Whither the Dollar? Withering or Flourishing?

Includes: RWM, SBB, UUP
by: Joseph L. Shaefer

It would be a fine “flourish” indeed if I could answer the question posed by my headline that, long term, it would be the latter. Alas, long term, I am convinced that the U.S. government has embarked on a permanent policy of U.S. dollar degradation. Government leaders talk the talk of a sound currency / strong dollar, but they walk the walk of a leadership convinced that the most prudent course of action for the world’s largest debtor nation is to repay all those debts in dollars worth less. They can ensure this happens by printing too many dollars – not so many at one time as to panic current and potential debt-holders, but enough over time to debase the value of the currency. Better a declining dollar than having to repay debt at par and at pre-inflation, pre-dollar-degradation levels.

But that’s the long term – 3 years to forever -- and, as bright economist but brilliant investor John Maynard Keynes once observed, “The long run is a misleading guide to current affairs. In the long run we are all dead.” So what does the short term hold? After all, if I am correct in my previous articles that we are in for a rough summer, but that 2011 will close the year higher with a stellar rebound by summer’s end and autumn’s ascendancy, we should be most concerned with what might happen during this brief but volatile interregnum.

Regular readers know that I believe in buying important sectors when they are least popular. It’s the safest approach to investing but one of the worst approaches to being a money manager! Why? Because clients will understand if the market is down and so is a money manager. After all, “it’s a bad market.” But woe be unto the money manager who doesn’t go up when the TV sound bites scream that the market is up 100 points today. So, if my goal is to gather assets I should go along with the market and trust in superior stock selection to beat it some / much / dare we believe, most of the time.

That’s not my goal. My goal is to best the market for my clients over the long term, never forgetting that outstanding long term performance is the result of many short term decisions made well. That’s why I advocate re-allocating among sectors and asset classes as world and national events change – and also why I am sometimes early or at least too early in unpopular sectors or asset classes.

Right now, one of those short term decisions that I believe will continue to augment our long term performance is to bet on a rising dollar.

Am I nuts? Everyone knows the dollar is toast. Everyone knows we are printing far too many dollars. Everyone knows inflation is under-reported and likely to become far worse any day now. Everyone knows China is diversifying from dollars (in its latest purchases) into Euros. Everyone knows the Russians and the Chinese have agreed to settle some obligations in each other’s currency rather than the US dollar. (Oh, there’s a real stable “opportunity” – two opportunistic autocracies vying to see which will out-fox the other!)

Everyone knows. In fact, Jim Rodgers was recently quoted in the most recent Bloomberg Business Week saying, “everyone is bearish, including me. I read something like 97% of people are bearish on the dollar. So I bought dollars.”

In this age of immediate arbitrage, I cannot imagine any trade could survive if in fact 97% of people are bearish on the dollar. But I do imagine that it is probably 65% / 35%, or 75% / 25% or something like that. Whatever it is, I believe it is short-term overdone.

“When everyone piles onto one side of the boat, a lot of people are going to get drenched.” (I’m not certain how the MLA [Modern Language Association] or Chicago Style Guide tells us to delineate when we quote ourselves from previous writings, but I thought I should place them in quotes lest someone see these words and think I used them without attribution!) And I think a lot of people, in the short term, are going to get drenched betting against the dollar. What do I consider short term? The next 2-3 months or so. I expect to be positioning for a powerful move up come the fall, when the incumbents pull out all the stops to juice the economy as election season gets into full swing.

I expect, beginning with this fall’s full-force electioneering, that employment numbers will improve. I don’t necessarily expect employment to improve, but I’ll wager, either way, “the numbers” will improve. The same for housing permits, housing starts, and new and existing home sales. The same for published inflation numbers, balance-of-trade numbers, and every other measure of how we are doing.

Until then, however, I imagine the markets will swoon, along with some of my favorite long-term holdings in the agricultural, energy, infrastructure and metals and mining industries. Rather than sell all shares outright, I have partially hedged these positions by purchasing non-leveraged inverse ETFs. (See here for details.)

The two I believe may afford the best hedge now would be RWM and SBB. RWM (the ProShares Short Russell 2000) tracks the inverse of the Russell 2000, the smaller of all stocks traded in the Russell index universe. SBB (the ProShares Short Small Cap 600) tracks the inverse of the daily performance of the S&P Small Cap 600 Index – the smallest of the small, with similar characteristics. My logic in selecting these two for our clients is not only that they have run the furthest but also that they have the most difficult time in times of tight money securing financing.

I have one ETF to add to this small stable of positions I believe will do well during the summer swoon: UUP (the PowerShares DB US Dollar Index Bullish ETF). I’ve already noted that shorting the dollar may be the most lopsided trade in the market today. (97% / 3% if we are to believe Jim Rodgers' offhanded comment. When was the last time 97 traders out of 100 guessed the future direction of any investment correctly?) In addition to it being a lopsided trade, in April the US dollar hit a low not seen in years, causing many to despair and add their gasoline to that burning paper – but it has not violated that low since and, indeed, has remained roughly flat in the face of blistering attacks from all sides.

I believe the fundamentals are in place for a US dollar rebound in the short term. QEII ends this week. That means fewer dollars printed and pumped into the economy. And, fundamentally, the US dollar is the only ubiquitous currency accepted as a reserve currency worldwide. On my trip to Cambodia last month, the US dollar was the only currency accepted as legal tender. Like “Ghost-busters,” “Where ya gonna go?” The Euro? Being debased daily as the Eurozone struggles to bring its recalcitrants in line. The yuan? It’s not even convertible. The ruble? Puh-leez. It would be swamped the first day.
Cooler heads will prevail. I think they will prevail this summer. We are going long UUP to take advantage of this short-term situation.

Disclosure: We, and/or those clients for whom it is appropriate, are long SBB, RWM, and UUP. We also have a good cash cushion, some covered calls, and tight trailing stops in place.

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