Monday, November 03, 2008

Real asset returns and trends

The charts above are the monetary inflation adjusted S&P 500 index and a chart of the equally indexed true money supply, CPI, nominal GDP, and S&P 500.

We can see that the monetary adjusted returns of the S&P 500 is zero, or closely approximates zero with wild variances. During the 1970s inflationary period the stock market discounted the inflation into asset valuations. It took over 20 years for the market to recover in real terms as the tech boom and massive increases in productivity led to real wealth generation. However, during this boom, asset values were inflated and had to correct to the real cash flow potential of the underlying businesses. The attempt to reflate the economy burst last year as inflation exploded and asset values plummeted.

The latest credit induced bubble produced real wealth for holders of stocks until the end of last year. Historically, that wealth creation was above the average and given what we have observed, that real stock returns are zero in this credit based environment, these holders should have sold to the highest bidder.

I am willing to bet that we will see a period similar to the 1970s where we will see no real return on assets as long as we have massive monetary inflation and easy credit as evidenced by lower interest rates (Fed funds, libor, etc).

How do you make money in this environment? Of course this is the most difficult question that everyone is asking. I personally am using my trend following system that tracks the S&P 500. It is in the middle of a drawdown, but has recovered significantly from where it was (up 26% from its bottom). I fully expect that it will be short the market in the next couple weeks.

Another way would be to use the real s&p chart and look for relative bottoms to start dollar cost averaging into an S&P index strategy being long the market. The problem with this is that stock prices are completely unpredictable, which also means that you should not expect that prices will act how they have historically acted. Markets have tended to over correct below the monetary adjusted zero line (or 100 on the chart).

Commodities, theoretically, should rise in an environment of monetary inflation. I would tend to believe that current prices are not reflective of real values of commodities. Instead, they are artificially low because of the liquidation of positions by over leveraged hedge funds, investment banks, and central banks. That is unless we are going to experience monetary deflation because banks cannot find low risk places to earn money (i.e. credit contraction and destruction). This is what I've been trying to wrap my head around for the last six months without a definitive conclusion. These two opposing forces are battling it out in the market, both of which are probably bad for asset values.

Can you see why I am a trend follower? I'm just not smart enough to figure out what the outcome will be, so I follow prices and manage risk, something that the investment banks didn't do. It's more important to stay solvent than to be right.

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