The Denominator Effect
The single most important factor for higher asset prices
Summary
Price gains can be misleading when measured in nominal dollars
Reframing prices in gold reveals recent gains are largely explained by debasement
A breakdown in the dollar’s nearly two decade long uptrend could be the main driver of a continued bull market
[five minute read]
Introduction
Let’s start with a brief thought experiment.
I’m trying to get in better shape and so commit to double my weekly running routine.
In week one, I get out for a run on three days.
Because I like to push it, I decide to go for gold in week two and target six days of running.
Week two arrives, and I accomplish my goal. Six runs.
I doubled my running routine in just one week, a 100% increase. High five.
We meet for happy hour and I’m eager to share the news. You, my analytical friend, inquire about my running distance.
My runs in week one were eight miles each. In week two, I didn’t have the stamina to maintain that distance for six days. My week two runs averaged four miles each.
In week one, I ran 24 miles. In week two, I ran 24 miles... an increase of exactly 0%.
The mistake I made is obvious, but this error is surprisingly common when measuring performance in asset prices.
Let’s Do Some Math
I was initially measuring the following equation:
When I should have been measuring:
Let’s look at the relative performance of the NASDAQ index using similar logic:
Becomes...
In the first example, mileage was the true measure of my endurance. The number of runs was less significant.
In the second example, purchasing power of my investment was the true measure of value. Price was less significant.
Let’s make this less abstract.
Stagnation
Assume you are looking for an investment. You do some research and conclude that a broad basket of technology stocks will best fit your needs, and you elect to invest in the NASDAQ index.
Assume the total basket of goods and services you consume in one year is $100,000. Let’s further assume the value of one unit of the NASDAQ is standardized at $25,000. It takes four units of NASDAQ to cover the cost of one year.
Ten years later, assuming your quality of living is constant, the cost of goods and services you consume in one year has increased at a 7% cumulative annual growth rate and now totals $200,000.
Luckily, your NASDAQ shares have doubled and are now valued at $50,000 per unit.
The value of your shares increased 100%, but your purchasing power was cut in half.
Are you any better off? Clearly you are not.
The Denominator Effect
Let’s examine this visually and touch on something I refer to as the denominator effect.
A simple way to visualize this is to change the unit of account, or denominator, when calculating returns.
We measure most assets in U.S. dollars.
There is no perfect measure of purchasing power, so we will use a familiar asset as a proxy.
Gold is just a shiny rock with limited productive use. However, gold has maintained its purchasing power over time, outpacing the consumer price index since unlinking from the dollar in 1971.
The NASDAQ index first became widely accessible in the late 1990s with the launch of the Invesco QQQ ETF.
Since that time, the index has produced nominal annual returns of roughly 10%.
Gold has produced nearly identical annual returns of roughly 10% over the same time horizon.
Here’s a chart of the NASDAQ (QQQ) measured against the U.S. dollar, up 1,400% since launch of the ETF in 1999:
Here’s a chart of the NASDAQ (QQQ) measured against gold, flat for nearly three decades:
The last 25+ years have produced rapid technological progress underpinned by the proliferation of high-speed internet, the ensuing network effects, software applications, and more recently artificial intelligence.
Aside from perhaps only the Industrial Revolution, the last 25 years saw more innovation than any other era of human history.
Despite this, the index best designed to capture value accretion from technology has produced no greater return than a shiny rock.
Let’s touch on one final example.
Real Estate
Since 2020, national home prices have risen 54.9% (FHFA data).
If a home that has not been renovated or expanded to add square footage has increased nearly 55% in value, the accretion cannot be explained by the increase in utility or aesthetics.
Certain areas have seen increased demand and supply shortages, but the increase in the national average is largely explained by the denominator effect.
Conclusion
The U.S. Dollar is the denominator of nearly all asset prices and the single most important macro variable.
Since the beginning of the 2008 financial crisis, the dollar index DXY (measured against a basket of other currencies) has been in a steady uptrend. Today, the dollar is near the lower boundary of that uptrend channel.
Let’s observe clues elsewhere regarding the future expected path of the dollar.
The euro looks like it may be breaking out from a nearly two-decade long downtrend:
The British pound looks similar:
Lastly, the chart of silver has invalidated the potential double top I was watching and is confirming a significant technical breakout against 45+ year resistance.
In my last post, I spoke about the lack of fiscal space for the U.S. federal government, largely driven by our elevated debt/GDP ratio and associated interest expense.
The Trump administration knows this and wants to stack the federal reserve board with doves who support lower interest rates. All other factors equal, lower rates would alleviate fiscal pressures and drive the dollar lower.
If my bear case is going to be invalidated and the bull market in risk assets is set to continue, a weaker dollar would be the most likely driver.