In my last post, I explained how the rapid rise in financial assets is going to destroy retirement for many Americans. Counter intuitive isn’t it? Wealth in the form of financial assets measured in dollars has grown far too large for the economy measured in dollars, mostly due to central bank-induced ultra-low interest rates. Central bank policy has driven financial markets up without stimulating real economic growth. Now we have all sorts of claims on the economy in the form of rising debt, soaring stock prices and real estate that are far too large for the real economy.
To regain balance, the teeter totter has to move in the other direction. Financial assets have to fall and the real economy has to inflate in nominal value.
That’s why my top predictions for 2017 are for a substantial drop in the stock market, more consumer price inflation and a higher gold price.
Financial assets represent a claim on the economy. The bank lends you $10,000 for a car loan. The bank creates the $10,000 with a key stroke. The money must be paid back with interest. That’s a claim against future income. The holder of that loan has a claim against the goods and services produced by the economy because those goods and services generate the income to pay back the loan. The debt holder can also choose to use that income to bid for goods and services.
A financial claim against the future is created every time we create a debt or issue a share. None of this is a problem if the economy grows faster than future claims against it. But that’s not what is happening. Claims against the economy are growing far more rapidly than the economy that must pay out on those claims.
Let’s consider debt first. The 2008 crisis slowed down debt growth briefly but since then debt has accelerated higher while the economy has stagnated.
Equities are also a problem. Like debt, equities represent a claim on the real economy. And like debt, the growth in equity values is far more rapid than the growth in the real economy. The value of a share should represent the discounted value of future earnings but the economy’s earnings have been growing far more slowly than share prices.
In the chart below, the numerator is NCBEILQ027S, the Federal Reserve calculation of Market Value of Equities Outstanding. The denominator is the latest GDP estimate. The result is the ratio of equity market capitalization to GDP, sometimes known as the Buffet indicator because it is his favourite measure of market valuation. As you can see, the trend is up since 1982. The current reading is 118.7%. Since 2009, the ratio has doubled.
Since the Greenspan era of Bubble Finance began in 1987, the value of corporate equities owned by households has soared from $1.8 trillion to nearly $15 trillion, a gain of 7.5% per annum. Equity values have increased 65% faster than the 4.5% annual gain in nominal GDP during the same 29-year period.
Real estate is the same story. Since 1999, the value of owner-occupied residential real estate in the Fed’s Flow-of-Funds report has risen from $10.1 trillion to $22.7 trillion or 5.2% annually. The chart below puts it all together. The vertical dotted line marks Greenspan’s arrival at the Fed in 1987. Since then, the historical relationship of financial asset values to the current level of national income has been shattered. After reaching 440% at the peak of the dotcom bubble in 2000 and 460% on the eve of the 2008 meltdown, household net worth is now nearing 500% of GDP.
Here’s my point, dear reader. There is far too much paper wealth for the real economy to honor. The real value of debt, stocks and real estate must revert to a level that reflects the productivity of our economy. That’s the teeter totter I mentioned earlier. I see the market value of these assets falling while the prices of real goods and services climb until relative balance is restored. What will retain its value in real terms in this adjustment of relative values? Something that cannot be created and destroyed the way financial assets can, something from the real economy that takes effort and investment to produce, something that is not a claim on future wealth because it is itself real wealth: Gold.