The Things that Produce Real Wealth vs. Phantom Wealth
Our friend Michael Pollaro, the keeper of long-term data on the true money supply and author at Forbes as well as occasionally a guest author on this site, recently sent us the following chart of a relationship he keeps a close eye on. It depicts the annual change rate in new orders for non-defense capital goods and compares this series to the Wilshire total market index.
Photo via thedailysheeple.com
As you can see, there are slight leads and lags discernible near turning points, but there is no regularity to those that would allow us to make any definitive pronouncements on which trend is likely to lead the other. It is however clear that the two series are often directionally aligned (or to put it more simple: economic expansions and contractions often coincide with rising and falling stock prices).
What is interesting about the current situation is that the stock market is usually supposed to be forward-looking (it isn’t, at least not anymore, but this is still widely assumed – see our previous missive on this topic), but evidently, people are buying fewer of the things that are actually needed for future real wealth generation. Further below you will see that things are a bit more complicated than they look at first glance though – what is at work here is that in some industries, businessmen have just realized that they have malinvested their capital. Anyway, a noticeable gap has opened up between these two series, and it will likely be closed one way or the other. Note by the way the eerie similarity in the recent behavior of new orders and the stock market to what happened near the end of the 1990s stock market mania.
When house prices and stock prices rise and these items are traded back and forth between people at ever higher prices, no new wealth is created (note here that one must differentiate a bit between a general rise in stock prices and moves in individual stocks, which can happen for very good reasons). On the contrary, to the extent that these higher prices prompt misguided investment decisions, they will end up consuming capital and destroying wealth. As a rule, they are merely a symptom of monetary inflation. In fact, the vast bulk of the stock market’s rise over the past century has to be attributed to monetary inflation.
This is also why perma-bulls will be right precisely 66.5% of the time in the modern-day fiat money and credit bubble era, making this on average a safer stance for stock market analysts than espousing bearish views. Sadly, it is occasionally somewhat less safe for their clients. For instance, well-known perma-bull Abby Joseph Cohen, in her role as Goldman Sachs chief equity strategist, published a list of “10 tech stocks you must own” in the summer of 2000. Approximately 18 months later, this basket of stocks was down by 89% – exactly as much as the DJIA during the bear market of the Great Depression. Another notorious perma-bull, Laszlo Birinyi, was not only bullish as always in early 2007, but when asked for his top pick, recommended the stock of sub-prime mortgage lender NovaStar Financial for its high dividend yield. In this case, those who listened to him lost 100% of their investment within a few months if they held on (on the way to zero there were a number of harrowing days, such as a single day loss of 63% on November 15 2007).
One might object that these perma-bulls were and are making their clients a lot of money when the stock market is rising, and this is true. The problem is this: in order to come back from an 89% drawdown, a portfolio must gain almost 900%. In order to come back from a 100% drawdown, one needs a luxury miracle, i.e., nothing short of divine intervention will do. These examples not only illustrate the potential dangers of listening to perma-bullish advisors, they also illustrate a more general problem with the phantom wealth gained due to monetary inflation: it can disappear in a flash when the malinvestment of capital that takes place during a boom driven by monetary expansion is eventually unmasked. Ultimately one must never lose sight of the fact that the prices at which stocks trade exist only in people’s heads. Sudden reassessments of value can and do happen.
A Highly Imbalanced Economy
Our friend BC has inspired us to show the next chart, which compares the growth rate of non-defense capital goods orders to the growth rates of the most recent gross output data of selected industries. Gross output data are only available up to Q1 2015, but it is probably safe to assume that recent trends have persisted. These data series certainly look a bit worrisome in toto.
In order to complete the picture, we show an update of two charts below which we have presenting fairly regularly in the past, as they convey some information about the way in which the economy’s production structure is changing due to monetary inflation (for a quick backgrounder on the capital structure, see: The Production Structure). The first chart depicts the ratio of capital goods to consumer goods production. A rising ratio indicates that more and more resources are drawn toward higher order goods production to the detriment of consumer goods production – a result of the distortion of relative prices wrought by monetary pumping and too low administered interest rates.
As you can see, the economy’s production structure has historically never been more imbalanced than it is today. As we have previously mentioned, the expansion of global trade and the associated increase in the division of labor has probably also contributed a bit to the overarching trend. Nevertheless, it is striking that this ratio once moved in a sideways channel from which it only broke out to the upside after Nixon defaulted on the dollar’s gold convertibility and the era of the pure, unanchored fiat money system began. We don’t believe it is a coincidence that an increasingly imbalanced-looking capital structure happens to perfectly coincide with the biggest credit expansion in all of history.
To illustrate this point further, we also want to show a dehomogenized chart that depicts business equipment production as well as durable and non-durable consumer goods production separately, all indexed to 100 as of 01/01/1980. As you can see, the three data series have drifted ever further apart during the fiat money era.
We believe the important take-away from these charts is that by arresting cyclical corrections every time with renewed monetary pumping before they had a chance to fully play out, the central bank has created a large secular trend in the course of which imbalances have continued to grow and fester. At the same time, the huge amount of monetary inflation and credit expansion that has taken place in this time period has vastly increased the above mentioned “phantom wealth” in the form of an extreme advance in stock and real estate prices, while at the same time leading to stagnation and ultimately the decline of median real household incomes.
Given that it can be shown that a secular trend has played out in the course of which the production structure has become grossly distorted, it is probably not too far-fetched to conclude that a secular correction of this trend could one day play out as well. Naturally, this is an event that cannot be “timed” – after all, even our severely hampered market economy is still able to create large amounts of real wealth, and as long as there is real wealth that can be misdirected, central banks can always hope to ignite another boom with monetary pumping.
And yet, we are surely all aware that something has changed in recent years. The economy’s pool of real funding – its free capital, the saved real resources that are available to fund long-term investment projects – has evidently come under grave pressure due to the succession of credit booms in recent decades. At the same time, governments and their ever-growing bureaucracies continue to over-regulate and over-tax economic activity, undermining the foundation of real wealth generation even further.
This is a topic we will no doubt return to in the future, as there is a lot more that can be said about it. In this article we merely wanted to present the underlying idea – a secular boom has played out, and so far it has only been interrupted by cyclical busts. What happens if the next bust is not of the cyclical, but of the secular variety as well?
Charts by: Saint Louis Federal Reserve Research