After the Deleveraging Comes the Deluge

October 6, 2008 – One of the basic premises of my portfolio strategy is to avoid the US dollar. My basic recommendation in this regard is simple, straightforward and has been consistent now for several years. Don’t hold dollars in a bank. Don’t hold dollars in a money market fund. Don’t hold any dollar denominated debt.

One of the main reasons for this strategy has been that the dollar is being inflated. Real interest rates (i.e., after adjusting for inflation) are negative, so anyone holding dollars loses purchasing power. The other reason for this strategy is now becoming increasingly clear as the global financial crisis deepens. Dollars have counterparty risk, so hold gold instead. That portion of your wealth you hold in gold is not dependent upon anyone’s promise or financial capacity to make good on their promise.

As a practical matter, subscribers in the U.S. need to hold some dollars. But I recommend that they only hold the dollars needed for a month or two of living expenses. Keep your liquidity instead in gold, and then simply exchange your gold for dollars from time to time as you need to replenish the dollars required to meet your living expenses.

The reason for this course of action is that the dollar is backed by nothing but government promises. It is fiat currency, and the important point is that every fiat currency in history has eventually collapsed. That’s a compelling record.

One does not want to take a position contrary to that record unless there are good reasons for doing so. There are no good reasons to expect that the dollar will survive as the lone fiat currency success story. In fact, the ‘writing is on the wall’ for the dollar. It is already suffering from the same illness that kills all fiat currency.

Fiat currency does not survive because it is inevitably created in excessive quantities, the result of which means that the currency’s purchasing power is inflated away. Just look what the Federal Reserve has been doing to the dollar, aside from the fact that the dollar has already lost more than 90% of its purchasing power since it was taken off the gold standard by the dictate of President Nixon in 1971.

Since January 2007, M3, the total quantity of dollars, has been climbing by double-digit annual rates of growth, which is an unprecedented expansion and far exceeds the rate of GDP growth during this period. This comparison shows that money is growing faster than economic activity, which is inflationary because more dollars are available relative to the goods and services being produced.

Presently, the Federal Reserve is pumping money into the banking system at record rates. The Federal Reserve’s balance sheet has increased from $918.5 billion at the end of July to $1,498.7 billion this week, which equates to an astounding 63.2% increase in barely two months.

The Federal Reserve is the engine of inflation, and this unprecedented increase in its balance sheet to create dollars ‘out of thin air’ further fans the inflationary fires already well underway. We experience this inflation daily through the relentless rise of the cost of living, but there is a crosscurrent that can muddy the water somewhat.

The price of some things is falling, like house prices in Stockton, California and other cities that were at ground zero in the home building and home financing frenzy that drove prices to extreme levels of overvaluation. House prices are falling back to earth, even as the currency we use to measure those prices – the dollar – is inflating away and purchasing less and less.

Another area where prices are falling is the stock market, as is clearly illustrated in the above charts. The first chart measures the weekly price of the S&P 500 Index in terms of the dollar, while the second chart measures this same index in terms of gold. In both charts the S&P 500 Index is declining, but it is declining more rapidly when measured in gold. The reason of course is that the dollar is being devalued against gold, or to state it as we normally do, the gold price is rising.

To some extent the above charts are diverging in that their respective rates of decline are different. But I think we are close to the point where these charts diverge by actually heading in different directions, like they did from 2003-2007. The S&P 500 will continue to head lower in terms of gold, but I expect will soon start heading higher in terms of dollars.

This conclusion will not come as a surprise to the long-time readers of these letters. There have been numerous recitals of monetary history in these letters over the years, particularly examining the events that typically unfold when a currency collapses. There is one common denominator seen time and again. As the flight from the currency builds momentum, there is eventually a rush into equities. It is a way to escape from the collapsing currency. I think we have reached that point or are very close to it.

The liquidity crisis and persistent de-leveraging that has been prevailing more or less for eighteen months is winding down, and is being supplanted by another growing and threatening monetary peril. The flight to safety has begun.

We are at the beginning of one of those rare moments in time when return on capital becomes less important than the return of capital. We have entered an environment when everyone should be looking at ways to protect their wealth. The flight to safety means that avoiding counterparty risk will increasingly become the most important objective in managing one’s wealth.

The way to avoid counterparty risk is to buy tangibles and near-tangibles, like equities. I call equities a “near-tangible” because they convey to the equity holder the ownership of the tangible assets owned by the company.

Not all equities of course meet this need for safety, because some – like banks and financial service companies – should be avoided in a currency collapse. But the shares of commodity producers and those of essential consumer goods should do well, regardless what happens to the currency because their products will likely remain in demand and the price of their products will rise as the currency inflates.

Will this divergence that I am expecting in the above charts begin next week or next month? Maybe the divergence won’t begin until next year. No one can possibly know, but I expect the turning point is close.

We can only watch and wait to see how events unfold because timing can never be predicted. For example, long-time readers of these letters may recall an article that I wrote on May 24, 2004 for Letter No. 345, entitled “Time to Avoid Leverage”, which was my paean to avoid leveraging one’s investments. Here are some key snippets of what I wrote back then.

“The stock market is ready for a big collapse, maybe a 1987-type crash even. Therefore, you do not want to use any leverage in this environment…

If there is a stock market panic, there will be a rush for liquidity. Investors and the banks that hold the collateral securing the debt that they loaned to investors to leverage their positions will sell everything they can if the price of the collateral starts declining. Because stocks are a popular and frequently used collateral for trading, banks watch stock prices closely. If the value of the collateral the bank holds starts to diminish and the prospect appears to the bank that the borrower has few resources available to put up more cash to support his trading or investment position, then the bank protects itself by selling the collateral, which is the key point. One popular form of collateral is gold, and to a lesser extent, silver…

Our monetary system is due for a severe shock. In fact, it seems safe to say that it is long overdue because debt at all levels has grown to unsustainable levels. An overvalued stock market may lead to a collapse that could be the trigger that gives the monetary system that severe shock [and be] the first liquidity crisis since the 1987 stock market crash…

In the immediate aftermath of the 1987 stock market crash, gold fell. It declined because there was a rush to cash, so gold was sold along with other assets. Gold declined for a while, but as the panic deepened gold started climbing back, and soon was over $500 per ounce.

If the stock market collapses from here, which I consider to be a good possibility, gold may also incur a setback – not a collapse, but just a setback – along with stocks. Gold will for a while get sold along with other assets in a rush for liquidity.”

Those words from over four years ago look prophetic now, and I recommend that you read the entire article because there are some useful insights to today’s financial crisis. So Letter No. 345 is attached hereto.

Clearly though, I was a couple of years too early. The stock market did not collapse back then. Instead, it subsequently climbed higher to make a double top on the S&P 500 and a new all-time high on the Dow Jones Industrial Average (thereby forming a bearish divergence between these two averages), before both of these averages and the rest of the stock market as well started heading south. So my article about reducing leverage because of the liquidity crisis I was expecting was, frankly, two years too early.

The point is that perhaps I am two years early again by saying that the above charts will diverge because safety of capital will become paramount as the flight from the dollar begins in earnest. But then again, maybe I’m not too early.

There is no way of predicting the timing, so all we can do is watch events unfold day after day and week after week. But when the direction of the above two charts does start diverging, we will know that the final collapse of the dollar will have begun. There will be a rush out of dollars into near-tangibles like stocks of commodity producers and of course into tangibles themselves, like gold and silver.

The conclusion therefore seems quite clear. The limited supply of gold and silver will be dwarfed by a tidal wave of paper looking for a safe home. It will be a deluge of paper trying to buy the available gold, just like as happened with every other fiat currency in history that collapsed.