Paper Money versus Physical Stuff

Yes, sometimes I do think “Outside the Box” or model price charts, if you will.  Long-term secular trends are my game especially when I’m without my model price charts.

One question that keeps me on the right side of the market is the question “Paper versus Stuff?” What does this mean? I’m asking the question whether paper money is gaining in value or worth versus stuff or physical assets.

Huh?

Yes, a lot of people don’t get this but “Paper” or the money in your pocket does have a market value.  This value is not recorded in any financial newspaper or stock exchange but it’s there.  It’s implied.  See the people all around you, including yourself, are buying and selling products and services on a daily basis.  Tens of trillions of transactions are occurring daily where a sophisticated interplay is occurring between a buyer and a seller.  The seller of stuff is willing to accept “paper” for a product or service.  The buyer is willing to part with “paper” only if they get a product or service of equal value in return.  If value, whether paper currency or product and/or service, is mispriced there are simply no transactions.  In other words the holder of paper is willing to save their money until something of value comes along for a transaction to occur.  Likewise if a seller of a product or service doesn’t get equal value in terms of “paper” money the seller is happy not to transact.  The interplay between these two parties, the back and forth, is called price discovery.  Price Discovery or market forces are one of the great and important forces of the market-based economy and the real defeater of communism in my opinion.

When you know what you are looking for you can gauge the value of paper money quite easily.  The most simplistic way is the price of gold bullion.  Gold is the ultimate in “stuff” or physical property.  If the price of gold increases relative to the currency you are transacting or doing business, the price of paper currency or the $20 in your pocket is coming down.  Conversely if the price of gold is falling the $20 in your pocket is increasing in value.  Yes, a time lag may occur before the economic actors take the market signals into account but rest assure the value of your “paper” is fluctuating.

To me this is rather simplistic stuff and quite frankly should be well known especially by market participants in the market place.  Where I hope to separate myself from the crowd is how I view “paper versus stuff” relative to the equity markets.  I like to watch what an ounce of gold buys in terms of the Dow Jones Industrial Average (DJIA).  I have charted this ratio on my Bloomberg screen and have reproduced this chart for you to see.

Ratio of Dow Jones Industrial Average (DJIA) versus an Ounce of Gold

Ratio of Dow Jones Industrial Average (DJIA) versus an Ounce of Gold

As I have said I do like secular or long-term trends and charts.  This chart spans some 20 years.  Back in 1993, one unit of gold could purchase 10 units of the DJIA.  Starting in 1995, the “Dow” unit value relative to the price of an ounce of gold started to skyrocket climbing up to 40 Dow units for every ounce of gold.  In other words, equity values relative to the price of gold in US dollars massively outperformed in terms of rates of return.

From 1999 to mid-2001, as I highlight on the chart above, the unit value of the “Dow” struggled around 40 units for every ounce of gold – forming a multi-year top in the process.

From the years of mid-2001 to mid 2011 saw a collapse in terms of what an ounce of gold in US dollars buys of the DJIA index.  A low was reached on August 31, 2011 where an ounce of gold only purchased 6.36 units of the “Dow”.  As one reflects on this ten year period physical stuff in general (housing, gold bullion, and commodities) lead the way in terms of rates of return instead of paper or currency in each national currency of choice.  (Physical “Stuff” had its own super cycle with notable bull markets and collapses in its own nominal dollars, Yen, Euros, etc.)  Financial assets and equities in particular offered little returns and probably substantial negative returns to the average investor over this period of time.

(As an aside, the “Dow” and an ounce of gold in US dollars had a ratio of 1 to 1 back in 1980.  Even though the ratio from the above chart fell from 40 units of the “Dow” to 1 ounce of gold to 6.36 units to 1, I did have the worry of a 1 to 1 ratio if the financial policies of the US administration (both fiscally and monetarily) continue down the wrong path as the Carter administration did in the late 1970’s.)

The Plunging of Gold on April 15, 2013

In my theoretical battle between “Paper Currency” and “Physical Assets”, paper money has had a series uptick in the last few days.  In other words currency is gaining in value versus stuff.  This is a big change in the last 10 years.  Paper money is the foundation of the modern financial economy and when the foundation is solid and gaining in value this helps equity valuations as a whole.  Equity valuation cannot increase substantially without a good foundation with which to build upon.

So looking again at my chart above, you will notice on the same day gold is plunging in a 7-sigma price move (that’s big by the way, Thanks ZeroHedge), the “Dow” had a breakout relative to gold since the financial crises of 2008.  This is very positive for US equities and for me at least substantially eliminates the worry of a possible 1 to 1 ratio of the “Dow” versus an ounce of gold sometime in the near future and maybe my lifetime!

Secular Long-Term Bull Market in the US is Coming into Focus

You will also notice on the chart above that I have included the years 1993 and 1994.  In these years, as you can see, this ratio solidly crawled along 10 “Dow” units for every 1 ounce of gold.  This is a good foundation for market participants to establish a base value for paper money in daily transactions and from which to build valuation in the equity markets per se.

Let me complete the picture for you by bringing in our model price work.  I have been blogging in my monthly strategy pieces (here) the S&P 500 is currently trading at EBV+3, where the index is today.  We’re on the cusp of a positive transit of EBV+3 in the S&P 500 certainly sometime in the near future.  As I have written the last positive transit of EBV+3 on the S&P 500 occurred in mid 1992 signaling the start of a bull market in equities that lasted some 8 years beyond this positive transit.  This positive transit in 1992 and the subsequent bull market could not have occurred without paper money not only maintaining value but also gaining value relative to physical assets or stuff. These events are eerily similar, aren’t they?

Conclusion

April 15, 2013 was an important day for US equity investors in my mind.  Gold bullion prices collapsed and even though the market in terms of the S&P 500 Index was down over 2%, a strong secular trend – one of my favorites (“Dow” units to an ounce of gold) – broke out to new highs placing this ratio the highest since the financial crises of 2008.  Over the last 5 years the US has been healing from the largest financial crisis since the Great Depression with policy actions, both fiscal and monetary, taking place with close scrutiny and criticism.  Market prices don’t lie, over the long run, and in my opinion “the market” likes what is going on, policy wise.

With the gold price, especially in US dollar terms, falling this is telling me the fever of the financial crisis has broken and the pieces of the puzzle are falling into place not only for a bull market in paper currency, more specifically the US dollar but also a bull market in US assets i.e. US equities.

P.S. You don’t have to look at the above chart very often – I look every 6 months or so – but investors should keep this in their back pocket to ensure they are on the right side of any market you are invested in.  I know I do.

modelprice

One response to “Paper Money versus Physical Stuff

  1. John bowman January 5, 2016 at 2:58 am

    Nice to finally see and hear intelligents. Much appreciated all the best stay well. John B.

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