IN A WORLD OF FIAT MONEY, EVERYTHING IS RELATIVE
Joseph M. Miller
Introductory Note: The reader will not derive the maximum benefit from this essay without taking the time to read the referenced materials.
In a world of fiat money, it becomes not only important, but vital, to have a solid frame of reference when an investor attempts to allocate his assets among various investments. This point was forcibly brought to my attention when I read a very excellent essay by The Contrary Investor that can be read at:
www.gold-eagle.com/gold_digest_03/ci120203.html
I encourage everyone who has not read this excellent work to do so. It is a well done "Heads-Up" on today's investment climate.
In the essay mentioned above, the author describes to us the unprecedented increase in fiat money worldwide. They go on to ask the question, where has this money gone? They then give us their considered opinion of where the money has gone.
This brings us to the vital question of what can a prudent investor use as a solid frame of reference when making investment decisions? A review of history uncovers one basic recurring theme. That theme is the basic fact that investment sectors, such as the major stock indexes, go from an undervalued condition to an overvalued condition and back again ad infinitum. When we realize that fact, we then need to find a way to determine when stocks are overvalued and undervalued, so we can do what has been the accepted best advice ever given to an investor, buy low and sell high.
One item that seems to fit the requirements for determining long-term valuation is the relationship between the Dow Jones Industrial Average and the price of gold, using the US Dollar price for each in the equation. The chart below shows this relationship from 1916 to 2002. Currently the ratio is in the neighborhood of 24-25, down from a peak near 40.
The chart above gives us a history of the behavior of the index for nearly 100 years, and thus gives us a fairly long history to base conclusions about what it is telling us near the end of 2003. It is very important to keep in mind that we are considering a ratio. As such the ratio at any given moment tells us nothing about the absolute level of the numbers used to determine the ratio at any given point in time.
Keeping the above in mind, what can this simple little chart tell us? First item we see is that it has ranged from a low level of around 1 to 3 up to ever-higher levels in 1929, 1969, and 2002. If one draws a trendline along these tops, it shows these tops line up very well. I believe a great deal of the reason for these ever-higher tops can be attributed to the loss of purchasing power of the United States Dollar over that period of time. Since the Federal Reserve was formed in 1913, the dollar has lost about 95% of its purchasing power. And as we all should already realize, the loss of purchasing power is continuing at an accelerated rate. The following chart shows that fact.
The next item of interest is that from the time an inflection point was reached in 1929 and 1969, about a decade was needed for the index to fall back to the low level of 1 or 2. Is it reasonable to assume history will repeat after the inflection point in 2000? My answer is yes, based on the current evidence available. If yes is the correct answer, and I believe it is, then we can expect this ratio to drop on an irregular basis from now until about 2010, until it again reaches a level of 1 or 2. That means that we can expect the dollar value of the DJIA to drop relative to the dollar value of gold for several more years.
This brings us to a very important point in this essay. What will the absolute level of the DJIA be, and what will the absolute level of gold be in dollars when we reach a level of 1 or 2 for the index? If we assume a deflationary recession/depression to bring us to a low level, then at a 1:1 ratio we might expect a DJIA price of around 2000 and the same price for gold. On the other hand, if we have a severe inflationary or hyper-inflationary recession/depression, we might expect the same 1:1 ratio to show a DJIA of 36,000 with a gold price of $36,000. Quite different scenarios to consider. Of course, an outcome something between these extremes is more reasonable to expect.
You are probably asking what could possibly cause the second scenario. The best way to answer that is to invite your attention to what is said at this address: www.fee.org/vnews.php?nid=5660.
The information there will tell you how such large numbers can be created much better than I can do it in this essay.
That leaves us with the question of how do we allocate our investment funds? Do we leave our money in the stock market? If we do and we have a deflationary future, then the purchasing power of the money we have invested will drop drastically. We find that the same thing happens if we have a hyper-inflationary future, because the large nominal dollar amount of our investment will not buy much because of the lower purchasing power of the dollar. It looks like we are dammed either way if we stay with the stock market. Fortunately, we don't have to stay with the regular stock market. We can transfer some or all of our assets into gold assets, i.e. gold bullion, coins, or mining stocks. In this way we can come out ahead no matter which way the economy goes or where the absolute levels of the DJIA or gold wind up when our ratio reaches its next nadir in this cycle.
The above rests on a belief that the ratio will continue to behave in the future as it has for the period since the early 1900's. No one can assure us that it will. All we can do is make a considered judgement and invest accordingly. In a fiat money environment, where everything is relative, one needs to go back to basics. There is nothing more basic than the value of gold throughout recorded history. I will grant you the value of gold does fluctuate over time, but it does so at a lower rate and with less violent action that any other possible alternative.
ABOUT THE AUTHOR
Joseph M. Miller is a 71-year-old retired investment professional who has been a student of and a participant in the financial markets since the 1950's. He earned a MBA degree from the University of Chicago and is a retired member of one of the large US financial exchanges. He lives in the Great Smoky Mountains and concentrates on handling his personal financial portfolio.
DISCLAIMER
This essay is a personal opinion based on personal reading and observation. It is provided as food for thought and a basis for additional research for anyone reading it. It is not intended as investment advice or a recommendation to buy, sell, or hold any investment vehicle. Each reader must do his/her own due diligence by adding the information from this source to information from other investment sources prior to making investment decisions.
The author may be reached with questions or comments at: jmiller585@mchsi.com
December 8, 2003
Email this Article to a Friend 
Printer Friendly Version
