The Dollar, The Fed and Portfolio Building

Reader JackS asks;

Do you think that the Fed's obvious slant towards bailing out Wall Street instead of the dollar will cause further decline for the dollar next year?

While I am not sure bailing out Wall Street is Priority One, the dollar may not even be the fourth priority.

There are a lot of moving parts to this, some more important than others. Obviously a weak dollar does not matter for Americans buying goods and services in the U.S. Oof, that is pretty much what Bernanke said to Congress, and my hunch is he'd like to take that one back.

As far as where the dollar goes, I don't have a trader's answer. I have felt that the dollar has been on a clear, obviously lower path for all sorts of reasons that have more to do with economics and less global demand in the future.

If that turns out to be correct, there will be periods where the dollar has big rallies. This was the case for the first few months of 2004 and all of 2005. In 2005, the dollar rallied about 12.5%.

The way our client portfolios are structured, the weak dollar has been a big help, but if the dollar has a counter trend rally the portfolio will lag. If you are heavy foreign, as I am, know that a dollar rally will hurt your performance.

This is not something I am worried about. Every portfolio is threatened by certain outcomes; a strong dollar is one of the threats to what I am doing. Knowing that ahead of time will make it easier for clients should it happen.

Candidly I do not know at what point the dollar decline becomes serious enough to become a topic of conversation for the Fed. The drop in the dollar thus far has not dominoed into a radically different inflation picture, or caused so much faith being lost by our trading partners that it affects trade enough to alter the U.S. consumer's access to merchandise.

There are nasty implications for all of these things and more, but from where I sit, trying to navigate the stock and bond markets (and that is probably where you sit too), there is no great need to quantify what, if anything, will happen and when. What I think matters is understanding the argument for why the dollar may go down, deciding for yourself whether you believe it or not, and then structuring your portfolio accordingly.

From a portfolio standpoint, being right about the magnitude of this sort of thing matters little if the portfolio decisions are wrong. It is easy for people to focus on the wrong thing, in this case correctly guessing the magnitude of some future event which is very complicated. Knowing that you will be better off owning foreign stocks if the dollar declines (picking direction, even if not easy, is easier than picking magnitude) is simpler and more important.