March 13, 2000 – Everything you can think of about this multi-year rise in the stock market has been unprecedented – its duration, the price appreciation, the IPO speculation, the breadth divergences, the divergences between the Dow averages and the Nasdaq. Well, you get the picture. I could go on and on listing the once in a lifetime events that have characterized this stock market. But instead, all of these occurrences can be simply summarized in one word, unprecedented.
Given this description about all of these unique events which we have been witnessing in the stock market, is it not fair to ask whether the stock market’s final chapter may also turn out to be unprecedented?
I’ve been pondering this question a lot lately, given the extreme state of affairs the stock market has worked itself into. The Nasdaq is setting record highs, while the Dow heads south. Internet companies with huge losses selling at unheard of multiples to sales soar ever higher while an established blue-chip like Proctor & Gamble loses 30% of its market value in one day. It was therefore of great interest to read some excellent research by Paul Macrae Montgomery, an investment strategist with Legg Mason Wood Walker Inc. in Newport News, Virginia.
Paul’s name may be familiar to many of you. He is well known for discovering the ‘magazine cover indicator’. By this model, magazine headlines are a good contrary indicator, or in other words, when you read something on the cover of Time or Business Week, trends are about to turn.
The material that I was reading discussed the relationship of stocks and bonds. What stood out for me was Paul’s conclusion that: “Except for Japan in 1989 and Weimar Germany [i.e., circa 1922], this is the highest stock/bond ratio we are aware of in a civilized country.” Those words leapt off the page I was reading because for years I have been using those two examples to explain what could happen to this stock market.
As I see it, there are only two possible outcomes for the stock market. In what I have labeled my ‘Nikkei scenario’, the stock market crashes to return to normal valuations. In the other alternative, my ‘Weimar scenario’, the stock market just keeps climbing and climbing until stock prices eventually reach infinity, i.e., no one is willing to exchange any stock for the currency being used. Thus, it is apparent from these two scenarios that the key to determine which outcome will prevail when writing the stock market’s final chapter is to first determine what will happen to the currency.
In Japan’s case, the Yen survived, so the stock market collapsed. In Germany’s case, the Reichsmark was destroyed, so stocks there just kept going higher and higher in Reichsmark terms.
Thus given the outrageously high stock/bond ratio for the US market – which is at a level that has never before been seen except for Japan in 1989 and Germany circa 1922 – what will be the final outcome for US stocks? To answer this question, one has to first determine what will happen to the Dollar?
It has been a cornerstone of my investment thinking that in time, the Dollar will be destroyed. This conclusion is based in part on historical evidence. After all, no fiat currency has ever survived for more than a couple of decades, so why should the Dollar be any different? Is there any reason that the Dollar could overcome the weight of history? No, I don’t think so because my conclusion about the eventual destruction of the Dollar is also based on logic.
The Dollar is nothing but some empty promise based upon the credit extended by the nation’s banks and the Federal Reserve. That extension of credit eventually reaches an extreme, where credit gets extended to projects of ever declining quality and/or for purposes of ever growing dubiousness. When that stage finally gets reached, the result of this precarious condition causes nearly all credit to be doubted – this questioning of credit worthiness then sets off a credit crisis. The currency, because it itself is based on nothing but credit, then gets sucked up in the turmoil.
The Dollar as fiat currency has so far survived several credit crises, but sooner or later, it is inevitable that one credit crisis will be so severe that it will kill the Dollar. Here’s what Ludwig von Mises has to say in his masterpiece, Human Action, about this eventuality:
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
Thus, will the stock market bubble pop like it did in Japan, with the Dollar surviving for the time being as currency, as the Yen – another fiat currency – has so far survived? Or instead will the Dollar collapse, with the result that the stock market heads to infinity in Dollar terms because the Dollar goes the way of America’s first fiat currency, the Continental?
The jury is still out on these two alternatives, but I continue to suggest that the weight of the evidence before us makes it increasingly likely that alternative number two is the most likely outcome – the stock market goes to infinity because the Dollar is heading the way of the Continental. As a consequence, stocks are better than money, or to more accurately state this point, stocks are better than what today masquerades as money, namely, the fiat currency we call the Dollar.