This Rally Isn't So Great...

Americans are feeling a lot more optimistic and relieved now that the stock market has finally recovered some with the S&P 500 trading up 10% for the year flirting with the psychological 1,000 level. Yet, how real is a 10% move when the purchasing power of those gains is dropping in the meantime? It seems foolish to assert that a new bull market is on while the US currency is losing its purchasing power.

The US government is robbing the world by destroying the value of our currency. The dollar has been in a steep downtrend since the early 2000s. In an effort to fight the fallout from the technology market crash, the Federal Reserve dramatically lowered interest rates. The dollar collapsed falling over 40% in the next six years until the 2008 global credit panic caused a massive flight to safety. Throughout this drop in the dollar the stock market managed a strong rally gaining roughly 90% between 2003 and late 2007. But, with the dollar losing 40% of its purchasing power, the real gains are far less impressive.

The credit market panic in 2008 fueled a large surge higher in the value of the dollar. Investors demanded dollar-denominated assets in a flight to safety of proportion not seen in decades. The dollar gained roughly 25% in value in late 2008 as Lehman's bankruptcy brought widespread fear of a financial market collapse. Yet, as TWS postulated in early June, the dollar will likely give back the entirety of its advance, and much more.

The advance in the stock market must be viewed in the context of the large-scale jump in the monetary base. Day after day pundits, bloggers and other writers advance the notion of the Great Depression and argue that the charts look the same. We are in a bear market rally and will fall again, they say, even providing excellent chart analysis and plenty of economic data to back their point. Jason Tillberg wrote an article for Seeking Alpha with that very mentality. Yet, TWS responded with comments that charts are deceiving in this environment. Tillberg and others are missing a crucial part of the story. The Federal Reserve changed the rules!

The unprecedented increase in the monetary base is like nothing the US has ever seen. The Great Depression saw increases of 25% in the monetary base yet the 2009 year-over-year change has topped 100%! The US doubled its monetary base, an action that does not come without consequences. So, as the equity markets have rallied this year and are now trading up 10% year-to-date, the dollar has eroded in value trading down 4.5%. The real return is actually around 5% then when considered in the context of purchasing power.

Dollar-denominated assets will naturally inflate in price with such dramatic increases in the monetary base. A long-term chart can no longer track investor psychology when the underlying money in the system changes substantially. As inflation expectations are beginning to increase, the pace of the dollar's erosion may significantly accelerate. Asset prices can and will rally far beyond our expectations but do not expect that to buy you nearly as much in the world.