Currency Wars, Gold and How The Stocks React

gold chart

Back when I started stock trading blog in 2008, the idea that the U.S. dollar could be devalued to such a point that people would begin losing confidence in it, was a wacky fringe idea passed around in gold bug circles and so called “alternative news” sites. I was critical of this concept and thought it was total BS back in 2008.

Fast forward to today. The national debt just crossed above $16.5 trillion and the debt to GDP ratio broke above 100% for the first time since World War II. As of December 2012, the debt to GDP ratio was 103.9%! Back in 2008, the debt to GDP ratio was 74%. In 2008, the national debt had just broke above $10 trillion. In just the last 5 years, the national debt has increased by 53.6%!

Both Parties Keep The Spending Binge Going

I chuckle when I hear someone say that the most recent President is to blame for the national debt. That’s just not true. BOTH parties are to blame for the national debt. Between 1977 and 1980 during the Carter administration, the national debt increased by 42.3%. From 1981 to 1988, Reagan exploded the national debt by a whopping 188.6%, the biggest increase by any President on record. From 1989 to 1992, Bush senior increased the national debt by 55.6%. From 1993 to 2000, Clinton increased the national debt by 35.6%. From 2001 to 2008, Bush junior increased the national debt by a whopping 89%. From 2009 to 2012, President Obama increased the national debt by 53.6%

So much for the incorrect stereotype that one party is better or worse when it comes to increasing the national debt!

Both parties talk a good game when their running for election but as soon as they get into power and the magical checkbook and pen is handed off, they spend like there’s no tomorrow. At this rate, maybe there’s not, at least for the U.S. dollar.

What Was Once Fringe Thinking Has Now Gone Mainstream

I’ve totally evolved in my position on gold since 2008. Take a look at the performance chart below.

gold chart

Since January of 2008, the S&P 500 is up a pathetic 2%. Gold, over that same time span, is up a whopping 100%!
I’m all about the charts folks. Politics and all other personal opinions aside, this is about money and the chart shows that your money would have doubled in gold, since 2008, while in stocks it went absolutely no where. You can’t argue with this chart and everyone knows it.

Is the S&P 500 Going Up, Or Is the U.S. Dollar Going Down?

It has been difficult to try and make money trading since 2008. It can be done and I’ve built up my blog at GuerillaStockTrading.com showing people the tools I use to do just that. But it’s hard work and the returns are small. It’s sort of disheartening to learn that I could have just put my money into gold in 2008 and today I’d have double the money. No constant trading. No constant brokerage fees. No sitting in front of a computer monitor hours a day. No charting. Just park myself in gold and do nothing and I’d be up 100%.

When I learned about the concept of the petrodollar trade got me thinking. When a currency is devalued, the cost of everything goes up, including stocks. You can study this relationship in real time by considering Iran and how their currency plunged 50% in value due to economic sanctions and their stock market has gone up 30% as a result!

So the question came to my mind to ponder: has the S&P 500 really gone up since the Global Financial Crisis of 2008, or is really the U.S. dollar going down?

This is a difficult concept to chart because currencies are measured relative to each other. Just because the U.S. dollar might be going down because the euro is going up, it doesn’t mean that the U.S. dollar’s absolute value is going down. Trying to find a benchmark for the absolute value of the U.S. dollar is tricky because currencies aren’t measured that way. One method is to consider how a gram of gold buys the same amount of oil today as it did back in the 1950s but it takes many more U.S. dollars to buy oil. You can read more about this method by going here. However, there’s another way to test this thesis.

We can use what is called an inverse formula to test if the S&P 500 is indeed tracking the U.S. dollar. While the absolute value of the U.S. dollar being devalued is masked by the fact that currencies are measured in relative value to each other, we can still plot what are known as perturbations and see if a positive correlation exists between the S&P 500 and the U.S. dollar. We do this by using the inverse variation formula: y = k/x.

If the S&P 500 is indeed being influenced by the U.S. dollar, we would expect to plot the two on a chart and see an inverse relationship between the two. Below is that chart.

gold chart

The chart above should send chills up your spine. It’s an almost perfect mirror image of the other! Since 2008, we see an inverse relationship between the U.S. dollar and the S&P 500. When the U.S. dollar goes up, the S&P 500 goes down and vice versa. It proves that the price action on the S&P 500 is directly connected to the U.S. dollar.
In a Wall Street Journal article entitled Currency War Has Started by Francesco Guerrera, Francesco writes:

Currency wars have been a staple of modern finance ever since the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s. As Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co., says: “Most governments believe that their currencies are too important to be left to the markets.” So policy makers have often tried to manipulate the value of their currencies by intervening in the markets. (Source: http://finance.yahoo.com/news/currency-war-started-034400974.html)

This is incredible! This article was carried over the mainstream Yahoo News service and it comes as courtesy of the Wall Street Journal! Back in 2008, the only places on the Internet where you would find such an article would be on gold bug blogs and other alternative news sites.

The Bretton Woods system of fixed exchanged rates was an agreement for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and the IMF could bridge temporary imbalances of payments. The U.S. dollar, in turn, was tied to the price of gold. It was a system developed to prevent the kind of currency wars we are seeing today.

On 15 August 1971, the United States unilaterally terminated convertibility of the U.S. dollar to gold. This brought the Bretton Woods system to an end and ushered in the era of currency wars.

Since 1971 and the end of the gold standard, the U.S. dollar has lost an estimated 90% of its value. We experience this loss in value of the U.S. dollar in terms of how much everything costs, or what is called inflation. See this article for what things cost in 1971 to what they cost today.

What the 1990s Can Teach Us

Critics of my inverse formula applied to the S&P 500 and U.S. dollar as proof the S&P 500 is going up because the dollar is going down will argue that the relationship between the price of stocks and the dollar has always been there and is not something new since 2008. But that would not be true.

If we chart the S&P 500 and the U.S. dollar’s price performance during the 1990s and the huge run up in the stock market, we see that during this time, the inverse relationship between the S&P 500 and the U.S. dollar was absent.

gold chart

In fact, if you look at this chart carefully you’ll notice that for years both the U.S. dollar and stocks went up together. This is the normal relationship where the Federal Reserve has to raise rates to cool off a rip roaring economy and stock market. The increase in interest rates makes the dollar go up in value. That is the normal relationship between the dollar and the S&P 500.

So what has changed since the 90s? The national debt went from $4.9 trillion in 1995 to $16.5 trillion as of January 2013. Assets of the Federal Reserve’s balance sheet went from an operating average of about $700 million at the end of 2007, to $3 trillion as of January 2013. This is the result of massive government intervention to try and jump start the economy via TARP, QE1, QE2, Operation Twist, Dollar Swap, and QE3 over the last 5 years. All this government action has caused the value of the U.S. dollar to drop.

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