For well over a half century, the US Dollar has been a lynchpin in the global economy. As a projection of the United States’ political, military and financial might, it has been all-powerful and unquestioned. It has been the primary means of exchange for goods and services the world over, including all commodities and much international trade. Now, that dominance may be coming to an end for financial, economic and political reasons.

Over the past year, the US dollar/euro exchange rate has declined from $1.25 to $1.50. To be sure, part of the reason for the current weakness of the dollar—and its negative outlook over the next two years—is a normal cyclical phenomenon regarding rate expectations. Australia, Norway, and China have already begun tightening policy, and market participants are looking for the next major-economy central bank to make a move. 

The widespread assumption is that the US Federal Reserve will be among the last central banks to follow suit and raise rates because its economy, along with that of the United Kingdom, is the most structurally challenged and therefore needs as much monetary flow as possible. Moreover, along with the UK, the US will have to reverse its quantitative easing policy before it embarks on rates rises, which are therefore some way off. 

The expected disparity in rate movements around the world means that the dollar is going to be unattractive on a yield basis and helps to explain some of its weakness. However, there are a number of other longer-term phenomena that explain why the dollar can be expected to remain weak. While the financial and economic crisis has exacerbated and highlighted a number of these trends, many have been evident for years.

One of the primary influences on the value of the dollar is the perceived creditworthiness of the US government, which is currently running a deficit of $12 trillion. The markets are prepared to cut the US a lot of slack because it is the world’s largest economy and remains the issuer of the world’s reserve currency. That makes it easier for the government to sell bonds and support itself in the short term. Nevertheless, the current situation does raise concerns.  

One ongoing concern is in the labor market, which has shown some stabilization, but jobs are still being shed and not enough quality jobs added. These factors will undermine the ability of the US to grow, as the consumer fails to buy in to the recovery. The $12 trillion government deficit cannot be tackled without a stable and resilient underlying growth story and this does not bode well for the Dollar. 

Another negative influence on the value of the dollar is it diminishing role as a reserve currency. Excluding the Chinese central bank, which does not report its holdings to the IMF, around 40% of global reserves are in dollars compared to 55% a decade ago, with the difference lost to a range of currencies such as the Euro and Sterling.

When Chinese central bank holdings are taken into account, the future appears even bleaker for the dollar. Standard Chartered estimates that at the end of 2008 the Chinese central bank held 82% of its reserves in US dollar assets. That heavily overweight position is no longer appropriate given concerns about the stability of the dollar following quantitative easing. Changing direction will take time, but there is already evidence that China is adding to gold holdings, for example, as an alternative to the dollar.

As this complex process unfolds, gold will become a natural safe haven for individual investors and sovereign entities alike.

An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.
Author: Laurence J. Peter

If the world’s largest economy falls in the woods and no one is listening, does it still make a sound? How, exactly, does one call a bottom until you have actually felt the impact? Many analysts, pundits and would be guru’s have tried to successfully predict a turnaround while investors are still flapping their proverbial arms on the way down. The fact is that any optimism for a sustained market rally is purely wishful thinking until the economic wounds are given time to heal from the inside. Stimulus Packages? Fed Auction Windows? Bailouts? All Band-Aids. Certainly, it is instinctual to apply immediate pressure to the wounds to prevent imminent bleeding, and this is not wrong. We do not suggest that the work of Bernanke, Paulson, et al was without merit. However, to deny the realities that we are faced with is irresponsible at best.

While some believe we have merely witnessed a speculative bubble in commodities, we disagree. Simple supply and demand issues will continue to drive oil, coal, gold and other commodities. With half the world’s populous in China and India awakening to a new-found hunger for growth and technology, demand will certainly continue to grow beyond sustainable supply. Also, the present U.S. administration’s policies and actions have led, and will continue to lead, to further instability in key regions, throughout the world. This, alone, could lead energy prices even higher.
In addition, current Federal Reserve policy has clearly indicated a bias toward protecting Wall Street before the Dollar. We expect any policy shifts toward curbing inflation will come too little-too late. As such, Gold will continue to attract investors as a flight to safety.

Unless Congress passes an energy independence mandate tomorrow or the Middle East wakes up in the morning to a new dawn of peaceful harmony, the smart money will remain in Gold and Energy.

The funny thing about New Years and Birthdays is that we all expect something profound to come of the arrival of a date on the calendar. We mark the occasion with high expectations, but the truth is that some things just don’t change that abruptly. For that matter, the 60’s didn’t end right on time in 1969. This is not to say that putting 2008 behind us and hoping for better things in the New Year is a bad idea; it just may take a little more time to pay the price for the indiscretions of the past 8 years.

Wall Street and the greater economy will not reach an easily definable turning point and begin an uninterrupted bullish rise equal to the bearish fall. Not for New Years day, not for Inauguration day, nor, for that matter, for the Ides of March, nor any other date on the calendar. The world economy will, certainly, recover and evolve in ways as yet unclear. It will take time and there will be further downside to the markets before such recovery will begin. On the road ahead, the housing market, unemployment, and the long term effects of the medicine being prescribed for the crisis, namely a flood of monetary supply, will all be critical issues for some time.

Despite the modest movements in the indexes recently, some important things have, in fact, been happening. There has been some accumulation in certain sectors, and a clear indication of rotation has been apparent. We do support the belief that we will see another strong leg down later in 2009, but expect a moderately sustained rally in many areas. Investors have become slightly more willing to step in, but are being very selective and are frequently pulling out quickly in order to capitalize on profits. In a success hungry market, there are few long term buyers in place just yet. Watching the charts on certain performers in the past few weeks, you can easily see a wave pattern where many investors appear to be taking profits after 4-5% gains and buying back in on the dips. On the road ahead, short gains may become more acceptable than in the past. P/E ratios near 10 will become the norm as opposed to 20-30 in the past. Among other things, the market is still in a phase of reinventing itself and there will be a new set of norms moving forward. Watch, also, for metals and mining stocks to gain significantly as public works programs begin to kick in. The Obama administration seems completely determined to waste no time in moving ahead with its policy of ground level stimulus.

So, regardless of the highest hopes and firmest resolutions for the New Year, 2009 is likely to see some highs and lows and be looked back on as a defining year in many respects. The US auto industry has an opportunity to redefine itself or to fail trying. We will also see whether the US economy will emerge with the same dominance that it has enjoyed in the past. The entire financial world will most likely not resemble its former self. There will be new rules and norms and, perhaps, a new list of key players. The government’s involvement in the business sector is at unprecedented levels, and whether, and how soon, it will be able to pull back remains to be seen. 2008 is already seen as a year of crisis and collapse. 2009 will become a defining moment in time.

“It takes a Great Drummer to be better than No Drummer”   jazz great Chet Baker

Karl Marx was apparently more of a capitalist than any of us knew. We may have just misunderstood by thinking that those with ability were the upper class and those with the need were the working class. Today we have finally come to realize that it is the other way around. It is the workers who, through taxes, are providing for those in need: the bankers. It’s like the Great Depression, only the ones in the bread lines are investment bankers and CEOs. We have experienced some of the highest level of government intervention in the economic machine since the 1930s. As yet, we have seen little positive to come out of it which makes it all the more difficult to accept. It remains to be seen what the implications will be for the future of the economy, the free market, or the Dollar. In hindsight, we will at some point look back on the policy choices of Ben Bernanke and Henry Paulson as genius or reckless desperation.

One change we can be sure of is the fact that the banking and market system may never be the same. This is not your father’s Wall Street. When times are bad, we have a tendency to seek out someone to blame. The present crisis threatens to create a Witch Hunt mentality where many fingers will become stiff from pointing elsewhere. Regulation will change for sure in many previously untouched venues of the financial industry. Government involvement in the financial sector will have, as yet, unknown implications. Interestingly enough, the arguably liberal policies have come out of a professedly conservative administration. When crisis hits, the usual ideological lines become noticeably blurred.

In terms of investment strategy, present conditions have shown the only viable plan to be one with a very short term time horizon. One can stick to fundamentals and wait patiently for things to come around to reason, or you can stay vigilant and ride the short but drastic swings that have become prevalent.  The market has, at the very least, been predictable in its unpredictability.

We are facing two major factors that will continue to affect our investment strategy well into the New Year. One is the likelihood of a severe deflationary environment. Some fear its arrival; we believe that it has already begun. What happens in such cases is that prices, particularly for commodities, come down by extreme and unreasonable amounts. Sure sounds positive for consumers, at first, but the problem is that it also adversely affects producers and, in many cases, reduces the incentive for production and innovation. This quickly becomes a spiraling problem as job reductions lead to decreasing demand which accelerates price deflation and so on. This will make commodity based investing a very difficult proposition for some time.

One exception to this trend leads us to what we believe will be the greatest opportunity in the year ahead: Gold. Several factors are beginning to take shape that will have a large impact on some precious metals. While we are seeing quite a bit of deflationary pressure, there is also a mounting threat of supply shortage. Platinum producer Lonmin has announced that it will close several of its South African mines and stop growth projects. Other cost cutting measures will have Lonmin reducing its London offices by over 30% and focus more on its Johannesburg operation. In Zimbabwe, gold production fell by about 65% from the same period last year. Here, the problem is an exhaustion of producing mines. Meanwhile reports have surfaced that the demand for Gold has reached record levels. Holdings being liquidated by institutions looking to shore up their liquidity have apparently begun to make its way into the hands of an increasingly active retail sector. Demand for bars and coins have doubled, while Gold holdings in exchange traded funds has more than tripled. Slowly and quietly many are positioning themselves for a coming jump in gold prices.

On the demand side, the Saudi’s have reportedly spent about $13 Billion Riyal moving from large Dollar holdings to the safe harbor of Gold. In China, the world’s largest holder of Foreign Exchange Reserves at nearly $2 Trillion, many domestic analysts are expecting the government to triple its current Gold holdings. Traditionally, over 60% of mined Gold is used for retail items, while the rest is spread between industrial use and investment speculation.  Much of what drives the price, however, is the speculative part. With a coordinated global effort to throw fiat money on the economic fire, those that look ahead are planning for what that will mean for currency valuations once the financial market finds a bottom. As we all know, price is a function of supply and demand. Yesterday, we pointed to supply concerns in Zimbabwe and South Africa. As governments and large institutions begin to hoard the precious metal, demand will rapidly push prices toward our $2000 target.

"I killed the Bank."    
Andrew Jackson, when asked what his greatest accomplishment had been.

With all the varying opinions and views circulating amongst the experts and Joe the Plumbers, there is at least one thing most would agree upon; that we live in historically monumental times. The world as we know it stands at a crossroads of change as the basic precepts that we have come to accept as basic truths have come unraveled. With China’s growth, Russia’s capitalistic renaissance, and the meltdown of the long revered free market policy epitomized by Alan Greenspan, the old rules do not apply. Apparently it only takes one good crisis to level the playing field. In addition, we could not think of a better sub-plot to the economic crisis than to have it take place simultaneously with what will go down in history as an historic election here in the US.

All of this brings to light not just minor nuances in generally accepted principles, but potentially broad changes in the very fabric of what we thought we knew. In the not too distant past, many would have questioned whether we were, in fact, capable of accepting a break from the old standard and embracing truly new ideas. It can no longer be questioned. This aside, however, we are also facing other monumental changes as a result of the economic crisis that have divided the various schools of thought along vituperative lines of discussion. Recent policy action has been formulated by the relative few and debated by many. Not since the McCarthy era have we heard the word socialist or communist so often. Now it has worked its way into campaign mudslinging and our economic discussions primarily as a result of the unprecedented intervention of the US government into the financial sector. The purists from each side of economic theory manage to wave their respective flags that we have done to little, or too much, but the clearest thinkers understand that what needs to be done to correct a problem may be different than what should have been done to avoid it. Perhaps the most difficult thing to correct is the growing distrust of the political and economic process. There is a flaw in the system and finger pointing is widespread. No other person or institution has been the focus of more attention and disagreement than the Federal Reserve. The controversy and concern regarding the stewardship of a central banking system has long been expressed.

In any case, it is not so much the process but the results that are the primary concern of Main Street America. What is systemically necessary to support our financial system may not produce what is best for the average “Joe”. Wall Street will undoubtedly respond to active policies promoting liquidity, to rate cuts and to federal injections of cash but will a top down approach prevent or prolong a consumer recession? In simple terms, easy money led to a housing bubble; the bursting of the bubble cost Wall Street huge sums of money and now the Fed is working feverishly to put out the fire. No one should argue the merit of trying to throw water on the most visible part of the fire and not allowing it to spread, but in this case, the gas leak in the basement that caused the fire is being ignored. That “leak” is at the consumer level where rising foreclosures and unemployment will continue to feed the flames of recession if not addressed.

For the investor, it will be important to look at, not the immediate effect of policy shifts, but the likely results. In the short term, the relative weakness in the Pound and Euro has given the Dollar a boost and this will likely continue. As a result, US companies with a large emphasis on exports will suffer and commodity prices will not recover much during this time period. A higher Dollar index has also served to subdue the rise of Gold prices, for now. Looking ahead, however, many things will change. The monetary policy of the US Federal Reserve is very likely to have a very different effect in the future. As the playing field levels a bit more, the Dollar will likely suffer from the near zero Fed target rate and possibly further by the inflationary effects that such policy will eventually lead to. Despite the chance that we could see a deflationary spiral if the crisis worsens and the consumer segment of the economy falters, it is more likely that a moderating of circumstances will occur. As a result, we expect the possibility of another sharp rise in oil and other commodities is increasingly likely. A larger balance of this growth, however, will come from new sources in the emerging economies..

"The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries." Winston Churchill

Indeed, we are at an historical crossroad with little precedent. Referring to the government intervention on behalf of AIG, New York Senator Charles Schumer called it an “unprecedented step—in unprecedented times”, but is it? Have we not faced a financial crisis with global reach such as that which we fear now? The very same financial pundits who have avoided the utterance of the word “recession” certainly would never resort to saying aloud the phrase “Great Depression”. We dare say it only to draw a corollary of events and actions that we may learn from the past so as not to repeat it. This is not to suggest that we are anywhere near the statistical depth of problems faced during The Depression but simply to examine our crisis management policies.

In very simple terms, the Stock Market Crash in 1929 was preceded by six years of unmatched prosperity including what could be called a bit of a housing bubble. At the early signs of trouble the Federal Reserve, still in its infancy, lowered rates and pursued an easy money policy to try and preserve the bull market. The markets continued to fall nonetheless. The Fed later began to tighten the money supply but it was too late. Congress created the Reconstruction Finance Corporation specifically to facilitate billions of Dollars in loans to financial institutions and insurance companies in order to prevent their failure. From there, Roosevelt’s new administration took the government even further into its interventionist policy. Some certainly have credited the government intervention and monetary policy with ending the crisis, while others blame it for prolonging the misery. The fact is that the US took longer than most to emerge from the darkness.

Once again, it is well understood that many factors led to this crisis nearly eighty years ago some of which are very different than the challenges we presently face. Some of the events and the policy decisions, however, are all too familiar. In broader terms, it is poor economic policy to pursue an easy money policy in order to preserve a mirage of prosperity. Austrian economist and a contemporary to the Depression era, Ludwig von Mises stated “imprudent granting of credit is bound to prove just as ruinous to a bank as to any other merchant”. It is equally improper to expect the taxpayer to “share in the misery” by spending their money to save one institution after the other. Certainly it is almost unfathomable to imagine the fall of one large institution after another, but we are equally concerned with the alternative path.

In terms of finding an appropriate path in such difficult conditions, we can once again look to the past. Gold, as a hard asset with and inherent perception of stability, has a long history of success during difficult circumstances. In fact during the Depression some hard asset stocks such as the Homestake Mining Company actually increased during the downturn. We believe that, however severe the present crisis becomes, it will be Energy, Gold and other commodity stocks that will outperform many others. Our best clients are aware of the position we have accumulated in GLD, a gold bullion ETF. We also view the purchase of OEX Puts as an appealing opportunity; using an 8% trailing stop to protect one’s profit.