There's Still No Long-Term Case For Equities

After four weeks of sickening equity-market declines, logic says a lot of savvy stockpickers are sifting through the wreckage with an eye on value. History supports their optimism, as market plunges are frequently followed by rallies.

No doubt a big snapback on the upside may be coming our way, but for buy-and-hold types, they shouldn't expect to be rewarded with long-term gains assuming they jump back in. It's become repetitive in this column, but the ongoing run on the dollar says a multi-year bull rally is highly unlikely.

The reasons why are elementary. When investors buy shares in any company, they are buying future income streams. Dollar devaluations are by definition a devaluation of those income streams and that's why we'd be naïve to expect a return to the market glories of the ‘80s and ‘90s anytime soon.

Also, and along the lines of the above, with the dollar in continued decline, the investment in productivity enhancements that makes companies more attractive is reduced. Looking back to the barren 1970s, not only did a weak dollar erode returns, but it also led to a great deal of capital consumption on land, buildings and other consumptive goods at the expense of the enhancement of our capital stock.

We've seen much the same in recent years. Much as the hard assets of yesterday shined in the ‘70s, so have they done well since 2001. To paraphrase economist John Rutledge, investment in the tools that make us more productive has fallen in concert with a great deal more investment in metals, farm land, and buildings. 

Evidence supporting this basic claim about returns abounds, and can be found in equity returns in the decades since 1950. When the dollar is weak equities do poorly (over the last 10 years gold is up 591%, versus a 3.3% decline for the S&P), when the dollar is strong equities do well, and when the dollar is strong and stable, stocks do really well.

In the 1950s, despite a top tax rate of 91%, the S&P 500 rose over 250%. No doubt the end of the human tragedy that was World War II had something to do with this, but a major driver was a dollar that had a strict definition of 1/35th of an ounce of gold. With the greenback stable, investors could more rationally commit capital to the best ideas, and markets soared.

This rally continued into the 1960s, and was given more fuel by the posthumous Kennedy tax cuts that brought the top income tax rate down to 70%. Still, the S&P only rose 54% in the ‘60s, and what restrained the rally was market knowledge by 1966 that our commitment to the Bretton Woods dollar was in decline.

The 1970s confirmed late ‘60s bearishness. President Nixon severed the dollar's link to gold in 1971, and the dollar went into freefall. With investors no longer protected, stocks predictably wilted and the S&P only rose 17%. Measured in severely depleted dollars, the market measure actually fell a great deal.

Moving to the ‘80s, the dollar soared and gold declined as markets started to price in the election of a president (Ronald Reagan) who ran on restoring the dollar's reputation. Gold fell throughout much of his presidency, and with the dollar stronger, the incentive to invest in the concepts of the future rose. The S&P increased 121% during Reagan's two terms.

Moving to President Clinton, though he perhaps fell upon this bit of luck unwittingly, his appointment of Robert Rubin as Treasury Secretary was a godsend. For all his faults, Rubin was a strong-dollar Treasury head, and with this apparent to investors, the dollar continued to rise, gold and oil fell, and stocks soared; 208% on Clinton's watch.

All of which brings us to the lost years of George W. Bush and Barack Obama. The Bush administration lit the dollar match early on with consistent signals that a weak dollar was preferred by the Administration. Gold and other hard assets of the past quickly shined amid a blast to the our 1970s past, a recessionary housing boom was born followed by a government-created crisis related to that recessionary boom, and stocks fell over 20% during Bush's two terms.

And then President Obama, oblivious to the real mistakes made by President Bush, has doubled down on them. Stocks are certainly up since his arrival; the rally arguably related to Obama not achieving in full his anti-growth ideas, but the dollar has continued its horrifying descent and the latter ensures future history books lacking any mention of a Barack Obama bull market. It quite simply won't happen.

After that, the U.S. economy continues to suffer bailouts of failed ideas, which means the economy and new ideas will be restrained by the perpetuation of failed ones. As for the Fed, its distortion of rates means that the second most important price in the world - credit - will remain scarce for our central bank vainly trying to reshape market realities.

Most important in all this, however, is the dollar. With it weak, and worse, weakening, investors have no real incentive to buy future income streams. And with investors to varying degrees staging a strike, look for lots of rallies and stalls, but don't expect much more than that. Another Reagan-Clinton style market rally will remain a distant object until we strengthen and stabilize the world's most important price, the U.S. dollar.