In an environment of ultra expansionary monetary policies, asset classes might trend higher in nominal terms and trend lower in real terms. I had discussed the quantum of new money creation in my earlier article on justifying the price of gold from a money creation perspective. In this article, I will use the same honest currency to discuss the silent crash of equity markets.
The word crash might be an understatement here, as the equity markets in the United States have slumped by 80% since the year 2000 in gold terms. Many investors will argue that in the period 1980-2000, equity markets trended higher in gold terms. The objective of this article is not to prove that gold is a superior investment and equities are an inferior investment. I just want to stress on the fact that all asset classes might underperform compared to hard assets (honest currencies) in a prolonged environment of expansionary monetary policies.
In the current scenario, interest rates are expected to remain at near-zero levels until mid-2015, budget deficits in the United States is expected to remain above USD1 trillion on an annual basis and the Euro zone crisis promises to be a prolonged one. All these factors combined ensure that governments will continue to print money and the Dow might continue to trend down in gold terms for another decade (if not more).
The chart below gives the Dow-Gold ratio from January 2000 to September 2012.
In January 2000, investors needed nearly 39 ounces of gold to buy one unit of the Dow Jones Index (DIA). Currently, investors just need 7.6 ounces of gold to buy one unit of the Dow Jones Index. This is what I call the silent crash in equity markets. In gold terms, the Dow Jones Index is already down by 80% in the last ten years. During this period, the government debt in the United States has nearly tripled and the total credit market debt outstanding has more than doubled. With debt being money in the current financial system, the enormous money creation has supported the equity index at higher levels. However, in terms of an honest currency, the index has slumped.
The discussion so far was just the story of the past. The key question before investors is - Will the Dow-Gold ratio continue to trend lower and ultimately reach 1?
I am of the opinion that the Dow-Gold ratio will trend lower over the next decade and there is a high probability of the ratio reaching 1. Again, there are two possible outcomes. First, the Dow Jones crashes and the Dow-Gold ratio reaches one and second, gold surges leading to the ratio touching one. I believe that gold will go ballistic at one point of time resulting in the ratio touching one.
Creating and maintaining asset market inflation is one of the primary objectives of central bankers, and I had discussed the reasons for the same in one of my earlier articles. In order to create asset market inflation, central bankers will continue to flood the financial system with liquidity. This will be positive for the precious metal in the long-term.
Further, the CBO expects deficits of USD10 trillion over the next ten years for the United States. Funding these deficits would necessitate the creation of more money. At the same time, problems in the Euro zone promise to be prolonged and expansionary monetary policies of the ECB will also lend support to gold.
With a lagging effect, money creation does have an impact on inflation and as inflation surges on the back of higher energy and agricultural commodity prices, gold will also trend higher.
Talking about new money creation, it is extremely important to mention here that governments in the advanced economies have gigantic off-balance sheet liabilities. There is no source of funding these liabilities other than printing money.
The net present value of healthcare spending change (2010-2050) for some of the major advance economies is significant in terms of percentage of GDP.
The net present value of pension spending change (2010-2050) for some major advance economies also deserves a mention and will contribute to pressure on government finances in the long term.
Given these factors, it is next to impossible to visualize a scenario where the current money creation exercise will end. Clearly, the long-term trend for gold is higher and as inflation surges, gold will go ballistic resulting in the Dow-Gold ratio touching one.
Of course, by this conclusion, I am not suggesting that one should invest all their savings in gold. Diversification is of paramount importance in the current financial and economic environment. However, having gold and silver along with industrial commodities is essential for every portfolio.
I would personally consider investing in physical gold. However, the SPDR Gold Shares (GLD) ETF is also a good investment option seeking to replicate the performance, net of expenses, of the price of gold bullion. The Market Vectors Gold Miners ETF (GDX) and the Market Vectors Junior Gold Miners ETF (GDXJ) can be considered for exposure to gold mining companies. I suggest gold mining stocks as they are making healthy profits at operating levels with surging gold prices. Investors might argue that I am suggesting investing in equities after talking about an 80% crash in the Dow Jones index. It is important to diversify and the objective should be to beat inflation with sufficient headroom. I am of the opinion that investing in equities might help investors beat inflation. This is especially true for stocks, which will benefit from booming precious metal or commodity prices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.