Investors know that denominators matter when determining the value of an asset. If we relied on price alone we’d be fooled into thinking that the S&P 500 at 1340 in November of 1999 has the same value (and thus the same return prospects) as the S&P 500 today at roughly the same level. Denominators allow us to assign meaning to price. The most commonly used denominator when valuing stocks, or the market as a whole, is earnings– the E of P/E. This allows us to know that the market is far less overvalued today at 23.3x normalized earnings than it was in October 1999 at 43.2x normalized earnings. Please see my prior posts on why normalized earnings multiples are a far better determinant of future long-term returns:
However there are other important denominators besides fundamental measures such as earnings, sales, cash flow, etc. that can allow us to look at the price of something and help derive its true value and thus its merit as an investment. Adjusting prices for inflation, purchasing power, and a stable unit of measurement is the topic at hand.
One of the most challenging financial concepts to truly understand is the real return of a given asset. We know that most returns we see in financial media, investment marketing documents, and our brokerage statements are nominal returns and do not incorporate the effects of inflation. Most of us also know that inflation diminishes the purchasing power of our assets, sometimes slowly and sometimes rapidly. When evaluating rates of returns therefore, we can usually just make a mental adjustment for the effects of inflation: stocks have returned 8% per year over the last x years, while inflation has been 3% per year, so my real return is 5%. Easy enough.
However, we tend to underestimate the effects of even a small growth rate, compounded over long periods. The chart below shows the relatively contained monthly inflation rates, most often between 0 and 1%, adding up to a significant rise in overall prices of nearly 1,600% since 1940.
But what happens when inflation is not a complete adjustment for changes in the real value of our assets? And I don’t just mean to suggest when CPI is an inaccurate, incomplete, or even artificially manipulated measure of inflation. Which, though beyond the scope of this article, rigorous analysis and common sense suggests is highly likely. Please see John Williams’ excellent ShadowStats.com for such an analysis.
Instead, I am focusing primarily on our unit of measurement, the U.S. dollar. If the dollar were a stable store of value and $1 today was more or less worth the same as $1 a decade ago or a decade hence, then we’d be able to judge asset prices without making adjustments. All else being equal (like earnings), a 10% drop in the price of stocks would make them 10% cheaper and a 10% increase in the price of stocks would make them 10% more expensive. Similarly, a 10% drop in our asset prices would make us poorer by the same magnitude and a 10% increase in asset prices would make us that much wealthier.
As colleague Brian McAuley penned in Sitka Pacific’s June 2010 client letter
If the dollar was not constantly changing in value, we would be able to see the true change in stock prices just by looking at historical prices. But since the Federal Reserve is always de-valuing the dollar (i.e., seeking a positive inflation rate), it sometimes is difficult to see the true nature of price changes without filtering out the dollar. If we were able to see the history of stock prices only in dollars, the sideways trading range of the S&P 500 over the past 11 years would appear rather benign. However, as we have discussed a number of times, this period has been anything but benign for stockholders. Although the S&P 500 is currently only 18% below its high price in 2000, if we use adjust for inflation using the Consumer Price Index (CPI) the S&P 500 is down 34% since 2000. And if we adjust the price of the S&P 500 with the price of gold, which is something we can invest in (unlike the CPI), the S&P 500 is down 85% from its high.
I’ll use an extreme example to prove the point. In Zimbabwe, for the 12 month period ending in June 2008, the Stock Exchange Industrial Index went from 15,000 to just under 6,000,000,000,000 and continued rising to more than 9,688,095,700,000 by October, a gain of more than 538,000,000%!
Most people would not look at this situation and determine that the value of Zimbabwean stock market rose, but that the value of the Zimbabwean currency (ZWD) fell. Indeed, changing the denominator from ZWD to a relatively more stable store of value, like the USD, shows the real change in the value of the stock market index over the same period.
And the USD was hardly a global beacon of stability during this short period in which it lost 25% of its value against gold and nearly 10% of its value against a trade-weighted basket of foreign currencies.
So why would we look at the US stock market any differently? Besides magnitude, isn’t the US dollar or any other fiat currency subject to the same forces of devaluation as its Zimbabwean counterpart?
Quite a Rally, Aye Mate?
I have a friend who happens to be very good at calling market bottoms. He called me on March 6th, 2009 and told me to buy stocks. “Which ones?” I asked. “It doesn’t matter, mate” he replied, “just buy the market, the S&P 500, whatever.” Well, I thought and then proposed, “only if you do too.” And so we each bought the S&P 500 Index fund at the lowest closing price in more than decade. I’m up 90% on my money, so I decide to call my friend and thank him. ”I can’t believe we almost doubled our money!” I said, thanking him profusely. “You may have, mate, but I’m up a measly 20%.” What happened?
Well, it turns out my prescient friend has the bad fortune (in this case) of being Australian. When he buys the S&P 500 Index fund he had to convert his savings from Australian dollars to the U.S. version and when he wants to spend his gains, he must do so in a vastly stronger Australian dollar. And while the S&P priced in U.S. dollars has increased more than 90%, the said unit of measurement has actually declined by 65% over the same period, offsetting his paper gains.
The debasement or devaluation of the U.S. dollar is obviously more than just the effects of inflation. In fact, over this period, Australia has registered only a moderately higher CPI of 6.3% over the 2 year period vs. 5.1% in the U.S.
And lest you think the issue is simply a matter of a particularly strong Aussie dollar, our friends in Canada (-35%), Switzerland (-42%), Japan (-24%), India (-44%), Singapore (-27%) and even the troubled Europeans (-11%) and Brits (-13%) have seen the gains from their brilliant, market-bottom purchases of the S&P 500 whittled down.
The Anti-Currency Money
The fact that denominators matter does not tell us which ones we should pay attention to and what they are telling us. If there were an inherently and persistently superior currency than the U.S. dollar that has stood the test of time and held its value from generation to generation, then we should all use that currency as our unit of measurement. We should convert all of our U.S. dollar savings into it, gauge the relative attractiveness of other asset classes to it, and measure our true wealth and purchasing power in it. While some are better than others, no such currency exists.
Gold (and to a lesser extent, silver) on the other hand, has been viewed as a store of value for thousands and thousands of years. The value of currencies, including U.S. dollars, used to be anchored, in varying amounts, to gold’s value. In fact, the U.S. dollar gained its status as reserve currency of the world in part because nearly all other major currencies could no longer hold their value relative to gold. With a promise to allow foreign central banks to convert their U.S. dollars to gold, the Bretton Woods Agreement in 1944 established a system whereby most major currencies were convertible to the dollar which was convertible to gold, all at a fixed rate. Today, and since 1971, no such anchor exists. We are in a new monetary era defined by fiat currencies. It is important to remember that this era remains something of an experiment, with only a short 40 years of historical experience. Yet gold remains a reference point, though volatile and subject to speculation, fear, and greed, for what paper currencies are truly worth.
The “Real” Paradigm Shift in Commodity Prices
In a recent post, I critiqued Jeremy Grantham’s excellent research piece titled “Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever.” While I agree with his general premise of a paradigm shift in supply and demand, he fails to account to for the dramatic decline in the denominator, or unit of measurement, of commodity prices– the U.S. dollar. The first paradigm shift in commodity prices followed the final unhinging of the dollar from the gold standard in 1971. Accounting for the dollar empowers us to put the dramatic rise in commodity prices in proper context. Consider the remarkably similar charts of oil and gold which begs the question, are oil and gold going up or is the dollar going down?
Foreign oil producers have long demanded sufficient payment in gold. Devaluations of the dollar are always met with an attempt to receive higher prices for the oil that is produced.
Bull and Bear Stock Markets
Sustainable secular bull markets feature rising prices and valuations independent of the denominator. The gains from the last long-term bull market in U.S. stocks during the 1980s and 1990s were registered not just in nominal U.S. dollars (top chart) but in real, inflation-adjusted dollars, Deutsche marks, yen, francs, silver and gold (bottom chart). Contrast this with the market action since valuations peaked in 2000, whereby each market rally (top chart) fails to register gains relative to gold (bottom chart) or other perceived stores of value.
Gains made on the back of a depreciating unit of measurement are ultimately unsustainable or result in little true wealth creation for investors who earn, save, invest, and spend in that currency. The initial rebound from the low in 2009 was built on the foundation of inexpensive valuations based on the long-term earnings power of the market. Indeed, the initial gains in the market were also registered relative to gold. Since late 2009, however, the market’s gain has been of a very different nature– not only have stocks actually declined versus gold and other currencies, but they have been powered by normalized valuations going from expensive (19-20x) to more expensive (23x). This makes the gains over the last year or so particularly vulnerable.
What Happens Next?
As always, the likely course of asset prices is difficult to predict. However, the conditions present in the market suggest that the value restoration project in stocks, underway in fits and starts since 2000, will eventually resume. This means any additional gains in the market carry heightened risk, particularly for the buy and hold investor. Of course, nimble traders with good risk management may be able to create a better risk/return dynamic, as even expensive markets can become more expensive. Additionally, there are pockets of attractive stocks, relative value opportunities, and special situations that may provide returns less burdened by the overall market’s overvalued state. History however, suggests that market prices broadly will eventually resume declining relative to several denominators, in particular, normalized earnings and gold.
To what degree nominal prices of stocks broadly decline, if at all, seems to be depend in large part on what effect politics and policy will impart on well-entrenched global economic forces. At the risk of oversimplifying, consider two paths:
The first, a highly interventionist policy, much like the one we’ve seen over the last several years, features more and more fiscal stimulus, budget and trade deficits, persistently overly-accomodative monetary policy and additional quantitative easing, and tireless support for the nation’s largest corporations and financial institutions. The second path features a step-away from additional stimulus, increased austerity measures, increased taxes, deficit reduction, a righting of monetary policy toward neutrality with no follow on quantitative easing, and perhaps increased regulation and burden sharing by banks and corporations. As investors we must attempt to stay out of the debate of what should be done, and focus instead on the range and probabilities of various outcomes as well as the magnitude of the impact of each.
The Political Path
Current politics suggest that a highly interventionist policy will continue. There is likely to be more non-traditional, hyper-accomodative monetary policy in the years ahead. When combined with structurally high under/unemployment and the prospect of continued and growing deficits and a desire to keep marks high on bank balance sheets, it seems likely that U.S. dollar will continue to lose value against gold and to a lesser extent, consumer prices broadly. This makes it unlikely that we will revisit the nominal price low of roughly 680 on the S&P and 6,600 on the Dow in 2009. An extreme case of significant devaluation and inflation could even allow the market to hold or continue its nominal price gains indefinitely, though I suspect it would feel more like a mini-Zimbabwe than true prosperity.
The Economic Path
However, we must also give weight to the possibility of a truly deflationary environment taking hold. Absent politics and the current monetary policy mindset, this would be the path of least resistance for an economy that must de-lever such as ours. In this scenario, gold and other perceived stores of value may not go up at all or even decline. However, the value of paper assets like stocks would decline by much greater amounts. At the real stock market lows in 1980-1982, the Dow/Gold ratio averaged around 2x (and briefly hit 1x) and the normalized P/E on the S&P 500 hovered around 8x. The more deflationary (and gold standard era) lows of 1921and1942 saw only slightly higher multiples of 2-3x Dow/Gold and 8-9x normalized P/Es. Using similar multiples would value the Dow today at roughly 4,000 and the S&P at 500. These are extreme numbers and do not represent the most likely scenario, however they do provided a solid historical reference point as an anchor for just how cheap markets can get.
The Middle Path
With the tug of war between inflationary policies and deflationary structural forces, a combination of nominal and real price declines seems plausible. Gold doubling in price once more to $3,200 and the Dow or S&P falling by approximately 30% to say 9,000 on the Dow or 950 on the S&P at some point over the next several years would leave the market at a very healthy level of 2.8x. Even modestly growing earnings over this period would show the market to be cheap on a P/E basis as well. From these levels, the value restoration project would now be close to completion and future returns to investors in the stock market would be promising.
As always, the key for investors will be how well you manage getting from here to there. In an environment where holding either U.S. dollar cash or a broad market portfolio may be detrimental to real wealth preservation, more active asset allocation is required. Portfolio managers who have a broad toolbox of assets to choose from, nimbleness and flexibility, and a eye on the denominators that show us real value, will be in an enviable position to capitalize on the next great bull market in stocks.