Monday Monetary Meltdown: The Fiat Currencies Witch Spooks Markets

by: Philip Davis

Oh what a World, what a World

It’s funny how much damage a splash of cold water can do, isn’t it? Especially when that splash of cold water is reality and the witch is fiat currency. You are very, very lucky because I do not have to rant on about this for 2 pages here because I already told people this was going to happen in March of 2007, when I warned that rising oil prices were indicating a serious issue with fiat currencies and would eventually undo our then-indestructible rally. The title of that post was "Are We Heading for an Economic Tornado?"

The Dow was just above 12,000 at the time but, to an old fundamentalist like me, it seemed a little pricey and my dire warning at the end of the article sounds more like a recap of the last 3 years now when I said:

If we manage to topple the entire house of cards that is commodity pricing, perhaps we won’t need sub-prime mortgages to buy ourselves affordable housing at realistic interest rates. There is certainly a storm brewing as a vacuum of money has been left in our heartland as the Broker/Commodity/Financial triumvirate has funneled $6T away from you and the things you enjoy (consumer goods) to force you to spend it to maintain the things you need (cars, tractors, appliances). They’ve created a storm that threatens to tear the global economy apart.

As I’ve said many times, I don’t have the power to fix things (but, if appointed dictator for life, I will serve) - I can only tell you what’s going to happen and how to profit from it. At the time we were buyers of gold, looking to ward off a probable slide in the dollar and what looked like inevitable inflation. Now we are sellers of gold because, in this post-crash Gobal economy - who can afford it? Sure speculators can afford it but just like houses or oil (or tulips for that matter) - eventually they have to find a real buyer. Did you know gold demand is plunging in Asia? What? They didn’t tell you that in any of the 100 TV commercials? I am shocked…

Actually, I can tell you the easiest way to time the gold market - count the number of commercials from people who want to buy your gold vs the people who want to sell you gold. If the buyers outnumber the sellers, then you should be buying. If the sellers outnumber the buyers, then you should be selling. These people can afford to spend millions of dollars on TV ads, they probably have some pretty good macro analysis backing up their advertising buys!

You don’t need an infomercial for things people really want. Shamwows may be great but you don’t see Bounty wasting a half hour telling you the benefits of paper towels so when a guy spends a half hour trying to tell me how important it is for me to buy gold to get rich - I have to wonder why is he selling it to me then? Gold is not like a Toyota, the man on TV isn’t making it in his factory (we hope!). Gold is a substitute for cash so if the guy wants my cash more than the gold he has - that’s a problem. The same goes for oil - if oil was so scarce and valuable, then they wouldn’t be taking 85 Million barrels a day out of the ground and selling them when the prices drop. Oil’s value is as a cheap and convenient source of energy - when it ceases to be either cheap or convenient, people will swich to alternatives and demand for oil will be permanently destroyed. The switchover takes time, but it’s happening already and, had our economy not crashed and had the prices not dropped by 50%, it would probably be moving along a lot more quickly. Hmmmmm….

Nonetheless, we are now long on oil because oil is at key technical support when priced in Euros. It’s a tricky dynamic here because the price of a Euro matters more than the price of a US barrel of oil but we already shorted EUO (ultra-short Euro) last week so, despite today’s sell-off, we think the Euro should toughen up here and that means oil should be able to hold the line at $70 too.

We have standard ways we play the oil Futures higher and we have upside plays on both USO and DIG - which is about as bullish as we’ve been on oil since last year’s crash to $35. Oil is our optimistic bet on the global economy and also a bet on summer driving season, which kicks off next weekend. After July 4th, if there isn’t serious technical improvement, we’ll be quickly heading for the exits on oil and the economy in general!

I gave the outlook for the week ahead in Part II of the Weekly Wrap-Up and the fact that there was a Part II should tell you right there I’m in no mood to go over it again here. Both the Euro and the Pound are down this morning but it’s just more of the same nonsense and I think the panic over the Euro is overdone - not so much because the Euro is such a solid currency but - compared to what? Despite the wishes of the gold bugs, we need currencies and it is almost an indisputable fact that the Euro is one. Until the gold bugs manage to distribute gold to 6Bn people around the globe and effect a reasonably accurate measure of exchange and replace ATMs with machines that spit out strips of shiny metal and re-educate the people to price things in grams (and we’ve seen how well metrics caught on in America the first time), then I really don’t think I’m ready to start sizing fiat currencies for a coffin. Since the Euro is, in fact a recognized fiat currency, then you have to convince us how it is really that much worse than Dollars or Yen for us to be eliminating it from our currency portfolios.

Was that too much reality for a Monday morning? Sorry Euro bears but I’ve been thinking about this all weekend and there’s just no end game to the downfall of the Euro. They have a 500M person trading bloc of 22 countries that use the Euro as their official currency with a combined GDP greater than the United States and twice as big as Japan. There are not enough Dollars or Yen in the World to replace them (although I’m sure Ben would be happy to try) and the collapse of the Euro would chase people out of other paper currencies, not into them so how likely is it that the G8 is going to let that happen in the near future?

The Euro is down this morning because Gang of 12 Member UBS says the Dollar will become the "growth currency" over the next decade and Libor rates are once again shooting higher, putting a huge crimp in cash availability for corporations and Sovereign entities alike. At the same time hedge funds are dumping oil almost as fast as BP is spilling it as we’re down 20% for the merry month of May. The move and the move out of the metals is what’s pushing the demand for the dollar higher (oil trades only in dollars) but we can expect a re-balancing back to the Euro once things settle down a bit.

At the same time, who pledges to reform the Yuan? Yes, that’s right. Who? Yes. Who is pledging to reform the Yuan? Absolutely. Perhaps it’s not a classic comedy routine but Andy Xie compares the Chinese stock market to a "Poor Man’s Casino" (as opposed to the rich man’s casino that is the US market) and we got 3 cherries on the Shanghai this morning as they completed a 5% bounce (up 1.5% Friday and 3.5% today) and flatlined near the top all day. The Shanghai fell from 385 to 310, which is 20% but spike (386) to spike (308) it was a 78-point drop and our 5% rule predicts a 16-point bounce, which is right about where they are so we’re not impressed yet and neither was the Hang Seng, which gained just 0.6% or the Nikkei, which fell 0.3% or the BSE, which was pretty much flat.

Europe was down at their open but is recovering just ahead of ours (9:15) and we are in the same "wait and see" mode we were in on Friday but, as I said in the weekend post, we’re pretty bullish now and will be looking for downside covers if we can’t crack those key 1,100 and 10,200 technical levels on the S&P 500 and the Dow.

I sent out an Alert to Members this morning discussing position sizing and scaling in and the key point to make here is that we take our Disaster Hedges first and then we buy stocks that are covered by those hedges. It’s still that kind of market. We hope to hold the lower end of our range and do some consolidation down here and we don’t really want to see a sudden jump back up as we’ll be right back to forming air pockets under our bullish positions but expecting this market to calm down without getting some kind of Xanex drip is probably unrealistic. Meanwhile, we continue to completely disregard Cramer’s advice and sell premium while the VIX is high.

Lots of data this week, hopefully it will confirm - if not a recovery - then at least some stability.