A Tale of Four Stock-Market Decades

Erratic monetary changes would turn the veil into a fluttering and distracting screen-a bullfighter's cape that induced entrepreneurs and economists alike to waste their energies charging off after spurious signals of opportunity and value, profit and loss. - George Gilder, Wealth and Poverty, p. 217.

Stock-market behavior is frequently reduced by commentators to a function of sentiment. If markets are going up, confidence is generally said to be strong or bordering on irrational, while downturns are often explained away as a loss of confidence, or overdone pessimism.

But the direction of equity prices - particularly in hindsight - can often be explained with more depth than the image of expanding "bubbles" randomly "popping." During peaceful periods of stable money, easy taxes, light regulation and free trade, stocks tend to do well, while changes in these controlling variables can lead to corrections.

Markets, if free, represent the combination of exuberance, indifference and negativity such that prices over time are fairly representative of the future outlook for the market in question. In any market, for every bullish buyer there is a bearish seller, or vice versa.

Perhaps too little discussed is the role of the dollar when it comes to both the direction of stocks and the kinds of assets that perform well. Economists tend to ignore the changing value of the dollar in their analyses, but as the 1920s, 1970s, 1990s and the decade just completed show, the direction of the dollar and its instability loom large when it comes to explaining market outcomes.

From this point of view the 1920s stock market resembled the '90s market, while the stock market of the decade just passed mirrors that of the 1970s in ways that are fairly impressive. The call - at least based on the evidence presented here - is once again for a stable dollar defined in terms of gold.

Stock market returns in the 1920s and 1990s. As 1920s dawned the Dow Jones Industrial Average stood at 72 which, according to Lords of Finance author Liaquat Ahmed, was the midpoint "of its range for the last twenty years." But in the decade that ensued, the Dow rallied all the way to 381 by 1929.

About this subsequent rally, it should be said that it was very uneven. As Ahmed noted about the 1920s bull run, "Of the thousand or so companies listed on the New York Stock Exchange, as many went down as went up." Textile, coal and railroad firms which represented the "old economy" were struggling, while automobile, radio and consumer appliance stocks were rising with great gusto.

Fast forward to the 1990s, and a rally very similar to that which occurred in the 1920s revealed itself. While the Dow rose 429 percent during the 1920s, in the '90s it rose 328 percent. The Nasdaq actually jumped 788% during the decade.

But as in the 1920s the rally was very uneven. Indeed, as author Nathan Lewis observed in Gold: The Once and Future Money, despite a major stock-market boom from 1997-2000, "most stocks actually fell, and most businesses stagnated." Lewis went on to point out that by the end of 1999, "a year the S&P 500 gained 19.5% and the Nasdaq composite index 85.6%, a full 70% of NYSE listed stocks were lower than they were a year earlier."

According to Ahmed, on September 3, 1929, the day that the Dow Jones topped out, "only 19 of the 826 stocks on the New York Exchange attained all-time highs. Almost a third had fallen at least 20 percent from their highest points." The Fed had raised interest rates to restrain just twenty stocks.

This scenario might sound familiar to investors who struggled to keep pace with market-index returns in the '90s. Doing so proved very difficult given the narrow nature of the stock-market rally. Indeed, with just a few companies accounting for a great deal of the market's gains, only a money manager willing to narrow his own portfolio to a small number of high performers would stand much chance of beating the broad stock market indices.

Just as the Fed raised rates in the late '20s to correct what was a narrow rally, so it did once again towards the end of the '90s rally in early 2000 - for remarkably similar reasons. To quote economist Charles Kadlec in the Wall Street Journal in March of 2000, "the overall market's price/earnings ratio has increased to 30 times current earnings from 17, suggesting that stocks may be overvalued. But virtually all of this increase can be attributed to the 25 stocks with the biggest market capitalizations in the Standard & Poor's 500 index." "In other words, Mr. Greenspan is threatening to slow the growth of the U.S. economy and throw people out of work because 25 stocks may be overvalued."

In the 1920s the hot, "new economy" stocks were GM and RCA, which had respectively risen twenty and seventy fold during the decade. Much the same, investors in 1990s market leaders such as Microsoft, Dell Computer, Cisco and AOL achieved outsized returns much greater than they would have from the S&P itself.

The dollar's direction in the 1920s and 1990s. With respect to currency behavior in the '20s and '90s the parallel is less clear. In the 1990s the dollar price of gold fell 31 percent, and in hitting a modern low of $250/ounce in 1999, the dollar fell into "deflationary" territory according to some economists. In the 1920s, however, the US was still on the gold standard, with the gold price fixed at $20.67/ounce.

It would be difficult to compare a decade of stable money values versus one in which the dollar's price was fixed. But in considering the dollar's fixed definition in terms of gold, Stanford economist Ronald McKinnon's point about gold being a metal "whose floor price is fixed but whose ceiling price is not" should perhaps be taken into account.

Indeed, according to Arthur Laffer, "By 1970 that price (gold) had risen to $47" despite the fact that the official price remained at $35 per ounce until August 15, 1971. It might also be asked whether the price of gold in private markets had fallen in the 1920s. Although I can find no evidence for that, a great deal of anecdotal evidence exists to bolster the claim that something was amiss with the value of the dollar in the 1920s. Be they commodity prices other than gold, or less accurate government indicators, there were signs of negative inflation during the decade.

In The Forgotten Man, economic historian Amity Shlaes observed that in the late 1920s, farmers suffered "falling grain prices." In their book Monetary Policy, A Market Price Approach, economists Manuel Johnson and Robert Keleher noted that from 1921 to 1930, "prices actually fell 1.1 percent per year." Further on in Monetary Policy, Johnson and Keleher discussed the Fed, and the fact that "it disowned any responsibility for the drastic decline of commodity prices which had been underway since 1925."

Ahmed revealed in Lords of Finance that "Since 1925, U.S. wholesale prices had fallen 10 percent, and consumer prices 2 percent." His explanation for this seeming conflict with the gold standard was that since "the price of gold was fixed in dollar terms, the first symptom of a gold shortage was not a rise in its price - that by definition could not happen - but a fall in the price of all other commodities."

Concerning the notion of a shortage of gold, according to Ahmed, in the 1920s the Fed "was required to have 40 percent of all the currency it issued on hand in gold." But while those were the guidelines under which the Fed was supposed to have operated in the '20s, New York Fed president Benjamin Strong did not adhere to this rule.

Instead, in the 1920s massive amounts of gold reached the United States, this inflow likely due to increased productivity on the part of US producers laboring under rates of taxation that continued to fall. Production generates money demand, and with US workers enormously productive, more and more gold reached the United States.

But perhaps incorrectly fearful of the inflationary implications of the rising gold inflows, Strong, according to Ahmed, "began to short-circuit the effects of additional gold on the money supply by contracting the amount of credit it supplied to banks, thus offsetting any liquidity from gold inflows." In effect, gold, or money, was withdrawn from circulation.

Logic tells us not to concern ourselves with questions of "money supply," but what's hard to figure is whether money quantities take on different meaning when a commodity - gold - is to a high degree the supply of money. Whatever the answer, falling commodity prices in the '20s mirror what happened in the 1990s, when commodities fell across the board.  Without being able to prove that excessive dollar strength drove the private market price of gold downward (much as a weak dollar drove its private market price upward in late '60s/early '70s), the performance of non-gold commodities raises questions about monetary policy in the '20s that are hard to dismiss out of hand. 

In terms of investment, the certain beneficiaries in both decades at least in the near-term were once again "new economy" companies producing advanced products, while "old economy" firms more in the commodity space suffered.

Notably, the "match" that lit the economic fire in the late '20s was the Smoot-Hawley tariff bill which was originally crafted to help farmers weather declining commodity prices. Similarly, with gold having fallen to roughly $250/ounce once again in 2001, tariffs were raised on steel and agricultural products. The question then is whether these tariffs would have seen the light of day in a truly stable-dollar environment?

Stock market returns in the 1970s and the '00s. From February 5th of 1971 to the decade's end, the Nasdaq rose 51 percent. Over that same time frame, the Dow Jones Industrial Average fell 4 percent. In the decade which just ended, the Nasdaq fell 44 percent, while the Dow declined 9 percent.

But just as impressive stock market rallies in the '20s and '90s masked a very uneven economic climate, so did poor returns in the '70s and the decade just past hide the fact that some people - at least on paper - were achieving great wealth. Indeed, author David Frum described the 1970s this way in his 2000 book, How We Got Here - "If you had the nerve to borrow a lot of soggy cash, and then use it to buy hard assets - land, grain, metals, art, silver candlesticks, a book of Austro-Hungarian postage stamps - you could make a killing in the 1970s." Frum noted further that when Forbes magazine "published its first list of the 400 richest Americans in 1982, 153 of them owed their fortunes to real estate or oil. (On the 1998 list, by contrast, only fifty-seven fortunes derived from real estate or oil.)"

Futurist George Gilder observed about the '70s that while "24 million investors in the stock markets were being buffeted by inflation and taxes, 46 million homeowners were leveraging their houses with mortgages, deducting the interest payments on their taxes, and earning higher real returns on their down payment equity than speculators in gold or foreign currencies." Gilder also cited a 1978 Fortune magazine study in which half the new multi-millionaires were in real estate.

Fast forward to the decade just completed, real estate was yet again the hot asset class. Perhaps subconsciously seeking to hedge their wealth against inflation, Americans to some degree exited the much subdued stock market in favor of land speculation.

The Wall Street Journal reported in 2007 that "Commodities traders - long considered poor cousins to blue-blood investment bankers - are rapidly climbing out of the pits and into the corner office." Whereas technology firms received the lion's share of Wall Street's attention in the '90s, billionaire steel magnate Lakshmi Mittal's firm ArcelorMittal seemed to be making the biggest acquisitions. A USA Today headline blared, "States battle rise in copper thefts" as the commodity soared in value.

A Bloomberg story from May of 2008 noted that absent the profits of Exxon Mobil, Chevron and ConocoPhillips, "profits at U.S. companies are the worst in at least a decade." Just as "new economy" firms captured a much greater share of profits during the '20s and '90s, "old economy" oil producers roared back this past decade."

The dollar's direction in the '70s and the '00s. The answer to the dollar riddle isn't particularly obscure. While the dollar was strong - perhaps excessively so - in the '20s and '90s, in the '70s and the recent decade it was extraordinarily weak.

The dollar price of gold once again tells the tale. In the '70s, gold jumped from $35/ounce all the way to $875 for a brief time in January of 1980. In the decade just concluded, gold traded as low as $253/ounce in 2001, but not too long ago briefly hit $1,200/ounce.

In the 1970s President Jimmy Carter complained that our "intolerable dependence on foreign oil threatens our economic independence," and his proclamation paired well with President George W. Bush's 2006 State of the Union suggestion that Americans were "addicted to oil." Had a weak dollar not driven oil's price skyward in both decades, it's fair to assume that both wouldn't have mentioned oil at all.

Commodities, and most other hard assets including housing, stamps and rare art, tend to do well in dollar terms when the greenback is weak, and they tend to list when the dollar is strong. At the very least these fluctuations retard investment as the changing value of goods in currency terms distracts investors from focusing on the best place to put their capital.

Conclusion. If it's agreed that the '90s somewhat resembled the '20s, and that the '00s in many ways mirrored the ‘70s, it should also be concluded that unstable currencies are problematic and inefficient for directing the proper use of what is limited capital.

When money is cheap, a shift into hard assets leads to a decline in future production. Conversely, when money is particularly dear, money flows into intangible concepts at the expense of less vibrant, but still important parts of the economic whole. Whatever the direction of currencies, instability leads to capricious wealth redistribution and general uncertainty that makes it difficult for economic actors to optimize their actions.

The answer to all of this remains a stable dollar in terms of gold, and one in which monetary authorities seek to avoid dollar strength as much as dollar weakness. Currency instability is a problem no matter the way in which those who watch our money err, and until we acknowledge that the dollar's value must have both a ceiling and a floor, periods of uneven investment resulting from the variability of money will remain with us.