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U.S. Dollar beginning to look ill

Todd Stein & Steven McIntyre
The Texas Hedge Report
October 11, 2004
Courtesy of

Where Do We Go From Here?

In all honesty, we haven't the foggiest. In the short run, market irrationality can reign. The stock market has a funny way of sucking in the maximum amount of people before heading south to cause the maximum amount of pain. Rest assured, the pain will come; the only question is when.

We could point out that the VIX near 13 is at six-year lows. We could point out that earnings warnings have accelerated as the markets in aggregate trade at very rich multiples. We could point out the mounting signs of out of control inflation despite what those worthless government CPI numbers spew. We could point out that if history is any judge, and absent some sort of horrific deflationary scenario, rates have one way to go (up) over the coming years, which historically kills P/E ratios as earnings are discounted by larger numbers, making asset class shifts to bonds more attractive. We could point out the frothy behavior in today's market, which is more indicative of a top and not a bottom. How else can you explain the revival of mindless speculation in stocks such as Taser rallying on its near daily press releases or the other heavily shorted net moon-shots in recent weeks which have lifted the Internet Index up 30% over the last year and seen most net stock indices triple since their post-bubble bottom?   We could point out the egregious amount of debt at the consumer level and mention the monumental trade imbalances, which have so endangered the safety of the U.S. dollar. We could point all of this out and it still may not matter - for awhile.

We have been negative on the dollar for several years now and continue to be so today. Most people in the United States are unaware that their currency has suffered a tremendous drop in value over the last two years. Raw material prices, healthcare expenses, housing costs and education tuitions all have skyrocketed in recent years, yet the cheerleaders in the financial press continue to claim that there is little inflation, using bogus hedonistic statistics cooked up by government bureaucrats.

The American public may be clueless, but foreign investors and central banks aren't so dim-witted. In fact, a number of countries including China, Japan and Russia have publicly stated their desire to diversify their reserves out of the U.S. dollar and into Euros or gold. Considering the amount of Greenbacks sitting in Asian central bank vaults, any significant diversification to another reserve currency would create a frightening flood of dollars in the open market.

So what could cause this currency reckoning to occur?  There are many things that could lower confidence in the mighty greenback such as a terrorist attack, a stock-market crash or some other six-sigma event. However we think that the answer lies in this J-curve chart showing the exponentially increasing amount of personal, commercial and fiscal indebtedness incurred by the American people.

These trends are not sustainable. The American government, business community and populace cannot continue to borrow their way into prosperity. We cannot pinpoint the exact date, but the question we continue to ask ourselves is how much longer Asian central banks will continue to lend Americans money at record-low interest rates while incurring heavy losses on currency translations? Once China, Japan and America's other creditors decide the game is up, the demand for dollars will head south and a vicious cycle will commence. And if U.S. policymakers continue to keep rates low and attempt to paint a rosy picture, America risks Weimar-style hyperinflation. Protect yourself. Also keep on your calendar March 31, 2005 as it is the end of the Japanese fiscal year, which may further lessen Japan's appetite for U.S. debt securities.  
October 8, 2004
Todd Stein & Steven McIntyre
Texas Hedge Report

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Todd Stein & Steven McIntyre are internationally known analysts and editors of The Texas Hedge Report, a market newsletter that highlights under and overvalued securities in the equity, bond, currency, and commodity markets.
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