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Today's WrapUp by Chris Puplava 05.12.2006  Mon   Tue   Wed   Thu   Fri   Archive

ARE THE DOW JONES AND GOLD APPROACHING PREVIOUS RECORDS?
Dose of Dollar/Inflation Reality Needed!

I am concerned with the lack of reality in the financial markets, the economy, and the country as a whole. It seems most stories on CNBC are spun with a positive light, and that reports from the White House on the economy are always “growth.” Both the financial media and government seem to want to paint a rosy picture for everyone and I think we need a dose of reality. No one seems to be listening or paying attention to what Texas Congressman Ron Paul says, “What the Price of Gold is Telling Us.”

I haven’t read anything by anyone with more of a clear understanding of the present economic situation of this country than this article by Congressman Ron Paul. I highly recommend everyone to read his “Texas Straight Talk” articles. Congressman Paul explains the present situation in plain English for anyone to understand. Below are some of his valuable points:

The point is that most who buy gold do so to protect against a depreciating currency rather than as an investment in the classical sense. Americans understand this less than citizens of other countries; some nations have suffered from severe monetary inflation that literally led to the destruction of their national currency. Though our inflation-- i.e. the depreciation of the U.S. dollar-- has been insidious, average Americans are unaware of how this occurs. For instance, few Americans know nor seem concerned that the 1913 pre-Federal Reserve dollar is now worth only four cents (See chart below). Officially, our central bankers and our politicians express no fear that the course on which we are set is fraught with great danger to our economy and our political system. The belief that money created out of thin air can work economic miracles, if only properly “managed,” is pervasive in D.C.

Figure 1.

Source: http://Sharelynx.com

The higher the price for gold, the greater the concern for the dollar. Instead of dwelling on the dollar price of gold, we should be talking about the depreciation of the dollar. In 1934 a dollar was worth 1/20^th of an ounce of gold; $20 bought an ounce of gold. Today a dollar is worth 1/600^th of an ounce of gold, meaning it takes $600 to buy one ounce of gold. (Note: RELATE THIS TO HOW MUCH MORE MONEY IT TAKES TO BUY A HOUSE. Instead of thinking that your house is making you rich as its price soars, think of it as your dollar falling off a cliff and losing its purchasing power).

A soaring gold price is a vote of “no confidence” in the central bank and the dollar.  This certainly was the case in 1979 and 1980. Today, gold prices reflect a growing restlessness with the increasing money supply, our budgetary and trade deficits, our unfunded liabilities, and the inability of Congress and the administration to reign in runaway spending.

As you watch CNBC or other financial media, you’ll notice a great deal of hype about the fact that the Dow Jones Industrial Average (DJIA) is once again approaching the all-time high it hit in 2000. You also might witness the coverage about gold as a “mania market” as it approaches its all-time high reached in 1979. However, neither of these analyses of the current situation takes into account the destruction of the dollar’s worth due to inflation.

The DJIA peaked at 11,722.98 in January 2000. As of 05/11/06, the price of the DJIA was 11,500.73 and the inflation adjusted price (CPI adjusted) for what this value would be in 2000 is 9,779.88. That is 16.5% below the 2000 peak and yet the financial media is ready to declare victory?

Now let’s take a look at where we are with gold and its previous historic high. The high reached in gold was $850 an ounce seen in January 1980. Adjusted for inflation, that would correspond to $2088.90 for an ounce of gold today!

Gold in 1980	In 2006 Dollars
$850.00	$2088.90

Let’s look at it from a reverse perspective. The recent (05/11/06) price of gold is $715.10 an ounce, which would correspond to $290.98 an ounce in 1980 adjusted dollars, nearly 66% below its previous peak.

Gold on 05/11/06	In 1980 Dollars
$715.10	$290.98

My question to the financial media is this: how can you call the current action in gold a mania when it is selling for a 66% discount to its 1980 peak and be elated about the current price of the DJIA when it is still 16.5% below its 2000 high?

The graphical representation of the effect of inflation on gold is shown below in charts provided by Sharefin from http://Sharelynx.com.

Figure 2.

Figure 3.

Source: http://Sharelynx.com.

As I mentioned above, the 1980 $850 an ounce price of gold in unadjusted terms (non-CPI-adjusted) would be worth $2,088.90 an ounce in 2006 dollars (CPI adjusted). To compare the inflation adjusted versus unadjusted price of gold, I took the average yearly price of gold per ounce in unadjusted terms and corrected it for inflation. I then plotted them together to show the disparity between the two as seen by the chart below.

Figure 4.

The blue line above is the price of gold not corrected for inflation. As can be seen, we are indeed approaching the peak of gold in nominal dollars but, when looking at the inflation adjusted price (red line), we are far from the mania peak seen in 1980.

The point I am trying to make is that it has taken a truckload of money and multi-decade low interest rates to prop up the markets from the previous bear market. Gary Dorsch explains the fuel that was needed to prop up the markets in his 321gold editorial, “Central Bankers’ Worst Nightmare – The Gold and Bond Vigilantes,” in the following:

In the US, the Greenspan Fed inflated the M3 money supply by 72% or a whopping $4.3 trillion over six years to a record $10.27 trillion, and then decided to stop publishing the M3 measure on March 24th, 2006. Greenspan's magic formula for dealing with global crises and restoring the DJIA to record highs was his ability to inflate the US M3 money supply, while keeping the bond market vigilantes under wraps. The Fed had plenty of outside help from Asian central bankers.

This massive amount of money printing sent the dollar index plunging and gold soaring shown by the charts below.

Figure 5. U.S. Dollar Index - Six Year Chart

Source: >http://StockCharts.com

Figure 6. U.S. Dollar Index - 30+ Year Chart

Source: http://Sharelynx.com.

Figure 7.  Gold – Four Year Chart

Source: >http://StockCharts.com

Congressman Ron Paul points out the following inflationary periods of rampant money printing by the Federal Reserve along with commentary from his article, “What the Price of Gold is Telling Us.”

• Since 2001 the dollar has been devalued by 60%.

• In 1934 FDR devalued the dollar by 41%.

• In 1971 Nixon devalued the dollar by 7.9%.

• In 1973 Nixon devalued the dollar by 10%.

These were momentous monetary events, and every knowledgeable person worldwide paid close attention. Major changes were endured in 1979 and 1980 to save the dollar from disintegration. This involved a severe recession, interest rates over 21%, and general price inflation of 15%.

Today we face a 60% devaluation and counting, yet no one seems to care. It’s of greater significance than the three events mentioned above. And yet the one measurement that best reflects the degree of inflation, the Fed and our government deny us. Since March, M3 reporting has been discontinued. For starters, I’d like to see Congress demand that this report be resumed. I fully believe the American people and Congress are entitled to this information. Will we one day complain about false intelligence, as we have with the Iraq war? Will we complain about not having enough information to address monetary policy after it’s too late?

For further reading on the increase in the supply of dollars and the destruction of the dollars purchasing power and its ties to gold, please read the recent FSO editorial by Nick Barisheff.

The Hidden Tax and Wealth Destruction

To fund our numerous social programs, tax cuts (loss of tax revenue) and war with Iraq, the government has two choices. Oddly enough the public as a whole really only seems to care about one of them: taking the people’s money through taxes. The other option is having the Fed print money out of thin air for the government to spend. As most people would be up in arms if the government raised taxes, the government’s path of least resistance, and unknown by most Americans, is for the Fed to print money. This however, is also a tax, albeit a hidden one. The Fed can take your money from you to spend it as they wish through taxes or they can print more dollars and make your money worth less, in a sense an inflation tax that is unseen with no one shouting foul play as their wealth is being destroyed.

The return of the DJIA to its previous highs is misleading as mentioned above due to the decline in the value of the dollar. Gary Dorsch points out in his editorial, “Central Bankers’ Worst Nightmare – The Gold and Bond Vigilantes,” that “while the DJI is celebrating its hard fought recovery to record highs, the DJI has also lost 60% of its value to gold since its peak of 42.5 ounces in 1999. Investors were much better off owning an ounce of gold, than a share of the Dow Jones Industrials over the past six years.” This can be seen below when plotting the DJIA relative to the price of gold.

Figure 8.  DJIA/Gold Ratio – 6 Year Chart

Source: >http://StockCharts.com

Think of this chart like the exchange rate between two currencies. What this chart shows is the DJIA depreciating relative to gold. In 2000, gold was 1/44th a share of the DJIA. Today, gold is now worth 1/16th of a share of the DJIA, meaning it now takes far less gold to buy a share of the DJIA than it did six years ago due to the depreciation of the dollar.

The inflation of the M3 money supply by the Greenspan Fed by 72% over six years has lead to the dollar being devalued by 60% since 2001, and the DJIA losing 60% of its wealth relative to gold since its previous peak!

SO WHAT!

I know those who have seen their homes double in value over the past few years or those who have seen their stocks appreciate since the 2003 market bottom will have a hard time with my argument that their wealth is being destroyed and say that they can’t see/understand how it is happening; basically, that the rampant money printing isn’t hurting them.

As it stands right now I can clearly identify several groups who are feeling the effects of inflation on the loss of the value of the dollar and those who aren’t being hurt necessarily. Let me try to explain the situation with an example. Let’s say you’re 30-40 years old and bought a home for $500,000 in a neighborhood of track homes in 2000 and you see it appreciate to $1,000,000 by 2006, not far from the truth in San Diego! Let’s assume that you get bored living at your end of the cul-de-sac and want to move down the street to the other end of the neighborhood. So, you sell your home for $1,000,000 and buy one down the street for $1,000,000 as that home has also doubled in price. Basically, your appreciation on your home didn’t help you after you sold it to buy another. What happened was that your asset inflated in price along with every other asset.

What happens to those who don’t have assets that inflate? Now let’s use a younger generation. For example, let’s say your child goes to college in 2000 and graduates with a degree in 2006 and enters the workforce. Since they just finished college and are just entering the workforce they are unlikely to have owned a home or condo that inflated in price, or equity in the stock market. They will have seen homes/condos double in price while they are in school and their hopes and dreams of owning a home will now be twice as far from them than when they began school. They didn’t have assets that kept up with inflation and are suffering and the wage for entry-level jobs most certainly didn’t double over the same time frame.

The falling dollar also hurts those who travel abroad. I’ve mentioned the loss of the DJIA in terms of gold, losing 60% of its value since 1999. The dollar index, which measures the dollar's value against a basket of currencies, has also lost its value relative to other currencies as seen by Figure 4 above, where the dollar has depreciated nearly 30% since early 2002. Those who want to travel to Europe or other foreign countries will find that their dollars go for far less than they did just 4 years ago making it more expensive to travel.

In effect, the surge in the supply of dollars by the printing presses of the Fed are inflating asset prices that furthers the gap between the rich and the poor, the haves and have-nots. Those who can’t afford to own a home now will be even more unlikely to own a home in the future. Yes, the housing market got ahead of itself by extremely low interest rates and is beginning to cool, but the Fed is unlikely to let the housing market bubble burst as the extraction from home equity loans is what helped fuel the recent economic expansion. Therefore, the path of least resistance to support the housing market is, you guessed it, inflate the money supply. This in turn will make it even more unlikely for future generations to own a home as prices continue to rise faster than wage gains.

Let’s say you’re rich, own a home, and don’t travel abroad, and are still saying to me, “so what,” as you aren’t feeling the effects of inflation. What happens when the world wakes up to the fact that their dollar reserves are losing their value? What will happen when the world is no longer forced to buy crude oil in US dollars or when the Iranian oil-bourse opens where foreign countries can buy crude in Euros? When foreigners unload their dollar reserves (increasing the supply of the dollar) and use Euros instead of dollars to buy oil, (decreasing demand for dollars) the value of the dollar relative to foreign currencies will fall as it has been since 2002.

As the dollar falls its purchasing power buys less and less of foreign goods. As the dollar’s value falls foreign goods and imports will become more expensive to us, causing a rise in import inflation. Electronics from Japan, consumer goods from China, and cars from foreign auto makers that are made abroad will rise in price.

This will likely happen over a period of time as dollar devaluation makes its way through the world economies and currency markets. This also isn’t a problem if we can produce our goods here at home instead of buying them from foreign countries by exchanging our dollar for their currency. Here’s the dilemma--we have moved from a manufacturing based economy over the decades to a service economy making us vulnerable to import inflation as what we consume comes more and more from overseas.

If you believe my argument that the dollar’s value is falling due to irresponsible printing by the Fed and we will be faced with higher asset prices and import goods in the future, what are you to do? The best answer to protect your wealth is to put it into something with a finite supply that cannot be increased out of thin air by governments, and whose value will increase faster than inflation. The standard investment for protection against inflation has been and will be gold. As shown in Figure 6, the DJIA has lost nearly 60% of its value relative to gold. Gold obviously was the better investment since 2000. Also, housing prices have risen as more dollars are chasing assets sending their prices higher, but gold has risen even faster, up nearly 123% since 2002. For gold to reach its previous peak in 1980 in terms of 2006 dollars (which is $2088.90), it would have to rise by roughly 200% from today’s levels. There is no guarantee that gold will reach those heights, but if the Fed continues to print money (can’t tell anymore with the discontinuation of M3 data), gold will continue to head higher.

Today’s Market

The markets continued their decent downward from yesterday’s fall, the biggest one-day decline since January on data supporting inflation fears that will lead to more interest rate hikes.

Michael Sheldon, chief market strategist at Spencer Clarke LLC, commented on the recent data saying that "The trade report was impressive, but the deficit will probably head higher over the next few months because of the fact that oil prices rose sharply after March. The other implication of the report is that first-quarter GDP is likely to be revised higher, and that had an impact on the bond market, which led to bond yields rising to new cycle highs."

The trade deficit narrowed 5.6% to $62 billion while analysts from MarketWatch had expected the deficit to widen to $66.9 billion. The improvement came from record goods being shipped to Canada and Mexico.

The University of Michigan’s consumer sentiment index plummeted to 79 from 87.4 in April, its lowest level since last October’s 74.2 reading due largely to higher gasoline prices and a softening labor market.

Import/export price data was released today showing that prices of goods imported to the U.S. in April rose 2.1% largely due to an 11.5% rise in petroleum prices.

Treasuries and the dollar responded to the economic data with the benchmark 10-year note yield rising to 5.184% and the dollar index fell slightly, down 0.15%.

The movement downward was broad based today as declining to advancing issues was 3 to1 on both the Nasdaq and the NYSE, with down volume representing 81% of total volume.

In S&P sector breakdown, energy was hit the hardest falling 3.39% followed by materials and industrials, down 2.14% and 1.58% respectively. Defensive sectors fared better today, with the health care and consumer staples sectors down 0.23% and 0.80% respectively.

Chris Puplava

© 2006 Chris Puplava
Puplava Financial Services, Inc.
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