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MONEYization #6

Ned W. Schmidt, CFA, CEBS
January 18, 2005

The global financial phenomenon of individuals and businesses moving their funds to monies in which they have the highest confidence, or money which has a higher store of faith.

The recent counter trend rally of the U.S. dollar certainly has stimulated emotions, both verbal and of a trading kind. Mouses around the world clicked and hard drives whirred, as "astute" traders moved out of their short dollar positions and Gold. Each time $Gold fails to go straight up forever emotions run high, and a manipulator can be found under every bush. That investments are to give instantaneous and continuous gratification continues the assumption. This misconception, learned during the Great Stock Market Bubble, just does not seem to fade. The motivation for writing this week is that recent rally by the U.S. dollar, which is creating an opportunity in Gold and Silver.

Much attention has been given to the dollar index. Reliance on this index as a long term framework for making investment decisions is dubious at best. This index is a trade weighted index and as such does not necessarily reflect the true value trends for the dollar. As a trade-weighted index it reflects the dollar's value about as well as the CPI reflects the performance of inflation. Perhaps that both are produced by government statisticians might be enough said.

A trade-weighted index is created by applying weights to the movement of relative money values based on the amount of trade between the countries. For example, let us suppose that in the base period the U.S. did not trade with Europe but did have a lot of trade with the Noland, a small country off the west coast of China. Subsequently, the dollar crashed against the Euro but rose against Noland's currency. The trade-weighted index would show the dollar going up. Nonsense.

This construction of the dollar index therefore reflects more the relative value of trade not market value changes of national monies. The S&P 500, and similar measures, weight the movement of securities based on the total value of the market capitalization of the underlying stocks. If it were calculated using the methodology for the dollar index, MSFT's price change might be weighted based on how much business it does with, for example, GM. To the world, that the dollar loses value against the Euro or the yen is more important than if it gains value against a number of small trading partners. While this exaggerates the situation, the picture provides the message.

Short term use of the dollar index for understanding may be of some value as the manipulations of the statisticians are not as dominant influences. What those analysis shows is nothing more than a counter trend rally that is likely to fade, and indeed may be already fading. For time and space purposes see, "Watch the Trend, Not the Bounce" by James Turk. As this article wisely advises, investors should keep their eyes on the major trends and not react or worry about bounces. Too many were probably expecting Gold to reach US$500 NOW, rather than when the market is ready to achieve that level.

Investments are generally viewed in two ways, technically and fundamentally. What the technical analysis portrays is that the dollar has been (1) breaking to all times lows and (2) rallying against the down trend. Neither of these conditions suggests the dollar is ready to rocket upward. That all said, nothing is to prevent the mouse clicking, fund traders from causing the dollar to overshoot on the upside. The irrational movement of the NASDAQ to recent unsustainable levels is an example of what these funds can do if enough leverage is applied in one direction in a desperate attempt to create performance.

Technical analysis of the dollar index on a long-term basis may give not give an accurate picture of the dollar's value. Shorter term analysis as done in the article mentioned in the paragraph above are somewhat more reliable. What is really important is what the dollar is doing against major currencies. Falling to record lows against the Euro is indeed an important technical breakdown. Should the yuan every float, is the dollar going to appreciate against it? This pent up depreciation potential is naturally not a component of the dollar index. The fundamentals, though, are where the real story remains.

Ultimately, the "technicals" will reflect the fundamentals of the dollar. As the recent trade report indicated, the fundamentals have not yet improved. More importantly they are not likely to improve until one, the U.S. dollar collapses, or two, the U.S. economy enters a massive recession. Until that time the dollar will simply continue to depreciate. Certainly that depreciation will not happen every day or every week, but between now and the future it will.

A major problem with the dollar's fundamentals is the shift in the nature of the trade deficit. In years long past the trade deficit would rise and fall with the value of the dollar in a natural rhythm. More recently that trade deficit has taken on a structural character as well as a cyclical character, though that latter will have to wait for another time.

chart 1

Chart One plots the dollar index, left scale, along with a line for the cumulative trade deficit of the U.S., using the right axis. In that chart are also two triangles so that the time period covered can be divided into three distinctive environments. Each of these times has different characteristics with implications for understanding how the dollar is likely to perform.

From the beginning of the chart, from the left, to the first triangle, the dollar index and the trade deficit seemed to move in some kind of harmony. While overall the U.S. was running a trade deficit, the size of that deficit did respond to changing values for the dollar. Such as it is supposed to be according to the textbooks. The error is expecting that type of performance to be repeated currently. This time things are indeed different.

In the years between the triangles, the value of the dollar rose. That appreciation was fueled by the Great Federal Reserve Stock Market Bubble I. Expectations for the U.S. economy were distorted by a misguided monetary policy. As the dollar appreciated, the trade surplus worsened. Insatiable consumer demand was stimulated by the Federal Reserve. During this era the beginnings of the structural trade deficit began to arise. Real work was no longer necessary. Stocks and housing would make all rich. Consumers would just sit naked around their computers ordering stuff off the internet. The world would be wonderful, and the NHL would always play the full season.

The latter period, after the second triangle, is where the restructuring of the U.S. economy by the Federal Reserve is starting to show its ugly head. Dollar peaked almost three years ago. The U.S. trade deficit has not improved. An improvement in the trade deficit does normally lag the depreciation of a currency. However, that turn in the trade deficit is just not evident. This situation is unique, and suggests that something other than a mere currency problem.

Much excitement greeted the announcement that 2.2 million jobs were added in the U.S. during 2004. Of that number, only 76,000 were added in manufacturing. The structural problem of the U.S. economy starts becoming apparent if one reflects on those numbers. If those 2.2 million workers are fairly normal, they will likely spend their incomes. A fairly reasonable assumption is that people work so they have money to spend. But, only 76,000 more people are making real stuff. Real stuff is real goods, that can be touched and used. Ever try to wear an online mortgage application? Ever try to use an online bank statement as a kitchen table?

For every one new worker in a factory making stuff, 29 new people were out spending their income. 29 new people were out buying things, consuming, for every one new person actually making something real. Productivity cannot happen unless some workers are really working. Where does the stuff wanted by those two million new consumers come from? Those goods are just imported. On balance, the U.S. is now forced to import $700+ billion, at an annual rate, more goods than it sells to the world. Why? Cause that is where the stuff is now made. U.S. workers are too busy doing internet mortgages, speculating on Florida condominiums and washing their SUVs to be involved in making real stuff.

Last month the U.S. exported about $9 billion of consumer goods. If the dollar collapsed and exports of consumer goods improved dramatically, the impact on the U.S. trade deficit would not be much. The U.S. simply does not make the stuff. By the way, the U.S. also runs a deficit in advanced technology goods. Do you think Dell makes all those computers in a secret plant in Wyoming? Maybe if the dollar falls far enough a bridge can be built so Europeans can drive to Disney World, and spend their dollars there. Short of a depression that might be the only way to remedy the trade deficit, and the way Congress is spending money the funding for the bridge might be possible.

About a quarter of the trade deficit is with China. Does anyone believe that if the dollar's value falls that Christmas trees, microwaves and toasters would then be made in the U.S.? Maybe if it falls far enough those factories making t-shirts will be moved to the U.S. Maybe if the dollar falls far enough, oil will spurt out of the ground all about us too. The U.S. is importing about a $150 billion of oil per year now. Will a lower value for the dollar suddenly create energy independence? A structural trade deficit does not change until the value of the money collapses to the point that making toasters is cheaper at home than importing them, or no one is willing to accept dollars in exchange for toasters.

The structural problems will cause the dollar's value to fall over time. Does that mean everyday? No, of course not. The lemmings on Wall Street are trying to rally the dollar, creating an opportunity in Gold and Silver. You should be taking advantage of this opportunity. Too many investors put more money into paper equity mutual funds than Gold in recent weeks, and some day they may be trying to pay bills with regrets.

chart 2

Signs of another structural problem can be observed in the second chart. In that chart is plotted the dollar index and the U.S. money supply, M-1. The dollar index uses the left axis. Money supply has been inverted and uses the right axis. As the M-1 line goes down, the size of the money supply gets larger. That methodology just makes it easier to see the picture.

As more U.S. money is created the value of it keeps going down. Quite simply, the world just about has all the dollars it really wants. Another structural problem therefore exists. The demand for dollars has been sated. Can there be anybody in the entire world that wants dollars that does not have them? Any attempt to create more dollars will result in further depressing the value of the dollar. The world's ability to adsorb more dollars is approaching exhaustion.

So the Federal Reserve, with their secret inflation fighting strategy, keeps increasing the number of U.S. dollars in the world, and consumers keep sending them to other countries. The world keeps not wanting all those dollars. The dollars get sold and the value goes down. The dollar value of Gold keeps rising because of that. Nothing in the fundamentals has changed to make the dollar worth more over time.

Less this sounds too pessimistic, sources of optimism can be found. The solution to the problems of the U.S. Social Security fund has been discovered. We will turn the money over to Wall Street. Hey, they made us all rich in 1999. Beauty of this solution is incredible. Wall Street will manage that money in such a way that Social Security deficit is eliminated and all will retire with far greater retirement checks. The beauty of this strategy simply can not be denied. Given that Washington and Wall Street now seem to have the solution to the problems with the U.S. Social Security System, is owning Gold more or less wise?

chart 3

Yes, the dollar can rally in the short-term as the mouse clicking, fund managers attempt to play a change in momentum. Their problem is that the global financial market has far more dollars to sell than funds have the ability to buy. Supply is just a whole lot bigger than potential demand. So as the bobble heads mouth on about growth in the U.S. economy, growth in Europe, the PPI and whatever other nonsense they want, you just keep buying Gold whenever the opportunity presents itself.

The last chart, from The Value View Gold Report, shows the recent record of US$Gold and our intermediate indicator. Fund managers covering their dollar shorts have created another opportunity for Gold buyers. Many months have passed since the last buy signal. The latest one was expected, and recently went out to our subscribers. Whenever the fund managers are selling Gold and buying dollars, an opportunity is being created for investors. At this time next year, with Gold over US$500 and Silver around US$9, wise investors will be celebrating.

January 17, 2005
Ned W. Schmidt

Ned W. Schmidt, CFA, CEBS is publisher of THE VALUE VIEW GOLD REPORT. That report now includes a weekly message, TRADING THOUGHTS, to help investors identify timely points for buying Gold and Silver.

You can join him for the Gold Super Cycle

His monumental report, "$1,265 GOLD," with 255 pages and 98 graphs, is now widely known, and is available at or from the author. This work has now been read by investors in over twelve countries.

Ned welcomes your comments and questions. His mission in life is to rescue investors from the abyss of financial assets and the coming collapse of the U.S. dollar. He can be contacted at

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