If you sold out of the stock market last year — or even back in June or early July 2008 — you probably feel pretty good right now. And if you took the cash and spread it around to a group of well-run banks, so as to take advantage of the FDIC insurance, then you must be feeling fine. Read no further. Take the rest of the day off.

But if you still have some skin in the game, let’s talk.

“Markets Routed” — The World Wants Its Money Back

“Markets Routed in Global Sell-off,” was the banner headline of the Financial Times this week. It seems like anything that can go wrong will go wrong. It’s Mr. Murphy’s market, right?

How bad can it get? It’s already bad, but can it get worse? Markets go up and they go down. That’s what markets are all about. Still, it’s one thing to live through a market pullback or correction. It’s another thing entirely to experience a total rout. It’s like what happened during Napoleon’s retreat from Moscow. There’s no relief from the suffering.

Evidently, the world wants its money back. It’s selling. In fact, a lot of people want out of the market right now. Are you one of them? I don’t blame you if you are looking for a way to bail out. But before you pull the “Eject” handle, let’s think this through.

Sure, it’s easy to wish that you sold your stocks six months ago. But you didn’t. Neither did I — at least not all of them. Why didn’t we sell? Were we focusing too much on the long term? Did we miss some sell signal? Where’s that bell that they’re supposed to ring at the top of the market? What the hell were we thinking, that we’re bulletproof or something? Well, before we get too far ahead, let’s look back and see how we got here.

Looking Back at a Weak Dollar and Expensive Oil

From the end of 2006 to July 2008 oil increased steadily in price. Also, between late 2006 and July 2008, the U.S. dollar declined in value, particularly against the euro. Both run-ups — the price of oil and the value of the euro against the dollar — were too much, too fast. The apparent strength in both oil and the euro (and the weakness of the dollar) masked the fact that the trading numbers were outrunning the pure economic fundamentals.

Here’s the key set of points. The eurozone economy was not that good last year. The dollar and the U.S. economy were just not that bad. Oil was just not worth that much. Despite the Peak Oil thesis — in which I believe strongly — the world really wasn’t coming to an end last summer. (And it didn’t.)

So by this past July, oil was too expensive and the dollar was too cheap. I said so both in writing and on Fox Business News and other media. As you can see from the charts, by the second week of last July, oil was selling at $147 per barrel and the euro was over 1.6 relative to the dollar. Too much.

What happened, then? In mid-July, the dollar began to strengthen, due to central bank intervention. And the price of oil fell. Both changes were rapid, even abrupt. A surprise? No, not really.

I expected the dollar to strengthen, and I said so. And I expected the price of oil to decline from the $140s to about $100-110 per barrel, with a possible excursion down into the $90s per barrel. I actually thought that a stronger dollar and declining oil prices would be “good” for the overall world economy, because this would leave more money in the pockets of consumers — especially energy users.

But now in hindsight, it appears that the run-up in oil prices from 2007-mid-2008 sapped household and consumer income across the world. The oil run-up and simultaneous dollar devaluation were enough to trigger the mortgage crash. Of course, the mortgage crash was coming, and it was always just going to be a question of causation. Now it’s up to history to assign naming rights to the meltdown.

Not Just a Chest Cold — a Case of Tuberculosis

Let me use a different analogy. The dollar decline and energy run-up did not give just a chest cold to the world’s credit-driven economy. The yearlong decline of the dollar and rising oil price gave the world economy a case of tuberculosis. And it’s a strain of TB that is resistant to all the usual antibiotics.

So here we are. The world economy is sick. And I mean really sick. The markets are coughing up blood. None of the usual remedies will work. There’s no magic pill. From here on out, it’s trial and error. It’s hit or miss. And the prognosis is grim.

Investment Pain

Let’s get back to whether or not to sell your stocks.

First, I’m certain that it’s painful for you to watch your investments decline. You worked hard for the money with which you bought stocks over the years. And now the value of those stocks is falling. It just stinks.

This market meltdown is not like Goldilocks sneaking into your kitchen and eating your porridge. No, this is like Goldilocks breaking into your house and burning the place down using magnesium flares as accelerants. Years of hard work are just turning into smoke and ashes right before your eyes.

I have to say that declining markets are plenty painful for me. It hurts twice as much because I edit Outstanding Investments. That is, I have both money AND a reputation at stake in this process. Agora Financial does not give out personal investment advice. But the last thing I want to do is offer up a bum steer when it comes to helping you make your financial decisions.

The OI Investment Thesis

Outstanding Investments has a straightforward investment thesis. We invest in energy and resource plays because over time — we believe — energy and resource investments will become more valuable. There are a number of reasons for this, including geological scarcity, past underinvestment and increasing future demand. But it’s a basic idea, and we think it works. At least, it has worked for the past six years or so.

For the past few years, OI has been selecting investment ideas in companies that appear to have bright futures in a looming era of rising energy and resource demand. And many — most, really — of the investment ideas did well. Some did very well. A lot of readers made a lot of money. Whether it was oil, gold, refineries, cement or energy infrastructure, it seemed like we were investing in places where the world was going. Right?

But now it seems like the investment locomotive — energy, resources and related infrastructure — has derailed. Energy prices are declining. Energy-related stock plays are down. Commodities are down. Mining and infrastructure stocks are in the dumps. The falling tide is leaving us high and dry.

But does that mean that the whole OI investment thesis is unraveling? Not so fast, pilgrim. Let’s keep on thinking this through.

Until we meet again…
Byron W. King
October 17, 2007

When Bad Things Happen to Good Investments, Part I was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“In the current weak dollar situation,” said German economist Peter Bofinger to Der Spiegel last week, “[a treaty should be signed by the central banks of] China , South Korea, Japan, Russia, and other countries that have huge dollar reserves…so that they don’t dump massive amounts of dollar onto the market.

“A similar treaty already governs the gold market in Europe,” continued Bofinger, one of the German government’s ‘Five Wise Men’ advisers. “It is something that the World Monetary Fund could coordinate.”

Why smart people feel they need to spout such idiocy is, of course, all too clear. “As international investors wake up to the relative weakening of America’s economic power,” says The Economist, “they will surely question why they hold the bulk of their wealth in dollars.”

Indeed, “The dollar’s decline already amounts to the biggest default in history,” notes the venerable weekly, “having wiped far more off the value of foreigners’ assets than any emerging market has ever done.”

But the U.S. government pulled off a far greater debt default more than three decades ago — an absolute default that somehow, incredibly, allowed the bankrupt to continue growing his debts at an ever-quickening pace.

Whatever you think of gold as a measure of value or price today, Richard Nixon reneged on the terms of U.S. borrowing — as they then existed — when he shut the “gold window” at the New York Fed on Aug. 15, 1971. The U.S. dollar was no longer redeemable for gold, a crucial commitment under the Bretton Woods Agreement signed amid the rubble of World War II.

Foreign governments, not least in Europe, found the terms of their lending were void.

The immediate outcome — and the obvious aim — was to usurp gold as the world’s premier monetary asset. The dollar had secured Bretton Woods’ stability, but it was still just the chain, not the anchor. And it had faced trouble from gold as early as 1965, when French President Charles de Gaulle baulked at “America’s exorbitant privilege” of issuing paper that no one else could refuse.

Less than two decades after the Bretton Woods system began, de Gaulle started to demand gold bullion in exchange for the dollars sent eastward by U.S. business and travelers. What to do, wondered Washington’s finest?

“Hmmm…[stroke pointy beard, evil glint in eye] with gold out of the way — locked in a dungeon, say, like some metallic mad aunt — the dollar could reign supreme at last!”

Thus, the paper-made dollar has now measured all things, and paid for them too, for more than 36 years. The No.1 currency held in central bank reserves, it has been greeted by cheering crowds during most of its reign. And across much of its empire, the dollar still has client kings only too happy to applaud it in public.

Zhou Xiaochuan, head of the People’s Bank, told Henry Paulson at a meeting of G-20 economic leaders in Johannesburg last week that China supports a strong U.S. dollar. Chucking Paulson’s throwaway phrase right back in his face — the U.S. Treasury secretary again said, “A strong dollar is in our nation’s interest,” on Nov. 19 — must have raised a laugh from the other central bank delegates. Either that, or it gave them heartburn.

The U.S. Treasury loves a strong dollar; Beijing loves it too. So how come the damn thing now looks all puny and weak?

“We all know that the U.S. dollar has no economic value,” as the Iranian president, Mahmoud Ahmadinejad, put it last week.

“Buying currency is like buying a little bit of an economy,” agrees Germany’s Süddeutsche Zeitung newspaper. “That’s why the fall of the U.S. currency has political and economic implications far beyond the present financial market crisis.”

“They get our oil and give us a worthless piece of paper,” Ahmadinejad spat. But for now — and unless Iran really wants the USS Enterprise to divert its bomber flights from Afghanistan to Tehran — worthless paper is all the U.S. has to offer. That leaves America’s biggest creditors, like all big-time lenders, stuck with a quandary.

China, Saudi Arabia, South Korea and Japan all want it both ways. They’d like their debtor — the United States — to both settle up now…but also keep spending more money. If the dollar were to strengthen on the back of, say, higher U.S. interest rates, the resulting loss of U.S. consumer spending could destroy their economies. Just look at China.

The Chinese economy, set to grow by 11.5% in 2007, has been built on servicing the demands of foreigners, rather than domestic shoppers. It holds a whole heap of U.S. Treasury bonds as a result. But funnily enough, now that’s it’s grown so big so quickly, most of those foreigners today earn and spend euros, not dollars.

EU-China trade doubled between 2000-2005, making Europe China’s largest single export market.

“The slight depreciation of the dollar does not mean the currency is weak,” mused Mr. Zhou in Johannesburg this week. Clearly, he’s learning a lot from Hank Paulson, if not from George Orwell’s vision of a communist hell in 1984 . “Slight” now means “huge.” “Weak” means “destroyed.”

But in the European Union, this “slight” drop in the “strong” dollar is really starting to hurt — not least because the massively weaker dollar is weaker only in terms of the euro. That means exports from China are also cheaper thanks to the dollar-linked yuan.

That’s why the Chinese currency, the yuan, remains closely pegged to the U.S. dollar. Allowing it to float freely instead would just invite hedge fund speculators and investment funds to buy a piece of the Middle Kingdom’s future. They’d sell the current world No.1 to achieve it, long before China got a chance to spend its $1.43 trillion in foreign currency reserves.

Hence the unstoppable rise of the euro. “It could easily climb to $1.60,” reckons Peter Bofinger, “an appreciation of another 10%, which would eat into annual economic growth [in the eurozone] to the tune of half a percentage point.”

What to do? I don’t doubt that the U.S. subprime crisis will continue to go global. So central banks the world over will soon try to fend off recession by devaluing their currencies alongside the dollar.

“I think we’re now at the point where other central banks will join the U.S. Fed in cutting interest rates,” said Benedikt Germanier, currency strategist at UBS in Zurich, to Bloomberg on Nov. 20. “The Bank of England will join, and we also, in fact, expect by the second quarter of next year the ECB will join.

“So while it keeps the dollar weak for now, there’s scope for other central banks to cut rates too, and that could eventually put a floor under the dollar.”

Such a race to the bottom, however, might come too late for the eurocrats in Brussels. EU commissioner Peter Mandelson warned Beijing on Nov. 23 that China may face “anti-dumping” trade tariffs if it fails to address its ballooning trade surplus. Today the wonks will take their fight to China itself, when a commission led by Jean-Claude Trichet, head of the European Central Bank, lands in Beijing.

Trichet will officially request that the PBOC let the yuan float more freely against the basket of currencies that have already replaced its dollar peg, easing pressure on the euro as the world’s No.1 long for its growing short-dollar position.

Nicolas Sarkozy, president of France, will also be in town, as will the prime minister of Portugal — currently head of the European Union as part of its rotating presidency — and the European Commission president himself, Jose Manuel Barroso.

But what can the eurocrats offer Beijing in return for no longer pursuing its national interests on the currency markets? To soothe China’s fears of a rout of the dollar — and a rout denominated in yuan, rather than euros, at that — might they drop Bofinger’s crazy scheme into conversation, we wonder.

“It’s not just enemies of America like the presidents of Iran and Venezuela who are ridiculing the United States,” the Suddeutsche Zeitung tells its German readers. “In Europe too, some dream of the end of the superpower. They should remember that just seven years ago, the euro could buy only 82 American cents and there was speculation over the end of the EU’s currency. [Now] the dollar may well lose its role as the world’s unofficial currency. As long as the shift isn’t too abrupt, that could be good news for the global economy.”

Oh really? Just how could King Dollar abdicate his throne without unleashing open revolt?

“During the third quarter of 1999, European central banks had become increasingly concerned at the danger of an uncontrolled fall in the gold price that would reduce the value of their own holdings,” explained Philip Klapwijk, head of the GFMS consultancy in a 2003 paper for the London Bullion Market Association.

“This fear, coupled with the need to provide a framework for Swiss and British gold sales, plus other intended disposals, led to the deal announced in Washington [in September 1999] to limit sales to 2,000 tonnes over five years and to cap lending and derivatives activity at existing levels.”

You can guess why “Wise Men” like Peter Bofinger think the Central Bank Gold Agreement (CBGA) offers a model to Asian and Arab governments looking to move beyond the dollar standard. Since the CBGA began a little over eight years ago, the gold price has not only found its floor. It has soared nearly three times over against the U.S. dollar.

The CBGA, therefore, stands as a paragon of crossborder co-ordination. And if sales quotas and agreed ceilings could work for the gold market, why can’t they work for the dollar?

Hmmm…let’s see now:

• Is it because gold — even after it lost its official role in the world’s monetary system — still retained real intrinsic value?
• Is it because gold, used as a store of wealth for more than 5,000 years, appeals to jewelry consumers, as well as dentists, microchip fabricators and skyscraper designers?
• Might it be that even after the United States stopped backing its dollars with gold, the metal continued to be the world’s premier monetary asset — no one’s to print, inflate or peg?

Once the dollar loses its role as the supreme “reserve currency,” on the other hand, just what other uses might it be put to exactly — wallpapering the inside of central bank vaults? Rolled up for use in the People’s Bank restrooms?

Just who in the hell would want to buy yesterday’s fiat paper?

Regards,
Adrian Ash

November 27, 2007

Goldfinger? Bofinger! was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.