The Hindu Business Line : US: Wall Street-Main Street disconnect

Nominal returns are meaningless and, unless measured in terms of real purchasing power, the returns in any stock market could be misleading. Clearly an investor would be worse off even with a 20 per cent annual return, if inflation in the economy is 25 per cent, as it is not the number of dollars or rupees but what one can meaningfully purchase using the same that counts, says SHANMUGANATHAN N.

Through the previous articles in this series, I have explained as to why the US economy is in terrible shape — annual trade deficits of $800 billion, burgeoning fiscal deficits (even under the terribly flawed cash accounting systems), unfunded liabilities of $65 trillion, bursting of the housing bubble, the dollar that is losing value against other currencies, negative real interest rates etc.

In the light of Dow Jones Industrial Average (DJIA) hitting a new high of 14000, a question that I am often asked is: “Why is that despite all the above-mentioned problems, the DJIA keeps hitting new highs?”

Isn’t the stock market supposed to be a good indicator of the economic situation, and surely, if the indices keep making new highs, the real economy cannot be in as bad a shape as my articles suggest.

To understand the apparent disconnect between Wall Street and Main Street, it is necessary to put these nominal returns in perspective. The worst performing economy this year (and indeed the past several years) has been Zimbabwe, where the GDP today is less than half of what it was in 2000.

It would be very interesting to note that the best performing stock market of the year, by far, is also Zimbabwe where the Zimbabwe Industrial Index (ZII) has returned in excess of 600 per cent. Does it mean that there is a negative correlation between stock markets and the economy? Not at all!

It is just that the ZII has been a primary beneficiary of the rabid monetary expansion. So we are witnessing a boom in the stock markets amidst an economy that is severely contracting and a currency that is well on its way to being the modern-day Papiermark of the erstwhile Weimar Republic.

Much as I am bearish on the outlook for the US economy, I am not comparing the US economy to Zimbabwe’s here. I am just using an extreme example to convey the point that nominal returns are meaningless and unless measured in terms of real purchasing power, the returns in any stock market could be misleading.

What eventually matters is not the number of dollars or rupees, but what one can meaningfully purchase using the same. Clearly an investor would be worse-off even with a 20 per cent annual return, if inflation in the economy is 25 per cent.

Dow records in perspective

The Graph plots the last 35-plus years’ history of the DJIA, wherein the index has moved from 800 in January 1970 to more than 14000 today.

But what appears as a 35-year bull-run in stocks (without any significant nominal losses for an extended period) masks the terrible losses in purchasing power in the 1970s, during which period inflation was 15 per cent and short-term interest rates went to a whopping 22 per cent.

The 35-year record can thus be broken into three periods by measuring the Dow returns in terms of ounces of gold. The graph below shows both the nominal returns of the Dow as well as the DJIA returns plotted in terms of ounces of gold.

The first period — from 1970 to 1982 where the DJIA stayed nearly flat — as mentioned earlier, witnessed very high commodity prices and high interest rates. Gold prices also had moved from $35/ounce to more than $850.

Measured in terms of gold, the DJIA fell from more than 20 ounces to just about 1 ounce. Even measured against other leading currencies, the dollar lost more than one-third of its value in the above period.

The second period ranges from 1982 to 2002, where the DJIA moved from 865 to more than 12000. Measured in gold ounces, it reflected a nearly 40-fold increase as gold prices fell to a low of $260/ounce. The dollar also appreciated against all leading currencies in this 20-year period.

The third period began in 2002 where the Dow was 12000 and DJIA/gold index was more than 40. Five years down the line and despite nominal increases in Dow, the DJIA/gold Index has lost more than 50 per cent of its value and is quoting below 20 today.

Accompanying the falling real returns, the dollar also has lost a significant portion of its value against other leading currencies.

It is quite possible that the DJIA/gold ratio could well go to “1” as happened in the previous commodities cycle of the 1970s. In fact, the fundamental of the US economy is much worse than the 1970s and the expansion in money supply much greater today warranting the DJIA/gold ratio of even lower than 1.

What lies ahead?

We pretty much think Whether it goes there or not is something that only time will tell, but it is certain that measured in ounces of gold, the DJIA would lose a significant portion of its value in the years ahead.

What however happens in nominal terms to the DJIA index is something that would be interesting to speculate. From a monetary perspective, there are three options before the Fed today.

So what is likely to be the outcome? Given Bernanke’s speeches and recent actions, we can virtually rule out the tight monetary policy option.

At this point, we can only hope that Helicopter Ben desists from carrying out his policy speeches into action and chooses a less inflationary approach.

That would imply allowing speculative credit to get destroyed (as opposed to socialising the losses through hyperinflation) with significant losses in the housing prices and the consequent rising unemployment.

Irrespective of Bernanke’s actions, US equities that have been in a bear market for the last five years (measured in real terms) would continue to remain so, for perhaps, another decade.

What Bernanke could influence through his policy actions would only be the nominal values of the indices.

For an average US citizen and for central banks around the world who are holding dollars, the way to protect their wealth would be to shift into other commodity-backed currencies or just plainly the commodities themselves.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram@benchmarkconsulting.in . His previous articles can be accessed at http://financial-musings.blogspot.com)

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