Trade and business are collapsing. Unemployment is soaring. The boom is busting worldwide on a very large scale. This is evident now.
In January of 2008, stock markets around the world began to recognize and forecast future economic decline by falling in price significantly. The U.S. stock market at that point declined 20 percent to its 2006 level, and the Shanghai Composite was down 20 percent.
By May Shanghai was down 50 percent. It is now down by 67 percent. U.S. stocks are now down about 50 percent, as the recession has worsened.
Recession and its anticipation forces the values of assets to go down, as values are determined by the cash flow returns that they bring. If those returns of cash to the buyer are meager or long-delayed, their value is less. An asset value is the present value of those future cash flows (or returns).
Stock prices reflect underlying values, sometimes slowly as information is found out about the future cash flows. Prices have already fallen drastically. They can fall a great deal more because values already have moved even further down and because values can move further down in the future. Bear markets are instances when values are declining, causing prices also to fall.
In this situation (of a stock bear market), cash is king. Cash will be able to buy those stock assets at much-reduced prices and values. In a situation where the market prices are slow to reflect the value declines, it is prudent to wait until the decline is over. Speculators who bet on stock price declines (short sellers) do even better, while incurring the risk of price rises.
We are seeing the process of debt deflation and depression working out. Companies that have large debts go down faster and into bankruptcy when their cash flows cannot service the debts. Enterprises subject to large drops in demand come under pressure. The deflation and depression can intensify even more and go on for some years, because of the large excesses produced by the prior monetary growth rates around the world. They produced large debt buildups, mispricing of assets, and mal-investment. Government actions to halt the recession can also prolong it.
The government attempts to halt the recession process by spending more money. It gets it by printing it. That dilutes the value of the cash we are holding while waiting for the lower prices of the stocks.
We know already that this has happened in America. This can be seen in this chart. Do you see that vertical rise in M1 (a money supply measure) to the right? That is the inflation being done by the Fed. See also the monetary base that is under the Fed’s more direct control.
That vertical rise from 900 to 1800 is unprecedented in any American history ever! It implies a halving of the worth of the dollar, except that instead the dollar has gone up! That is because the money has not yet fully gone to work or been put to work in the depressionary economy. Some of it is just sitting there. Some of it has gone to foreign banks. Some of it has been loaned to corporations as commercial paper.
The dilemma for investing in stocks is that cash is king for buying stocks as they go lower. But at the same time, the Fed is making cash worth less and less. Eventually that money will be put to work, and the cash will decline in value because of inflation: Stocks will start to rise in price and so will goods and gold. Gold is already rising. As with its bailouts and deficit spending, the government’s money creation complicates investing.
Few of us know when the money inflation already done by the Fed since last September will work its way into prices and by how much. Furthermore, it is possible that the Fed will take back some of that base money at some point. But usually it does that too slowly. The odds favor a rise in inflation at some juncture, and the dollar will rapidly sink and gold rise.
The amount of the monetary growth since September is huge. It may go higher yet.
Among other things, gold is a proxy for goods in general. But its price does not move smoothly with the prices of goods. It often lags behind for years, and then rises steeply. It falls steeply at times. It seems to be above its usual relation with goods prices at present. Its parity is probably around $600, but the price is $885. It has risen sharply. That is because of the Fed’s inflation in the base and anticipations. Gold is anticipating an inflation in goods prices to come. It also anticipated it by 2008 in March when it hit $1,000.
As matters get worse for stocks, the government is inclined to inflate even more, and that supports the gold price. It is no accident that gold rose sharply last week. The Secretary of the Treasury said: "We’re at the beginning of this process of repairing the system, not close to the end of that process, and it is going to require much more substantial action on a very dramatic scale." Gold has risen since Obama’s election. In addition, the British economy has very serious problems that threaten the pound.
Gold is not entirely a one-way street. Gold is subject to the declines in prices that occur because of the depression. Like stocks, it too is subject to conflicting forces: the depression on the one hand, and the Fed’s inflation on the other. At this time, the Fed’s huge inflation is winning out, and the depression is also causing a flight to gold for safety. The declines in goods prices are less important. The gold market is telling us that these prices will rise and/or that safety of wealth is in growing demand.
The prices of copper, nickel, oil, and other commodities will look relatively attractive if gold goes too high. Then, either they will be bid up in price (as inflation occurs), or else gold will stabilize as the depression holds down the prices of these commodities and other assets. My guess is that any government or money-stimulated recovery is likely to be weak and unstable. Higher prices will not be well-supported, but a weak recovery will induce even more government inflation and this will push gold up.
If the economic collapse gets so bad that the government inflates the living daylights out of everything and tries to save all the things going bankrupt, then gold will go very high and the dollar will fall drastically. That is a definite danger, given statements like Geithner’s and given the Fed’s past proclivity under Bernanke.
The best thing that can happen for the dollar, the economy, and stocks is that the government and Fed do as little as possible, drag their heels, and do not keep introducing trillion-dollar programs and so on. But if they start talking about more and more of these, the dollar may tank. Obama has already talked about more and more trillion dollar deficits! This is the clear and present danger to the dollar, the economy, and stocks. It is the support for gold.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.