Saturday, December 6, 2008

Nate's Official Take on the Dollar

This morning I received the following email update from Jack Crooks of Mr. Martin Weiss’s MoneyandMarkets team:

* The following quote is lengthy, it is Mr. Crooks speaking beneath the following line:


The gates to dollar heaven are guarded by skeptics

Dear Nathan,

I was doing some research earlier in the week, and I came across a blog I'd never heard of written by a guy I'd never heard of on a topic that we've all most certainly heard of... the U.S. dollar.

It was the same old story that's been beaten into the ground:
The U.S. dollar is doomed... the U.S. economy can't sustain its current account deficit... a U.S. economy on the brink of recession is terrible for the buck... blah, blah, blah.

Over the last several months, I've explained why the U.S. dollar is NOT DOOMED despite what have been, and will continue to be, some rotten tasting fundamentals in the United States.

You can read about my views in my past Money and Markets columns.
However, here's a different, more academic approach that builds an even stronger case for the U.S. dollar.

The first thing you need to know is this...

Markets Often Become Feedback Loops

Markets are driven by human nature and are not rational. If they were, there would be no uncertainty, no guesswork, and no market.
Because markets are driven by human perceptions and feelings, markets are completely irrational at times — sometimes longer than you may think. As John Maynard Keynes quipped, "Markets can stay irrational longer than you can stay solvent."

Most people think trends are driven by events, the changing fundamentals. But they're not. It's the perception of these events by market participants that counts.

And depending on the time frame and market environment, investors will perceive things any number of ways. This quote sums it up ...
"But what actually registers in the stock market's fluctuations, are not the events themselves, but the human reactions to these events. In short, how millions of individual men and women feel these happenings may affect their future." — Bernard Baruch

With that in mind, here's an important point that most investors have never considered:

While the fundamentals appear to drive prices, often times it's the prices that drive the fundamentals.

Think feedback loop here.
Let me walk you through the process...
Step #1. The price of an asset falls. The reason may be triggered by the market realizing that key economic fundamentals are deteriorating, e.g. a decline in GDP or a larger-than-expected unemployment report.

Step #2. As prices fall, collateral values fall. Banks and others who lent based upon the value of collateral then must call in loans or require more collateral. This reduces available credit.

Step #3. This decline of credit adds to the deteriorating fundamentals.

Step #4. Declining fundamentals lead to more price declines.
What we're left with is a self-reinforcing process where lower prices lead to falling collateral values, further weakening the fundamentals.

This feedback loop has played out right in front of our eyes in the current crisis...

The swift decline in prices, in the credit market primarily, has drained global liquidity.

The credit market problems forced institutions to sell other "good" assets in order to generate cash.

These other "good" assets were stocks.

This in turn has triggered more selling, and so on and so forth.
And this is why, when it comes to the currency market...

The Gates to Dollar Heaven
Are Guarded by Dollar Skeptics


Maybe you've heard of Ralph Nelson Elliott and his Elliott Wave Theory. Basically, this theory is a way of examining how markets move up and down in basic wave-like motions.

According to Elliott, there are five major waves of any up or down move. On a basic chart, it looks like this...



Let me show you how this theory relates to the U.S. dollar right now.

Right now, the first wave of that five-wave uptrend pattern is where I think we are with the U.S. dollar...

Wave #1 of an uptrend follows the end of a five-wave downtrend. Naturally, there are plenty of skeptics of such a reversal move.

These skeptics are still stuck on the same old story, refusing to accept the potential for a major trend change.
The evidence is there — the U.S. dollar can rally. It's done so over the last several months. Take a look...

The skeptics hold on to the same old argument about why the U.S. dollar is destined to become a banana republic currency, but you may want to reconsider the premises.



The argument of the skeptics goes something like this: The rally in the "doomed dollar" is only because of the fear in the market. Once this fear period passes, the dollar will tumble once again.

Here is my counter to that argument:

The U.S. economy is still the most efficient and flexible economy in the world. Just look at how often the U.S. government has been turning on a dime to find a solution to its economic problems.

Skeptics say this is a sure sign of weakness in U.S. financial leadership. But overall I see this as a sign of the STRENGTH of the U.S. system. And a huge reason why the U.S. will eventually emerge from this morass faster and stronger than the other leading developed nations the dollar competes against.

And guess what happens if this proves true?

It will lead to a strong self-feeding flow of international capital into... you guessed it... the U.S. dollar. Why?

First, the Fed will be expected to be the first to hike rates since the U.S. economy will recover first. That will be a big catalyst for money to flow into the buck. And...

Second, long-term capital will be excited to see a major economy poised for real growth potential — that will lead to a lot of foreign direct investment into the U.S. And that effectively means buying the dollar to buy U.S. assets — another big kicker for the lowly buck.

Look, the beginning of any new trend is loaded with skeptics. But keep in mind, at a certain point prices begin to influence the fundamentals.

As momentum builds based from a self-reinforcing feedback loop between prices and fundamentals, greater momentum will build behind the U.S. dollar.

That will eventually lead to capitulation — the point when more and more skeptics become believers.

And that inflection point marks the beginning of a multi-year dollar bull market.

The most powerful leg up is when the market catches on to the underlying fundamentals that were not quite visible to those stuck on their dollar bear story. And I think that next leg is dead ahead.

Best wishes,

Jack




Jack’s article begins with “Dear Nathan,” just because I am on their email list, it was not *directed* at me, I know. Or was it?
I was doing some research earlier in the week, and I came across a blog I'd never heard of written by a guy I'd never heard of on a topic that we've all most certainly heard of ... the U.S. dollar.

Hmmm… I have a new blog that just started this past week and I’m sure he’s never heard of me although I wrote a book on the overall subject that was begun in 2005, and I have owned an economic education company (State of Mind Seminars, Inc.), and have been an investor in both real estate and the equity markets for well over twenty-five years.
It was the same old story that's been beaten into the ground:
The U.S. dollar is doomed ... the U.S. economy can't sustain its current account deficit ... a U.S. economy on the brink of recession is terrible for the buck ... blah, blah, blah.
Over the last several months, I've explained why the U.S. dollar is NOT DOOMED despite what have been, and will continue to be, some rotten tasting fundamentals in the United States.

Hmmm… Would it be arrogant to assume that he could he be speaking of “Death by Numbers?” http://economicedge.blogspot.com/2008/11/death-by-numbers.html

I did say that our SYSTEM is DOOMED but I never said that being on the brink of recession is terrible for the buck (on the brink of recession? Ahh, it’s finally been made official and we are a year into it). In fact, while I did NOT talk directly about the dollar in that article, in past articles and updates I have been very specific on my position of the U.S. dollar, so I will reiterate it here just to make my position official.

Nate’s Official Position on the Dollar:

During the largest LEVERAGED credit bubble in history, too much fiat currency was created by the shadow banking system and thus credit/monetary inflation occurred and took asset prices to completely unrealistic heights that are outside of historical norms and ratios. That growth went parabolic and is now collapsing under its own weight.

In order to DE-LEVER, to get out of or to pay back debt, what do you need? DOLLARS! Thus our dollar that was going down in value is now driven UP in value because demand for dollars has increased. Since the dollar is the world’s defacto reserve currency, this de-leveraging is occurring globally, not just in the United States. The rally thusly picks up steam and it turns into a short covering rally, just like all the bear market equity rallies we’ve seen in the past year.

The dollar is another “squishy” measurement because the dollar “index” simply measures the value of the dollar against that famous “basket” of OTHER currencies. Those currencies (and their relative weightings) are*:
1. Euro (57.6%)
2. Japanese Yen (13.6%)
3. Pound sterling (11.9%)
4. Canadian dollar (9.1%)
5. Swedish krona (4.2%)
6. Swiss franc (3.6%)
*rough weightings, source, Wikipedia http://en.wikipedia.org/wiki/United_States_dollar. For more detailed information about the basket and weighting, the current information is found within this .pdf bulletin from the U.S. Fed: http://www.federalreserve.gov/pubs/bulletin/2005/winter05_index.pdf

Thus, the dollar index is simply a RELATIVE measurement compared to that basket.

My thesis is: YES, our currency, the reserve currency of the world, the dollar; is in fact doomed. That’s what the underlying math of our debts tells me. History has also spoken; ALL FIAT CURRENCIES throughout the history of mankind have failed. They have lived very short lives for a multitude of reasons which I am laying out in my current “Cut the Crap” series of articles. All failed fiat currencies, every one, has failed not due to deflation, but due to inflation. Deflation strengthens the dollar and prolongs its life, UNLESS the excess credit (debts) do not get DEFAULTED upon, in which case the attempts to counter deflation lead to hyper-inflation which WILL eventually kill the currency, and the economic and political system that are tied to it!

Let me be clear, I have researched both the long term dollar and gold charts that span the past century. Those charts say that during times of credit deflation, the dollar strengthens and gold goes down in concert with equities. I grant the gold bugs that this time the fed has run completely out of bullets with regard to its normal bag of tricks. Thus "quantitative easing" has begun and the reaction of gold to this is not clear as yet, but I am hedging.

People will be initially fooled if inflation begins to happen in the next few years. Such re-inflation will NOT be real growth, it will primarily be monetary growth only, as is what occurred from about the mid 1980’s to today (President Nixon removed us entirely from the gold standard in 1971).

We HAD a choice, but so far have chosen to simply move the debts from one party to the other without default. Until and unless that changes, I am sticking to my thesis. Dollar strength now while deleveraging occurs, dollar weakness later AFTER deflation has run its course and is eventually overpowered. But that’s only IF the system is not CHANGED FIRST (in other words failed or defaulted). And the truth, since we’re cutting the crap here, is that the dollar index means NOTHING to the person who can’t pay back the loan on an over-inflated home.

Remember that currency and economic systems are changing and evolving all over the world still today, just as they have throughout the history of mankind. That evolution did not end with OUR current system (that would be an arrogant assumption), so while I say that the present system is doomed, I do not mean that the end of the world is coming or any other such nonsense! What I do mean is that some form of a new system, or a major revamp of the current system, will produce a new beginning. Clear?

Below are two charts of the dollar, courtesy of StockCharts.com. The first is a weekly candlestick chart from 2006 to today, and the second is a Point & Figure chart that I use to determine breakouts and to get initial targets for those breakouts:



In the chart above, from the upturn that began at about the 72 level, you can see wave 1 that took the dollar to about the 81 level. It then retraced back to 76 – that would be wave 2. Wave 3 took the dollar up to the 87 - 88 level. Over the past seven weeks the dollar has been consolidating in a wave 4 sideways movement while at the same time our equities have likewise been in a sideways consolidation pattern. Wave 4’s are followed by wave 5 (in this case higher) unless it was a more simple 3 wave a-b-c corrective move which the sideways consolidation is saying is probably not the case.



The Point & Figure chart shows the break of overhead resistance (red line) and a target that is way up there at 110.

Will wave 5 take the dollar all the way to 110? If you own stocks or real estate, you better hope not. I would say that it is unlikely for the next wave up to get to that level. It could be that the first five waves up is only the first move of a larger A-B-C corrective move that will eventually take the dollar to 110, I don’t know.

What I do know is that the economic and debt problems that are occurring here, in the United States, are also occurring in the other regions of the world which comprise the dollar index’s currency basket. Many would say their problems are worse than ours, on the whole, and thus the dollar would likely strengthen for that reason alone, an argument that I fully understand and agree with, to a point.

The point at which that entire theory comes undone is the point that the entire system of the dollar reserve currency comes undone and is changed in one form or the other. I believe change on that scale is coming, the math says so. The only question that remains in my mind is when? My thinking is that it will be further off than I think it should be; but it will be much, much, sooner than the vast majority of the world is ready for.
For the Record,

Nate

BTW, I respect the opinions of Martin Weiss and most of his team, especially Mike Larson whose blog, Interest Rate Roundup, is linked to mine. I note, however, that there are opinions within his team that conflict with one another. I think it’s healthy to have a team that’s comprised of differing opinions, but when it comes to investing your money, you need to have a thesis that is correct or you need to admit that you are wrong quickly if your thesis develops holes. So, both Jack and I are in agreement that the dollar will strengthen in the short term. From his article above, it sounds like we differ in the long run and I believe that’s because he doesn’t understand how the underlying math simply fails to work. Simply put, there’s not enough income to service the debt. Yet the debt is a symptom of a larger, underlying systemic problem with our political and economic systems. I will address those underlying problems in upcoming articles which will be out soon.