Eric Fry

A fertile imagination is usually the enemy of successful investing.

Imaginative investors tend to see their stocks as the “next Microsoft” or the “next Berkshire Hathaway,” even when the stocks they own are much closer to being the next Enron or WorldCom. That’s why successful investors are much more likely to possess a skeptical eye than a fertile imagination.

“But on the threshold of a crisis,” as we observed in yesterday’s Daily Reckoning, “a fertile imagination can be an investor’s most valuable asset. [During normal times], investors can focus only on buying quality stocks one-by-one from the bottom up, without also trying to envision what tragedies might befall them from the top down. But in the context of a euro crisis that could become a dollar crisis that could become a global monetary crisis, it may be time to begin imagining the unimaginable.”

It may be time, in other words, to begin considering that the next phase of the global monetary system might not include the US dollar as its reserve currency…or that the next two decades of life in America might not look anything like the last two decades.

Not just any sort of imagination will do. The wrong kind of imagination is already running rampant in the US economy. As Bill Bonner put it recently, “the dollar pretends to be real money. Debt pretends to be capital. And regulators pretend to be smarter than capitalists.”

This game of make-believe is not likely to end well.

Therefore, to prepare effectively for the end game of the world’s make-believe monetary “system” will require the imagination of a Sean Egan, at least, if not the imagination of a Vladimir Lenin.

Over the weekend, Egan-Jones Ratings Co., of which Sean Egan is president, cut its rating on US government debt from AAA to AA+, becoming the first of the four credit-rating agencies to do so. The downgrade will not likely cause any noticeable ripples in the financial markets because the financial establishment considers Egan-Jones to be an also-ran. It is not Moody’s or Standard & Poor’s which, from our perspective, is precisely the reason to pay attention to Egan-Jones’ assessment. This ratings agency has distinguished itself numerous times for being ahead of the curve.

But honestly, it doesn’t take much imagination to envision the United States as a AA+ credit instead of a AAA credit. Investors may need to think even farther outside the box than Egan, perhaps as far outside as Vladimir Lenin.

When most of us think of imaginative individuals, we might think first of J.R.R. Tolkien, and then maybe J.K. Rowling. Lenin would be third, at best. But way back in 1917, as Joel Bowman observed recently, Lenin offered some shockingly prescient predictions for the century ahead:

Germany will militarize herself out of existence,
England will expand herself out of existence,
and America will spend herself out of existence.

“Had he known the inherent shortcomings of his own political ideology,” Joel remarked, “Bolshevism’s bad boy might also have added, ‘And Russia will plan herself out of existence.

’

“As for the United States,” Joel continued, “it seems she is not content with simply spending more than she produces, foisting the unfunded obligations onto future generations; instead, she militarizes, expands, spends AND plans toward her own demise…as all once great empires eventually do.”

The process Joel described is the process Bill Bonner dubs, “Imperial Suicide” – the inevitable tendency of empires to implode upon themselves. Some form of this process appears to be underway in the “wealthy nations” of the West, not excluding the United States.

As empires implode, so do their national currencies. As some point, cause and effect become indistinguishable from one another. The economy and the currency of the imploding empire begin circling the drain together.

Imagination is the best protection. A fertile imagination will not prevent a euro crisis or dollar crisis, but it could protect an investor from the consequences of such a crisis.

To illustrate the destructive power of a currency crisis, let’s examine a few pages from recent history…

During the Argentine peso crisis of 2002, the shares of the Argentine oil giant, YPF, climbed more than 50% in five months, even while MERVAL Index of Argentine stocks fell. Unfortunately, YPF’s impressive, market-beating returns occurred in the context of a massive currency crisis, during which the Argentine peso lost about three quarters of its global purchasing power. In US dollar terms, therefore, YPF did not gain 53%, it fell 55%!

Argentine Oil Company YPF in Argentine Pesos and US Dollars During 2002 Crisis

An identical story played out in Brazil, as the real unraveled during the second half of 2002. Shares of the Brazilian mining company, “Vale,” climbed 40% between March and October of 2002, while the Bovespa Index of Brazilian stocks fell 40%. In dollar terms, however, Vale’s “strong” 40% gain was actually a 15% loss.

Four years earlier, the Russian ruble suffered an even more spectacular collapse than the Brazilian real. Amidst this harrowing currency crisis, Russian stocks soared nearly 300%… in ruble terms. But they went absolutely nowhere in US dollar terms.

Russian Stock Performance in Rubles and US Dollars During 1998-1999 Crisis

Just a wee bit of imagination enabled some investors to steer clear of these crises. But shockingly, the vast majority of professional investors failed to imagine these crises, even though Argentina, Brazil and Russia all possessed a rich history of monetary incompetence and chicanery.

In 1969, for example, the Argentine government trimmed two zeros off the existing Peso Moneda Nacional to create the new Peso Ley. In 1985, the government slashed four zeros off the Peso Ley to create the Peso. Then in 1992, the government cut three zeros off the Peso to create the Austral, simultaneously linking it to the US dollar, one-for-one. Ten years later, this peg to the dollar ruptured and the Argentine currency swiftly lost 75% of its purchasing power…again.

In other words, investors required almost no imagination to envision the Argentine currency crisis of 2002. Today, however, investors will require an imagination so vivid and wild that it would border on hallucinogenic. They must not merely imagine that an Argentina might have a currency crisis…again…they must try to imagine that the euro might splinter apart…or that the dollar might suffer a disastrous hyperinflation. Today, the looming potential crises are not unfolding in banana republics or in chronic economic basket cases, they are unfolding in the world’s strongest economies.

As your editor pens these words, he is sitting in a beach chair, digging his toes into the warm sand of one of Laguna’s nicest beaches. The sites before his eyes are beautiful, tranquil and comforting. The folks lounging in chairs nearby are playing cards, drinking beer and sharing laughs. A short distance away, others are a playing in the surf.

Life is good, even if the economy isn’t perfect. A true crisis seems unimaginable. After all, even the 2008 crisis wasn’t that bad. And today, the Apple store in the mall is always packed, most of the restaurants in town are full…and the dollar is still strong enough to buy a nice vacation almost anywhere in the world.

A currency crisis that triggers an economic crisis – or vice versa – just feels like a bunch of wacky, doom and gloom stuff. And it may well be. We hope it will be.

But what if it’s not? To prepare effectively for a large-scale currency crisis requires a lot of time and energy, as well as a dose of good luck. So a lack of imagination is no longer a viable luxury.

In the context of America’s legendary resilience and economic might, a catastrophic currency crisis seems almost unimaginable… But the time has arrived to begin imagining it…not because it is certain, but because it has become less unimaginable.

A Brazilian newspaper recently featured the following photo:

US Dollar as Toilet Paper

It’s just a joke, right?

Regards,
Eric Fry
The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial's Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.  Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research, institutional research products dedicated to international investment opportunities and short selling. 

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry  supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts.  His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

  • Sweet Baby Jesus

    Imagination?

    It doesn’t seem to matter how much do diligence I do. Something always happens.

    Flood, hurricane, drought, the CEO runs off to Brazil with the corporate treasury. Now my preacher says the economic down turn is caused by my Emperor/President having sex with Sun Demons.

  • Bill

    As long as the US dollar retains it reserve currency status, wouldn’t it be acceptable to own any fungible asset as long as it inflates at least at the pace of the US dollar?

  • http://wallguys@hotmail.com Randy stoehr

    Hey Eric, So enjoyed the comment about toes in the sand @ laguna. My inlaws had special friends in emerald bay. Co-authored a legal book many years as a winter project in their home in the canyon overlookin it all. On several occasions we (they) rented Hoppy’s and Graces Boyds well worn summer trailer home in the now extinct historical Dana Strand Club. The gated (locked in a time warp) community of 1950’s trailer park between Dana Point and Saltcreek beach. If i remember correctly the site sat on 20 acres of slope from the PCH to the waters edge. all the trailers terraced overlooked each other roofs and sat on 1/4 acre spots. the club office open only 6 days a week ,8-430pm. a 1940’s switchboard gal in the office was the only link to the world. I believe it ended in 1988 when the real estate values south of it began fetching over $1.5million for a 1/4 acre lot. A developer bulldozed the site. A quick glance on google earth reveals lots of empty lots still for sale. (i see there is a “tram” that splits the property lines that transfers folks from the highway to the beach.used to be a hidden concrete drainage 1/2 pipe folks snuck down to the beaches on.)How cool is that? Lazy Bums! Thank you for jarring the brain on such sweet memories. Rand

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