“”[W]hat the United States owes to foreign countries it pays – at least in part – with dollars that it can simply issue if it wants to.”
Charles de Gaulle,
President of France
“I agree that the dollar is probably over-rated,” wrote a Daily Reckoning reader, in response to my harping on the subject, “but if not the dollar…what? Surely not the euro…”
Longtime Daily Reckoning masochists know that we live in an imperfect world. Justice is not meted out with the regularity and fluidity of laxative elixirs; nor are fools as quickly or dependably separated from their money as, say, married men or IRS audit victims. Even the earth itself tilts on its axis… and migratory birds, responding to the seasonal impulses triggered by the listing globe, sometimes get lost.
And yet, somehow, sometime, somewhere – the books are balanced. People get what is coming to them. After 180 days, the sun is back in the sky as it used to be…and life goes on.
With this rather poetic approach to the mishaps and cycles of life, we take yet another peek to see if we can spot that yeti of the currency markets – the bottom of the euro. We will also suggest an alternative.
The trigger for this reflection, should you wish to blame someone, was an article in Grant’s Interest Rate ObserverIn this piece, Grant proposes an answer to the question posed by our reader above. If not the dollar, what?
Well, the New Zealand dollar…for example.
The fall of the dollar has never been a popular theme with Americans. It does not resonate in the collective imagination the way “the top 1% of taxpayers” or “saving Social Security” does. Americans feel they have little direct stake in the international value of the dollar. So what if it falls? Doesn’t that make U.S. goods more competitive on global markets?
Yes, it does. And the fall of the dollar is not a bad thing, in any case, just like the fall of the Big Techs is not a bad thing. Both are merely the market’s way of restoring balance – and making sure people get what they have coming to them.
That is probably the disturbing point to most Americans. After a spending spree that has been going on for years…and one that has driven savings rates down to negative levels…there must be many people who ask themselves, perhaps in a quiet moment, when CNBC is turned off, how it could be that they are able to buy a new car or a new house, without earning more money or saving any?
There must be a nagging suspicion that there must be a catch somewhere.
The catch is the dollar itself – which has made this spending spree possible.
Peter Bernstein, in his book The Power of Gold, observes that even the discovery of huge new supplies of gold in 15th century did not actually make the Spanish richer. The money came in from the New World…it was spent…and it was gone. The world’s supply of gold increased. But Spaniards got no lasting advantage. In fact, they were probably made poorer by the whole episode, as the easy money actually discouraged investment in productive enterprises.
The rising dollar has given Americans a similar increase in purchasing power. Foreigners were happy to accept it in payment for goods and services…and to lend dollars to American businesses and institutional borrowers. The circle seemed virtuous – Europeans saved, Americans borrowed. Foreigners produced. Americans bought. U.S. corporations (including mortgage lenders such as Fannie Mae & Freddie Mac) borrow the excess dollars accumulating in Europe, for example, allowing further consumption spending by Americans.
Not only does the willingness of foreigners to lend money fund the current account deficit, it actually increases the value of the dollar. Grant explains: “To buy these securities [bonds issued by Fannie Mae, for example], they have obtained dollars by selling their own currencies, euros not least. In this way, foreigners underwrite more leveraged American balance sheets while contributing to the rise of the dollar exchange rate.”
But at some point, for no particular reason and at no predictable time, the virtue of the circle is called into question. Perhaps, a slip of the tongue by Alan Greenspan, or Wim Duisenberg, or George Soros… maybe just a rumor… or a moment of clarity, such as the one that struck then- president of France, de Gaulle, in 1965, when he observed that the Americans could not only pay for things with dollars but also control their value.
“What lends value to a paper currency?” asks Grant. “Is it approximately the same set of psycho-speculative factors that caused the boom and bust in U.S. Internet stocks? If the answer is ‘yes,’ as we believe it is, the currency markets are driven by momentum, not value.”
Momentum will carry a collective sensation a long way. Whether it is a stock, an army, or (Edward’s favorite) Pokemania, it can go much further than you might think. But fads eventually pass and financial assets are eventually marked down to their real values.
So what’s the dollar worth? “We see in the dollar,” writes Grant, “the world’s least rare financial claim. Believing in neither a New Economy, nor an Old Economy, but only in a Cyclical, Evolving Economy, we refuse to accept that the world’s demand for dollars is infinite.”
There must be times when the shelves that hold dollar-based assets become temporarily over-stocked. It is impossible to tell for certain if this is one of those times or not. But since the world’s press is so overwhelmingly favorable to the greenback, we can’t help but think that supplies must be bountiful. A value investor with a contrarian streak might well decide to lighten up on the greenback, just in case.
Which brings us back to the question at the beginning of this letter. If not dollars, what?
Grant’s suggestion: Kiwi bonds. The New Zealand currency is down 40% over the last 4 years – from about 70 cents U.S. to around 40 cents. Readers of the world news will instantly identify a culprit – New Zealand’s government took a left turn a year or so ago. And yet, bond yields, growth rates, interest rates and balance of payments considerations provide no corroborating evidence. On the fundamentals, the Kiwi dollar is no worse than other dollars.
And yet, thanks to the momentum recently, and perhaps even still, favoring the U.S. currency, prices in New Zealand are marked down by 40% since 1996. Houses, stocks, businesses – all are available at a deep discount. Telecom Corp. of New Zealand is priced to yield 8%. Several of my friends report that beautiful farms and ocean-front acreage can be bought at giveaway prices.
There are also Kiwi bonds. The 10-year note yields 6.75% – about a full percent more than similar U.S. notes. There is a risk, of course, that the Kiwi dollar could decline even further. But probably the greater risk for the average American is that it will not. We may have already seen the top in the dollar on October 25th. If so, Kiwi bonds will turn out to be very good places to sit out the bear market in U.S. stocks.
Your humble scribe… seeing euro bottoms everywhere he looks…
Paris, France November 7, 2000
*** There was a “return to the tried and true,” yesterday. In with the Old – out with the New. “Value investing” is back in style, said the International Herald Tribune.
*** The Dow rose 159 points. It is now only down 4.5% for the year.
*** The Nasdaq fell 35 point. It is off 16% for the year.
*** But investors have short memories. They seem unable to recall the world in which George W. Bush got arrested for drunk driving, when the Dow was below 1,000 – and sinking. The ‘old’ – in investors’ collective memory – goes back no farther than 1982, when the Dow began the longest and most impressive bull market in history.
*** Despite disappointments in dot.coms and now Big Techs, people are still very bullish. Richard Russell reports that last week $11.4 billion of new money went into equity mutual funds. Through August, the year-to-date total was $255 billion – twice the level of a year ago.
*** The public now owns $4.4 trillion of mutual funds – a figure that was only $1.3 trillion in 1995.
*** But while the public still believes in stocks, it seems to have lost faith in Technology. Cisco fell 1 5/8 ahead of announcing its results. Then, after the market closed, Cisco said it beat estimates by the usual penny. Still, in after-market trading, Cisco shares fell.
*** Cisco announced that sales and profits were up 67% above last year. But the “actual net income” was only 11 cents a share – about the same as last year. The stock, once $82, now trades at $55 – still about 70 times earnings.
*** “When Cisco Systems tells Solectron Corp. to jump,” writes Grant’s Investor Eric Fry, “the contract manufacturer says, ‘How high?'” After all, some 12% of Solectron’s revenues come from making widgets for Cisco. But when it comes to creative accounting, Solectron can hold its own. “[Selectron] will report what it wants, how it wants. And if the company feels like revising its fiscal 2001 earnings forecast both higher and lower on the same day, it will do that, too…”
*** Linux fell 42% to $17 and change. It was $320 a year ago. What were investors thinking?
*** “The evidence is in,” writes Uncle Harry Schultz, who economizes on verbs and articles, “Tech funds are shrinking; value funds increasing (in number & price). Nasdaq in major downtrend; DJIA hanging in here. My longer view: Nasdaq bear mkt will continue til decimated. But DJIA will stagger sideways in wide trading range, shorterm, benefiting from money flowing out of tech. ‘Tech’ will be the new dirty 4-letter word.”
*** Richard Russell: “My own belief is that the public will remain bullish unless or until the Dow breaks below its bear market low of 9796.03, the low that was recorded last March 7.”
*** Since I am surveying sooth-sayers, I will say some sooth myself: I don’t think there are many Dow Theorists among the lumpeninvestoriat. The 9796 mark will come and go with hardly a soul noticing. Investors will not abandon stocks willingly. They will have to be destroyed by them first.
*** William Fleckenstein quotes Justin Manis on how the bottom will be reached: “Changing valuations from crazy to merely excessive is not the way a bottom forms… ‘fair- value’ if such a thing exists at all, is never a market bottom, because historically important bottoms are made at extreme undervaluations.
“If/whenever that 3,000 [Nasdaq] neckline is decisively broken,” Mamis continued, “the floodgates of selling will open. Any declines that follow such break will terrify the public… Excuses that ‘It’s only a paper loss’ will no longer ring true – the losses will look very real because the much higher prices they paid will no longer look achievable! Once someone knows he won’t ever get his money back, his mind switches to the other extreme: ‘Then the hell with it.’… the public sells down, not up.”
*** The WSJ includes a warning from Bruce Bent, who helped develop the money market mutual fund industry. Bent notes that the risk of holding money funds has quietly increased: “People are going into money funds,” he says, “and they are not getting what they think they are getting.” Fund managers have been increasing yields by buying more marginal paper – such as commercial notes, asset-based securities and short-term funding agreements. As Ray DeVoe put it, “More money has been lost reaching for yield than at the point of a gun.”
*** The decline of credit quality was a major theme at the contrarian bear fest hosted by Jim Grant in New York last week. Our man on the scene, Thom Hickling reports:
“The historic mortgage finance boom continues to drive a national real estate boom,” according to Charles Peabody of Mitchell Securities. During the second quarter, 83% of household mortgagers took out loans at least 5% larger than the previous loan amount – or stated differently, they pulled out at least 5% equity. For comparison, during last year’s second quarter only 58% pulled out at least 5% equity.
“Last year, 7 banks failed. Estimates are that 12 – 22 banks will fail in 2000. And some think that the regulators are going easy on the big banks because of the elections. It could be setting the stage for many more bank failures to come. During the ’91 recession 127 banks failed and nearly $6.2 billion was lost.
“Bankruptcies will be heading up in 2001. There’s about a 18 – 24 month lag between big credit card marketing campaigns and ensuing rises in bankruptcy filings. After a slight downturn, filings are moving up again…well over 300,000 in the 2nd quarter of this year.
“Expansion of credit card lines reached $2.8 billion a new record. Credit card companies are aggressively marketing to higher risk clients.”
*** Meanwhile, the euro held above 86 cents yesterday. The low point for the euro occurred on Oct. 25th at 82.96 cents. It is possible that the euro will collapse to lower lows. But is also possible that Great Currency Battle has turned against the dollar… Yes, more below…
*** “An investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.” – Warren Buffett.
*** My friend John Forde celebrates his birthday today, along with Leon Trotsky, and my son Edward, who turns 7.
*** This is also the anniversary of the Bolshevik coup d’etat in Russia. For the next 70 years, Russians were trapped by the logic of communism and the terror of the KGB… Americans are now trapped too, albeit much more comfortably, by the logic of democracy and the terror of the IRS.