Remember the Falling Dollar?

Includes: GLD, OIL, UDN, UUP
by: Investment Pancake

It’s such old, stale news, I’m surprised you are reading this article at all. But you don’t hear much about the fate of the U.S. dollar so much these days.

Maybe the topic is just cold, after years and years of steady coverage. Or maybe the mini rally the U.S. dollar experienced earlier this year, and during the peak days of the credit crisis, have convinced a number of people that the dollar has somehow regained its footing, after years of steadily sliding against most rival currencies. Or maybe most of us figure that since our functional currency, what we spend for coffee and mortgage payments, is the dollar, who cares what other currencies are doing?

Either one or more of these views would be a mistake. If you invest, it is important to measure your portfolio performance in real terms, adjusted for inflation and dollar performance. And moreover, the fluctuation in the price of U.S. dollars has all sorts of ramifications on the global and domestic economies, and corporate profits. This is just one topic too big to ignore.

So the first question, is the dollar going to fall? Answer: yes. From a technical standpoint, I mainly look at the daily and weekly moving averages, and when short term selling momentum overtakes long term buying momentum, I take the view that the asset in question is in a bear market. In the case of the U.S. dollar, the 20 week simple and exponential moving averages are firmly lower than the 40 week simple and exponential moving averages.

On a shorter term view, the 50 and 65 day simple and exponential moving averages are firmly lower than the 200 day simple and exponential moving averages. Perfectly straightforward bear market, from a technical trading perspective. Obviously, just because we are in a bear market today does not mean we will be in one next week, next month, or next year, because bear markets almost always end at some point.

But while that may be true, momentum is a self-perpetuating thing, which is why trends tend to last a while. And the new downward trend the dollar confirmed over the past couple of months is, in terms of trends, still a baby. With a long, dubious future ahead of it.

In terms of fundamentals, the reasons for a falling dollar are plentiful and familiar. Historic trade and budget deficits, for starters. That, and the fact that as a policy tool, a week dollar fuels domestic growth and corporate profits – both of which are in short supply and high demand at the moment. It’s hard to see anyone within the administration shedding too many tears, should the dollar drop 30% over the next year. The main policy objective, I would guess, it ensuring the decline in the dollar is “orderly.”

That sets up the next portion of this article, which is what, if anything, investors should do to mitigate dollar risk. One obvious answer is to hold non-dollar denominated assets – like foreign stocks and bonds. There are countless exchange traded funds that offer cheap and easy exposure to those asset classes. Dollar drops, and all things being equal (which they are not), these assets should go up in price, right? Maybe. Maybe not. A falling dollar can do complicated things to the earnings of a non-US corporation that does business with the US, which can do complicated things to the stock price of that corporation. It's an imperfect hedge, to say the least.

Second approach: invest in domestic equities. Lots of US companies do business abroad, sell hamburgers and coffee in Europe in Euros, and then repatriate earnings in dollars. When the dollar falls, such businesses make hay. And vice versa when the dollar rises – I mean, just look at McDonald’s (ticker MCD) latest earnings today. Problem there? Really imperfect hedge. All sorts of things influence equities prices - separating out dollar relevance is a statistical quagmire, and most studies that attempt to do it end up with conclusions that more often than not get disproved. Once again, another very imperfect hedge.

Third: buy commodities that are denominated in dollars. When the dollar falls, it is common for a commodity like oil or gold to rally somewhat. Again, a number of ETFs and ETNs give some direct exposure to commodities like these – SPDRs Gold Shares (NYSEARCA:GLD), iPath Crude Oil ETNs (NYSEARCA:OIL), for instance.

The thing is, this investment alternative is a “supply/ demand” play, which is to say, it amounts to a zero sum bet that someone dumber than you will pay more for this asset in the future. Another commodity play is to buy something that makes, refines and sells commodities. Rather than invest in commodities, I typically invest in assets that generate cash flow from commodities. Master limited partnerships are a highly tax efficient method to gain exposure to commodities – particularly in the energy commodities space.

Or you can buy mining companies, refineries, timber REITs. The correlation of the dollar to at least certain commodities prices is pretty good, sometimes, but can and does break down. I'd say this approach is a reasonable hedge, but one with plenty of risk.

A fourth approach is to own “dollar short” funds – of which there are somewhat fewer to chose from. One widely traded fund, for instance, is Power Shares U.S. Dollar Bear Fund (NYSEARCA:UDN). With these, my question is, what is it, exactly, you are investing in? A company? Nope. A payment stream? Nope. A pure gamble that outcome X will happen? Yep.

But when it comes to hedging dollar risk, the correlation of these assets to the risk in question is probably the most direct – certainly relative to investing in equities or even commodities. The main problem with this approach is that you're investing capital into air, at a potentially huge opportunity cost.

The story of the U.S. dollar is old, but remains as relevant today as ever. And perhaps the story will start to get a bit more press, too, if nothing else more interesting gets in the way. Until then, it makes some sense to pay attention to what’s going on in the currency markets – even if you don’t have a European vacation planned in the near future.

But even while this may be true, the problem I see is that as far as I can tell, there is no "home run" strategy to mitigate dollar risk available to smaller scale investors. You might even conclude that like so much of what we find in life, the falling U.S. dollar really amounts to a huge problem with no real solution.

Disclosures: The author owns none of the assets discussed in this article