Thursday, June 19, 2008

Real Versus Nominal Stock Market Returns

Because the price of gold seems to be going through what is known as the summer doldrums, which is basically a period where there is no trend and a time where it can be more difficult to make profitable trades, I have decided to focus this post on another topic for the meantime.

What I will try to illustrate here is the effects of excessive money printing and inflation on real stock market returns over the past 10 years.

The chart below shows the S&P 500 divided by the price of gold:

One wonderful characteristic of gold is that it is able to sniff out the effects of excessive money supply growth. The amounts of money the government is printing is sometimes also known as M3, and M3 is a statistic the US Government fairly recently stopped calculating.

Although we no longer have M3, gold is just as able to detect money supply growth. This is because as the government prints (either physically or digitally) increasing amounts of money, that paper will start chasing only a finite amount of gold, and, thus, gold will rise.

Therefore, the above chart shows what I would say is the real value of the S&P 500 if the effects of money supply growth are stripped away. In other words, the bull market in stocks that began in around 2003 was not real. It was an illusion.

But why was the money supply increased so dramatically over the last couple of years? I think it was a way for the Federal Reserve to try to reinflate the stock market bubble that burst in 2000. Unfortunately, rather than reinflating stock prices, this newly printed money found its way into the housing sector, and began pumping up another bubble. Now that the housing bubble has popped, the money supply is again being increased to reinflate this bubble, but rather than reinflating home prices, it is inflating commodity prices now.

The next chart shows an ETF that follows the S&P divided by the price of crude oil over the last 10 years:

I feel that the above chart is dramatic proof that the S&P has not been rising in value in real terms. In other words, an 8% per year "growth" rate in the S&P 500 over the last several years is useless if everything you need to live on is rising by 25% a year.

Another example is to look at the S&P 500 against the CRB Index. What I like about the CRB index is that it measures a basket of items that an ordinary person would use on a daily basis. Items such as: gasoline, natural gas, corn, wheat, cotton, live cattle (beef), coffee, orange juice, and sugar.

As you can see, the stock market has not been successful at keeping up with the cost of even everyday necessities.

If investing in stock cannot protect against the ravages of inflation and excessive money printing, then what should the ordinary investor do? I think the best answer is to invest in the commodities themselves. In this type of environment, I personally try to invest in tangibles that cannot be created readily (like paper money can). Here are some ideas:

1) Physical gold, silver, platinum, or palladium
2) ETFs that invest in hard commodities:
  • GLD for gold
  • SLV for silver
  • JJC for copper
  • JJN for nickel
  • USO for crude oil
  • UNG for natural gas
  • DBA for agriculture
  • COW for livestock
  • RJA for a mixture of all of the above


thomas said...

Thank you for an excellent article.I am long gold myself.

Gio said...

Great post. I never looked at the market from this perspective. Isn't the price of oil and gold skewed by speculation? I imagine you'd have to do a little more math than just divide $/oil, but I get the point. I think it all can be explained by supply and demand.


Danny Merkel said...


You bring up a good point with the subject of speculation. I agree with you that it can all be explained by supply and demand.

Boone Pickens I think boiled down the cause of oil's increase by saying that we've simply got 85 million barrels per day of supply and 87 million barrels per day of demand.

Also keep in mind that the number of traders speculating that oil will rise is exactly equal to the number that think oil will fall.

Probably the dumbest -and thus the most likely- thing that the US Government can do is suppress the natural forces of the market by capping prices or discouraging investment.

Gio said...

"Also keep in mind that the number of traders speculating that oil will rise is exactly equal to the number that think oil will fall. "

... everyone in Hawaii thinks gas goes to $5. hehe.