Fistfuls of Dollars

by Paul Mampilly

Large gains are piling up in commodities markets and prices are surpassing levels that are well beyond those dictated by demand and supply calculations. Some commentators and journalists have even raised the “B” word (i.e. bubble) with respect to these gains.

The largest gains have accrued to industrial and precious metals with copper, zinc, aluminum, silver and gold that have each marked multi-decade high levels. Increasingly, the stock explanation of “soaring demand from China and India” can no longer explain the surge in the prices of these commodities. Capuchinomics believes that something larger and potentially more troubling is afoot.

As we search for explanations we find little in the last quarter century by which to compare the current commodities boom and its implications for contemporary financial markets. However, this much we do know, investors can put away the market handbook of the last financial era, which ended in 2000. This handbook in hindsight can be summarized in two lines: “Buy the dips in US stock and bond markets. Hold and never sell.”

Following these two guidelines over the last bull market has minted millions of millionaires in the US who have by skill (few) or by chance (most) invested their money in stocks and long duration bonds. This largely accidental achievement has inured both professional and amateur investors to easy success and a belief that these markets always go up. They are not aware that the handbook’s two line rule is not a coda. The context and circumstance that made following the handbook’s rules so profitable no longer exist: disinflation, declining interest rates, a rising dollar and declining real costs for raw materials (i.e. commodities). Investors still betting on a “buy the dips” strategy are in for a surprise.

The intuitiveness of this strategy is appealing, especially as the current environment looks so familiar to previous “buy the dips” opportunities i.e. the Federal Reserve is putatively near the end of a rate hiking cycle, after which many believe is a rate cutting cycle, followed by higher stock and bond prices. However, the resemblance to the “buy the dips” era is superficial. Today there are new factors to consider, ones that make recent history a poor model on which to base future investment choices.

After a bear market, and a cyclical bull market, the factors that converged to bring about the greatest bull market in history are now reversing, permanently. Without manipulation of government statistics (eg: use of rent over housing prices in inflation calculations), inflation would be rising steeply. Interest rates of all maturities are now rising. Commodity and raw material prices have been rising for 5 years now. Critically, the dollar, after a year’s hiatus is declining again.

This is an unpleasant concoction for US financial markets. The predicament of the dollar in particular has malevolent implications that will define the next epoch in financial history. However, after screaming about the dollar and imbalances (the twin deficits) and interest rate conundrums, critics of the dollar and US finances have grown subdued. This has emboldened the dollar’s apologists to make their case.

This week, Gerd Hausler, the IMF’s director of capital markets poked fun at the impotency of dollar critics like Capuchinomics, saying that “It would not be serious for us to cry wolf and pretend that the dollar was about to collapse in the next six months. You cannot compare a small country to a big country, especially if it is a reserve currency country.” Hausler clearly missed out on the exciting times in US capital markets between 2001 – 2003 when the dollar’s decline was accompanied by collapsing asset prices, despite being a big country and having the world’s reserve currency.

The IMF though has an excellent track record, of being wrong. Remember Argentina? Even as that country was piling up ruinous deficits and debt, the IMF refused to admit there was a problem and insisted that things would magically work itself out. And sure enough now, the IMF and Hausler claim that the US and the dollar will be just fine and that market stability is “as good as it gets.”

Capuchinomics thinks otherwise. The US dollar is a diseased currency, afflicted by the widely known but largely undiscounted twin (budget and current account) deficits and its economy dominated by speculation and debt driven consumption. We think that the precipitous rise of industrial and precious metals are leading indicators of wider price increases in all dollar denominated commodities that will lift inflation and interest rates in the US.

This view is still filed under “crank and crackpot theories” by most financial analysts and commentators. After years of predicting a dollar crisis without success, cranks and crackpots predicting the currency’s demise deserve their notoriety. Yet, even a casual observer can see that the current environment is ripe to catalyze a crisis. The Iranian nuclear issue, the ongoing Iraq debacle, the $8.4 trillion national debt, the bursting housing bubble are all lined up at the ready to precipitate the dollar’s decline. Alan Greenspan, ex-Federal Reserve chairman the man responsible for the dollar’s sad predicament thinks a devaluation of the dollar is both “unlikely” and “probably ill advised.” Thanks Al. We’ll check back with you after the housing prices have collapsed and the dollar broken by soaring inflation.

A dollar crisis will have far reaching ramifications for Asian central banks who have accumulated treasury securities in quantities that threaten their own economies. The US is going to have even larger deficits in the future as it must fund the baby boomer’s retirement, the war in Iraq and higher defense spending. This need for funding is occurring just as Asian central banks are beginning to lose their ardor for treasuries. Oil producing Arab states too are losing their desire to hoard treasury securities. All of this is occurring with the backdrop of rising raw material prices and higher inflation.

The IMF is right about one thing. The US’s reserve currency status allows it more options than a country like Argentina. It can choose to “break the bank” i.e. maintain the value of the dollar or “break the dollar” i.e. save the economy. By this we mean that the Federal Reserve could raise interest rates precipitously to defend the dollar but will not. Instead they will allow the dollar to sink by keeping interest rates low. Congress pandering to a suddenly pathologically insecure electorate is readying protectionist legislation and a pork filled 2007 budget, that could precipitate a “break the dollar” event.

As we wrote earlier, recent history is a poor guide for what is occurring today in financial markets. However, history does provide a central lesson: times change, human behavior does not. The real fundamentals in financial markets now and forever are fear, greed and fairness. Using such an analytic framework we can begin to construct a vision of what lies ahead for investors. Extrapolating the lessons of the last bull market that ended in March 2000 to the contemporary period is a strategy for maximizing losses and minimizing gains.

Inside this week’s issue of the Capuchinomics behavioral finance newsletter we provide our thoughts as to how subscribers should position themselves for markets that we think will resemble a period far beyond the purview of current statistics and analysis.

[Editor’s Note: Paul Mampilly, CFA is the Editor & Publisher of Capuchinomics. Paul previously worked at Bankers Trust, Deutsche Bank and ING as portfolio manager/equity analyst between 1991 and 2003. He earned his MBA from Fordham University and his BA from Montclair State University. Paul was awarded the Chartered Financial Analyst (CFA) designation in 1997.

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