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 underperform. 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 its 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 Barak 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 Benanke 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.
