King Dollar and the Guillotine

The US trade deficit continues to rise. It is well over 5% of GDP and going to 6%, and such levels normally mean a serious correction in the value of a currency. While the dollar has dropped, especially against the euro, it has not dropped as much as you might think on a trade weighted basis. (I have done extensive analysis of this problem in previous letters, under the theme "What if they gave a dollar devaluation party and no on came?")

The dollar is doing better than it should because China has fixed the currency to the dollar, and the rest of Asia is in a competitive currency devaluation race (Greg Weldon's terminology) to see who can make their currency lower in order to attract US consumers. The world and especially Asia will continue to be addicted to the US consumer. They sell us their products for electronic dollars, and then buy our government paper and stock. The world either owns 35% (BCA Research) or 42% (Morgan Stanley) of our Treasury debt. Morgan Stanley also reports foreign investors own 18% of US long term securities and stocks.

Why would foreign central banks continue to buy and hold large positions of dollar denominated US assets when it is clear the dollar is over-priced? Because they have a Hobson's choice. They can take pain now or take it later. Politicians are the same all over the world. They prefer to take their pain later, even if it will be more severe.

If a country stops taking dollars and buying US assets, then their currency will rise and make their products less attractive to our consumers. In export driven economies, this is a disaster, especially for the politicians, as it assures a recession at the very least. Thus they continue to support our spending habit.

Canada, Mexico, China and Japan account for 47% of the trade weighted currencies. The Canuck is flat for the year, the peso is actually down 10% and the yen is down more than 10% for the year, much to the consternation of the Bank of Japan, as noted above. The Chinese currency is pegged to the dollar, so there has been no movement. (These and other currency figures cited are from A. Gary Shilling's INSIGHT newsletter)

Thus the drop in the euro is the single major reason the dollar has dropped slightly on a trade weighted basis, when seen on multi-decade chart.

Is there a limit to this? Of course. We can't sell more than 100% of our assets, and we are now selling $500 billion a year. At this rate, the rest of the world will own 100% of our government debt in ten years, even as we grow the deficits. Clearly this is not sustainable. When does the pain of taking over-valued dollars become more than the pain of selling less to the US? I think it is when China allows their currency to float. Asian countries do not necessarily want an over-priced dollar; they simply want the price of their currency to be favorable in relation to their neighbors. The gorilla in this process is China, and when they allow the renminbi to rise, that will be the real end of the dollar as the rest of Asia will feel comfortable inletting their currencies rise as well.

There is an increasing call from many corners of the world for the Chinese to allow the renminbi to float. They have not responded to the pressure, but as do all countries will act when they feel it is in their own best interests. That will probably be when they think their own consumer demand is growing and solid, and thus can sustain a possible slowing of sales to the US. When that will be is anyone's guess, so the dollar could be surprisingly strong even when by all rights it should drop. But China could be the surprise move which sets this set of dominoes in motion. This is one area we will watch closely this year, as it will be a surprise and will be the transition to a much lower dollar fairly quickly.

(Sidebar surprise question: which country has the third largest trade surplus behind Japan and Germany? Answer a few paragraphs below.)

By the way, this is not the end of the world, as some would have you think. The dollar dropped by over 1/3 against all currencies in the 80's and early 90's, and the US seemed to move along just fine. Inflation dropped during that time and the economy grew. A falling dollar will help our exports, of course. I expect the Bush administration to tacitly approve a weak dollar policy while continuing to say the market should determine prices.

The one real exception is the euro, as the European Central Bank seems quite content to let the dollar drop. Even with the weakness in Europe, I think it is likely the dollar will continue to drop against the euro. In 2002, I predicted the euro would rise to parity by year end, and it has gone decisively past that point, to $1.05. Those readers who opened euro denominated bank accounts at Everbank are happy today. The "natural" target of the next 12-18 months, if not sooner, is around $1.17, which is where the euro started about four years ago. You can buy a euro denominated CD from Everbank by calling Chuck Butler: 314-984-0892, ext 102. (Full disclosure: Everbank has a business relationship with my publisher. I know of no other US based bank from which you can buy CD's denominated in foreign currencies. If you know of one, I will be glad to add them to the list.)

I believe Europe will resist a drop much further than $1.17 until China starts the dollar tumbling down the hill so they can stay competitive as well. It is truly every country for themselves in the currency markets.

(The answer to the question above is that bastion of capitalism: Russia. Their trade surplus in 2002 was $44 billion. They also have the lowest taxes of any major country. Khrushchev loses. Reagan wins. And the biggest winners are the Russian people.)

This naturally brings us to that international currency: gold.

Gold Has a Lot More Glitter to Come

Gold has finally gotten off the floor, and has become the hot investment of the year, up around 35% or more, depending upon which day you look. I think it has more room on the upside.

First, gold finally broke through the $325 barrier. Dennis Gartman tells us that the reason is that the Bank of Canada finally finished selling all the gold it wanted to at that level. There now seems to be someone major selling in the $355 area. When that supply is worked through, the next level of resistance is $385 per one of my favorite gold technicians Ian McAvity.

Central banks are not in some vast conspiracy to hold down the price of gold. They simply want to sell what they have. They do not understand the yellow stuff, and don't want to own it. As gold rises, they will sell more. The prefer electrons to hard metal, which in theory can earn interest. (The lease rates on the gold they lend to banks and dealers are quite small, which is the way they make something on their gold holdings.)

My long held belief is that gold acts like a currency, and if the dollar drops another 10% against the euro, you could easily see another 10% rise in gold. Because gold is so thin a market, it could rise much further fairly quickly, if central banks decide to limit their sales.

And as Paul McCulley of Pimco points out, gold needs to rise as a sign that the world is dealing with its deflationary problems. For a very fascinating and well written historical study of the relationship of gold to inflation/deflation see his January essay at www.pimco.com .

When the need of central bankers coincides with the direction of the market, we should pay attention. Thus, I continue to be a long term fan of gold and gold stocks (at least since March of 2001).

Rallies in a Secular Bear Market

The primary trend of this market is down. We are in a secular bear market. (For a detailed discussion of what a secular bear market is go to www.absolutereturns.net and read the relevant chapters in my book-in-progress called Absolute Returns.)

Secular bear markets usually do not end until P/E ratios are in the single digits, which is far from where we are today. This primary trend is likely to last for the remainder of this decade, at a minimum. I do not have the space today, but will write in an upcoming e-letter about the very well-reasoned analysis done by Gary Anderson and separately by Ed Easterling. Anderson gets as much as $60,000 a year for his newsletter on stocks and timing, depending on the assets under management. He is quite sharp. Hedge fund managers among my readership will want to pay attention and review his work. He shows why we could see 4-5,000 on the Dow before this cycle is over, even though he is somewhat bullish this moment.

Easterling, another hedge fund manager, takes a very different approach. His work suggests that we could be in a sideways trading range for at least another ten years, with some serious risk to the downside as well.

But that is the future. What about this year? I read everywhere or at least from the cheerleaders, that the odds are that we will see a rise in the market, because there has only been one time in history when the markets went down four years in a row. The odds are only one in a hundred.

With all due respect (actually with no respect at all), that is the worst statistical garbage I have read in quite some time. First of all, there have only been three times when the market have even had a chance to go negative four times in a row, and one of those times the market was down less than .5% in year, so that hardly counts as down three in a row. So if that type of statistic was valid, then the odds would be either 1 in 4 or 1 in 3.

But it is meaningless. The conditions in any one given year are the reason for the market to go up or down. I am going to discuss why this market could significantly rise and/or significantly fall. It has nothing to do with odds. If any broker tries to get you to buy stock based upon this "statistic," hang up or fire him.

First, how can I think the market might rise if I think we are in a long term bear market? Let's look at a few reasons.

While the performance of the stock market in any one year is random from a statistical standpoint, over a complete cycle, there is more solid footing. There have been two 50% rallies in the Japanese Nikkei while it has dropped over 75% in the last 12 years. There have been at least a dozen 20% rallies. They were all hailed as the end of the bear and the beginning of a new bull.

Ed Easterling has allowed me to reproduce a chart with some very interesting statistics on bull and bear markets. What we find is that in most long term secular bear cycles the market goes up 50% of the time in any given year. In bull markets they go up 80% of the time.

As noted above, bear markets have historically ended in single digit P/E (Price to Earnings) ratios. If this market were to go directly to that single digit P/E without a few years where the stock market actually rises, it would be the first time in history in the US, and I cannot think of or find an example in any major market anywhere else. There seems to be something about the psychology of a bear market that demands a respite. Bear markets do not end when there are still bulls in the corral. These bear market cycles take years, and typically longer than a decade, to shake out.

I should point out that for the market to go directly to about single digit P/E ratios would require a drop of at least another 50-60%. I do not need to discuss the kind of devastation that would produce in the world.

What could spur a rise this year even as the markets are historically way over-valued? I met with the manager of a major long short hedge fund this week. Their approach is based on value. They buy value long and sell bad companies short. They did quite well last year, performing in the top 10% of long short equity funds. Today they are close to 50% in cash. His problem is that he can't find enough companies he feels comfortable about to invest.

There are not just enough stocks with low enough values to interest him. This is not surprising. But the intriguing piece of information was that he can't find anything to short. All the obvious stocks to short have large short positions already from other hedge funds and individual investors. To get in today is very dangerous.

That is because these hedge funds are very sensitive to their relative standing to each other and to profits and losses. A long short hedge fund is supposed to preserve capital. If a "short rally" starts and a hedge fund holds its position it can quickly drop more than their previous historical losses, making investors nervous. Most long-short equity hedge funds did not have a particularly good year last year, and do not want to have a second losing year, even if it is small. Thus many managers are "scared money." If a short position begins to deteriorate, they could bail very quickly, creating a short rally. (You have to buy the stock long to cover your short position, thus in theory driving the stock up even further.)

In his opinion a significant short rally was possible. But what if such a rally begins to create a market in which all stocks start to move? Then momentum traders move in and create more buying. Many hedge fund managers with significant cash will not have the discipline to let the market run from them and will begin to chase the market in an effort to at least stay near their S&P 500 benchmark. Hedge funds that are traders (and there are hundreds of them) will smell blood and profits and help drive the feeding frenzy. By the time the market has moved 20%, the cheerleaders are proclaiming the end of the bear market, and the small investors pile in, chasing the now hot mutual funds.

What could be the fuel to keep such a rally going? Trimtabs tells us that companies are going to have to fund their pension plans by over $100 billion over the next year. As an example, General Motors will increase its pension contributions by $3 billion (cutting its profits by 26% in the process) this year. That is just one company.

These companies have fixed positions for their pension funds. For instance, their consultants may have them in 50% in stocks, 40% bonds and 10% cash. Since they lost 20% on their stocks last year and their bonds went up, they are now "underweight" on stocks, so that means they will plow much of the new cash into the stock market in an effort to get back to their target allocations.

Mix in large increases in the money supply and you have the conditions for a bear market rally. In the table I mentioned above, the average gain in positive years in bear market cycles was 24%!

Underlying all this is going to be the repeal of the dividend tax. If this happens, it will put a new and higher floor on the eventual bottom of the bear market. This makes dividend paying stocks worth more. You can argue that dividends were much higher in previous bear market cycles, and that did not keep the stocks from going much lower, but I would point out the dividends were taxed in past bear markets. This will not start a new bull cycle, but I do think it changes the equation on the eventual bottom. While that may be cold comfort when the Dow is at 6000, that level is a lot better than 4 or 5,000.

Let's be clear about one thing. Bush is not putting out this dividend tax repeal as a ploy. He is dead serious. This is not a negotiating position. I know from personal experience here in Texas that when he stakes out a position, he argues and pushes for it aggressively. He is not looking for a compromise.

He tried to change the tax structure in Texas in 1998.e is very hard to say "no" toHeHe He did not have close to a majority of his own party supporting him. He eventually lost that fight, but he did not back down.

This time he will get most of his party (hopefully McCain will come along) and a few dems and he should get his dividend tax repeal. While I am generally in favor of all tax cuts, this one is important in that it will change the corporate culture in America. Dividends will rule, and dividends require actual profits and not stock pumping to get your options cashed.

I believe the hope from the Bush team is that this will put new life into the stock market, or at least a base for a few years at the least. Whether it will remains to be seen, but it is a brilliant political move and also a proper philosophical move as well. It may well be the most important long term contribution from the Bush presidency.

Let us make no mistake about this. Bush is putting his re-election on the line. If this tax repeal fails, it could very well tank the market and sour the mood of the country. That could tank his re-election. He could argue it was those bad democrats, but it would probably ring hollow to those whose retirement accounts are down. This is an all-or-nothing, bare knuckles political brawl.

20 January 2003

John Mauldin
John@2000wave.com
http://www.2000wave.com/index.asp

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