The dollar, any currency, has several major functions in an economy. The one we are most familiar with is that of ‘a medium of exchange’. That means we go to the bar with a ten in our pocket and exchange that for a beer and a sandwich. We have exchanged money for goods. The second is what we call a ‘store of value’. You can take that ten and put it in your pocket (or in your bank account) and leave it there and you’ve got purchasing power tomorrow. The third function of currency is as ‘a unit of account’. Which is what happens when we say we buy $1 trillion worth of stocks when what we really own are a bunch of electronic blips on a computer at Fidelity, but we account for everything in dollars. We use the currency to account for the real value of the goods. That is only different from the medium of exchange in that we use it whether we make the exchange or not. Money, to be any good has to be ‘legal tender’. That means we can use the money to pay our taxes, pay our bills, repay our loans and other legal obligations (see Shakespeare The Merchant of Venice). Since it is legal tender, the other party has to take it, even if it is worth less than the dollars they lent us or whatever.
All of those functions of money have gone on for quite a while now. The Romans looked at money much as we do today in every day usage, so did the Chinese and the Etruscans. Some of that applies in one sense or another when it comes to international exchange in currencies. Whether we are trading Sterling for Yen or Rubles for Loonies, we are just exchanging one thing for another at a varying price, medium of exchange.
When we buy oil from Venezuela, they take dollars for the oil (medium of exchange, not legal tender). They then take those dollars and buy whatever they need from other folks (medium of exchange). The beauty of the dollar is that they can actually do that. The same thing doesn’t work with Venezuelan Bolivars or even Swiss Francs necessarily. There is no assurance that the other folks they are trading with will accept bolivars or francs. The dollar acts in international trade much like it does in everyday transactions here in America. No other currency works quite as well as that. So dollars are the world medium of exchange.
Many foreign central banks keep a lot of their surpluses in dollars (store of value). They don’t have to, but they choose to for a variety of reasons. Most of these reasons date to the era right after World War II when about the only currency that was readily available internationally was the dollar. There were plenty of them and the world’s leading central bankers decided at Bretton Woods to agree to accept dollars at a fixed exchange rate and that the dollar would be exchangeable into gold at a fixed price. So, dollars are the central banker’s store of value.
We are not the world’s unit of account or the world’s legal tender, but two out of four is at least one more than any other currency has going for it. It is these two reasons why the dollar is an issue today.
So, is the dollar overpriced? Is the dollar underpriced? We don’t know. We suspect that the dollar has been temporarily overpriced due to the huge dollar rally driven by the flight to safety trade during the financial collapse late last year and earlier this year (store of value). Much of the decline in the dollar from its highs is likely due to unwinding that safe haven trade (store of value).
Imagine if you are a European businessman with some spare cash sitting around and then the bottom falls out of your economy, your market and your bank. Wouldn’t you like the idea of having some sliver of your assets in dollars, where no matter what, you would be able to retrieve those dollars in the future? Yes, you would. That is one reason why the dollar rallied during the crisis. Now that the crisis is past, the benefit of having that safe haven has receded. So too has the price.
Will the dollar crash? Probably not, just because so many people have such a vested interest in the way things are. Will the dollar go lower? Probably. So, why do we say that it probably won’t crash but it will go lower? Largely because the dollar is still the world’s reserve currency, it is the medium of exchange and the store of value for many folks. That is a fact that most people can’t get through their thick skulls, the dollar is special. That is also why having more central banks use currencies other than the dollar as their reserve currency is important. The day may come when the dollar isn’t the medium of exchange and store of value it is today. On that day, the dollar becomes no better than the Brazilian Real or the Saudi Riyal or the Israeli Shekel. When we have just another currency, all our bad habits of running huge trade deficits and fiscal deficits will become a lot more expensive and painful. We may have to straighten up, and quickly.
If the dollar does set out on a long period of slow erosion of value, then the day when we are no longer the world reserve currency will arrive a lot sooner than you might expect. This administration, like most administrations before it, will let the currency slip even though they will talk a lot about a strong currency. The idea is that a cheaper currency makes buying imports more expensive and makes our exports more attractive. So, the theory goes, we will narrow or eliminate our trade deficit. Good luck on that. It hasn’t worked for the last forty years and it won’t likely work now. The reason is oil. Oil is most of our trade deficit and we will keep buying it even with a depreciated currency. So, as long as most of our trade deficit is oil, this approach will not work.
Would we be better off with a strong dollar? We might be. If we can trade a few jobs for a stronger currency we will get the benefit of cheaper oil and hence lower trade deficits. We will also make a better store of value and medium of exchange for everybody else in the world. That would keep the dollar the world reserve currency. You don’t need Euros if the dollar is as good as gold. You don’t need gold either.
Economic News (we’ve discontinued the Good News section since most of the economic news seems to be good news these days.)
Retail Sales recoiled from the cash for clunkers spending orgy and fell for the month of September. The drop of 1.5% (including auto sales) was not as much as most had feared, so this is good news. Excluding auto sales, retail sales rose 0.5%, far above most guesses for what that gain would be. This too is good news and one more indicator that the recovery is on.
The Federal Reserve released minutes of their latest meeting. The FOMC Minutes blah, blah, blah, trust us, blah, blah; we know what we’re doing. No we’re not going to raise rates until it is necessary. Too bad for you if we wait too long to do the right thing.
Consumer prices (producer prices not out until next Tuesday, which is funny as producer prices are usually released the day before consumer prices) rose very modestly in September. The rise of 0.2% was mostly due to higher costs for cars (what’s up with that since everyone who bought a car in September got a fabulous deal?), energy and medical services. At the same time, home ownership costs fell for the first time in years. The core rate, which excludes food and fuel, rose 0.2% also.
You might ask how housing costs have fallen lately for the first time in several years. You might ask why the 30% or greater fall in home prices hasn’t been more important to housing costs than maybe it has been. You can ask, but the short answer is that housing costs in the inflation numbers have no basis in housing costs unless you are a renter. The cost of a home in the inflation statistics is calculated on a rental equivalency measure rather than on house prices. You can think of it as how would your housing costs change if you rented your own home from yourself? Other costs, like utilities and insurance also figure in there, but the bulk of it is an implied rent. That implied rent has actually been going up over most of the last several years as the number of people renting has slowly risen as a percentage and as more people rent more expensive space. For those of you who keep track (and we believe that only your pundit really does) your pundit forecast this several years ago and has had that “I told you so” moment several times since.
Consumer sentiment, the University of Michigan version, slipped to 69 from over 73. Most folks expected the consumer to stay roughly at 72 after a big rise in early September. The bigger than expected decline questions a strong fourth quarter in consumer demand.
On the plus side of the ledger, industrial production rose by 0.7%, the fastest rise is several years, arguing that the recovery is actually gaining some steam. Luckily, most of us will stick around to see how this battle of the statistics turns out. Go industrial production!
This really ticks us off. We have heard a lot about how the last decade has been a tough one for equity investors in the US. Yes it has been. Since September, 1999 people who bought the S&P 500 have gotten less than nothing for their investment. Hold the cream of the crop of US stocks and you end up with a -0.15% return (that’s compounded), or about -1.38% cumulatively.
What does that say about investing in the US and what does it say about the future? Well, it says that if you want to make money in stocks, don’t buy them when they are at the most expensive level they’ve ever been before or when everyone else wants to buy them. If you can avoid paying far too much in the first place, you can fare much better as an investor. Actually, the lost decade for American investors says far more about when it started than when it ended. Warren Buffet, who during the age of the internet investor was considered a doddering old fogey (he’s still richer than all those guys put together), said that he foresaw a poor future for investing in America in 1999. He was right, again. Buying even good businesses at the wrong time can be bad for your performance. What we ought to looking at is the -22% return on the NASDAQ since then, (and recall that the NAZ actually gained over 50% from September 1999 to March 2000).
Today, things have changed. We are past the remarkable valuations reached at the absolute nadir of prices in March, but things still aren’t back to normal. Stocks are cheap, largely because we’ve gone nowhere for a long time. During the whole decade the other pundits are wringing their hands over, things were generally getting better. Companies were growing their revenues, earnings, dividends and cash flows. That may not be very apparent right now, but before this cycle is over it will be abundantly clear.
The last time we went this long without making any money was in 1982, when we took out every low since 1974. That was eight years of pent-up growth and earning power just waiting to explode. It ushered in a period of time when returns were among the highest ever recorded for a protracted period of time. We could see the same thing again, or at least something similar.
If there is one thing we’ve learned in over 30 years is managing money, it’s you can’t look into the future while staring at the rear-view mirror.
Really, this is weekly stuff. Global markets were fairly benign last week. US stock markets were up. The large cap indices gained 1% give or take. Small caps didn’t fare quite so well with only small gains. Energy and utility stocks paced the gains.
Outside the US, developed markets gained more than emerging markets, especially Japan, which had sat out the prior week’s advance, declines in Korea hurt the emerging indexes.
Government bond markets around the world tended to slip back last week. In the US, wave after wave of new issues may have finally overwhelmed the market’s ability to absorb more bonds without a shift in investor appetite. Most other segments of the bond market continued to advance. Mortgages, municipals, high grade corporates and high yield corporates all made modest gains.
Real estate securities slipped in the US but gained modestly overseas. Our global orientation paid-off with a modest gain.
Commodities were generally higher, pulled by a surge in energy prices and increasing signs that a global recovery is under way. Dollar weakness contributed to the attraction of commodities.
It was 22 years ago today that the US stock market went through its biggest panic ever. October 19, 1987 saw stocks fall over 23% in one day. It was caused by round after round of index arbitrage overwhelming the stock exchange. Big institutional investors would buy cheap index options, then turn around and sell the relatively expensive shares, which would drive down the index options even more, so they could do that again and again and again. The Dow Jones Industrials fell 508 points on the day, from a starting point of about 2700. We’ve actually had bigger one day drops (in points) since then but from a level of 12,000 it just isn’t the same.
The so-called ‘circuit breakers’ imposed on the markets after Black Monday have been largely rolled back to the point where they are meaningless. Today, stocks have to fall 10% before we trigger the first circuit breaker, and 30% before we give up for the day. The first circuit breaker is a one-hour trading halt to allow news to disseminate and for the proverbial ‘cooler heads’ to prevail. These circuit breakers are more akin to the farmer who closes the barn door after the stock has made their escape. Down 30% isn’t a time to stop trading, it is a time to get a new business line. The old circuit breaker, put in place about a year and a half after Black Monday, stopped trading for half an hour after a 2.5% decline or advance. Then we stopped trading for an hour after 5%. At 10%, we stopped for the day. The current breaks were implemented in the 90s when we routinely had to stop trading because we’d exceeded the top of that 2.5% range. Greed and fear, baby.
The year is quickly getting away from us. November will be here shortly and we have already started gathering data on the year-end cap gains distributions. We don’t expect much this year as last year was so devastating to investors, even the bright boys and girls who run our funds for us. Capital losses were widespread last year, especially in the fourth quarter. Since most mutual funds have a September fiscal year-end for tax purposes, the declines in the fourth quarter last year were in this tax year. Any gains between now and year-end won’t impact this tax year. We may still see some examples of funds that have capital gains, but we expect few. The earliest returns agree with that outlook.
Have a really great week.
Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.