Tuesday, August 30, 2011

Denominators Matter! What the Price of Gold Tells Us About the Value of Other Assets

Value Restoration Project

 excerpts

  • Denominators allow us to assign meaning to price.
  • 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.
  • 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.
  • 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%!
  • The fact that denominators matter does not tell us which ones we should pay attention to and what they are telling us. 
  • 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.
  • This means any additional gains in the market carry heightened risk
  • Current politics suggest that a highly interventionist policy will continue.
  • However, we must also give weight to the possibility of a truly deflationary environment taking hold.
  • With the tug of war between inflationary policies and deflationary structural forces, a combination of nominal and real price declines seems plausible.
 Gold is not in a bubble then.  As shown above, there are three possiblilities: strong inflation, strong deflation, or mild inflation or deflation.  In any case, value won't return to the market until the multiple of gold is much lower than now.  Even at 1800, the multiple to the Dow is between 6 and 7.  At market bottoms, this would have to come down to 2 or 3.  That means either a Dow around 2000-4000, or gold around 10,000.  It seems hard to believe, but that is what history suggests.

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