The Ignorant Investor

I frequently read The Big Picture for Barry Ritholtz's excellent insight into the markets, but I disagree with him here:

Since Bernanke gave his Jackson Hole speech, the S&P 500 is up 25% but in gold, commodity and other currency terms, the gains look not as good. In gold terms, stocks are up just 6.6%, in oil they are down 13.6%, in CRB terms they are down 8%, in Euro’s they are up 11.8%, in CAD up by 15%, in AUD up by 8.5%, in CHF up by 10.5% and in yen up by 19.5%. I make this analysis to point out the nominal world the Fed is trying to jump start to deal with too much leverage in our economy where in reality, REAL gains are the only thing that helps a country’s standard of living.

This is all true, but during the 1990s, you could have pointed to stocks and compared them with gold and seen the opposite trend. We measure the value of financial assets and currencies by auction prices set by thousands of traders. The value of assets can be traded for goods and services, but the rate of exchange varies from moment to moment. This variation is only partly based on what we'd consider reality. In large part, auction prices depend on the mood of buyers. What is popular or a "must have" for a trader in one day, can be a "must dump" the next day. How real can an asset price be when it can vary by 3,5,10 percent in a single day of trading?

The S&P500 is made up of companies that produce goods and supply services. Most of them do a portion of their business outside the dollar zone and so function across currencies and national economies. Their profits should reflect not just our standard of living, but also that of people in other countries, yet the S&P500 has consistently underperformed other equities in the past 10 years. Small and mid-sized companies, many of which presumably have a much greater exposure to U.S. currency than their larger cousins, have done much better over the past 10 years than the S&P500. Why? Because they trade at a higher multiple. They are in favor with traders, who are willing to pay 70% or so more for a dollar of earnings of a small company than they will for a dollar from the likes of GE or Exxon. If the S&P500 traded at the multiples it did in the 1990s when it was in fashion, we're be looking at levels of 25,00-30,000. We'd be having a different conversation.

I'm not making a case for that level of valuation in the S&P500, but it's happened before when traders and the public go mad for large cap stocks. And it's the kind of thing that's happening now with the price of gold. I own some GLD, and its value keeps going up. But there isn't anything any more real about it than stocks. It's a piece of paper that reflects an asset that for some reason people believe is a store of value that can't go down. All it takes is a change in fashion for it to drop like a stone.