This week the Dow Average lost 2.2% and bond values continued to fall – but stock market strength and gold both added 4.5% in the trading week. While mixed messages and smoke and mirror economics are continuing themes in "the market," recent activity actually makes a lot of sense. The chart below shows the most recent twelve months of investment activity; a discussion follows.
Look at the spike in yields – the 10 Year T-Note is up a whopping 61% in the period with most of the rise coming in just the last few months.
What does this mean?
One of the basic tenets of finance is: A dollar today is worth more than a dollar tomorrow. To illustrate this, consider that a dollar today is only worth $.98 next year with 2% inflation (a.k.a. the cost of money).
In the same vain, if someone borrows $1 today and must repay it along with 5% interest in one year’s time the borrower’s current value of a dollar is $1.05 (the value of a current dollar plus the cost of debt). The future value of that money when payment becomes due is $1.03 adjusted for inflation, where future value is equal to: principal plus interest less inflation.
Under this same theory, rising yields also causes the future value of a dollar to rise, as more interest must be paid for a dollar borrowed today. Continuing with our example above, if interest rates were to double to 10% the current value of a dollar borrowed is $1.10 and the future value of the repaid dollar is $1.08 – less the 2% inflation rate.
Did you see that?—when interest rates went up (from 5% to 10%) so did the future value of money (from $1.03 to $1.08). That’s strict theory.
But nothing is absolute.
Currencies that seemingly rise from weak monetary policies should not be considered a sign of future strength. Instead, rising yields in weak monetary environments (like we are experiencing today) indicates inflation – not strength. The expectation of future inflation (due to weak monetary policies) causes the current value of a dollar to fall because investors know that it will be worth less in the future. This market dynamic drives yields higher against the will of government powers because more interest is demanded by investors to cover the cost of the falling dollar. In short, inflationary pressures – not monetary strength, is currently causing yields to rise.
That’s the reason gold was up strongly this week.
These same dynamics ring true in the stock market where stocks in high demand generally produce higher valuations – but not necessarily stronger companies. For instance, Apple was up 10% this week and it drove the 15-51 Indicator higher because activist investor Carl Icahn took a significant position in the company and is pushing CEO Tim Cook to increase and accelerate the Apple stock buyback program – a move that would limit supply and cause an additional rise in stock price.
But one shouldn’t misinterpret a resulting rise in Apple’s stock price to be due to strength. Instead, the move would result from a shift in corporate policy to a strong stock pricing posture. In other words, a much more aggressive stock buyback program doesn’t make Apple a stronger company even though its stock price has risen substantially. It’s strictly an effect of its corporate monetary policy.
Just as higher yields do not automatically make a stronger currency – higher stock prices do not make a company stronger.
Many TV pundits and Wall Street power brokers misrepresent a rising Dow Average as "strong" which they purport indicates strong, or strengthening, stocks and/or economics. But nothing can be more shortsighted. In fact, people who subscribe to this position are always the same people who get blindsided by major stock market corrections – and Wall Street is full of them.
I am proud to say that the last major stock market correction that caught me off guard was Black Monday, October 19, 1987, when I was a senior in college – which by the way, was when the seeds of LOSE YOUR BROKER NOT YOUR MONEY were originally sown. But I digress…
Strong dollar conditions under strong money policies that produce higher yields indicate strength; just as pro-growth economic policies under responsible fiscal governance that produce strong economic growth and higher stock prices indicate strength. Contrary conditions are inflationary and ripe for correction.
Unfortunately that’s the condition we're in.
With established interest rates already near zero, and with all the monetary tricks being employed to keep rates at all-time lows, it looks like the Fed is finally losing control of yields – a condition that will really shake-up world financial markets.
Since the U.S. economy emerged from "recession" in 2010, the Dow Average is up 42% and the 15-51 Indicator added 88% – while Real GDP grew at just 7%. As a result, both portfolios remain substantively inflated. See below.
Major stock market corrections always follow a prolonged and rapid rise in prices.
Plan ahead, stay tuned – and let me know if you need help.
See Last Week’s Blog:
Prelude to Mutiny