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Why the Dollar Won't Collapse and Strategies to Play it Either Way

|Includes:BHP, GLD, MON, POT, RDS.A, RIO, The United States Oil ETF, LP (USO), XOM
As the Fed warms up the printing presses on the good ship QE2, a new round of Dollar worries emerge.  Everyone seems to think that Captain Greenback will wind up on the rocks.  

Is there any chance Ben Bernanke might be able to thread this ocean liner through the narrow canal?

Rather than panic and drown in a sea of inflationary talking points, we're going to calmly put on our life preserver and build a framework through which we can make sense of this madness.

It starts with a quick look at why Americans are so touchy about inflation in the first place.


You see, it wasn't that long ago when we had our own inflationary scare and that's still a recent memory for many people, especially our policy makers and central bankers.  Everybody thinks about their childhood in the 70's and early 80's and remembers the stagflation.  They remember the energy crisis and the gas lines.  They might even recall when Richard Nixon tried to control prices and wages by setting legal limits on each.  A mere decade later the U.S. Dollar was worth half of what it was and people were were mad as hell and were shouting that they weren't going to take it anymore.  Everybody bought gold.

It's a visceral memory.  Emotions are powerful things.  But there's an academic sensitivity to inflation as well.  There is a collection of sensible, rational people that are highly attuned to the mechanics of inflation and spend a lot of time devising new reasons to be concerned about it.  Most of them wear horn-rimmed glasses and bow ties.

Let me boil all of their knowledge down for you with one easy chart, one of my favorites from my personal archives:

Alternatively, that chart could be titled "The Amount of Stuff $100 Used to Buy You".  As you can see, the actual amount of stuff is less and less.

By most standards I am still considered a "young whippersnapper", but even I remember how much cheaper everything was when I was a kid.  I remember paying less than $1 a gallon when I first got my driver's license.  A date at the movies was like ten bucks.  You could buy a starter home for well under $100k for a few grand extra you could put a new Dodge Neon in the driveway.  Chicken McNuggets, oddly, were the same price, but the concept of a Six Dollar Burger was heresy.

And I know you old timers totally have me beat.  I'm sure that more than a few of you remember your first job paying $5-$10,000 per year.  Some of you might even remember lusting over Harley Earl styled Cadillacs on the showroom floor.  That was when a couple thousand bucks was a lot of money, enough to purchase a gas-guzzling status symbol.

Anyway, my point is that there is a very strong, inverse correlation between the value of a dollar and time.  There is a lot of academic evidence to support this conclusion and there are countless personal anecdotes that reinforce the same story.

Nobody needs much convincing that this is the reality we have always faced and will continue to face.  So let's take a look at why things are this way.

A slow leak

Why does it have to be like this?  Why can't we just have dollar that's strong and stable and a proper store of wealth?  We even tried to do this during the adolescence of our nation and fixed the value of a dollar to certain amount of gold.  What happened?  Why does the value have to always go down?

There are two major reasons, a complicated one and a simple one.

The complicated one is that we are a debtor nation.  Our country finances a large portion of its budget by borrowing money from its citizens and other countries.  Like any business, the U.S. earns money and then spends it.  It earns money from taxes and then spends that money on things like national defense, public schools, and first class plane tickets for our elected representatives.  Sometimes, it spends the money it makes to bailout failed banks.  (Sorry, that was a cheap shot.)

But the problem is that the United States spends more money than it earns, and with a policy like that it takes the concept of debt management very seriously.  Countries like China or Japan call up the U.S. and say, "Hey, we will loan you $1 trillion so you guys can buy more stuff.  Pay us back in thirty years and in the meantime give us a little bit of interest."

The U.S. happily agrees.  They borrow a few trillion dollars that they get to spend right away and as long as they can maintain some positive inflation -- and they're pretty good at this because they also control the printing presses -- the U.S. gets to pay all these people back with Dollars that are less valuable.  It's a sneaky way to get a bigger bang out of each buck that we borrow.

The other major reason why we have adopted an inflationary policy is that it induces people to spend money.  When somebody spends money, a business somewhere makes a profit.  As businesses make more profits and pay more salaries to their employees, the government gets to keep a piece of that action for themselves in the form of taxes.  The more money businesses and people make, the bigger the government's slice!

It's a very natural cycle, too.  When people in the U.S. make money they want to spend it because spending money is fun.  But they are also psychologically programmed to believe that if they don't spend it, they won't be able to buy as much with those dollars later on.  They remember how much cheaper gas and houses and Chicken McNuggets were when they were kids and assume that when they get older, those goods will only be more expensive.  An inflationary policy keeps them spending today and not next year.

Ben Bernanke's single greatest fear is that we all suddenly become Japanese.  That is not to say he's worried we'll develop an unhealthy interest in robots and karaoke, but rather that our psychology turns deflationary.  Deflation and the deflationary mindset that it causes give people a big time incentive to not spend money.  They walk into the Cadillac dealership and decide that while the deal of the month may be a pretty good one, all they have to do is wait a few more months for an even better deal.  The young family out shopping for a house chooses not to buy because prices will probably be cheaper next year.

That, my friends, is disastrous for an economy.

Deflation may seem cool because your dollars get more powerful with time, but it's actually really scary because everything in the economy grinds to a halt.  GDP goes down, tax revenue dries up, and the U.S. is forced to borrow even more money to pay for stuff, debts that it has to pay back with more valuable Dollars.  Ugh.  

So you can see why the Federal Reserve wants to slowly increase the price level over time and why they want the rest of us to be afraid that our paper dollars have nowhere to go but down.

It's all relative

The bad news is that the rest of the world is trying to do the same thing.  And in the global currency markets, currencies are priced in terms of other currencies.  Technically, they're just ratios.  There isn't really an absolute standard by which currencies are valued and there is no Cadillac or starter home to use as a universal benchmark.  I know some people like to use an ounce of gold as a historical baseline, but even that has complications.

Here's a chart of the Dollar Index and it's always gone up and down relative to these other currencies:

It's clear, however, that the U.S. has done a marginally better job than its peers at debasing its currency.

Go USA!

Right now the Dollar is pretty cheap relative to these other countries.  In fact, it's historically cheap.  The Dollar Index is near all-time lows against the currencies of other developed countries.

The U.S. certainly has its share of problems, but are they as bad as the problems in these other nations?  Are we really in as much trouble as Europe?  Do we have the same massive problems that Japan does?  If it came down to it, would you really rather have a pile of Euros or Yen instead of Dollars?

The U.S. Dollar might stink, but it's probably the least dirty shirt in the currency closet.

A better way to evaluate the Dollar

Consider Purchasing Power Parity (NYSE:PPP), which is a way of pricing currencies against a fixed basket of goods, a more intuitive way for individuals to think of their currencies.  PPP is based on the "theory of one price" which basically says that absent things like tariffs and other barriers to trade, identical goods should have identical prices all around the world.

The most famous example is The Economist's "Big Mac Index" which measures how much a Big Mac costs in different countries around the world.  Using this global icon as a unit of exchange, you can get a sense of which currencies are strong and which are weak.  Based on their latest highly scientific findings, the Big Mac baseline here in the U.S. is $3.71.  We know that Canada has a strong currency and it costs about $4.18 up north.  That's not too bad, but in Brazil, it costs $5.26 and in Switzerland it costs $6.78!  The average for the whole Euro area is $4.79, which is more than I'm willing to pay for fast food.

On the cheaper end of the Big Mac spectrum is Russia, where one costs $2.39.  South Korea is interesting at $3.03 per Big Mac, but China is the big winner in terms of having undervalued currency.  Over there it costs $2.18.

There's a little bit more work and a whole lot of math that goes into the official calculation of Purchasing Power Parity.  But the concept is exactly the same.

Here's a table of some major countries.  A value above 100 means that the currency is stronger (more expensive) than the U.S. Dollar.  A value under 100 means the currency is weak, and has relatively less global purchasing power than the U.S. Dollar.

United States 100
Canada 118
Mexico 66
Australia 134
Japan 145
South Korea 76
New Zealand 117
Czech Republic 79
Denmark 155
France 116
Germany 111
Greece 103
Hungary 72
Ireland 132
Italy 115
Norway 156
Poland 69
Spain 102
Sweden 125
Switzerland 164
Turkey 85
United Kingdom 155
Click to enlarge

Again, Switzerland appears to have the most overvalued currency.  Not only are Big Macs twice as expensive in Zurich but everything else is too.  It costs 164 US Dollars to buy $100 worth of stuff in Switzerland.

Noticeably missing from that table is China.  Those PPP figures are all calculated by the OECD (Organization for Economic Co-operation and Development), of which China is not a member.  We've all heard stories about how cheap things are in China, from food to lodging to labor.  A few years back a friend of mine went to China and he said they would buy beer for about $0.40 a bottle and enjoy them on the beach.  So we already know that the RMB is super-weak relative to the rest of the world.  It's pegged to the Dollar at a very low level.

If you were thinking about shorting the Dollar keep in mind that it's already one of the cheapest currencies in the world on a PPP basis.  On top of that, when you short the Dollar you are in one sense shorting the Chinese RMB, widely agreed to be one of the most undervalued currencies in the history of the world.

Come on, who really wants to bet against 40 cent beer???

The perils of universal "truths"

It ain't what you don't know that gets you into trouble.  It's what you know for sure that just ain't so.
-Mark Twain

The thing that should scare people most about shorting the Dollar is that just about everybody agrees it's a good idea.  Remember last year when the entire world  in agreement that the Dollar had nowhere to go but down?  Or how about the apex of universal Euro hatred back in May?

As soon as everybody piled onto the same side of the seesaw, everything started to move the other way.

Why do people do this?

Past performance is NOT indicative of future results

In the world of psychology there is a concept known as the recency effect.  It's a cognitive bias that describes the disproportionate emphasis humans place on recent events, especially when it comes to forecasting the future.  When we look out to tomorrow, we think of yesterday and assume we'll see it again.

When it comes to investing, it is the assumption that past performance will indicate future results.  For some reason, nobody takes this ubiquitous disclaimer seriously and the reason is that their brains simply aren't wired to.  That's why there's a disclaimer to protect people from their own natural biases.

Consider the following recent events:

1.  A massive rise in commodity prices over the last decade.

2.  Substantial depreciation against most major currencies over the last decade.


3.  The Dollar is now one of the cheapest currencies in the world on a purchasing power parity basis.

So it's no surprise that everybody hates the Dollar.  And because of the recency effect, everybody assumes this trend will continue.

At this point investors should not be asking if an epic Dollar crash is in front of us.  They should be asking if it's already happened.

How to play it

Jens Nordvig, director of currency research at Nomura Securities, was on Bloomberg earlier in the week and the host asked him about his number one trade for the next couple weeks.  He said, "the next couple weeks you want to be long the dollar going into the [FOMC meeting].  I think the dollar is going to surprise you."

He actually got laughed at!  Though Tom Keene, classy bowtie-wearing guy that he is, followed the laughter up with a compliment for taking such a bold, against-the-grain view.

It carries risk, but that's one thing you can do.  PowerShares offers a US Dollar Index Bullish Fund (ticker: UUP).  Generally speaking, I'm not a fan of funky ETFs like this that are based on derivative contracts; they are much more effective trading vehicles than investments.  But this is a fund that will make money in a short-term Dollar rally.  And in a risk on / risk off world where everything correlates something like that can be a nice hedge as we figure out exactly what the Fed is going to do.

Another option is to just hold on to your dollars for the time being.  I know that interest rates are super low right now, but this is one of the best times in history to sit on a large pile of cash.  Your purchasing power has actually increased a little bit in the deflation of the last few years and even with quantitative easing on the horizon, there aren't too many serious threats to your purchasing power.  It takes a lot of discipline and I'll understand if your hunger for yield sends you down another path.

Commodities are the worst things to own in a Dollar rally.  Things like crude oil (NYSEARCA:USO) and corn and gold (ticker: GLD) gets killed when the Dollar strengthens.  So be careful with that stuff or companies that are direct plays on the commodities boom.  That includes agricultural companies like Potash (ticker: POT) or Monsanto (ticker: MON), oil refiners like Exxon (ticker: XOM) or Royal Dutch Shell (ticker: RDS.A), and miners like BHP Billiton (ticker: BHP) or Rio Tinto (ticker: RTP).  

Don't panic -- I like those kind of stocks over the long run because we all know:

  1. The Dollar always goes down over the long run against real assets and physical goods.
  2. The world's population and need for resources will keep increasing until about 2050.

So a Dollar rally can be a good time to pick up stocks like that a little cheaper than they usually trade.  Otherwise, steer clear.

If the markets still make you nervous and skeptical, the good news is that you don't even have to be an active investor to benefit from all this currency knowledge.  A more fun way to play the Dollar is to use what you know about it to your advantage as a savvy traveler.

It's hard to believe that a night at this hotel:

costs basically the same as this one

for the American traveller.

This is how big a difference purchasing power can make.  It sounds nuts but you can stay four nights at the Fiesta Americana Grand Los Cabos for $169/night and get a $200 credit for food!  This is the kind of thing that's possible when you take a stronger currency to a country where the local currency is weak.  I can't even wrap my mind around how awesome a deal the average Brit gets in Mexico right now.

When you're planning your next a vacation, take these factors into consideration.  Grab a PPP table or the latest findings from the Big Mac Index and hit up the countries that are cheaper.  Now's a good time to visit Latin America and the Pacific Rim (ex Japan).  It's not a good time for that Great European Adventure you've always dreamed about.  Don't worry, though, the Euro will have its day in the gutter.  And when it does, I guarantee they'll appreciate your tourist dollar!

 

Here's the Big Take-Home Point

We all know that over the long run the Dollar only gets cheaper against the goods we buy.  We feel this intuitively and see it when we look through our past.  After today, you all know why that trend must continue.  Let's hope that Chief Bernanke is able to kindle a little bit of inflation to get things moving again.  

Because of this, most investors lack appreciation for the Dollar in the capital markets and don't properly identify opportunities.  From their perspective, their dollars just get cheaper and cheaper over time and they don't understand that every other country is pursuing a similar policy objective.  In order to identify the real opportunities in the currency world, one needs to understand all the different ways to measure value.  Tools like currency cross rates and purchasing power parity will help you spot these opportunities.  They might be big-money macro bets like shorting the Japanese Yen against the Turkish Lira or they might be something simple like helping you enjoy a week of the good life on vacation in a country like Mexico or China.

A lot of people are afraid about a Dollar crash right now, but they're about ten years late to that party.  The time to worry about a Dollar crash was in 2001 and by any stretch of the imagination, that's exactly what we've had since then.  It's certainly possible that the Dollar isn't done going down, and in fact, it's highly probable that it will keep going down against real assets over the long run.

But in the meantime, the Dollar will bounce all over the place.  Against the other major currencies, don't be surprised to see it exhibit some relative strength through 2011 and into the coming decade.

 



Disclosure: Long XOM, long GLD
Stocks: USO, GLD, POT, MON, XOM, RDS.A, BHP, RIO