The confusion with the absolute versus the relative is a common mistake in investing. An 8 percent annual rate of return means your investment is worth 8 percent more at the end of the year in absolute terms than at the beginning. But this does not necessarily mean that you can buy 8 percent more goods and services with this absolute value. If prices have changed at all, the increase or decrease in your purchasing power will NOT equal the 8 percent increase in your absolute or nominal wealth.
Relatively low inflation over the last two decades has allowed many investors to focus on absolute measures of value. However, all absolute values must be viewed in the relative sense.
For example, at the same time the Dow was hitting 10,000 again last month, the Nikkei Index, a price-weighted index measuring the Japanese stock exchange, was also crossing 10,000 again from a high of nearly 40,000 in 1990. But both the Dow and the Nikkei are price-weighted indexes that are meaningless in absolute terms.
Without knowing the relative value of their underlying currencies, interest rates, tax rates and other economic conditions, price-weighted indexes such as the Dow Jones Index are absolutely meaningless measures of value.
Therefore, when the Dow Jones Index passed 10,000 again last month, I found it difficult to be as sanguine as many of those CNBC commentators. From my perspective, the increase in the Dow is nothing other than a diminishing-dollar rally. In other words, this was a stock market rally that was not driven by growth and profits but a relief rally driven primarily by the falling dollar.
Consider that the dollar lost nearly 25 percent of its value against most other currencies during the Dow’s climb back to 10,000. So, what did we really gain by Dow once again reaching 10,000?
To stress this point further, consider two different Dow absolute-value
First, consider the “dreadful” scenario, where the Dow is back at 6,600. But also consider a few more factors: Gas is $1.60 per gallon, mortgage rates are 6 percent, the unemployment rate is 8 percent, inflation is non-existent and the new president is considering lowering taxes to stimulate growth.
Now, consider the second “drastically improved” scenario where the Dow is back above 13,000. But also consider these relative measures for comparison: Gas is $4.50 per gallon, mortgage rates are 12 percent, one euro has the same purchasing power as two dollars, gold costs $1,500 an ounce, the unemployment rate is stuck above 10 percent, inflation is rampant, and your taxes are 30 percent higher than just one year ago.
These are not extreme scenarios. In fact, the first scenario reminds me of the good old days of March 2009, when the Dow Index was sitting at 6,600.
And the second scenario is growing more likely with each daily crank of Bernanke’s printing press. Inflation could be right around the corner, unemployment is inching up closer to 10 percent each week, the state and federal governments may require higher taxes to pay for their growing debt burdens and pension obligations, and the dollar is cracking against most all currencies.
Given the two scenarios, I think I would prefer the Dow Index to be back 6,600. In fact, I would argue that if you are considering retirement, your investment dollars would stretch a lot further under the first scenario than the second – even if the Dow Index and your portfolio is half of its absolute value.
So, what does this mean for investors today? As I mentioned in my April column in The Lane Report, investors should not only focus on the absolute value of their portfolios but also understand certain “market risks,” such as dollar devaluation and hyperinflation.
While hyperinflation may help the U.S. government pay its debt to the Chinese (and others) with rubber nickels, it is the worst thing that can happen to dollar-denominated-asset holders. There are many hedging techniques, such as shorting U.S. Treasury bonds and buying foreign currencies, that can help hedge your portfolio if hyperinflation does occur.
An investor with their home in the United States, a job that pays them in dollars, and most of their other assets in the U.S. stocks and bonds, has extreme dollar-related risks. If you are that investor, you should be more concerned with the relative value of the dollar than the absolute value of the Dow.