Free Markets?

¹²Free Markets?

By Howard S. Katz | 17 March 2010

A reader named Mac at asks the following question:

"…in regards to stocks and the broader commodities— if we see a pullback/crash in these asset classes, my thinking is that capital will shift back into the US dollar, at least in the short term…. I am of the view that it is still possible for gold to take a short-term hit in the event of a global market sell off…. I am wondering if a panic in global markets will take the form of 'sell first, ask questions' later, where even holders of assets like GLD might start unloading en masse while running to US Treasuries."

As a theoretical matter, it is important to keep in mind that it is highly unnatural for a stock market to continually go up. In a free market, wealth initially is created by the great producers. Then it passes through to the general public. The stock market is a capital market and, as such, is in competition with all other capital markets. For example for most of the 19th century, safe (what we today call AAA) bonds yielded 5%, and stocks yielded 8%.

The extra 3% was what the market felt was a fair return for the extra risk on stocks. This means that the P:E ratio on stocks was always close to 12:1. And since earnings remained constant, stock prices could not climb. (Different companies on the stock market are always in competition with each other. If Ford makes more money, GM probably makes less. For NYNH&H to make more money, other railroads had to make less.)

Charles Dow invented the Dow Jones Industrials in 1896. But he had constructed a rail average as early as 1885. This rail average remained flat from 1885 to 1896. And his Dow Jones Industrials, despite a few ups and downs, did not change much from 1896 to 1932. In short, for the 47 years in which the U.S. economy was a free market (and for which we have real contemporary stock prices) these prices did not go up.

This validated the prediction made by the free market economists of the 19th century that under a free market (including a gold standard) wealth flows through to the average person and does not remain concentrated in a few hands. But of course you know what happened next. The U.S. stock market rose by a factor of 341 times between 1932 and 2007. Over the middle of the 20th century, the real wages of the average working man slowed their gains. Once the last tie to gold was cut in 1971, real wages went into the worst decline in American history, and that is the condition which obtains today.

That is, it was the revolution instituted by the New Deal to rob from the average working man and give this wealth to the rich people who trade in the stock market. This is, of course, the exact opposite of what you have been taught, and the reason is that your education has been a pack of lies. Whenever there has been a redistribution of the wealth, in any society, at any time in history it has robbed from the poor and given to the rich. (Under the New Deal, the graduated income tax was used to hide this fact, but the wealth transferred via taxes could not approach the wealth transferred in the opposite direction via monetary policy.)

Therefore, the U.S. (and all other) stock market(s) are wildly over priced. [[But NOT if we adjust for inflation, of which there was scarcely any over the long run of the 19th century to the 1920s— cyclical inflations were matched by cyclical deflations, until we decided that deflations— such as that of 1929—33 were too painful to bear.: normxxx]] If the DJI were to drop to 41 (its 1885-1932 'true/real' value) or 697 (its 1885-1932 value in inflated/nominal terms), it would be a long overdue correction which would restore the country to economic health. Note the stock bear market of Oct. 2007 to March 2009. It was caused by the Fed tightening of 2004-06. The price structure of the markets is so distorted that even a return to semi-normal interest rates caused a 50% bear market in stocks.

What the (U.S. and world) power structure is desperately trying to do is to keep pumping up the markets to prevent such a return to health. [[But they are not just being perverse; the cost of such a return— while perhaps salutory in the long run— would be just too much for any democracy and even most modern non-democracies to bear.: normxxx]] However, this gets harder and harder, and we must continually be on the alert for a major stock market decline. This is not imminent and will not occur until Bernanke tightens, but when that happens, it will be beautiful to behold.

Note that gold stocks are affected both by the price of gold and by the price of stocks. They sort of follow a middle-of-the-road path between gold and stocks. So if (when) the U.S stock market tanks, one should switch one's precious metals portfolio away from gold stocks and into gold or silver bullion.

We will not see another replay of late 2008 where everything went down. That was a very unusual event where the New York Times hit the panic button, scared the blazes out of the entire country and almost caused their own bankruptcy. Their fight with the Boston Globe unions was one for the history books and violated all of the left-wing labor relations principles that they have been preaching to the country for much of the past century.

[ Normxxx Here:  Well, yes; we saw a genuine 'panic' in October, 2008 (with a somewhat more subdued retest in March of 2009). But these were quite common all during the 19th century and was one of the reasons for the establishment of the Federal Reserve: "to smooth things out". But in the end, the function of all CBs is to preserve the (big) banks and thereby the accumulated wealth of the rich— at the expense of everyone else. This has most recently been blatently demonstrated by Paulson, BB, and Geithner. It was a major reason that the American populace rose up and 'killed' both the First and Second Bank of the United States!)  ]

For the most part, gold (and other commodities) can ignore a rise in interest rates for a much longer time than stocks. For example, the Fed tightened in 1973. Over the next two years, the stock market fell almost in half, and the price of gold went from about $65/oz. to almost $200. The Fed next tightened in 1978. From '78 to '82, the stock market went sideways, and from '78 to early '80 the price of gold went from $350/oz. to over $800.

A stock market decline will have to be preceded by a Fed tightening, and this tightening will almost certainly be triggered by an outbreak of rising prices (itself caused by the commodity pendulum). When the Fed does tighten, the best strategy will be to be in gold because the lag between the Fed tightening and stocks declining is much shorter than the lag between the Fed tightening and gold declining.

You should be in gold, but watching stocks out of the corner of your eye because stock bear markets are easy to predict. They start off slow and build momentum. After a certain point, all signals are lower, and you can safely go short (especially if the play looks to last until October as many stock bear markets end with an October crash).

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Normxxx    
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