Staying On the Right Side of the Inflation Trade

“Stocks rose to another high for the year [yesterday],” according to the Associated Press, “after Federal Reserve Chairman Ben Bernanke said central bank officials expect the economy to continue recovering.” It’s true stocks soared yesterday, but we’re not so sure the “recovering economy” was the primary cause.

No, we’re going to stick with our working hypothesis: the stock market is soaring because the dollar is tanking. The more the dollar tanks, the more the stock market soars. This inverse correlation makes perfect sense. If you are holding a rapidly depreciating asset, why not exchange it for an appreciating asset…or at least an asset that offers the potential to appreciate?

This dynamic – falling dollar, rising stocks – is just another way of saying the stock market, in aggregate, has become little more than an “inflation trade.” This particular inflation trade may contain a variety of stock symbols and may attract continuous, hyperactive blather on financial news networks, but it is still just an inflation trade.

Believing that a dollar bill will buy less tomorrow, US investors will use their dollars to buy almost anything today, including richly valued stocks. US stocks, as an inflation trade, have performed adequately so far in 2011. The S&P 500’s 7.5% year-to-date gain roughly equals the Dollar Index’s year-to-date loss.

Over longer time frames, however, the US stock market has delivered a much less effective hedge against the falling dollar than, say, gold or silver. During the last 10 years, for example, the S&P 500 produced a cumulative total return of 33.7%…when measured in US dollars. When measured in Australian dollars, however, this gain flips to a 35% loss!

Total Return of S&P 500 Over the Last 10 Years in US and Aussie Dollars

In fact, in terms of every major world currency, as well as numerous minor world currencies, the S&P 500 has been a losing bet for the last decade. In terms of the precious metals, the S&P 500 has been a very large losing bet.

Total Return of S&P 500 Over the Last 10 Years in Currencies and Precious Metals

By simply exchanging dollars in April 2001 for any of the currencies or precious metals in the chart above, a dollar-phobic investor would have received a greater total return than by buying US stocks. Bear in mind that this chart does not include in its calculation the interest an investor could have earned in any of these foreign currencies. For perspective, the Aberdeen Asia-Pacific Income Fund (a closed end fund that holds Australian and Asian debt securities) has delivered a whopping total return of 289%!

So you see, inflation isn’t all bad, as long as you’re on the right side of the trade. The US dollar, as a store of value, has been a complete disaster for many, many years. The critical question for investors is whether this trend will continue…or reverse.

We cannot see the future, of course, but we can hear what Fed Chairman Ben Bernanke says about his future intentions. And during yesterday’s press conference we heard the chairman promise to continue pursuing inflationary policies, while also dismissing the inflation he has already created as the “transitory” result of “robust global demand.” In other words, the inflation problem isn’t a problem.

The longer he spoke, the more the financial markets seemed to realize he wasn’t kidding about this inflation stuff. The US stock market – remember, it’s an inflation trade – rebounded from early morning lows to end the day at a new three-year high. Meanwhile, the classic inflation trades, gold and silver, rocketed from early morning losses to post huge gains. Silver jumped $2.36 an ounce to a new 31-year high of $47.84. (As we write, silver is flirting with $50 an ounce). Gold gained $21 an ounce to a new all-time high of $1527.35.

And what about the almighty dollar?

Bernanke declared, “the Federal Reserve believes that a strong and stable dollar is both in American interests and in the interests of the global economy.” The foreign exchange markets seemed to choke on their laughter.

The dollar stumbled to a new two-and-a-half year low…and continues stumbling today. By contrast, the Australian dollar, Canadian dollar, Singapore dollar and Swiss franc are all hitting new all-time highs!

At some point, perhaps very soon, the “overbought” gold and silver markets will conspire with the “oversold” Dollar Index to embark on ferocious counter-trend moves. We should be prepared for such an eventuality, but not perplexed by it. The ending of QE2 in June would provide a reasonable excuse for such countertrend moves. But if/as/when the dollar rallies, don’t forget to hit the bid.

The greenback remains a sick puppy… and inflation is its life threatening disease.

Eric Fry
for The Daily Reckoning