This "new era" we live in is very strange indeed. It is now widely recognized that the "wealth effect" of the stock market has played an enormous role in our perception that we can spend ourselves rich. Simply stated, the more we spend, the more profits companies make, the higher their share prices rise and, because everybody now owns stocks, the more wealthy we become.

It all started a while ago when the US economy was surging ahead and inflation was nowhere in sight. Because the market is forward looking, and looking forward all that anyone could see was more economic growth and thus higher corporate profits, future profits discounted to present values kept on increasing. This lead to higher price/earnings multiples for companies as the economic growth implied ever increasing profits. Because inflation was nowhere in sight, there was no reason to believe that the ever growing US economy, and by implication US companies, could not keep on growing at unprecedented rates.

The tremendous economic growth and ever increasing stock prices became a problem for analysts that used fundamental evaluation techniques to analyze stocks. This dilemma was quickly solved by abandoning fundamental analysis in favor of relative analysis. Relative analysis can be summarized as follows: Assume two comparable stocks, A and B, in the same industry. If company A is less than company B, then buy A. This generally causes A to increase relative to B, which makes B more attractive to buy. So now buy B, until it eventually becomes more expensive than A, then buy A again, etc. Anyway, this form of share price analysis led to a rapidly increasing stock market because there is always a bargain somewhere if you play by these rules. Since we don't need fundamental analysis any more in the "new era", there is also no risk, right?

We also have to address the economic principle that the "new era" is based upon, namely rapid economic growth without inflation. Starting around 1995, most major economies in the world were in shambles. Japan was mired in recession, Europe was weak with record unemployment, but the US was strong and growing stronger. At the time, Japan's interest rates were closing in on zero, and Europe's interest rates were lower than US interest rates. So, in addition to being the only major economy in the world with strong growth prospects, US bonds also yielded substantially more than the bonds of other major economies. It was a "no brainer" for international investors to invest in the US bond and equity markets. Up until then, the US dollar had been steadily declining due to our ever-increasing trade deficit, which was about $95 billion in 1995. But starting in 1995, the US dollar started to strengthen because of a tremendous surge in foreign investments into the US.  Net foreign borrowing jumped from $28 billion in 1994 to $188 billion in 1995.

All this foreign investment into to the US caused the dollar to strengthen and the demand for US bonds caused US interest rates to decline. The trade deficit also ballooned, as would be expected, to an annualized value of over $300 billion at the moment. This had the effect of keeping inflation in check during our stock market boom and economic expansion. Credit in the US grew to record highs as individuals and corporations took advantage of low interest rates to load up on debt. But the ever decreasing interest rates meant that borrowing costs kept on declining and hence helped keep inflation in check. In addition, the US was importing more and more goods from outside the country with a stronger and stronger dollar, also helping to keep inflation at bay. So nirvana was finally reached, we could spend as much as we wanted to, if we run out of money we could borrow some at low interest rates, prices were declining and the stock market made everyone rich. US savings rates recently went negative, implying that US individuals were spending on average more than what they were earning.

Now review the basis of ever increasing stock prices, which were relative stock valuations, and ever increasing profits due to low inflation, coupled with low interest rates and a strong economy. As long as the economy was growing strong, corporate profits would grow and share prices could increase. The strong economy was fueled by low interest rates due in large part to foreign investments. A dilemma arises because the market has realized that interest rates are bound to increase from now on. So where could any good news possibly come from, if good news is actually bad news?

If interest rates decline, which should be good for the economy and businesses, the market will become concerned with inflation. But if interest rates increase, it will reduce economic growth, which will reduce corporate profits and hence cause share prices to decline. However, declining share prices will make all our new millionaires feel less wealthy and reduce consumer spending, which would further erode corporate profits and bring down share prices. The point is it doesn't matter what happens next. There is no more good news out there for the stock market and I believe the end of the biggest bull market in history is upon us.

PS. Another effect of what I believe is happening, and is going to happen, is that the US dollar will again start to decline. In fact the dollar has already started its descent. This bodes well for gold, because gold is predominantly mined and bought outside the US but priced in US dollars. As the lure of the dollar diminishes and money is repatriated to its native countries, I wouldn't be surprised to see gold trade substantially higher than where it is today. One of the reasons why the dollar is weakening is because there is a perception of renewed growth outside the US, primarily in Japan, Southeast Asia and in Europe. But the first two are intimately dependant on US economic activity for exports and therefore if the US economy slows down, it is not unlikely that the turnaround now experienced by Japan and Southeast Asia will be short lived. That leaves only Europe and Europe is by no means certain to be able to maintain strong economic growth if the rest of the world is slowing down. If the US dollar loses its appeal, and there is no other immediately obvious investment alternative, would investors turn to gold once more for protection of their wealth?