Do I Have It Right?

February 11, 2008 – Do I have it right? It is a question that I relentlessly ask myself, comparing what the various markets are doing against what I had expected them to do.

It is an important question, and I have been asking it a lot ever since the major stock averages last month broke below their August 2007 lows. Instead of breaking into new high ground, we can see on the accompanying chart that the S&P 500 Index broke down from its uptrend channel. It was not something I had expected.

One of my major premises has been that the dollar will inescapably collapse, just like every other fiat currency in the history of the world before it has eventually and inevitably collapsed. Given this record of fiat currency failure, my view has been that the dollar would therefore be no different.

While the collapse of the dollar would be unique because it is the world’s reserve currency – which is a position no fiat currency has ever held before – the dollar’s collapse would nevertheless have some predictable aspects to it. One of those would be a rush into tangibles and near-tangibles as a means of escaping anything that is dollar denominated.

In other words, the key to surviving the collapse of the dollar would be to avoid owning any financial asset, the value of which is based on the dollar. These would include dollar-denominated assets like bank deposits and debt instruments, regardless whether the creditor is the US government, a municipality or corporate borrower. The dreaded assets to avoid would not include, however, most equities.

Though equities may trade in terms of dollars, it would not be accurate to describe them as dollar-denominated. Take Exxon as an example. It trades on several exchanges outside the US, and owns considerable assets outside the US. Clearly, the stock of Exxon is not a dollar-denominated asset. It is an ownership stake in a wealth producing franchise, and if Exxon is well managed, it will remain a wealth producing franchise regardless what happens to the dollar and regardless what currency Exxon uses to report the accounting value of its worldwide assets.

If we look at the experience of countries whose currency has collapsed, stock prices rise in those countries in nominal currency terms, but generally decline in terms of real purchasing power (the exception to this rule would be gold mining stocks). The currency collapse generally reduces economic activity and therefore company profits. But if the company responds correctly to the currency collapse, it will survive. Just look at all the companies in Brazil and Argentina, for example, which survived the many currency collapses in those countries in recent decades.

So what I have been asking myself is why the stock market took out the August lows if the dollar is going to collapse. Right now, I don’t have the answer to that question, but I do have a reasoned guess to explain this unexpected event.

The stock market break is a result of the rush for liquidity arising from the credit crunch currently underway. People – at least those in the US – are not yet awakened to the ongoing collapse of the dollar. They are responding now only to the weakening economic conditions and credit crunch by selling stocks. This money pulled out of the stock market is being parked in money market funds, the growth of which is surging. Unfortunately, I believe money market funds are the wrong place to be for several reasons.

The interest you earn in a money market fund is less than the inflation rate. Many of these funds are holding low quality paper, and therefore your money is at risk. And worst of all, these funds are dollar denominated – and dollar denominated assets should be avoided. People should be holding gold and other tangible assets, which brings me to the chart immediately above.

When viewed in terms of gold, the S&P Index is in a major downtrend. This chart indicates to me that my analysis remains on target, or at least the part of it that concludes equities will decline in real purchasing power terms.

So despite taking out the August lows in dollar terms, I still expect the other part of my analysis will also be proven correct in time. Namely, equities will rise in nominal dollar terms as the real purchasing power of the dollar continues to collapse because of inflation. But clearly, gold is the place to be – not the S&P 500 or the Dow Jones Industrials.