading on fundamentals, but are instead trading on whether the dollar falls or rises.

Ever since Richard Nixon was forced to cut the US from the gold standard in 1971, the US, like most countries in the world, has been on a floating currency system. In short, currencies have value only relative to other currencies and are completely tradeable on currency exchanges. Much like stocks, in practice, currencies represent the value of the country relative to other countries and tend to show the flow of capital among countries. Those countries with strong economies and positive fundamentals tend to have stronger currencies. In addition, countries with low inflation expectations and high interest yields on government bonds (we'll discuss this more below) attract buyers.

In some cases, like Canada, Australia, and Norway, the value of those currencies is heavily dependent on their primary economic industries--commodities.

The bottom line is that one currency only has value relative to another currency, and the value depends on lots of factors and the general psychology of currency traders.

Although not perfect, the US Dollar Index (USDX) is one way of measuring the dollar against the currencies of the US' major trading partners, including the European Union, Canada, Japan, Great Britain, Sweden, and Switzerland.

By measuring the USDX, we are looking at the perceived value of the US relative to other key trading partners. It's not perfect, but it's a reasonable sign of things to come.

Currently, we are technically at support levels and have been bouncing for the last two days (today being an exception). Stocks have been rising opposite the USDX, so today stocks have bounced. The question we are forced to answer is one of market psychology. Why, exactly, is the dollar up or down, and since the stock market is moving opposite the currency, what does that mean? We'll attempt to determine that below.

Treasury Auctions
We have also see a couple of essentially failed Treasury auctions this week on the 2-year and 5-year notes. The 7-year auction is today, and the results may be crucial. This is what is forcing us to put this piece together so quickly.

The debt markets, notably government debt, are the largest markets in the world. They dwarf the size of the stock markets.

When you buy a bond, you're buying debt. You're buying an IOU that states that the government will pay back your money in a given period of time (2 years, 5 years, or 7 years in reference to this week's auctions) with interest.

Government debt is usually considered a very solid investment. After all, they have millions of citizens that they can tax and pay off the debt (worst case, they can just print the money, but as a bond holder, that's bad for you because it causes inflation). In most cases, it's much less risky than loaning your shady, out of work cousin Lenny money for a car, right? If the government starts to print money, the amount of interest they have to pay rises or no one wants to accept the bonds.

As the maturity (the amount of time you have to hold the bond) on bonds gets longer, so does the risk. After all, what kind of interest rate would you want to give the US government your money for 30 years? You have to trust that the government is going to make good decisions and that when you get your money back, it's purchasing power (aka, it's "store of value") has not been significantly eroded (ie, inflated away by printing too much money). After all, if you're going to loan money to the government, you want to be better off for it, right?

So if you loan the government money for 30 years, you want a higher interest rate than if you loan the government money for 1 year. Your risk is higher, so you want a better return.

The rate of interest of government bonds (Treasuries) from the short term to the long term is the "yield curve." The further out on the yield curve you go, the higher the interest rate you expect.

Since every dollar created is backed by debt issued by the government, which is in turn backed by a promise (IOU) that the government will make good on its payments with interest, which is in turn backed by the government's ability to tax its citizens, then all currencies (money) are backed solely by debt. When they say "money is debt," this is what they mean.

The government auctions off bonds to raise money for government spending when taxes are not enough to cover the cost of running government programs (whether they are welfare programs, retirement programs, or funding wars). As discussed yesterday, the auctions for the 2-year and 5-year have not gone well. We'll get back to this in a minute.

Printing Money
As the credit crisis has hit, more and more governments around the world have been trying to raise money to pump into their economies. They have also been purely printing money. The way money is printed in the modern economy is that the Central Bank (ie, the Federal Reserve, the Bank of England, the European Central Bank, etc) buys the government bonds of its own country. It does this with money it creates out of nothing. It may sound ludicrous, but when the Federal Reserve buys bonds auctioned by the US government Department of the Treasury, it simply creates the dollars necessary to do so. When they say "money is created out of thin air," this is what they mean.

In modern parlance, no self-respecting government or central bank would refer to this as "printing money." That has negative connotations (and rightfully so). They refer to it as "quantitative easing" or "QE."

[Side note: A central bank can technically buy anything. Government bonds, mortgage backed securities, and paper clip purchases all imply that the central bank will print money out of nothing to complete the purchase. Often, when the government cannot find other buyers of its bonds but it needs money, the central bank will buy the bonds with newly printed currency. This is also referred to as "monetizing the debt."]

Economic Schools of Thought
It is impossible to do justice to the fundamental schools of thought on economics in such a short space. It is also impossible to draw conclusions about the direction we're taking without bringing them up. Please bare with this brief and very incomplete description...

The Austrian economists believe in the gold standard because it limits the amount of money that can be created based on the amount of gold owned by the nation. Since you can't just print gold, this imposes a practical limitation on the total annual amount of global currency creation that is capped at the amount of annual gold mining production.

The Keynesians and monetarists (Friedmanites) believe that gold, to quote Keynes himself, is a "barbarous relic." Both schools of thought opt to try and manage the economic fluctuations of the natural business cycle of the economy by having the government add or subtract money and credit in the economy at the right time. The Austrians believe this only fuels speculation and malinvestment.

Keynsians seek to add credit into the economy when the economy weakens and remove credit from the economy when it heats up. This way, government compensates for the poor economy by temporarily "propping it up" in bad times.

Friedmanites advocate manipulating the money supply instead of interest rates to accomplish much the same goal.

The Great Inflation/Deflation Debate
And now we come to the crux of it--the Great Inflation/Deflation Debate.

There has been an debate raging for years now on what happens in the situation that the world, and in particular, the United States, now finds itself in. The two camps are the inflationists and the deflationists.

The inflationists argue that, much like Argentina in 2001, the Weimar Republic in German in the 1920s, or even modern day Zimbabwe, that the constant increases in money supply (inflation) and artificially low interest rates will eventually destroy the currency (remember our discussion of supply and demand as it applies to currency?). Central to this idea is that as politicians continue to promise more than they can deliver, they will find a way to print money to make it happen. This will ultimately make each unit of currency worth less, which leads to a loss of confidence and a panic flight away from the currency to real, tangible things (like commodities) that cannot be inflated away.

The deflationists argue, on the other hand, that the modern world is not about printing money as much as it is the supply of credit. We live in a credit-based economy. So for any country to print more money, in reality the rest of the world has to allow it. Otherwise, the value of the currency (as a floating, freely traded security) will fall too far, and no government in its sane, right mind would allow that. So instead, countries will have to borrow the money by auctioning government bonds (Treasuries in the US). There is a free market check on the ability of any country to borrow--at some point their bond auctions will not be received well, and they will essentially fail. That will stop government spending since no government in its right mind would just print the money, and if credit is collapsing in the economy, the result will be deflation.

Phew. Hopefully that made some sense. Bottom line is that the inflationists believe that the government cannot and will not be stopped when it comes to printing money, and that the end result is a collapse in the currency. In this case, the currency is worth less and there is a panic to real things. They cite Argentina, the Weimar Republic, and the historic fact that all fiat (non commodity based) currencies have been destroyed over time.

The deflationists believe that the floating currency exchange system and the rejection of government bonds will stop governments from destroying their currency. They cite Japan and the multi-decade "deflationary" spiral.

[Quick side note: Japan printed a lot of money and lowered rates. That's not deflation. However, investors opted to take zero-interest-rate Japanese yen-based loans and invest the money in other areas of the world. The result was inflation outside of Japan. Don't confuse cause and effect! We'll touch on this more later as we discuss a possible upcoming US dollar carry trade.]

The Dredd Viewpoint
We tend to believe that both sides have solid points, but in the end, inflation must win out.

Why?

Can you imagine a scenario where the US government comes out and states that they are going to shut government down, including Medicare/Medicade, military, and Social Security programs because no one will buy bonds? Are you nuts? No politician would ever be reelected.

At the same time, the US debt is so large and growing that it cannot be paid of by taxation alone.

Debtor nations must have inflation. They need it because inflation erodes the debt. Plus, the nation can always just print currency to pay its costs. This should ultimately be reflected in the USDX as the supply of dollars rising becomes known relative to other currencies.

The other option is default. In a default, the government cannot pay its debts and refuses to print the money. In that case, the exchange value of the currency (ie, USDX) should fall because the currency is like the stock of the country.

So the end game in deflation or inflation is the same in fiat currencies--loss of confidence.

Why Is It Today So Critical?
Usually, when a government debt (Treasury) auction fails, the stock market drops. It's a vote of lack of faith in recovery of the economy if the government cannot get more money to stimulate and carry out its goals.

However, today we have a massive stock market rally. As usual, the USDX is down. It has only dipped slightly and is above support, but the market has had a monster rally, and continues to on any dollar weakness.

Remember that nothing is trading on fundamentals. Everything has been trading opposite the USDX, and the USDX has fallen to key support. In our opinion, the issue at hand with the stock market is NOT about economic recovery, but it is about inflation and the destruction of the dollar.

From this viewpoint, a failed Treasury auction may be taken as a sign that faith in the US government is waning. In this case, other countries may be of more interest to currency traders. In other words, a failed auction may be a "no confidence" vote in the US government, which would affect the currency more than most of its companies, which are, in fact, international companies. Those companies may be profitable if they can sell products to other countries. Thus, they are worth more than the US government, and conversely, the stock of the US government which is the dollar.

Conclusion
This is, believe it or not, a simplified view of things. But it is important to note that we are at an extremely critical junction now that you won't hear about anywhere else.

Today, we see weakness in bond auctions and in the dollar with bullish action in the stock markets. Is this the beginning of a massive dollar sell-off? If so, will it create massive inflation in the United States, including possibly hyperinflation?

Stay tuned.

Read more...

Stock Buy Signal and Implications for the Dollar

We've repeatedly commented on the inverse relationship between stocks and other assets and the dollar.

Assuming that relationship holds (and we may put some charts up later to prove this relationship), then what does this article from Bloomberg say about the dollar?

Dow Sends Buy Signal That’s Worked Since 1921: Chart of the Day
By Eric Martin and Michael Patterson

July 29 (Bloomberg) -- The Dow Jones Industrial Average is sending a buy signal that has foreshadowed gains of 18 percent during the past nine decades.

The 30-stock gauge climbed to more than 10 percent above its mean level from the previous 200 days, rebounding from 34 percent below the so-called 200-day moving average in November, according to data compiled by Bloomberg. Eighteen of the last 21 times the Dow rallied from at least 10 percent below the 200-day level to 10 percent above, it posted gains during the next 12 months, Bloomberg data since 1921 show.

The CHART OF THE DAY tracks the difference between the Dow’s last price and its 200-day average since 1989. The lower panel displays the measure’s price, along with the buy signals it sent near the start of rallies in 1991, 1999 and 2003.

“This rally, while it will have its fits and starts, is the beginning of a new trend, not just a bounce,” said Michael Williams, managing director of New York-based Genesis Asset Management, which oversees about $2 billion. “It is a significant opportunity.”

The Dow posted an average advance of 18 percent during the 12-month period following buy signals since 1921, Bloomberg data show. In the six-month period, there were 17 advances for an average gain of 8.2 percent. In three months, it climbed 18 times, averaging an increase of 5.7 percent.

Returns by the Dow Jones Industrial Average 12, 6 and 3
months after the buy signal.

Buy Signal 12 Months 6 Months 3 Months
June 11, 2003 13.36% 8.98% 3.01%
Jan 8, 1999 19.49% 15.38% 5.75%
March 5, 1991 9.05% 1.21% 1.11%
Jan 27, 1989 10.18% 13.46% 4.14%
Sept. 3, 1982 31.38% 23.02% 11.67%
July 18, 1980 3.78% 5.34% 3.48%
Aug. 9, 1978 -3.74% -7.76% -9.83%
March 7, 1975 26.43% 8.63% 9.11%
Dec. 7, 1970 4.73% 12.75% 9.69%
May 8, 1967 1.02% -6.60% 1.41%
Jan. 25, 1963 15.20% 1.18% 5.68%
July 24, 1958 33.51% 19.91% 8.53%
Dec. 13, 1949 16.26% 15.04% 3.15%
Nov. 6, 1942 16.66% 18.21% 8.29%
Sept. 11, 1939 -16.61% -4.49% -5.20%
July 6, 1938 -3.05% 10.95% 7.49%
Feb. 18, 1935 43.10% 19.09% 8.06%
Apr. 19, 1933 54.47% 23.53% 51.63%
Aug. 29, 1932 37.72% -31.68% -21.87%
Aug. 18, 1924 35.82% 14.36% 5.46%
Dec. 12, 1921 21.89% 12.53% 8.12%

Average 17.65% 8.24% 5.66%

Read more...

The Business Cycle, Recessions, Depressions, and Academics Gone Wild

The bulls out there fall into two camps:

1. Those that believe that the economy is recovering
2. Those that believe that inflation is on the way

The bears out there fall into one camp:

1. The economy is terrible and the market is going to crash

Here at Dredd, we tend to believe they're all a little bit right and mostly wrong. The real economy is nowhere near recovery. It will take considerable debt reduction in the private sector, through defaults, inflation, and/or time to rebuild consumer balance sheets in order to bottom in the economy. This implies stable jobs, real increased wages (real vs. nominal--consumers are broke because of inflation over time), and a stable currency. Since over 70% of the economy is consumer spending, the economy is going to have to make fundamental changes to solve the problem. That includes producing more things for other countries to buy (rebuilding the manufacturing base), fewer consumer-oriented businesses (retail is going to get much, much smaller), and increased savings from consumers (capital) that will ultimately be used to build new businesses.

At this present time, instead of this process happening naturally through defaults and bankruptcies, the government is assuming the role of the consumer and going into more debt. The base of our problem, however, is debt. So obviously, the government not allowing debt to be liquidated by assuming the role of an overburdened consumer in too much debt is probably going to end badly.

The risk to the government (and ultimately, the event that will make this very bad beginning of a depression into a full blown nightmare depression) is the effect of this behavior on the US dollar. Right now, consumers are saving for the first time in decades while government actions work to make the dollar itself weaker over time. This is the result of a belief in Keynesian and monetarist theories, in our opinion, incorrectly applied.

In brief, Keynesian theory states that for a government to make a recession less painful, it should step up spending when consumers are forced to retrench. It should do this through manipulation of short term interest rates, which in the US are now roughly zero percent. Of course, the corollary is that when the economy is good, the government is supposed to stop spending and save--which we did not do in the last 8 years, instead opting to cut taxes while ramping up an expensive war.

The monetarist theory roughly states that it is more effective to increase the money supply (inflate) during recessionary times. It approaches the problem in a similar fashion as Keynesian theory, but using money supply versus interest rates as the means to accomplish the same objective--increase government spending when consumers slow.

The Fed and the US government have opted to do both and apply Keynesian rate reductions and monetize debt to get us out of this recession.

Here's the problem. It's not a recession. It's a depression. The government is applying a band-aid to a cancerous skin lesion. It will not--it cannot--solve the problem.

A recession occurs as part of the natural business cycle. Businesses build up inventories based on increasing demands, they ultimately over project the demand, and then the demand dries up because the market is saturated with product. Then it takes some time to work off the inventories, during which time unemployment rises and the economy slows. However, once the inventories are worked off, things pick back up and are off to the races.

A depression occurs when there is too much debt in the system. At some point, people (or business or government) simply cannot take on more debt, and the person is in default.

People have been consuming far too long in the US relative to their incomes. So has government. The debt problem has to be resolved. At the same time, the government is trying to help consumers (and banks, notably) solve debt problems by borrowing money (taking on more debt)or printing more money (monetizing debt). It seems rather illogical that one can solve a debt problem with more debt. But that's government for you.

It appears that the government has, at best, misdiagnosed the problem and exacerbated it. At worst, they have allowed the Fed to save the banking system at the pure expense of generations of Americans to come. After all, something's got to give in this race, and it's likely to be confidence that the government call pull it off.

And that's where the dollar comes in.

In a fiat monetary system, like all countries have today, the currency is based on faith and credit. In other words, it is based on the premise that the government is "good for the loan." However, at some point, the debt level cannot be sustained and that will result in loss of faith, and a likely sell-off of the currency.

Are we at that point? It's hard to say. But we're following the dollar relative to other currencies to determine how much faith there still is out there in the dollar. Meanwhile, the politicians and Fed continue to plan on more spending, which implies more debt.

What will happen if they run out of willing buyers? Will the Fed simply find a way to print more money (inflate), or will the US have to default? It's clear that one of these two options is the end game. If the US dollar is basically the stock of the United States, what do you think will happen to the stock when it's common knowledge that it cannot repay its debts?

This will probably not end well. Hopefully the charts will keep us informed as to how the situation is progressing. We are auctioning off more debt even as we speak. Yesterday's auction results were not fantastic for 2-year notes, but they were okay.

Stay aware...

Read more...

"Where?" Part III: Inflation, Deflation, Real, and Nominal Prices

Our goal in writing this blog was to educate more people on money and markets. How they function and how not to be fooled by what is probably about to occur.

In the first discussion on this topic, we focused on what the economy is and what the main questions are that we are going to try and answer, notably "where" we are in the economic cycle. This was the beginning of a series that focuses on where we are.

This has turned out to be a more difficult undertaking than originally conceived. The answer is straightforward, although surprising to most, but to really prove where we are, there are many facets of economics and terminology to go through. Of course, it's simply not possible to teach a complete economics course here, but hopefully we can shed enough light on the situation to both prove our point and encourage you, dear reader, to learn more about the topic yourself.

In Part I of "Where?" we looked at economics and markets, notably the stock market, as a means of understanding our current financial crisis. We introduced the concept of charts, and as a reinforcement, please note that if you do not have a comfort level in what you are viewing and what it means, you simply must focus on understanding it. While putting the entire economic situation into context through fundamentals is necessary, in order to really get a sense of what's going to happen next and when we're through all of this requires some practice in viewing the charts.

Most notably in Part I, we reviewed the Dow Jones Industrial Average (DJIA) as a familiar means of viewing the economy in both linear and logarithmic charts (please study the logarithmic chart and burn it into your brain!). People tend to think "stock market is up, so the economy is good." This is not necessarily true, but to prove this point, we have to understand that most charts are denominated in dollars. The DJIA is, by default, in dollars. So understanding money, at least to some reasonable degree, is required to continue.

In Part II, we looked at the definition of money a bit. Since we look at the stock market, which is priced in dollars (money), then we need to understand a bit of what money is and is not. In summary, most people understandably think of money as a constant in the same way they perceive time. As an example, you have a sense of how long one minute is. A minute is always a minute. It's a stable, predictable thing. But from the standpoint of physics, time is not constant, though in most cases, it's close enough for us on a day to day basis. Money is similar. You think of how much your home costs in dollars (or euros, yen, krona, whatever) and you believe that the home is becoming more expensive or falling in price. In most cases, that is simply not true. The value of your money itself fluctuates, and that is a critical issue that most people do not really comprehend.

We also addressed the concept of capital vs. money. Please review Part II and make sure you get the difference.

We followed up with a supplemental piece on money. It has tipped our hand a bit as it shows our bias toward an honest money. In truth, we have some mixed feelings on a pure gold standard. There are advantages, and there are risks. The situation is similar with floating exchange rates, which we have today globally (with the exception of some countries that peg their currencies to the value of other currencies). We will delve into this topic in more detail at another time.

Here's the important takeaway from those money discussions. Your money changes value over time. In fact, it is largely constantly being inflated away (which we will describe in detail below). So your money, with almost no exception to any currency on the Earth, is generally losing its "store of value" attribute. Your currency functions primarily as a "medium of exchange" only. Given that, then you must realize that if you hold currencies exclusively, the value of your labor is being eroded away. This has an effect on the price of things around you because those things don't change--your money does.

Now we're going to put all of this together, with some concepts like inflation and deflation in order to make sense of our current situation and determine where we're likely to go from here.

Currencies and Inflation/Deflation

Modern currencies are an interesting study in the concept of money. First, the currencies are a medium of exchange simply because the governments command that they be used for exchange via legal tender laws. Governments are in a unique position in that they have a monopoly on force You will either use what they say is money, or you will not be able to buy things. Try trading your gold jewelry or a bunch of eggs for a buggy full of groceries at the store and see if the store accepts it as payment. Unless you've got a special relationship with the seller of the items, it won't be accepted. Those things do not meet the "medium of exchange" definition and are not money.

So, is money whatever the government says it is?

Absolutely not. And this brings us to the crux of our modern problem.

Currencies are subject to the laws of supply and demand like everything else. The more units of a currency that are supplied, the more the demand is negatively affected. Said another way, the government can force its currency to be used through legal tender laws (which makes the currency a medium of exchange), but if it creates a lot more of that money, then the currency starts to fail the store of value test as the supply rises.

Folks, this is what inflation is. Inflation is not about rising prices. Inflation is about increasing the supply of money, which has effects later on down the road. Modern financial commentators and economists speak about inflation meaning rising prices. However, if you think about inflation like this, you'll always be fooled as to why the prices are rising. Inflation, when viewed as rising prices, ignores the cause of price increases. It is about supply and demand--nothing more. So for our purposes, we will use the term "inflation" to mean a rise in the supply of money and "deflation" to mean a decrease in the supply of money. Keep in mind that when you hear of inflation and deflation in the media, they mean price increases and decreases. This is one reason that they often get it wrong when predicting what is going to happen next.

To illustrate this concept, let's look at a recent example. Suppose you bought a house in 2003 for $400,000. Your neighborhood hasn't changed, the local area hasn't really grown, you haven't remodeled and generally things have been the same. However, in 2006, you find that the house is worth three times ($1.2 million) what you paid for it in 2003. This was not at all an uncommon occurrance a few years ago.

The house does everything now that it did in 2003. Nothing's changed. Why is it worth more?

Guess what. It's not worth more. The supply of money (ie, inflation) has been increasing. Truth is, the money has lost its value. It takes more units of the money to buy the house. The house wasn't getting more valuable, the money was simply not maintaining its store of value property as the supply of it was rising (inflation).

You can see the phenomenon in many assets. Oil prices, food prices, price of gold and silver, etc. The price of any item in the world has two components that must be considered: the supply and demand of the thing itself, and the supply and demand of the money it's priced in.

So the first thing you need to do is stop thinking about how many dollars (or euros, francs, yen, pesos, etc) you have and start trying to recognize the value of something. If the supply and demand fundamentals of the thing you're looking at aren't improving but the price is rising, you should be taking a look at your money and see if its supply and demand fundamentals are improving or not.

But, you may ask, isn't the demand for money infinite? After all, who doesn't want more money? Therefore, if the government produces more of it, won't it all be demanded?

Money is unique in that there is no bit of money in the world that's isn't owned by someone. People don't actually care about money, the care about what money buys. Money itself is useless. Its value is only recognized when it is exchanged for something at some point. Thus the demand for money is all time based. People hold money for some time if they have stuff they need now, in anticipation of using that money later on (and in hopes that it maintains its "store of value" well). Otherwise they exchange it for things they need in the short term.

There are many other different and interesting "tendencies" of money that we will discuss over time. But for now, understanding that when money is inflated, it loses it weakens its store of value property is enough.

So, to summarize this bit on inflation and deflation, we need to think about supply and demand of the thing itself and the inflation/deflation (supply) of the money. For purposes of simplicity, we've skipped the idea of credit for now, but credit is very central to where we are today and where we're going. We'll come back to credit another time.

Asset Prices Adjusted for Inflation/Deflation

With all of that behind us, let's go back to the original DJIA logarithmic chart we posted in Part I.

And let's adjust it now for inflation (and pretend inflation started in 1982, like the government calculations for most things pretend):

What you are seeing is that inflation makes the magnitude of the run up of the stock market much smaller. For a moment, just ignore that most of the government numbers used for CPI (which is their measure of inflation) are doctored for political purposes, and focus on how even these underestimated number make the the top of the DJIA look more like just over 6000 versus 14,000.

Similar charts, using the log scale for more visibility:

Ok. Let's have a little fun. Let's adjust the inflation rate and interpolate what it was back when the DJIA began back in 1896.

Ouch. Think about what this means. If we had no inflation, the DJIA would be around 2000 today. That's the real value of the stock market adjusted for inflation. So think about your house value. The value didn't change--or didn't change much--in most cases. But the price went up. This chart is the exact same illustration, and it even uses fudged government numbers to calculate the inflation and make it seem lower than it really is.

The Grand Finale: Prices in Gold

So, it's taken several major parts of this series to get here, but we're finally up to the first major point we want to show to give you an idea of where you are in this economic cycle. Fasten your seat belts.

Instead of pricing the DJIA in terms of dollars, which it is, by default, priced in, we could theoretically convert dollars to euros and see what the DJIA looks like. We could convert it to most anything and look at a chart--and they're all valuable to review. But, perhaps the most interesting chart to review is the DJIA priced in gold, for it is very telling and will be the subject of more discussion as this series continues.

There's a saying that gold holds its value over time. A nice man's suit costs about an ounce of gold today, just as it did 100 years ago. If you think about prices in the manner we've discussed, then you realize that gold doesn't change its value, but the money changes in price. As currencies inflate, gold tends to hold its value better. After all, gold doesn't have much of a function in the world except as an alternative to currency, so its value is largely constant.

Let's look at the DJIA priced in ounces of gold instead of dollars.

The blue line is the DJIA in log form. The green line is the DJIA divided by the price of gold over time. This is a very different view of the DJIA, right? What is it telling us?

At certain points in history, the stock market often drops or generally underperforms. These are called secular bear markets because they last for long periods of time and are characterized by either stock market crashes, as in the 1930s/Great Depression era, or flat periods like the staflation of the 1970s. During these periods of turmoil, people flock to gold. These periods last a long time, typically around 15 years, during which time the financial system and economic system are in great distress. The stock market peaks, and gold rises. Note that this trend has started in 2000 and we are still in it. So that's the "where"--we're in a secular bear market. Note that they end when the DJIA is worth around 2 ounces of gold.

As of this moment, the DJIA is around 9038, and the spot gold price is 938.80. In other words, it takes about 9.6 ounces of gold to buy the DJIA.

Does this mean that the DJIA is going to drop to around 2000? Probably not. From the inflation-adjusted charts, you can see that DJIA is always much higher than its "true value." This is called the nominal price--which is the DJIA in inflated dollars. That's the price you always hear quoted. Then there's the real price--the price with the inflation pulled out. Of course, that's a tough one to get because it's a formula controlled by government based on a lot of assumptions. But if we believe that gold always holds its value over time (not every second of every day, but over long periods), then we can measure the real value of things in terms of gold to see what they're worth. Often, the gold-adjusted price is better than the inflation-adjusted price, but we'll have to use both of them now and again to get a sense of the real price.

We may be in a short term bull market with the price moving up, but the fact is our economy is not good and not healing. At some point, the DJIA and gold will meet. We do not yet know if that means the DJIA falls to 2000 and gold stays still, or if the DJIA rises to 20,000 and gold rises to 10,000. That, of course, is based on inflation, confidence, global currency flows, and lots of other things we have to take into account. We will touch on those over time.

Study that chart closely. We're going to pick up right here next time, and look more closely at what that chart is telling us. We'll dig deeper into real and nominal prices. We'll discuss secular and cyclical bulls and bears. We'll define periods of history by secular bull and bear periods. There's a lot of ground to cover and the hour is late.

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Consolidation

The market is a bit quiet in the last few days. Although the broadening top/megaphone is still in play, with these pull backs, the stock markets appear to be strengthening up for a run at the 1000 level on the S&P.

The dollar is having a technical bounce. It will be critical to see how far it bounces. The 50 day moving average is the first resistance. We'll investigate this later today.

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