If you look carefully at Japan's experience over the past decade, that's just what happened. After a period when most market participants expected the Bank of Japan to move to a more neutral policy stance - the market had priced in a modest rate hike in July 2000 - the collapse of Sogo bank that month moved the BOJ back to a zero-interest rate policy, which was followed by explicit quantitative easing several months later. In the 18 months following Sogo's collapse, the yen depreciated by more than 20% (the number of yen purchased by one U.S. dollar increased from 105 to 135). That initial depreciation then set up a subsequent yen appreciation to make up the lost interest rate differential. The chart below traces the path of the yen versus the level implied by purchasing power parity (PPP).
In short, quantitative easing is not a story about inflation. It is a story about capital market equilibrium and the need for exchange rates to act as the adjustment variable when the central bank lays its weight on the bond market. The likely outcome of quantitative easing is not hyperinflation. Rather QE is likely to provoke a relatively quick plunge in the exchange value of the U.S. dollar.
With respect to gold and precious metals, as I noted years ago in Going for the Gold, factors that influence real interest rates and the value of the U.S. dollar are the primary drivers of gold price fluctuations. Moreover, the level of gold stock prices relative to the price of the metal provides useful information that is well-correlated with subsequent long-term returns in those shares. While I consider our present holdings of gold shares in Strategic Total Return as moderate, and we would prefer some amount of share price weakness before establishing a more aggressive stance, the high gold/XAU ratio, weak leading economic indicators, and renewed real-interest rate pressures all appear supportive.
Valuation update
On the valuation front, we presently estimate that the S&P 500 is priced to achieve total returns over the coming decade of less than 6%. Though we use a variety of methods, the consensus estimate is at about 5.6% annually. I've detailed our estimation methodology in numerous weekly comments over the years. Below is a chart taking this analysis back to 1928. It would be nice, before quoting alternative valuation models, if Wall Street analysts would at least present similarly broad historical evidence that their methodology actually has a relationship with subsequent market returns. If a valuation opinion doesn't come with extensive historical evidence, it's noise.
That said, one thing that does concern me about the foregoing model is that our "real" inflation-adjusted version projects a 10-year real total return for the S&P 500 of just over 1% annually. That suggests that about 4% of the nominal return projection represents implied inflation, which would be consistent with post-war U.S. history, but may or may not be accurate in this instance. My guess is that, in fact, we will observe significant CPI inflation in the latter half of this decade. Still, it is worth noting that our projection for real 10-year returns is not compelling in any case. 10-year real returns for the S&P 500 have been predictably negative since 1998, but it is unfortunate that except for a few weeks in early 2009, we have not yet achieved a level of valuation from which we can expect a meaningfully different result.
It continues to fascinate me that Wall Street analysts choose to benchmark projected S&P 500 returns against the 10-year Treasury yield. A 10-year Treasury note has a duration of about 7 years (which also implies roughly 7% price fluctuation in response to a 100 basis point change in yield). The S&P 500 presently has a duration of nearly 50 years, which is the investment horizon one needs to have in order to be completely indifferent to the shorter-term path of stock prices. The models and comparisons made by Wall Street between operating earnings yields and interest rates are a complete absurdity, which can be easily demonstrated by looking at the historical record (which I've presented repeatedly).
