December 14, 2010

Why the Dollar Bears Are Wrong

The Investment View from Prescott, Arizona

With the Federal Reserve printing 100 billion new dollars each month (that they admit to) it makes sense that the purchasing power of your dollars will become less and less as the supply of dollars grows and grows.  However, the really obvious outcomes seldom come to pass when investing, making this seem like a crazy business.

Keep in mind that the value of any currency can only be measured against the value of other currencies.  All currencies can’t go down at one time.  One (or hopefully more) must go up as others go down.

So let’s see why I think the bears are wrong when it comes to the dollar.

When compared to the Euro-zone, our problems don’t seem all that bad.  Our banks have been propped up and made solvent over the past two years.  In Europe they have yet to deal with most of their financial problems.  Score one for a dollar that should rise vs. the Euro.

The other major currency is the Yen, which oddly enough has been extremely strong for years now, rising 40% in dollar terms since early 2007.  This is despite a really funky stock market over there that is still 30% below its 2007 highs.

If you think our federal debit is bad, Japan’s debt totals 120% of their GDP, or annual economic output, about twice the debt level that other developed countries carry.  Even the much maligned US federal debit is only 80% of our GDP.  Score one for a dollar that will likely get stronger vs. the Yen.

What other major currencies are there?  The value of the Chinese Remnimbi (or Yuan) is officially pegged to the value of the dollar, so it does not fluctuate.  Call that one a draw.

Many consider gold a currency, but unlike most currencies, it has an extremely limited supply.  According to goldpreciousmetals.com all the gold in the world would fit in a room 63 feet by 63 feet by 63 feet.  I hope that room has strong floors.

This limited supply of gold means that other uses, such as jewelry, medical and industrial purposes may greatly affect the price of gold along with what might be considered a currency valuation.  Also, when times get tough, gold gets sold.  Look at the stock market crash of 2008 when gold dropped to the $700 range and you will see what I mean.  In spite of the extenuating circumstances, gold has risen over the past few years, so let’s score one for gold being strong vs. the dollar.

So far we have a score of 2 for the dollar, 1 for gold and one tie.   But what the dollar has been doing ought to count for something, too.

The Dollar Index, which compares the dollar to a basket of currencies, hit its lowest point ever 2½ years ago and has been rising since then.  The facts are that the dollar is rising; however one would never suspect that from the popular news reports.

I had breakfast a few years back with Richard Russell and his wife Faye.  Richard has written the popular Dow Theory Letters for 55 years and lends great perspective to any conversation.  He made a comment to me that morning which has stuck with me ever since.  He said that the debt we have piled up all around us will create huge demand for dollars because people need dollars to pay their debts.

Professional traders would call this a “short” on the dollar.  Shorting is borrowing an investment and selling it to buy it back at a lower level, repay what you borrowed and pocket the difference.  Shorts make money when a market falls, but lose if the market moves up.

At some point, investors who are short are forced to buy back the investment to repay the IOU they created.  If there are a lot of short-sellers and the market moves up, it can create a buying frenzy as short sellers “cover their shorts”.

This powerful type of buying trend is called a short-squeeze and can be a gift to those on the right side of it but can wipe out those “caught short”.

Right now, the dollar may be experiencing the mother of all short squeezes.

Considering the pile of debt we have in this country, the short-squeeze that Richard Russell pointed out will be affecting the market for dollars for a very long time.  Score another point for a rising dollar as debt repayment creates demand for dollars.

My final point is that as an optimist, I have to say that anyone who has bet against the future of the United States has always lost.  I don’t think things have changed in that regard.

Count me as a dollar bull.

A Great Time of Year

This is sure a fun time of year.

The Acker music festival last week had performers in 111 downtown shops.  The streets were blocked off to accommodate all of the revelers and I got to see people I hadn’t seen since last year’s Acker Night.

The Yavapai College choral department put on a spectacular 2-hour dinner show where the diners were on stage surrounded by singers.

Yesterday was the annual Shriner’s Clothe-a-Child event, which got us all feeling a little like Santa Claus.

And Son, Matt, comes home from music school in Hollywood this week just in time to perform The Little Drummer Boy in church on Sunday.

I think I’m finally getting in the Christmas spirit.

How’s The Market Doing?

The market is giving off a lot or mixed signals these days.  Although prices have been going up, a lack of volume in the markets is a key question mark.

Normally when a market moves up or down on high volume it tells you what the institutions – pensions and mutual funds – are doing, and that is valuable information.

Since these funds deal in such large numbers they can often take weeks to months to buy or sell as much of a stock as they want and this does a lot to create the trends I like to take advantage of.

Even a little $30 million institutional trader like me can move the market with my trades if I am not careful.  Imagine what a $30 billion fund, 1,000 times bigger than Hepburn Capital, could do.  Considering that there are 25 mutual funds with assets greater than $30 billion, you can see that these outfits can generate a lot of trading volume and push the markets up or down depending on their activity.

It is comforting  to know that you are moving in the same direction as the behemoths of the investing world so as not to get swept away in the tide, but the low volume tells me very little right now.

So with the market moving up, I have been increasing our exposure to stocks, but the lack of volume behind the move sure makes me nervous.

Riddle:

Q: How many times can you subtract the number 5 from 25?

A: Only one time. After that, you would be subtracting from 20.

What We Were Saying Back Then

Fibonacci Strikes Again

A year ago in my December 15th newsletter I wrote the first of several commentaries on 12th Century mathematician Leonardo Fibonacci.  He had identified what is now called the “Fibonacci Sequence” of numbers that shows up over and over in nature, including the financial markets.

Fibonacci’s work could have been used to predict that the S&P 500 Index** would stall out and change directions at around 1120, which is half the way between the 2007 high and 2009 low, and it did as many as a dozen times over the past 14 months.

In that same article I mentioned two other parts of the Fibonacci sequence, one of which is that 61.8% of former levels were another natural point at which things often change.

A 61.8% recovery of the 2007-09 decline indicates that the market would likely stall out at 1224 on the S&P 500**, which it happened to do four times last week.

Coincidence?  Perhaps.  But I waited until we cleared that critical level of natural resistance before adding to our stock holdings last week.

There are no assurances in this business, but at least I know that the ghost of Fibonacci will be smiling on my work.

What’s Going On In Your Portfolio?

Both the Careful Growth* and Flexible Income* models are 83% invested these days, with about 17% in cash.

Careful Growth* holdings include investments in gold, Japan, Latin America, Energy and growth stocks of mid-sized companies.

With interest rates trending up in a meaningful way bond valuations have been sliding.  Our Flexible Income* and Municipal* accounts are hedged with a fund that goes up as the bond markets go down.  I do this so we can keep collecting income while offsetting potential losses in bond values with gains in the hedge.

Flexible Income* accounts also hold an investment that will go up as the value of the Euro goes down as well as a general currency strategies fund and some gold.

*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.

Balanced Strategy Description and Performance Information
Careful Growth Strategy Description and Performance Information
Flexible Income Strategy Description and Performance Information

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.