Increasing Value of Dollars Offsets Stock Declines

Many people, including myself, have been suffering from declining stock values. Those of us who track our account values may forget that the value of the dollar has increased, and to a surprising degree given the Fed's weak dollar policy. At this point in time, people who have a diversified portfolio that includes a dollop of cash should take heart from the fact that their dollars have increased in value and that this implicit increase, which does not appear on your statement, offsets the declining stock market. This increase in value may offer an additional reason to consider investing the cash in stocks and commodities over the coming year.

Since the summer, the dollar has increased against the Euro by more than 20%, and against the Australian dollar by about one third. Thus, if you are holding a portfolio that includes 1/2 stocks and 1/2 short term money market or treasuries, your decline is not nearly so bad as it seems.

The Dow topped at about $14,164 in October 2007 and is currently at 8,308, a decline of 41%. If you were holding 1/2 short term treasuries and 1/2 stocks, your portfolio has declined by a little less than half that adjusting for interest on your bonds. For instance, if you had $250 in stock and $250 in cash, your portfolio looks like it declined by 41% x 250 - 3% (interest on bonds) x 250 = $95 / $500 = 19%.

But in that calculation you're excluding the gains in the dollar, which are not reflected in your financial statement. The dollar gained about 20% against the Euro, so you've gained 20% x $250 = $50. Subtracting the $50 implicit gain in the dollar from the $95 paper loss gives you a loss of $45. So if you were diversified in cash you suffered a loss of $45 / $500 = 9% net of the dollar gain.

Although a 9% loss is unpleasant for all of us, it is hardly earth shattering to anyone who's been around the stock market via a 401k, mutual fund or brokerage account for the past ten years.

Thus, there is no need to panic. Rather, John H. Cochrane, a professor at the University of Chicago, gives some fascinating advice in today's Wall Street Journal. Cochrane, like Warren Buffett, argues that smart investors should be buying now. Cochrane suggests that the ratio of dividends to price or dividend yield indicates that current valuations are mediocre and that in light of recent history, this may be a buying opportunity, although not an excellent one. Whether to buy depends on your personal circumstances, cash flow, risk preference, time of life and the like. Cochrane argues that when the dividend yield is high and reaches six or seven percent, the market is low and stock prices historically have increased during the ensuing seven years, but when the yield is low and falls to below 2% as it did around 2000 the market is high and stock prices have declined during the ensuing seven years. Currently, yields are middling.

However, Cochrane's analysis does not contemplate money supply policy, which influences both the dividend/price ratio and stock prices. When the Fed is increasing the money supply, as it has, then yields are going to be relatively low and stock prices are going to increase over the ensuing period. The Fed has pumped money into the system repeatedly during the past 35 years, so Cochrane's chart shows a secularly declining dividend/price ratio since 1950. Moreover, the chart suggests that average returns since 1971 have been greater than average returns between 1945 and 1971. The lowest returns occurred around 1967, several years prior to President Richard M. Nixon's removal of the international gold standard. The highest returns occurred around 1946, not long after World War II and around 1982, upon the advent of President Ronald Reagan's "supply side" economics. Increasing money supply may be the causal variable that both reduces dividend yield and increases future stock returns.

Thus, the cyclical ups and downs need to be interpreted in light of the long term trend. What are the political ramifications of the stock market's depending on perpetual injections of money and what are the policy implications?

In order to reach 1981 levels, a huge amount of liquidity will need to be injected into the system. But there is already much waste in the economy in terms of bad real estate investments, unworthy purchases on credit and the like. To compensate for these the Fed will need to give the economy much testosterone. This would cause the dividend/price curve to continue to decline. However, there is the risk of intensifying the above-average inflation rates that have characterized the recent past. If Americans are willing to live with a declining stock market, then perhaps the Fed will restrain inflation and stop the dividend/price trend from following its 63 year long downward pattern. If the main point of American society is to increase the stock market, then more injections will be needed, and increasing welfare transfers from cash earners to stock holders will ensue, likely intensifying the already massive inefficiencies in the American economy.

Which will it be? Paper wealth? Or real wealth? Further monetary expansion? Or deflation and permitting the termination of badly managed firms?