forefathers’ expectations. Equities do well when economies do
better than expected, and that has been broadly the case for 200
years. Unquestionably, it’s very unlikely we have yet to reach our
economic peak. However, it’s very possible that the future will
be worse than the market’s current expectations, and there’s no
reason why that relative underperformance shouldn’t persist
for the next 200 years. Were that the case, it’s also not difficult
to imagine an average zero inflation (which actually existed for
over 90 percent of the known history of money). In that event,
a real return of no more than 3 percent on both Treasuries and
equities is wholly plausible.
It’s amazing that while the great majority of market commentators appear stuck in recent history, the collective wisdom
of the market has quickly factored in a future unlike any past
we have experienced. Individual investors may panic, but, like
a gigantic ant colony operating as if it had a collective brain, the
legions of buyers and sellers together form a new balance of
possible future worlds that can be traced to every new emerging
fact. It’s futile to ask if the market is right or wrong. The market
may weight 75 percent for Event A and 25 percent for Event B,
but the future is either 100 percent for Event A or 100 percent
for Event B. Until the future is known, a new data point can well
swing the market to 75 percent for Event B.
So it’s important to abandon such phrases as “The market is
in a funk,” and “Bulls have gone into hiding.” Not only do they
misrepresent the workings of the market by analogizing it to
a handful of overemotional investors, but they prevent small
investors from listening to what the market is telling us. By
increasing the cost of risk, the market is elevating the value
of cash. During the worst of the Great Depression, cash had a
12 percent real return—a mouth-watering investment by any
standard. This return was achieved by falling prices. Though
it’s of little consolation to the poor unemployed, those investors who kept at least 50 percent of their portfolio fully liquid
may have wondered if the crash was such a bad thing for their
personal fortunes after all.
linking Equity Prices to Future Consumer Prices
A stock market that drags price/earnings ratios to historic lows
is obviously factoring in falling profits. In the 1970s, this was
because of the rising price of oil. When, late last year, oil experienced even sharper declines than equities, there could be only
one assumed source of falling profits: falling prices. It’s therefore a relatively safe bet that one of two events will play out in
the next few years. Either a flood of newly printed money will
maintain our old course of price inflation and also revive the
stock market, or (despite some reversals) any new money will
continue to be hoarded in a swelling cash-and-Treasury bubble
while the price of everything we consume drops.
take a little heart in these troubled times. The value of their
equity investments have indeed fallen, but either those investments will recover or the costs of the goods they would buy
with the proceeds of those investments will be less. Of course,
if our investment portfolio is down 50 percent since mid-2007,
it would be optimistic to imagine that prices will fall (relative to
prior inflationary expectations) by 50 percent. But if we were
50 percent in equities and 50 percent in cash, it’s not unrealistic to imagine a 25 percent drop in future expected prices paid.
This might be achieved simply through future inflation averaging 1 percent a year instead of 3 percent a year.
We don’t have to be even that imaginative. The disappearance earlier this year of a significant spread between regular
Treasuries and Treasury inflation-protected securities (TIPS)
indicated the market’s consensus that there would be a near-ze-ro inflation rate for the next 10 to 20 years. Even if we view the
TIPS market as too specialized (i.e., small in the context of vast,
freely traded global markets) and the province of investors who
focus mainly on inflation, there are some more obvious measures of future purchasing power. My own preferred approach
is to review the value of investments in a basket of currencies.
Exchange rates are notoriously volatile, but, given the vast
volume of round-the-clock trading, they offer a unique perspective on equity-price movements. After all, if we invest in
multinationals, let alone foreign markets, then their market
valuations are strongly linked to exchange rates. More important, a basket of currencies should indicate future purchasing
power (as judged by the market) in a global economy of goods
and—increasingly—services. If a stronger dollar accompanies a
falling equity market because of fund repatriation, then we can
expect that a weaker dollar (as the result of a massive stimulus
package) will revive equity prices as U.S. companies borrow
more, sell more abroad and earn foreign currency. While the
market’s view of the future seems typically short-term, if currencies offer us an insight into purchasing power, extrapolation
to the long term should strengthen our conclusion.
The trouble with choosing currency baskets is the relevance
of their weightings. The most common way to value the dollar
is by using trade-weighted foreign currencies. There are two
shortcomings with this approach. The first is that volume of
trade with the United States is not a measure of a currency’s
importance, particularly in global purchasing power. Secondly,
a number of currencies, notably the Chinese yuan, are routinely “managed” by their central banks to maintain a certain
relationship to the U.S. dollar. Such management weakens the
market message of the exchange rate.
I personally choose a very simple basket—one-third U.S.
dollar, one-third euro and one-third British pound. With the
exception of the Japanese yen, these are the most freely traded currencies and are in sync with the world’s largest freely
