A World of Hurt
In a world where most investors think "currency diversification" means having two cans buried in the back yard instead of one, John Mauldin speculates on the buoyancy of the US dollar…and its unlikely future.
The US trade deficit is supposed to be the main mechanism by which the dollar is brought under pressure. As Bill mentions above, we suggested earlier the dollar was at its top. Shortly thereafter, it began to drop.
Part of the reason we suggested the dollar would fall was that for a time this past spring, foreign buying of US companies was rapidly slowing down. This foreign investment was a major contributor to the flow of dollars into the US for the past decade. "What could pick up the slack"? was the obvious question…and thus did the dollar drop.
The dollar fell against the euro by 11%…and likewise, against euro-associated currencies. But elsewhere, it has held its own fairly well. The question we pose today is: why? And given that the US trade deficit is now at its largest ever, can it possibly hold?
If the dollar is not dropping, it is because there are large inflows of dollars into the US. But there are no longer European companies buying US businesses, nor Japanese building US factories. Where is the money coming from? And why, seeing how weak the stock market is, hasn’t the dollar dropped further? Surely the world sees we are a bad investment?
Well, not exactly.
The rest of the world’s stock markets are doing as bad as or worse than ours. The world-wide carnage is astounding. As an example, the German exchange opened the Neuer Markt – its answer to the NASDAQ – just five years ago. There was much acclaim as the market soared. At the time, it was hailed as the engine for future European technology growth. However, the Neuer Markt eventually became the mechanism for corruption, fraud and large investment losses. Last week, they simply shut the new exchange down after losses of over 90% and little action on the exchange.
If you were in Argentina or Brazil, the S&P 500 would look like a good investment. On a relative basis, the US markets are not that bad. So, US investors are fleeing foreign stock markets, and foreign investors are looking for safe havens. "Due to large inflows as well as large net selling of foreign securities by US investors (roughly $20 billion in July alone)," reports issued by Morgan Stanley state, "net aggregate portfolio inflows totaled $71 billion in July, the second-highest total on record. Keep in mind that foreign investors are not the only ones exporting cash to the US – so too are US investors as they bail out of foreign markets."
Japanese investors have sent $40 billion to the US in just the first seven months of this year. They recognize that eventually, the Bank of Japan is going to have to destroy their yen in order to save the country. (It calls to mind the old line, "The operation was a success, but the patient died anyway.") The smart money is leaving.
If you are in Korea, it looks increasingly like they are in for a hard landing (recession). Plus, the central bank is determined to maintain a competitive posture for its currency. Latin America? The rest of Asia? Diversification seems like a good idea in most of the world.
"Won’t foreigners flee the dollar and go into the euro, thus driving the euro up and the dollar down?" you ask. Maybe, but not as much as you might think.
If you held a gun to my head and asked me which one fund you should you put your money into, if I thought you might pull the trigger, I would give you one name. But in the absence of physical coercion, I would strongly tell you that you need to diversify. And 99.9% of you would agree. For some of you, diversification means two coffee cans in the back yard, but at least you understand the principle.
Why would foreign investors be any different? Why put everything into a euro basket, especially when Europe may be slipping into recession? Having traveled in 40 countries, I can tell you that Americans are one of the few peoples comfortable with all their eggs in one currency basket.
Currencies are a relative value game. You put your money into another currency because you think that when you bring it back into your local currency, you will have improved your buying power over simply leaving it in your local currency. If the rest of the world perceives that competitive currency devaluation is going to prop up the dollar in terms of their local currency, and their goal is to maintain value in their local currency, it could be harder to drive the dollar down than one might think. If central banks are intent upon keeping their currencies low, it could become very hard.
A little deflation is not the end of the world, if the Fed can "reflate" the economy. Prolonged, systemic deflation will not be good, however. It will lead to lower home values, which will hurt the housing market, which will hurt jobs, which will hurt consumption and trigger a serious recession.
"Well, here’s what those same astute observers whisper, but are afraid to believe will happen," says Bill Gross of Pimco "If the American [mortgage] refinancing boom ends before a new investment boom begins, we are in a world of hurt. Consumption withers, investment rejuvenation will not have begun, and the U.S. global economic locomotive, such as it is, will grind to a halt. How long do we have? Twelve months at the most, even if Greenspan drives rates toward zero."
The list of problem "bubbles" is long: a consumer debt bubble, a dollar bubble, a bond bubble, a trade deficit bubble, a boomer retirement bubble, a housing bubble and so on. Each of these will eventually come back to trend. The forces of Economic History will see to that. What we would hope is that not all of these bubbles burst at the same time. It would be even nicer if they would deflate slowly. We have seen the stock market bubble burst as well as the bubble in capital spending. While this caused a recession, it has been very mild as recessions go.
The Fed has no choice. They will lower Fed rates. They must keep interest rates low to spur the refinance market. Lower mortgage rates act like a tax cut. It makes more money available each month for spending and saving. They hope this will stimulate the economy and thus create more investment.
Lower interest rates will also act to push the dollar down, without actually announcing a "weak dollar" policy. It is for this reason – massive stimulation by the Fed and lower rates – that I maintain the American economy may continue its slow growth dance for a year or more.
We will find that the third quarter was an improvement over the second quarter, but that the 4th quarter will be weaker. Overall, growth will be slow. It is precisely when you are in a slow growth environment, with very low inflation, that deflation can creep in.
The Fed, which is being urged from numerous quarters to act preemptively, will soon do so. Stimulus can have an effect for a short time. As foreigners continue to buy our bonds, rates will continue to drop. In fact, until there is some evidence that deflation is in check, interest rates will continue to fall. The value of the dollar, while remaining the go-to world currency, is resting somewhat firmly on shaky ground.
for The Daily Reckoning
October 18, 2002
P.S. Can the Fed reflate the economy, lower mortgage rates and ratchet down the dollar in the next 12 months? Can we slowly let one bubble burst before we have to deal with another? Will the market be so kind? Maybe. Maybe Not. History is on the side of Maybe Not. History says one or more of these bubbles run into a pin at the same time, and then we get a recession. Only this time, the Fed cannot cut rates 475 basis points.
This is why secular bear markets take years to fully run their course. It takes more than one recession to convince investors that stocks are too risky, and to look for more stable climbs. It often takes three or four.
I must admit, I find myself late at night succumbing to the all too human thoughts of the common pursuit of mankind: hoping we can put off the Day of Reckoning just a little longer while we get our houses in order. Maybe the Fed will be successful. Unlike some of the more stoic analysts, I hope we can avoid "the world of hurt."
Editor’s Note: John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly e-mail The Millennium Wave Investor. As well as a frequent contributor to the Fleet Street Letter and Strategic Investment, Mr. Mauldin is also authoring a book entitled "Absolute Returns", covering the hedge fund industry.
Well, how do you like that?
We had a hunch that this bear market rally wasn’t over. Too many people were becoming wary of Mr. Bear. They had begun to expect prices to fall on Wall Street. Mr. Bear never likes to live up to expectations. So, he backed off.
The euro dropped yesterday – down to just shy of 97 cents. Of all our expectations here at the Daily Reckoning, those regarding the Imperial Currency have been the most frustrating. The dollar should go down. It seems obvious that it will go down. Maybe that is why is does not.
The problem with the dollar, we think, is the competition. Asian countries are intentionally driving down their currencies in order to continue selling goods to the U.S. at lower and lower prices.
The Europeans let their currency fall unintentionally. As bad as the stock market has been in the U.S., Euro stock markets have been worse. In Germany, the DAX is down 56% from its high and France’s CAC has fallen 49%. To the Europeans, the U.S. still looks relatively safe. (John Mauldin, erstwhile friend of The Daily Reckoning, sheds more light on the buoyancy of the Imperial Currency below…)
In our view, European investors are taking a double risk. They’re betting not only that U.S. financial assets will not fall, but also that the dollar will remain at least as high as it is now. In search of security, we think they are doing the equivalent of keeping a hand grenade under their pillows. ‘Check the pin,’ we advise our European sidekicks.
Meanwhile, back in the U.S.A., Mr. Bear may have backed off…but we doubt he has gone into hibernation. Wall Street strategists are still overwhelmingly bullish. And the latest email we received from Michael Murphy tells us that "tech is on the verge of a big – and rapid – comeback. And if you get in now, you can erase much of the bad news of the last 2 and 1/2 years in short order…"
"Will you miss out on one of the surest wealth-building opportunities of your lifetime," he wants to know?
We can hardly resist, dear reader. Cisco, Nokia, Oracle…even our old favorite, the River of No Returns stock, Amazon.com…beckon like Lorelei.
But wait…who’s that hiding behind the tree…who’s got such fuzzy ears…and such sharp teeth? Could it be, Mr. Bear?
Eric, what’s the latest news from the Big Apple?
Eric Fry on the Street of broken dreams…
– Like an abusive spouse, Mr. Market (or should that be Mrs. Market?) has been treating investors very harshly for a very long time. Now, suddenly and inexplicably, he’s cozying up to them. Please forgive our cynicism, but we suspect he’s up to no good. Maybe Mr. Market is attracting investors with seeming kindness, only to inflict some new hurt upon them later.
– Nevertheless, he can certainly turn on the charm when he wants to. Yesterday, he delighted investors with a 239- point Dow rally, as the blue chips finished the day at 8,275. The Nasdaq tagged along for the ride, gaining more than 3% to 1,272…
– Behind every plaintiff’s attorney stands someone with a gripe – perhaps legitimate, perhaps not. These days, a growing number of the folks standing behind plaintiff’s attorneys are disgruntled investors…and not all of them have a legitimate gripe. Is that a surprise? Most of these plaintiffs have lost money and, by golly, somebody had better give it back to them. In fact, even if they didn’t lose money, they should have made more. And by golly, somebody better give them that money also.
– Apparently, this sort of reasoning makes perfect sense to some juries throughout this great litigious land. How else could you explain the $250 million verdict awarded by an Ohio jury last week to clients "maligned" by Prudential Bache? "The award is the largest on record against a brokerage firm sued by individual investors," the Financial Times reports. "It is being taken by many as a sign of Middle America’s new hostility toward Wall Street amid crashing stock prices and corporate scandals."
– What heinous crime against humanity did Prudential Bache commit? Just this: one of the firm’s brokers sold stocks on behalf of his clients and moved their money into more conservative investments like money market funds. In other words, the plaintiffs in this case sued for "damages" based on money they SHOULD have made.
– As stocks were tumbling in the fall of 1998 (Remember the Long Term Capital Management debacle?) Prudential broker Jeffrey Pickett sold $40 million worth of stocks and mutual funds out of his clients’ accounts without authorization.
– Unfortunately for Pickett and Pru, the stock market bounded higher shortly after the sales. In other words, Pickett’s unauthorized sales deprived his clients of potential profits, but they did not cause any actual losses. He deprived them of what they SHOULD have gained. One glaring problem with the verdict is that it flatly ignores the eventual losses that these folks also SHOULD have had. They "lost out" on the stock market’s colossal collapse from its peak in 2000.
– The jury found that Prudential acted with "malice" when making the unauthorized trades. Malice? Really? Did malice inspire Pickett to seek out safer investments for his clients? It seems to us that it was the plaintiffs who acted with malice.
– If any one of these folks have remained in money market accounts since Pickett sold their stocks, they are much better off than if they would have remained in the stock market until now. The S&P 500 has fallen about 5% from the lowest levels it hit in the fall of 1998. Money market funds, by contrast, have produced a positive return in double digits.
– During the bubble, few investors cared to familiarize themselves with the concept of risk. Most focused only the prospect of reward. As a result, legions of obstinate, greedy investors got what they deserved – large losses. The indignant Ohio plaintiffs "maligned" by a well-meaning broker who moved their assets into the safety of cash are very typical of most investors. They knew you should never sell stocks, because they knew that stocks always go up over the long term. They also knew that stocks, even expensive stocks, aren’t risky, because they are the best- performing asset over time.
– The last and most important thing that they knew is that anyone who disagreed with their bullish outlook was wrong. And not just wrong, but deserving of scorn or litigation. Anyone who argued against buying and holding expensive stocks deserved, at best, to be fired. Hanging was too good for them. Suing was just about right.
– In other words, a nation of bullish investors created a nation of financial advisors in their own image. No "fiduciary" dared to stand against the crowd, unless he secretly wished to manage the local McDonald’s.
– To be sure, many are the innocents who lost money in the market, despite their best efforts to invest prudently. But many more are those who raced to their financial demise by spurning prudence. To find one who wronged them or led them astray, they need only look in the mirror. Even so – in the aftermath of the bubble – few investors engage in honest introspection. Many prefer vindictive litigation.
Back in Paris…
*** Housing starts are at a 16-year high…as mortgage rates go up! Go figure. "House prices still soar," says a headline from San Francisco.
*** But industrial production is down again for the 2nd month…and consumers will "play Grinch" with the holiday spending season, predicts CNN/MONEY.
*** We’ve been waiting for consumer spending to drop. So far, the American Atlas shoulders his burden with little complaint. He’s been able to spend $1.20 for every $1 he earns thanks to the innovations of the credit industry – such as the interest-only mortgage loan and zero-percent financing of new cars. He has been able to improve his cash-flow thanks to financing tricks, but surely the weight of all that extra debt must be wearing him out.
*** "A significant slowdown in consumer spending is a major risk to the continued economic recovery," said an economist on CNN, explaining the obvious to the oblivious. "If consumer spending falls, the probability of the economy slipping back into recession is very high…"
*** There is relatively cheap and there is absolutely cheap. Relative to what investors used to think, ‘high- yield’ yield bonds are cheap. Are they absolutely cheap? We don’t know.
But our friend Steve Sjuggerud thinks they may be a good buy. High yield – or ‘junk’ – bonds pay high rates of interest. Investors demand a high rate of return on their money because they are note completely sure they will ever get a return of their money. Lately, as their fears have increased, the price of high yield debt has gone down – pushing the yields even higher.
"Take the Vanguard High-Yield Corporate Bond Fund (VWEHX) for example," Steve suggests. "It’s a well-run, conservative, high-yield bond fund. And it’s paying out nearly 10% (9.73%). Out of its entire bond portfolio of 243 different corporate bonds, only 7% of its assets are in the old "bubble" areas of high-tech and telecom. And total fees only amount to 0.27% per year. It’s Vanguard, one of the most respected names in the fund business, so you know there are no gimmicks here.
"The current atmosphere of fear and the ‘sell at any cost’ mentality has created an enormous opportunity in these bonds. It’s been an historic sell off. The long-term average difference between Treasury bonds and "high-yield" bonds is 4.5 percentage points. (So if Treasury bonds yield 4%, we’d earn 8.5% in high-yield bonds.) But today, that "spread" is nearly 10%, which is unheard of. This is the highest differential in memory…and it has created tremendous value for us as investors.
"When investors stop selling blindly and recognize the tremendous value (10% in income plus 20% potential in appreciation), they’ll buy and drive the prices of the bonds higher. If a $100 bond that pays $10 a year in dividends rises to $120 in value, that’s a 30% total return to you and me – 10% from income and 20% from capital gains. And that’s exactly what I expect to happen here.