Valley of the Dollars: excerpt from Basic Points
John Mauldin's Outside the Box

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Introduction

This week we look at another interesting essay by Donald Coxe, the Global Portfolio Strategist, BMO Financial Group. He is also the Chairman and Chief Strategist of Harris Investment Management in Chicago, and Chairman of Jones Heward Investments in Toronto. Coxe writes a monthly piece called "Basic Points" and his latest is this week's "Outside the Box."

This essay explores the current situation with currencies, gold and commodities. Plus I normally don't include investment recommendations, but felt that they deserved to be included this time. Today's letter is excerpted from the December 14, 2004: "Valley of the Dollars."

Valley of the Dollars: excerpt from Basic Points

Chart 1


Chart 2

For Americans, the bear market is over.

For Europeans, Canadians, Australians, New Zealanders and South Africans, the bear market grinds on. If we are right in our forecast that the Canadian dollar will reach par on the greenback by mid-2006, a Canadian holding an S&P Index Fund will need double-digit returns on the Index to earn what would be earned in a Canadian chequing account.

Global statistics on per capita GDP and per capita wealth tell us about incomes and net financial assets--but they are heavily skewed by the changing dollar values of local currencies. When the dollar went on a tear nine years ago, Americans' share of world wealth grew dramatically: Americans who kept all their savings on deposit with an American bank gained hugely in wealth compared with European and Canadian counterparts of equal wealth and savings who kept them in their own currencies with their own banks. The Americans' globally-adjusted wealth gains, just from cash, were so strong that they delivered comparable returns with foreigners who had balanced portfolios. Rarely was it so easy to achieve such huge investment out performance without assuming substantial volatility risk.

Based on the evidence of returns on financial assets from 1995 through January 2002, the stronger one's currency the better. "Sound as the dollar" was the mantra, as the world poured its savings into the US, the progenitor of the magic money machine, the New Economy, and the world's sole hegemon now that peace had broken out-- seemingly forever.

But a desirable level for a currency is not measured solely in terms of wealth. It is also measured in terms of the transactions of competitive economic activity. "Sound as the dollar" was the death knell for millions of American manufacturing jobs during that same time span. A company whose costs accumulate in the world's most expensive currency is at a punishing disadvantage in competition with competitors based almost anywhere else. In terms of global trade, a weak currency is a consummation devoutly to be wished. The currency lord giveth (in measurement of the value of people's savings) and the currency lord taketh away (in terms of employment income, and the value of employer pension plans).

In terms of mergers and acquisitions, changes in currency values produce a Pirandello-style role switch for acquirers and acquirees. During the 1990s, US multinationals were able to buy European and Canadian companies, using their valuable cash and their valuable stock to buy companies whose stock was denominated in a weak currency.

The game has changed. With the euro up from its low against the dollar by 60%, even if the relative share prices of an American would be acquirer and the Eurozone potential acquiree had remained in the same quoted relationship to each other, buying that Eurocompany would now cost the US company 60% more. Consider, for example Manulife's purchase of John Hancock: if the loonie had done what many prominent Canadians were predicting--fall to $0.50, Hancock would have been too costly for Manulife to buy. At some point in the loonie's plunge, the roles would have been reversed.

Another way currency changes can affect corporate power comparisons comes from the denomination of corporate debt. Consider two Canadian companies with roughly equal stockholders' equity as of early 2003. Each has substantial debt. One company has nearly all its debt in loonies, the other's is greenback-denominated. The second company's enterprise value rises sharply compared to the first company.

We hear routinely that in the financial world, bigger is better. Since February 2002, smaller, in currency terms, has been far better than biggest.

The Rule of Page Sixteen

Long-time readers have learnt our investing rules. One such rule oft cited in these pages is The Rule of Page Sixteen, which is, "You don't make or lose serious money from a story on Page One: you make or lose serious money from a story on Page Sixteen which is on its way to Page One."

For three years, this journal has talked of the inevitability of a major dollar bear market--a Valley of the Dollars. Given the basic data on the US dollar and the nation's towering trade and fiscal deficits, we were amused that the mainstream commentators continuously pooh-poohed the idea that the euro and the loonie were headed for major bull markets against the buck. When this bear market began to unfold, we were amused that the mainstream commentators kept finding other topics worthy of their comment, while dismissing the dollar's problems as a mere temporary nuisance.

In the past month, greenback groans have reached Page One. Faced with such an unexpected story, the media has naturally found forecasters with indifferent or dreadful accuracy records who scream of "Armageddon" and other such scary outcomes. A slow bleed isn't worth a front page story: what's needed is a prediction of a Crash producing blood in the streets. In the past week, the dollar decline has been on the front page of such publications as Fortune, The Economist and The New York Times, and Wall Street research has actually begun discussing the implications for sectors of the market and specific stocks.

To us, it looked as if the dollar was readying itself for a rally.

All this belated hand-wringing about the anemic dollar came at a time of year when the dollar traditionally experiences seasonal strength.

Why? Because American multinationals routinely draw down foreign deposits in December to finance dividend and tax payments, and global investment banks tend to square up their accounts in a manner conducive to dollar strength. Furthermore, when even the European Central Bank is expressing horror at the euro's strength, and the Chinese are publicly blaming the US for the dollar's weakness, we assumed that the authorities would be seeking an opportunity for serious currency intervention.

When the statistics on currency traders' positions were published last week, they disclosed a near-record short position on the dollar. So all that was needed to spark a sharp (if spastic) rally in the buck was a concerted move by the central banks...

It started on Tuesday and then got rolling on Wednesday with the announcement that foreign central banks and other shadowy institutions had bought a near-record 65.8% of the five-year notes at the Treasury auction, at a time the euro had already pulled back from its attempt to test 1.35 and the loonie had pulled back after threatening to trade through $0.85. The Asian central banks had not been conspicuous in playing their dollar-propping roles of the Great Symbiosis in recent months, arousing global concern that the dollar would enter free fall, with the big losers (winners?) being the emu, the loon, the kiwi, the 'roo and the springbok. (The currency bestiary includes the euro, the Canadian and Australian dollars, and the South African rand.) The euro fell two cents in 24 hours, and the loonie fell two cents in two days.

But the most dramatic action came in the dollar's shadow currency:

Chart 3

Chart 4

The Gold StreetTracks is the long-awaited Exchange-Traded Fund sponsored by the World Gold Council that gives the buyer one-tenth of an ounce of gold held in trust. It was greeted with the kind of enthusiasm from small speculators that would make almost any serious gold investor run, not walk, to the exit. The ETF's entry to the Big Board has, for now, provided the top for gold--and a floor for the greenback.

We are asked daily about our attitude to this new ETF. As we understand it, a US investor who makes a profit in this product is subject to the tax at the rate applicable to collectables, such as Old Master paintings, Babe Ruth autographs, and lingerie that had lightly clad Elizabeth Taylor during the filming of "Cleopatra". That tax is more than twice the tax on capital gains arising from securities trades.

So we can hardly recommend it as an alternative to quality gold mines for American investors. Its attraction lies in its convenience, liquidity and in the modest annual carrying charge: 0.4%, which is good compared with having a bank hold bullion in its vault.

When we wrote the October issue of Basic Points, arguing that the next of our core themes to attract the market's attention would be the dollar and gold, because the dollar would have to be greatly devalued no matter who won the election, and the dollar's plight was of no observable media concern. We were getting few calls or emails to update our views on the possibility of a major devaluation.

With the election out of the way, all that complacency vanished. We now get daily calls, emails and interview requests from the newly anxious. When the dollar droop gets to Page One, we become uncomfortable--and brace for a strong response from the central bankers, whose discomfort is really important.

Another indicator: our book, The New Reality of Wall Street, suddenly came from nowhere to be listed as #7 on Business Week's survey of best-selling business books. (We are in interesting company: one book by Donald Trump and one about him are on that short list.) We are bemused by this sudden rediscovery of our book but as far as we can tell, the book owes its new notoriety to some websites that note its prediction of a dollar bear market and how to profit from it. That BW revelation coincided with the new high for gold and the new low for the dollar.

Rarely has any big story we study run from Page 16 to Page One so fast.

Causation, coincidence or both? The commodity sell off occurred as the dollar was suddenly rallying.

It is a matter of record that postwar commodity bull markets have coincided with dollar bear markets. Does that mean the real story is the dollar, and commodities are mere messengers? The dollar's fall, and the outbreak of global inflation were certainly the keys to the commodity bull markets of the 1970s that ended in the early 1980s with the commodity Triple Waterfall crashes. It is also true that commodities--particularly gold--had sharp rallies during the Third Cascade of the two-decade-long decline, and those rallies came when the dollar's troubles were on Page One (most notably in 1987).

But we should be cautious about this post hoc ergo propter hoc reasoning.

Contrast this experience with the runup to the Triple Waterfall peaks for precious metals and oil 1975-81.

This was a period of sustained dollar weakness, soaring inflation and soaring interest rates. Silver rose to more than $35 an ounce and gold touched $850. Oil became a favored asset class for investors and speculators--and even for some pension funds. When the fall of the Shah in 1979 triggered another oil crisis, Exxon reported that 35% of its net earnings came from inventory gains. (The company filled all its storage tanks and vats with crude oil and leased tankers that it filled, then moored in Norwegian fjords.) Because of government price controls and excess profits taxes, it was tough to make money selling gasoline, so the easiest way to reward stockholders was to sit on the stuff.

As we were to learn, the silver boom came because the Hunts and their Saudi friends very nearly cornered the world supply of silver. They were able to buy up most of the bullion, but were defeated by the melting down of above-ground silver in the form of silverware, coins, trophies and chandeliers. (We recall those days well: our son had a piggybank we had been filling since his birth in 1967 with pure silver coins in anticipation of an upward revaluation of silver. When silver was trading at undreamt-of levels, we suggested he cash in his hoard. He agreed to sell half--face value roughly $62. We stood in line at the silver exchange in Toronto and got more than $1,000 in cash. That company went bust within a week and the Triple Waterfall for silver was on.)

The commodity crashes came when investors finally understood that the runaway inflation of the 1970s was giving way to disinflation (and later deflation). It began with Paul Volcker's announcement at the Belgrade IMF meeting in 1979 that the Fed was abandoning interest-rate targeting in favor of strict monetarism. It took the world a while to believe that pure Friedmanism would smash inflation, but when long Treasurys began trading near 16%, the game was over.

The two-decade-long commodity bear market was driven not just by disinflation. At its onset, there were massive "inflation hedge" inventories of everything from oil to copper around the world. First the speculators dumped their positions. Then, in the case of oil and the metals, companies began slashing their inventories. A New Idea had taken hold: Just-In-Time Inventories. Japan's astonishing competitive success got business's attention. By 1988, every new MBA had learned that lean was lovely--in inventories, as in the gym, cuisine and the arts of love.

These interrelated processes--falling inflation, falling interest rates, falling commodity prices, and a rising dollar--would feed on each other most of the time for two decades. The 1990s gave us a new mania to fill the vacuum left by the disappearance of the inflation hedge mania. The "New Economy" exuberance would eventually make $850 gold look like Puritanical caution.

Yet we cannot say we are repeating the 1970s: copper inventories, for example (on the Comex, LME and Shanghai Exchanges), are down 90% from their 2001 levels; the world gets by with oil inventories at less than half the level of the 1970s (in relation to daily consumption). Inflation worldwide remains muted, despite $40-45 oil and $440 gold. So this current dollar drop is different from the 1970s and 1980s.

However, it is true that the dollar's fall makes commodities cheaper for countries whose currencies are appreciating. Europeans are paying barely more for their oil now than two years ago because of the appreciation of the euro, Swiss franc and pound. But the Asian commodity consumers who are responsible for the price rises for energy and industrial metals are paying the full increase, because their nations are keeping their currencies tied to the dollar.

For now.

INVESTMENT RECOMMENDATIONS
  1. For three years we have prefaced our yearend investment recommendations as follows:
    • all other things being equal, avoid investing in companies who produce what China produces;

    • all other things being equal, invest in companies who produce what China needs to buy.

      That strategy remains intact.

  2. The yearend pullback in the commodity stocks is a splendid buying opportunity. The golds, base metals, and oils are very attractive for those with time horizons longer than a few weeks.

  3. The global economy is slowing down, partly in response to sustained high oil prices, but also in response to the overindebtedness and near-zero-savings rate of that great American hero--the US consumer. The safest "economy-sensitive" stocks are the basic materials companies, because they are so cheap relative to companies selling direct to American consumers.

  4. The dollar will fall in 2005. Watching the fire in the skyscraper across the street from my office, I thought how fortunate it was that there were no serious injuries and deaths, because the descent down the fire escapes was so orderly. We hope that is a metaphor for the dollar's descent, but will be watching for signs that the eurodollar market is experiencing strain. Maintain a strong overweighting in gold stocks as a hedge against a 1987-style panic.

  5. Dividends remain the best key to evaluating stocks generally. With Bush's re-election, the great dividend-paying stocks, such as those included in the iShares Dow-Jones Select Dividend Payers ETF, should be core investments.

  6. Where possible, invest in bonds issued in strong currencies.

  7. Geopolitical risks remain high, if only because Al Qaeda is showing signs of desperation as its havens get taken, and its leaders are captured or killed. 2005 could be a year in which a Page One story--a horror story--becomes, at least temporarily, the over-arching force in the financial markets.

  8. Barring a financial panic or a major turn for the worse in the War on Terror, 2005 could be a year of calm in the financial markets. The recent surge in stocks would suggests that estimates of global growth of 2.5% could be too low. We incline to the view that the equity buyers' enthusiasm is overdone.

  9. Paraphrasing Runyon, the race (in terms of economic growth) is not always to the swift (such as China and India), and victory is not always to the strong (in currency terms). But that is the way to bet.

Basic Points is a publication prepared by Donald Coxe of Harris Investment Management, Inc. ("HIM") and BMO Harris Investment Management, Inc. ("BMO HIMI") for the exclusive use of clients of BMO Nesbitt Burns Inc., Harris Nesbitt Corp., HIM, Harris Trust & Savings Bank (.HTSB.), BMO HIMI and Jones Heward Investment Counsel Inc. (collectively referred to as the "Global Asset Managers").
All rights reserved.
The opinions, estimates and projections contained herein are those of Donald Coxe and do not necessarily represent the opinions of HIM and BMO HIMI as of the date hereof, and are subject to change without notice. HIM, BMO HIMI and the other Global Asset Managers believe that the contents hereof have been prepared by, compiled or derived from sources believed to be reliable and contain information and opinions which are accurate and complete. However, the Global Asset Managers make no representation or warranty, express or implied, in respect hereof, take no responsibility for any errors and omissions which may be contained herein and accept no liability whatsoever for any loss arising from any use or reliance on this report or its contents. Information may be available to the Global Asset Managers which is not reflected herein. This report is not to be construed as an offer to sell or solicitation for or an offer to buy any securities. The Global Asset Managers and their affiliates and respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. Any of the Global Asset Managers may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. Each of the Global Asset Managers is a direct or indirect subsidiary of Bank of Montreal. Bank of Montreal or its affiliates may act as lender or provide certain other services to certain of the corporations mentioned herein and may receive remuneration from the same.
® "BMO" is a registered trade-mark of Bank of Montreal, used under licence.
"Nesbitt Burns" is a registered trade-mark of BMO Nesbitt Burns Corporation Limited, used under licence.
TM "The M-bar roundel symbol" is a trade-mark of Bank of Montreal, used under licence.

Conclusion

I hope you enjoyed this week's letter. To download the complete text of this issue of Basic Points or to listen to Don Coxe's weekly conference call, please visit www.jonesheward.com.

I hope everyone has a good Christmas and gets to spend some quality time with family and friends.

Your looking forward to having all his kids in town analyst,


John F. Mauldin
johnmauldin@investorsinsight.com



Disclaimer

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Posted 12-20-2004 3:40 AM by John Mauldin