One of the more challenging tasks in high finance is making the distinction between “paper wealth” and economic health. Are the two related? Sure. Are they positively correlated. Sometimes, particularly on the downside. Does one matter more than the other? That depends upon who you are.

Too frequently, writers will talk about paper wealth like stocks in the same breath that they talk about the country’s growth domestic output (GDP) – a key measure of economic well-being. Erroneously, they imply that if a stock market is hitting all-time nominal highs, the economy must be firing on all cylinders. The assumption is ludicrous. Americans barely feel the Great Recession ever ended due in large part to underemployment, sub-par 2% average annualized economic growth and wage increases that have barely kept up with inflation. Meanwhile, the top 10% of earners who own the bulk of market-based securities have been the primary beneficiaries of Federal Reserve efforts (e.g., zero percent target rates, QE1, QE2, Operation Twist, QE3, etc.) that encouraged corporate borrowing as well as speculative asset purchases.

Where’s the disconnect? For those who can afford to acquire riskier stocks and bonds (i.e., businesses with stock buybacks, higher net worth individuals, etc.), they may experience a temporary “wealth effect.” Yet the Fed’s policies did not actually improve the overall economy. Does anyone believe that with stock prices within a few percentage points of all-time nominal records that the U.S. economy could sustain itself without record-setting accommodation by the Federal Reserve? The $4 trillion with a “T” sitting on the balance sheet of our central bank as well as our inability to normalize rates pretty much tells the tale.

You don’t believe me? Then perhaps you should heed the words of the previous chairmen of the Fed. Alan Greenspan recently acknowledged that quantitative easing (QE) did not help the U.S. economy; rather, QE fostered paper wealth. Even more recently, Ben Bernanke suggested that Americans will not see normalized rate in his lifetime. In other words, the economy is relatively weak because it cannot function without lower-than-normal borrowing costs. Meanwhile, investors in paper wealth also require low rates to keep winning. Investors also require the Fed to walk a tightrope between the discussion of raising borrowing costs and the actuality of doing so at a turtle’s pace.

In truth, the economy might be better off if it suffered a genuine recession and worked through the issues until it demonstrated resilience without endless Federal Reserve rate manipulation. They’ve already created risks such that it may be more difficult to be of service in the future where their tools for economic stimulation – lowering interest rates, quantitative easing – may not mean as much with bond yields already at ultra-depressed levels.

Whereas some may deride stocks, bonds and market-based securities as though they are inferior to physical assets like land, property, metals and equipment, I do not share that point of view. There are advantages and disadvantages with both. On the other hand, the chief problem with paper wealth is that the bulk of the investment community appear oblivious to the risk. Even a run-of-the-mill bear market in stocks and higher-yielding bonds could set $1,000,000 back to $750,000; another collapse in faith could cut that portfolio down to $500,000 or $400,000. And then what? Hope and pray that central banks will be able to pump up the volume yet again over the next four, five or seven years, just so one breaks even?

Certain realities are indisputable. For example, stocks are ridiculously overvalued by virtually any respectable measure used in history. It does not matter whether you employ Tobin’s Q, Market Cap-to-GDP, trailing P/Es, cyclically-adjusted P/Es, price-to-sales or another valuation technique; in most instances, only the lunacy of the year 2000 appears worse. Second, the only means by which one can protect his/her paper wealth from a future bearish event will be his/her ability’s to convert his/her risky paper assets to less risky ones at a relatively beneficial moment in time. Unfortunately, most will fail that test, fearing tax ramifications or overestimating a lack in position liquidity or failing to have a plan for capital preservation beyond “hold-n-hope.”

Historically, there are a wide variety of paper assets that, while they may not be known for creating huge sums of paper wealth, they’re revered for the ability to preserve financial capital as well as promote some appreciation. For example, zero-coupon treasury bonds often move in the opposite direction of stocks on a given day. Over a period of 18 months, however, they might both achieve admirable gains. Zero-coupons via PIMCO 25+ Year Treasury (ZROZ) garnered close to 45% in an 18-month time span when the S&P 500 picked up approximately 25%.

Another reason to be cognizant of paper-wealth preservers? U.S. stocks as measured by the New York Stock Exchange’s Index has made virtually no progress over the last nine months. In contrast, muni bonds via iShares S&P National Municipal Bond (MUB) as well as currency havens like the greenback for PowerShares Dollar Bullish (UUP) have been spectacular.

NYSE Nine Months

MUB Nine Months

UUP Nine Months

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