10/31

THE US DOLLAR - TRICK OR TREAT?

It's Lonely At The Top...We won't rehash all the reasons why the US dollar is currently perched at such lofty levels on a comparative global basis.  We've been through all of that before.  You know, the attraction of US financial assets, the current perceptual safe haven status of the US currency, and finally the rather tenuous state of foreign economies.  The purpose of our current discussion is to review where we are now and the potential unintended consequences we face as a result of the current state of the dollar versus foreign currencies.  We bring this up as there sure seems to be potential currency "potholes" forming around the globe.  As you know, the Euro just happens to be the vehicle that gets the most press.  Couple a potential or a few potential currency crisis points globally with the fact that liquidity in the US credit markets is taking on an ominous tone and one has to wonder how much higher the dollar is going.  Bob Rubin was right in concept many years ago when he first took over the Treasury top gun position.  A strong dollar is in the best interest of the American economy and financial markets.  (In coincidental manner, so is a balanced global economy and financial system.)  Well, what about a dollar that is too strong? 

Are you ready for some charts?  We hope so, because here they come:

The Euro has been nothing short of a slippery slope.  It has become the most visible of the currency debacles in current media reporting.  Probably as it should be given the importance of the collective ECB union to the global economy.  As with other foreign currencies recently, once the Euro started losing parity against the dollar, the trend became self reinforcing to the downside.  US mom and pop investors may read the headlines regarding the Euro, but since their is no immediate day to day effect in their lives, news about the Euro has become that, another headline.  Unfortunately, the law of unintended consequences is catching up quickly in terms of foreign currency effects on US domestic corporate profitability.

It's not just the Euro that is losing ground against the US dollar.  Currencies of important trading partners to our economy are also fading fast over the course of this year:

(Chart courtesy of Pacific Exchange Rate Service)

The rising dollar relative to these major currencies puts significant pressure on global demand for US goods and services.  Plain and simple

Last but not least, the following charts:

(Chart courtesy of Pacific Exchange Rate Service)

(Chart courtesy of Pacific Exchange Rate Service)

(Chart courtesy of Pacific Exchange Rate Service)

Had enough chart work?  The last set of charts is a bit of an eclectic grouping, but representative of broad geographic areas.  Suffice it to say that the dollar is gaining at the expense of most all global currencies at the moment.

It seems inevitable that at some point a full blown currency crisis arises somewhere on the planet.  And sooner rather than later.  A slowing global economy is one where the perceptual economic fix is a weak currency.  Unfortunately for those countries suffering declines against the US currency, global oil is priced dollars.  This time around, a weakening currency is not a help in a global economic slowdown, but rather a guarantor of imported inflation.  In addition to the current Euro situation, other hotspots include Argentina, Thailand, and the Philippines.  As you may remember, the last few episodes of global currency implosion were "bullish" for the US dollar.  The dollar rose due to its global safe haven status.  Simultaneously, the Fed lowered domestic interest rates and flooded the US economic and financial system with its favorite tonic - money.  In past crises, this set of "fixes" was a shot of pure adrenaline to the US equity markets.  Should similar circumstances transpire in the months or quarters ahead, the ultimate outcome for stocks may not be quite the same as in past crisis periods.   

Estimated Prophet...With the dollar already towering head and shoulders above its foreign counterparts, a full blown currency problem (or simultaneous multiplicity of problems) in the near future that forced the dollar higher would go a long way toward basically cinching a broad based corporate profits recession in the US.  Relative to currency crisis periods of a few years ago, financial characteristics of the ultimate global engine, the American consumer, have been stretched.  Personal debt has continued to accumulate.  Household interest payments as a percentage of household disposable income is at an historic high.  The mortgage refi cycle is over unless interest rates drop substantially from here.  Banks are tightening lending standards a notch (although non-bank consumer lenders are happily expanding as if economic cyclicality has been permanently banished from the face of the earth).  Lastly, in 2000 the American consumer has been plagued by wealth effect withdrawal symptoms as the stock market hasn't (as of yet) participated in it's usual 20%+ annual giving campaign.  

What is probably the single greatest and most important difference between now and the currency crisis periods of Asia, Latin America and Russia over the last three years is the emerging negative effect on corporate profits.  As you may remember, most all the components of the Dow, the top 50 S&P hot shots and at least the top 25 NASDAQ chieftains rely in great part on international revenues as an important part of overall growth.  As has been dramatically displayed in 3Q earnings and is sure to be further borne out in the 4Q, a slowdown in the rate of change of corporate earnings is not a good thing for stock prices.  As always, change at the margin is the ultimate perceptual spoiler.  A dollar that appreciates from here all but guarantees that the following chart will continue to take a negative rate of change for the worse:

Although a strong dollar may be good for relative US purchasing power, it will not be good for enhancing domestic corporate profitability, especially among the multinationals.  Lastly, the ever widening trade deficit would most likely get worse if the dollar were to spike upward under the auspices of some type of global crisis (currency, political, militaristic, oil, etc.).  Again, contributing largely to the profits of foreign companies at the expense of the domestic crowd:

Many dark side prognosticators in the current market warn of the ultimate negative financial consequences of a declining dollar.  True enough.  Foreigners may just want their money back if the US dollar depreciates.  Likewise, we would contend that the negatives for corporate profits of an increasing dollar are just as dangerous.  Dangerous to stocks in terms of exacerbating already fragile perceptions regarding growth in revenues and profits among the darlings of the equity world.  Dangerous to the investing public in terms of deflating confidence in the symbolism of paper ownership of actual companies.  Has the dollar found itself in the ultimate catch 22?  Quite possibly.  No sudden moves, or we'll shoot (first and ask questions later).

Quite frankly we just don't know where the physical metal is headed over the near term.  Traditionally, gold doing the price "death watch" it has been doing over the last few years would be a sign of some pretty serious deflation just around the corner.  In today's world of high powered derivatives and hedging techniques, the tail often wags the dog (and not just in gold).  The carry trade performed by the banks/brokers leasing and simultaneously reselling gold has become a powerful effect on nominal price, albeit a force largely hidden and not understood by the public at large.  The arbitrage in this exercise has been a cheap source of capital for these banks and brokers engaged in the practice (simplistically leasing gold at a cost of 1-1.5% annually, selling it and reinvesting the capital in higher rate of return assets).  Couple this with the hedging and forward sales actions of the producers themselves as the price of physical bullion approaches its mining cost and the potential for price distortions in the underlying asset seems to multiply geometrically.  

The reason we bring gold up is its relationship to the dollar.  At this point the direct physical relationship between gold and the dollar is long but a memory.  Gold was a barometer and restriction on a Fed that might possibly be inclined to print too much money.  A barometer on inflationary pressures.  We believe the strongest linkage at the moment is the perceptual link.  Throughout history, mankind has needed some vehicle to represent the proverbial "storehouse of value".  Whether that is tulips, dollars or physical gold is almost immaterial.  It's the perceptual assignment of value that counts.  In today's world, the dollar is perceived as valuable, perceived as strong, and perceived as safe.  We believe directly related to and intertwined with the global perceptions of the dollar at the current time are perceptions regarding the US Federal Reserve as the ultimate financial policy making backstop to the dollar.  Faith in the dollar is faith in the Fed.  Ironically, most global currencies are presently losing the confidence of their holders and native originators in favor of the dollar.       

And now to gold.  What would happen if for some reason the global economic community began to lose confidence in the dollar?  Sparked by a potential diminution of the faith in the Fed.  Sparked by a collapse in the US equity market or segment(s) of the fixed income market.  Sparked by a geopolitical event.  Sparked by a realization that the dollar is simply over owned globally.  Sparked by a more than expected downturn in the US economy coupled with a sizable foreign trade deficit currently outstanding.  With global confidence already waning in many major and emerging market currencies, a reversal of fortune for the dollar just may be the spark that ignites gold, at least for a while.

We have witnessed many sectors that have had dramatic price jumps as institutional money tries desperately to reallocate away from over owned tech this year.  Last week we discussed the utilities, the pharmaceuticals, etc.  Monday's little display of excitement in the cyclical's was illogical, inconsistent with a slowing global economy, yet completely in keeping with short term momentum decision making.  Imagine an attempt at a reallocation away from the dollar.  A reallocation into the perception of safety.  A reactionary reallocation into gold?  

Like A Fat Man In The Eye Of A Needle...The collective market cap of some of the larger and more liquid gold equities simply fit on the head of an institutional pin (numbers as of 10/27):

Not only is the market cap of these larger (clearly a relative term in this sector) gold equities quite small, but we have to believe that they have been and most likely will continue to be subjected to brutal tax loss selling in 2000.  Remember our little discussion last week of the large amount of potentially involuntary (momentum driven) realized gains in tech land this year?  The paper gold's do not make massive economic investment sense from the bottom line standpoint.  Physical gold continues to sink approaching mining cost.  Those gold's saddled with debt have a layer of claim on the assets above the equity holders.  Nonetheless, if perceptions on the dollar were to turn sour on a global basis, gold seems a likely hiding place or perceptual (at least temporary) store of value.  Will this happen?  We have no idea.  We would just point out that the markets seem to be at the beginning of a broadening "process" of correcting imbalances.  Imbalances in equity valuations.  Imbalances in excessive leverage, etc.  Is a correction of currency imbalances so hard to imagine?  Is a correction of the overwhelming imbalance of faith and confidence in paper so hard to fathom?  Not hard at all, really.  At least so far, the history of mankind has upheld the theorem of reversion to the mean quite nicely.  Of course that was in the Old Economy.

Halloween Party...The market surely wasted no time in scaring away bearish ghost and goblins over the last few days.  We would suspect that most just ran for "cover".  After the last few sessions you may be interested to know that a big chunk of our discussion on Thursday will be dedicated to volatility.  As you know, we're certainly getting enough of that these days to go around.  November is here.  October mutual fund tax loss selling is behind us.  "Everybody" knows the market goes up in November and December.  It appears to us that a little month end window dressing was intended to get the ball rolling.  After all, October has been so horrible that it was probably time a little bit of that cash that was accumulating in mutual funds was put to work in a timely fashion.  Your money, that is.  Interestingly enough, the sharp run up in the Dow and the S&P over the last number of sessions was accomplished on a bit of declining volume.  Maybe this means it was a half hearted attempt, and maybe it doesn't:

The NASDAQ finally agreed to join the party today.  It remains to be seen in how much of a partying mood all three of these indices will be in the months ahead as 4Q earnings season approaches: