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Most people, myself included, gauge how we are doing financially by calculating our net worth and seeing how the number changes with time.
With stock markets and real estate valuations being at or near all time highs, I would venture to say that a large portion of us are feeling quite happy with ourselves right now.
But are we indeed doing better financially over time?
I’m afraid all the numbers we use in the finance community only pertain to the numerator in the financial big picture equation.
Higher salaries, higher portfolio values, higher home prices all get tallied on the numerator side of things.
What we really need to start focusing on is the denominator before we can accurately decide if we are indeed making financial progress or not.
The denominator is much harder to calculate because it requires knowing the total supply of money in the world.
As world governments continue to print money, increasing its circulating supply, the denominator gets larger, potentially wiping out any gains the numerator may have seen.
I am going to play devil’s advocate and argue that if we truly analyze everything that is going on in our current environment we may have just been financially treading water for quite some time, regardless of any increase our net worth calculation may have..
I think the easiest thing to do is give a hypothetical situation that may help drive home this point.
The Republic of Xrayvsn.
In the hypothetical Republic of Xrayvsn (ROX), the government, lead by yours truly, wants to keep its citizens happy despite its gross national product either remaining flat or even worse decreasing.
The government knows the best way to achieve this is to have its citizens believe that their financial status is continuously improving.
Fortunately the Republic of Xrayvsn has its currency, XRV, based on the FIAT system.
Without requiring a tangible asset to back up the currency, ROX has cart blanche to print more XRV to pump back into the economy.
To keep numbers simple, let us say that last year ROX had 1M of XRV in circulation.
Because of a bad economic outlook this year, the leaders decide to mask this negativity by doubling the circulating supply, creating and then giving, its citizens an extra 1M of XRV (making the circulating supply now 2M).
Savvy citizens of ROX make use of this free cash by investing it into the ROX stock exchange.
As more citizens invest a positive feedback loop is created which continues to drive stock prices higher.
The companies in the stock market have not done anything of note to justify these stock prices, maintaining, or even reducing, their productivity due to prevailing macroeconomic conditions.
The higher valuations are purely based on the supply of stocks being stable but now more valuable because of increased demand.
Do you consider the citizens wealthier, with lets say a net worth doubled from the prior year?
This net worth number would have you believe just that.
But if you account for the increased money supply, the net worth number doubling was really due to doubling of the circulating currency.
In my eyes that’s a wash and highlights how money debasement by printing more money can make net worth tracking a lot more challenging.
The denominator strikes again!
I’m sure this is not a shocker but the fictitious Republic of Xrayvsn was essentially a stand-in for the economic climate of the United States.
Our rising net worth (hopefully) and our supposed gains made by wisely investing in index funds over the past decade may not be due to the fact that we are the next Warren Buffet but rather because there is more M1 money injected into the system than ever before.
Raoul Pal, an incredibly knowledgeable individual who is the co-founder and CEO of Real Vision and former hedge fund manager, had a series of tweets that summarizes this concept and was the inspiration for this post:
But when we change the denominator to the G4 Central Bank Balance sheets, we can see that equities have traded sideways since 2008, basically counteracting the balance sheet expansion (and are probably cheap currently as 0.15 appears to be the mean) pic.twitter.com/OqC9Nor4gz
— Raoul Pal (@RaoulGMI) March 3, 2021
The S&P shows similar versus the Fed Balance Sheet but are roughly at fair value and essentially just counteract the Fed Balance Sheet growth (and suggests Non-US equities are cheaper). pic.twitter.com/MIriUzbdeG
— Raoul Pal (@RaoulGMI) March 3, 2021
So, what does this all mean?
We are looking at the wrong denominator for assets, as I have suggested before.
Broad based equities and Real Estate have trodden water since 2008, which makes total sense. To me it confirms the truthiness of this much used chart of Fed BS v SPX. pic.twitter.com/ud2aIKifqM
— Raoul Pal (@RaoulGMI) March 3, 2021
An interesting side note for the above chart is that the only time equities made significant real gains in respect to M1 money/federal balance sheet was from 2017-2020 (the ending of this true economic boom period seems to coincide with the start of the pandemic).
You might be thinking to yourself, “Well Xrayvsn, I could sell those shares and with the money received I can buy more things with it, so in fact I will have a wealthier lifestyle.”
That logic would definitely work if things are were treated in a vacuum.
Unfortunately things do not occur in a vacuum and a change to one part of the system will inevitably lead to changes that will percolate throughout the economy.
As more money is injected into the system it is a natural effect that things will then start to cost more.
If everyone on the planet had $1M what do you think it would do to the prices of finite, in demand, resources such as housing?
Prices of goods will start getting bid up to match the excess cash in the system.
The following tweet perfectly sums this concept up perfectly:
While the purchasing power of the dollar has gone up and down since 1913, it has never surpassed the purchasing power it had in 1913. $100 in 1913 would only be worth about $3.87 today. #btc #InflationHedge #BTC pic.twitter.com/P1bbDrVzrp
— Georgi Petrov (@georgi_petr) July 12, 2021
World governments that have FIAT based currencies are capable of printing money at any time to maintain their fiscal policies.
Incoming newly minted dollars serve to dilute the value of circulating money, a form of currency debasement.
Making more dollars that are worth less has the net effect of treading water financially.
In order to truly make financial headway, your returns/net worth needs to outpace the rate of inflation, which I feel is a lot higher than the reported CPI numbers reported by the government.
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I completely agree with what you’re saying that’s why asset allocation and diversification are critical in these times which include stocks, real estate, cryptocurrency and owning a cash producing business. With the certain passing of the infrastructure bill expect higher equity prices and more inflation to come.
Appreciate your comment. Yes I have been pivoting a bit in my asset allocation to hedge against inflation (I do not believe they will have us in a hyperinflation type situation like Venezuela but I have to believe some dark days are ahead).
Stocks, real estate, and crypto I see as decent hedges. Used to think gold was too but it seems to be so manipulated that it doesn’t rise in value as expected given current situation.
I really reduced my bond exposure because I feel inflation is going to hammer current bonds
Denominator is always growing so the numerator must grow just as fast at least.
Very true. I’m afraid the way the money printing is going on right now we may never raise the numerator enough