Fueling the Street
Greenspan’s easy money policies are creating ever more dollars – which are worth less and less. How many can the system take…before dollar holders decide to get out of the game?
The Street is thriving, thanks to interest rates we haven’t seen since the Kennedy administration and monetary growth we haven’t seen since Carter. And unlike other periods, where investors accused the Fed of "taking the punch bowl away" at the very moment the economy began to improve, this time the central bank keeps filling it no matter how wild the party becomes or how low the dollar falls.
The Fed’s easy money policy seems to be reviving the economy, while at the same time giving investors the confidence and courage of fighter pilots. As the Big Board returns to stratospheric heights, the question remains: Will the economy provide enough lift to prevent the markets from falling into a flat spin?
Most economists argue yes. They believe we are on the verge of growing productivity gains that will soak up the excess money sloshing around the economy, thereby eliminating Wall Street’s unspoken demon – future inflation.
The Wall Street consensus is that as the economy gains steam, the plethora of borrowed money will be invested into new capital, which will spur growth and employment. Once this occurs, the Treasury can slow down the presses, and after four years of cutting rates, the Fed can finally begin to raise them. The bulls believe that rising productivity and improved profits will make the stock market immune to higher interest rates.
The Demise of the Dollar: The Flies in the Ointment
It all sounds good on paper. But I think there are two flies in the ointment.
First, easy money has encouraged already overextended consumers to go even deeper into debt. With so much of this debt tied to variable rates, when interest rates go up – which they will inevitably do – consumption could slow to a crawl and bankruptcies could soar.
Second, excess greenbacks and poor returns on U.S. fixed investments have caused an exodus out of dollars. You can see this phenomenon in the dollar’s plummeting value against the euro. In the past two years, the dollar has fallen roughly 40% against the European currency.
But the dollar has declined relative to many other major currencies, too. The U.S. dollar index, which measures the market value of the dollar versus the trade-weighted average of six other currencies, currently sits at 86…down from its high of 120. Long-term support exists at 80, but I expect the dollar will break below this floor sometime this year. If foreign investors believe likewise, more dollars will be converted into other currencies…and into real assets.
The reason for this is simple. If investors become bearish on the buck, they will sell dollars. But no currency – not even the euro – is large enough to absorb a huge influx of capital without quickly becoming overvalued. That leaves investors with only one other choice – real assets.
Turning to real assets is exactly what happened in the 1970s. In 1974 my brother Richard, now an oil and gas lawyer, was an assistant to the Canadian ambassador in West Germany. He told me that hundreds of West German investors inquired about buying raw western Canadian farmland.
Were these investors afraid of the type of runaway inflation their country was tortured by in the 1920s? No, not one bit. They were worried about what they should do with dollar assets that had been sold. They believed too much money had gone into German marks and Swiss francs and that alternate currencies were becoming too expensive. So they began buying real assets. That included precious metals and even raw Canadian farmland.
That turned out to be a smart investment. A quarter section of land bought in southern Alberta in 1974 cost C$600. By 1980 that same quarter section could be sold for about C$1,200. During that same period, German investors who remained in 30-year Treasury bonds lost more than 40% of their repatriated capital.
Thirty years later, the dollar again faces a potential vote of no confidence by the citizens of the world. That puts the Fed on a razor’s edge. Weaken the dollar a bit, and the central bank can help ease the massive trade deficit. Weaken it too much, and the Fed risks a major devaluation…a devaluation that has already begun!
The Demise of the Dollar: Losing Superhero Status
I agree with analyst Paul van Eden when he says the dollar’s demise could just be starting: "The inflation of the dollar, the debunking of the American economic miracle, the arrogance of American Foreign Policy and, perhaps most importantly, the detrimental impact that the War on Terrorism is bound to have on American liberty – not to mention the misallocation of capital and increase in debt that go hand-in-hand with war – are all virtual guarantees that the dollar is going to lose some of its superhero status."
But it’s not just big investors who will be moving greenbacks into real assets. It’s also billions of citizens in the developing world who hold much of their savings in physical dollars.
Think about it. According to the Fed, there are 665 billion dollars in circulation. Now, there are about 285 million Americans. If Americans owned this stockpile of dollars, then every man, woman and child would have $2,333 in CASH, stuffed into their wallets, purses and mattresses. Of course, banks and retailers account for some of this money, but you get my point.
The truth is the dollar is held by everyone, everywhere. Princes hold it…paupers hold it…and so do communist dictators. The dollar is the currency that everyone in the world stashes away. There is a huge overhang of dollars that can be converted into something else without notice. And as the dollar continues to weaken, the world’s savers will increasingly opt to hold their savings in another type of currency.
But as in the 1970s, currencies outside the dollar will not be enough to absorb the exodus from the greenback. Real assets will have to take up the slack. That’s why we believe the secular bull market in hard assets is just getting started…and as the dollar falls, its prospects only look brighter.
for the Daily Reckoning
February 25, 2004
P.S. My colleagues here at the Daily Reckoning have put together a special report on how to position your assets safely outside the dollar. If you haven’t taken measures to protect yourself in the event of a dollar rout – or if you’re interested in profiting from its decline – it is simply a must-read.
See: Bonfire of the Currencies: 7 Ways to Sell the Dollar
Editor’s note: John Myers – son of the great goldbug C.V. Myers – is the editor of Outstanding Investments. Our man on the scene in Calgary, John has his fingers on the pulse of natural resource profits – including oil, gas, energy and gold.
This essay was adapted from an article in the February edition of:
What kind of God would make a world so simple we humans could understand it? We ask the question just to test our own thinking. Like lighting a match near a gas line, we look for leaks and jump back when we find them.
We think a huge, 50-year-old, dollar-centered credit boom in the U.S. is beginning to unwind. American assets are just beginning a major bear market. Before it is over, debt levels will be at half their present level. Stocks will be less than half today’s prices. Junk bonds will be worthless. And American workers, at least those who can find a job, will earn much less – relative to the rest of the world – than they do now. Gold, the anti-illusion metal, should be entering a major bull market. But what do we know?
Yet…imagine a world so obvious, so transparent, so predictable that every lump and numbskull could tell what was going to happen.
You see the problem, don’t you, dear reader? Everyone would take the most advantageous positions ahead of schedule; instead of waiting for a crash to wipe them out, for example, an investor would sell out in advance…and move the crash forward, long before it was ‘supposed’ to happen. God’s Own Plan would be ruined…corrupted by mortal simpletons…destroyed by his own nincompoop creations. God wouldn’t be God any more. He would be just another incompetent deity.
But what if just this sort of blow-up were part of The Plan?
Oh, the Great Puzzler…there seems no end to the mischief and subtle complexity.
Yesterday, for example, Alan Greenspan said that Americans have nothing to worry about. True, they have no savings…and job prospects aren’t so hot. But not to worry – they are getting richer thanks to rising real estate prices.
But what if the price of every house in America suddenly doubled, overnight? Would anyone really be even a penny richer? Of course not. Homeowners might THINK they were richer…and many would pay twice as much in mortgage payments.
People lurch from one illusion to another. As more and more people embrace the reigning illusion, they set in motion its own destruction…like passengers rushing to one side of a leaky boat, they soon swamp it.
Americans seem to think they need no savings. A bird in the hand seems hardly worth bothering with…not when there are two of them hiding in every bush. Nearly every investment has gone up more than the cost of money. Nearly every day, in nearly every way…things just get better and better.
Beating the bushes, they scare up birds and take a shot at getting rich. But the more bushes they beat, the fewer birds take wing. Dividend yields are below 2%. Residential real estate yields not much more. Bond yields are lower than they’ve been since Eisenhower was president – and bond prices are still going up. And what is left? Even junk bonds and emerging markets are sky high. Under the illusion that everything rises in price forever, investors have already bid everything up already. Where can it go from here?
Likewise, under the illusion that they will never really have to pay their debts, Americans have borrowed so much, they practically guarantee the end of the credit boom itself. Taking the most advantageous positions, individuals, banks and businesses – and even central banks – have borrowed so much that even at current low rates they have a hard time keeping up with the payments. And yet, they borrow still. Soon, they will have raced ahead to the end of the game…where they will be unable to borrow a single penny more.
And then, what will happen to the credit boom when there is no more credit? Imagine a world in which Americans had to repay their debts, instead of borrowing more. Imagine a president who submits a budget to Congress with a provision to pay off a half-trillion in federal debt…rather than add that much. Imagine the economy as Americans reduce debt to GDP levels from over 300% back to the 150% of the Eisenhower years. Imagine the strange world where Americans come to the conclusion that they will always have to pay their debts…and that stocks and real estate prices always go down…and that there are no birds in the bush worth beating for.
That day, dear reader, will be the day to buy!
Until then, here’s Addison checking to see what the lumps are up to…
Addison Wiggin en route for Puerto Vallarta, site of this week’s Supper Club meeting…
– "You have those [lumps] who are under-invested, frightened by the bear market and haven’t put their money back into stocks yet," an analyst told USAToday this morning. "They buy most days.
– "But you also have the profit-takers who have been in the market for a while and have made large gains, particularly in Nasdaq stocks. They are worried about a correction of some magnitude, so they’re locking in gains."
– For the past five days on Wall Street, those locking in gains have outpaced the market newbies…and have knocked Mr. Market on his arse. The Dow dropped 43 points, closing down for the fifth straight day at 10,566. The Nasdaq and S&P 500 lost 2 points apiece, closing at 1,991 and 1,139 respectively.
– The Conference Board revealed yesterday that consumers might finally have overcome their euphoric holiday shopping delirium, albeit a month late. In February, the consumer confidence index came in a full 5 points below ‘expectations’ at 87.3…down from January’s blissful 96.8. A survey of the dullards who track this number seriously showed the expected number to be 92.9. Our guess? Consumers are getting a little weary of Fed professions of faith in an improving jobs picture…and are starting to reign in credit card spending.
– But what’s this? One of the Fed governors was all but committing political heresy yesterday in London. The Fed’s Edward Gramlich, who is also a former director of the Congressional Budget Office, told bond traders that "fiscal austerity is the one tried-and-true approach to dealing with budget and trade deficits simultaneously."
– "That’s bad news," opines Bloomberg’s John Berry. "As Fed Chairman Alan Greenspan put it last week, there’s no constituency in this country for a balanced budget." Seems like your wistful editors might have had the same idea at one time or another. Rather, we suspect with a sigh, neither consumers nor the nimrods they’ve elected to Congress are going to go softly into the dying light of credit-driven, debt-drenched consumer capitalism.
– "There are serious deflationary forces at work in the world at large," writes our friend John Mauldin. "There is an imbalance in world trade, as the U.S. has accounted for 96% of the growth in world trade for the last few years. Thus, foreign nations have to be willing to either not take depreciating U.S. dollars and suffer the inevitable slowdown in their economies, or take less for their products in order to be able to keep their work forces producing and economies bumping along."
– The dollar fell a penny to $1.26 overnight against the euro…well above its historic low set last Tuesday. But in spite of last week’s retrenchment in the dollar, the imbalances in world trade remain a cause for concern – for anyone holding dollar assets. "The odds on a dollar crisis are high enough," explains Peter Bernstein, "to warrant setting aside some portion of portfolio assets as a hedge to protect the positive bets that most portfolios contain…a dollar crisis appears to be a real possibility. As all the necessary conditions for this catastrophe are in place, no investor can afford to ignore risks of this magnitude."
[Ed note: For a more complete look at Bernstein’s warning, see John Mauldin’s review on the Daily Reckoning website:
The Stubborn Trade Deficit ]
– "In case you were wondering," writes Chuck Butler on the Everbank Trading desk, "This is not the end of the dollar weakness! For anyone saying that it is, I have to ask, why they would think that! The Current Account/Trade Deficit is still out of hand, The Budget Deficit is growing like a weed, yields on assets are abysmal…The U.S. administration is in love with the weak dollar, especially in this election year…And they have a strong willingness to allow the markets to direct the dollar lower…So…There you have it! Besides, trends don’t end on a dime like that!"
– Suspecting that last week’s climb back to $1.25 was classic ‘short squeeze’ – too many short positions, all loaded with stop losses – Chuck says he’s got his "finger on the trigger" again. "I’m not totally prepared to sound the ‘all clear’ horn," says Chuck, "but the slate is clean, so to speak, and investors can now make new trades based on what they see the dollar doing…Hmmm…Myself? I would be shorting it again!"
[Special Announcement: Mr. Butler and friends at Everbank reveal their secrets to shorting the dollar in our first ever Special Reckoning Report – "Bonfire of the Currencies: Seven Ways To Sell The Dollar." NOW AVAILABLE! If you want a copy, read the following:
Bonfire of the Currencies: 7 Ways To Sell The Dollar ]
Bill Bonner, back in Nicaragua…
*** The price of gold shot up more than $5 yesterday.
*** Americans put $47 million into mutual funds last month – the boom is still on!
*** "Yes, I thought property in this area would rise, too," your editor replied to his wife as the conversation continued.
"Well, why didn’t you buy some property?"
"Hmmm…investors shouldn’t invest on the basis of what they think will happen," he explained, "but on the basis of what should happen…"
He was about to describe how he thought investors should position themselves…not according to their own dim view of the future, but according to what ought to happen. A good stock at a cheap price ought to go up. A bad one at a high price ought to come down. (The coast of Nicaragua was so beautiful, it ought to be more expensive, he thought to himself…but he left it out of his argument since it seemed to contradict his excuse.) A person might expect stocks to rise…and still bet against them. Or, he might think real estate prices would continue to go up…and still not want to buy…
But he was cut off…
"Oh…don’t start…" said the distaff half.