Dollar Rally

Dollar Rally: Dead President Bounce Redux
by Eric J. Fry
The Rude Awakening
Wall Street, New York
Friday, November 25, 2005

Eric Fry recounts a discussion with a colleague about the likelihood of a long-term Dollar Rally.

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Eric Fry, reporting from deep within the fog of post-
holiday merrymaking...

As gold inches ever closer to $500 an ounce, many long-time
gold bugs can scarcely believe their eyes. The barbarous
relic has not kissed the $500-mark since 1987. Over the
ensuing 12 years, the gold price plummeted against the
dollar, bottoming out at $252.50 on the final day of 1999.

But since that fateful day, the yellow metal has been
trudging steadily higher – nearly doubling in price over a
time span that has seen the Nasdaq Composite Index LOSE
half its value and the S&P 500 Index fall 10%.

Even so, the ancient monetary metal seems to have gained
very little respectability among American investors. As
recently as January of this year, in a column for New
Yorker Magazine, financial writer James Surowiecki
disdained gold as a "collective hallucination."

"Gold is valuable only as long as we collectively agree
that it is," said he. "It may be soft, shiny, durable, and
rare, but it has no more intrinsic value than feldspar or
quartz...Buying gold is the purest form of
speculation...You're buying into a collective hallucination
- exactly what those dot-com investors did in the late
nineties. One could say that gold is the biggest, most
durable bubble in history."

Your editors begged to differ. In the January 18 edition of
the Rude Awakening, we replied, "What is a U.S. dollar? Or
a share of Google? Or a 30-year Treasury bond? Aren't these
paper assets merely derivatives of a hallucination?

"To rephrase the question: If we investors are all
hallucinating to some extent, might some hallucinations be
more benign than others? Might the current market value of
gold, for example, be a less dangerous 'hallucination' than
the current market value of a dollar bill? Even conceding
the fact that our eyes may be deceiving us, we think we
perceive more value in an ounce of gold costing $432.00
than a U.S. dollar costing 1/432 an ounce of gold. Indeed,
we suspect that the dollar's illusory value is the sort of
deceptive apparition that entices unsuspecting investors to
stroll off a financial cliff.

"In the sterile environment of pure financial theory,
Surowiecki makes a valid argument. But when exposed to the
virulent microbes of real-world economics, his thesis
degrades rapidly. To be sure, the value of EVERY asset in
the world relies upon a collective judgment - or
hallucination, if you prefer. But this is hardly a
groundbreaking insight. No financial asset - gold included
- possesses an absolute, eternal value. Rather, all values
are RELATIVE.

"However, any financial asset whose relative value remains
somewhat constant over time is deemed to be a 'store of
value.' In this respect, gold has proven itself to be an
extremely lifelike hallucination - having successfully
retained its value relative to competing assets over
several thousand years. The same cannot be said for paper
currencies or government bonds, both of which routinely
find themselves cluttering the waste dumps of financial
history."

Perhaps our eyes continue to deceive us, but the gold rally
appears more lifelike every day. And as gold moves steadily
higher against ALL the world's major currencies, it steps
out of the shadows of seeming irrelevance into the bold
light of real-world demand. In other words, gold is moving
higher because long-term investors genuinely want the
stuff. Gold is rising, Bloomberg News recently explained,
"on signs of increased demand for an alternative to
currencies." This story line is so ancient that it has
become brand new.

A $500 price tag, therefore, emphasizes the yellow metal's
long march back to respectability and relevance. Gold
currently sits an 18-year high. At $514 an ounce, it would
reach a fresh 24-year high!

Gold's flirtation with two-decade highs is not merely a
curiosity for the gold-bug cult to behold. It is also an
indictment of the global faith-based currency regime....and
we think the charges are warranted. The world's faith-based
currency regime deserves gold's indictment. Which is why we
suspect that the NEXT $500 rise in the gold price might
arrive much more swiftly than the last.

Paper currencies, it bear remembering, roll off of printing
presses controlled by politicians and ignite when held
close to open flames. By contrast, gold, as James Grant
points out, "is recoverable at five parts per billion from
the earth's crust and has no central banker."

Gold's scarcity does not accord it any automatic
value...but it doesn't hurt, especially amidst the
exploding population of paper currencies and financial
derivatives.

"Just because gold has a long history of being used as
money, Surowiecki scoffed, "doesn't mean that it has a
future...In the speculative imagination, gold remains the
best hedge against Armageddon. It also remains a testament
to the tenacity of popular delusion."

Gold also remains the best hedge against the popular
delusions that support currency values. Net-net, gold's
behavior in recent days - as well as its behavior
throughout the millennia - suggests that some investors are
finding gold useful to hold in their portfolios, even if
the monetary metal is not absolutely essential.

One year ago, a colleague approached me to ask whether he
should sell his gold coins. In short, I replied, "No."
"But one of the other editors here at Agora thinks the
dollar is due for a big rally."

"I agree," I replied, "But that doesn't mean gold will not
rally even more. I would suggest doing nothing."

And so it has come to pass...Since that conversation late
last year, the U.S. dollar has gained 13.7% against the
basket of foreign currencies in the dollar index, thereby
enabling the dollar bulls of late last year to congratulate
themselves for a timely contrarian call. But gold has
soared 27% against that same basket of currencies...thereby
enabling your editors to characterize their inertia as
genius.

Because we suspect the gold rally is still much closer to
its starting point than its ending point, we also suspect
that the column we presented on December 28, 2004, is even
more relevant today...Please read on.

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"Eric, I'm about to do something stupid. Please talk me out
of it," one of your editor's colleagues pleaded recently,
"I'm thinking about selling my gold coins and buying a U.S.
dollar CD. What d'ya think?"

"Well, I would never try to talk ANY investor out of
anything," came the reply. "I may not know much, but I've
learned that 'stupid' investment ideas sometimes make a lot
more money than 'brilliant' ideas...especially MY brilliant
ideas. What's your time-frame? A three-month trade or a
three-year investment?"

"I'm looking longer-term," he replied.

"In that case, you should probably stay the course. The
dollar could certainly rally to 1.20 euros, or something
like that. But you cannot convince me that the long-term
trend for the dollar is positive. If you swapped out of
gold in time to catch a dollar rally, you'd feel like a
genius for a while. But I doubt you'd feel like a genius
for long."

"Yeah, but don't you think," the colleague persisted, "that
interest rate differentials will begin to support the
greenback as U.S. interest rates rise?"

Dollar Rally: Can't Reliably Trade Currencies that Way

"No," your editor replied, "not fast enough to make your
trade work. I've never met - or heard of - anyone who could
reliably trade currencies based on interest rate
differentials or on purchasing power parity or on any other
macroeconomic influence. You might as well trade them based
upon national caloric intake differentials or mean
temperature differentials...or whether the coin you toss
shows heads or tails."

"I know some investors who would disagree with you," the
colleague said.

"Yeah, I know," your editor replied. "I wish them well. But
I think the only currency traders who try to make a buck
based on macroeconomic influences are traders who have not
yet lost enough money to know any better.

"Consider this," your editor continued, warming to the
topic, "the United States has run a current account deficit
for two decades. The dollar's value fluctuated wildly
throughout that entire period of time, without ever
establishing a distinct trend in one direction or the
other. And today, the exchange rate between the dollar and
the British pound, for example, is almost exactly what it
was 20 years ago."

"I believe you," the colleague politely responded. "But I'm
just wondering if the dollar might rally for a while. It
FEELS like it should rally."

"I wouldn't argue with you," your editor replied, "But it
also FEELS like there are very few motivated dollar buyers.
Who in the world is buying dollars because they really WANT
dollars? Who? Nobody wants 'em - not the Chinese, not the
Indians, not the Russians, not the Brazilians...not even
the Americans! The remnimbi, the rupee, the ruble and the
real - four of the world's notoriously suspect currencies -
have become more coveted than the U.S. dollar. Isn't that
amazing? Many Russians would rather own a ruble than an
American dollar! So I can't get too excited about buying an
asset - even for a trade - that nobody in the world seems
to want."

"The only big dollar buyers in the world are forced
buyers," your editor continued, "like the central banks of
China, Japan and Europe. In other words, there appears to
be no 'real world' bid for dollars. I don't think I want to
be in a trade where I'm rubbing shoulders with central
bankers. I don't want to invest in an asset for which there
are very, very few natural buyers.

"On the other hand," your editor observed, "gold enjoys the
opposite situation: real-world demand. You can see it every
day in the U.S. financial markets as the open interest
expands for GLD, the new gold-based ETF. And you can read
about every day, as foreigners look to preserve the value
of their savings in gold rather than dollars. Net-net, my
friend, I would characterize your proposed swap out of
bullion coins into dollar CDs as a counter-trend trade – a
brilliant short-term trade perhaps, but most definitely a
counter-trend trade. I'm not predicting disaster for the
dollar, and certainly, I wish I had a few more of them in
my bank account. But I just don't want to own more of them
than I have to."

Dollar Rally: Align with the Prevailing Fundamental Trends

"I know you're right," said the colleague, "but I'm still
not sure what to do."

"I'm neither sure I'm right," your editor replied, "nor
sure what you ought to do. But when all else fails, it's
usually not a bad idea to align yourself with the
prevailing fundamental trends...And the prevailing trends
for the U.S. dollar are distinctly negative. I'm not
absolutely sure, for example, that America's gaping current
account deficit will hurt the dollar, but I'm pretty
certain it won't help."

"Yeah, that's probably true," he said.

"I know it's tempting to take a contrarian stance and buy
dollars, but be careful you don't become too contrarian for
your own good," your editor advised.

"But isn't that the time to buy something?" he asked, "When
nobody else wants them?"

"Sometimes yes, sometimes no," your editor replied.
"Contrarian investing is a means, not an end. Some
investments become unpopular for good reason, and I would
submit that the U.S. dollar is one of them."

Yesterday, the beleaguered buck tumbled to another record
low against the euro, stimulating anew the urge to adopt a
contrarian stance. But just because the American dollar
garners even less respect than an American politician, dear
investor, does not mean we should be buying the thing. The
successful contrarian investor does not blindly buy
something ONLY because it is unpopular. Rather, he examines
those investments and asset classes that have become
unpopular to determine if they might offer some sort of
overlooked opportunity...As a contrarian opportunity, the
dollar might be a trade, but we doubt it has become an
investment.

"We continually read, as do you, cautionary words about the
dollar bear market," James Grant recently observed, "It has
gone too far, too fast; everyone is on the same side of the
boat; gold is the new Internet stock, etc. We don't scoff.
But we believe - to quote from chairman [Greenspan] himself
- that there is now emerging 'a low probability risk but a
potentially very large outcome if it were to happen' of a
'run on the dollar, a run on the bond market and a
significant decline in stock prices.' A prerequisite for a
run is a widespread awareness of risk. Sooner or later,
there must be a crowd. So you can write it down: an
overwhelmingly bearish consensus on the dollar points
either to a dollar rally or a dollar crash."

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[Joel's Note: I trust you enjoyed your festivities
yesterday and hope you are not dull enough to be working
today, like me. Drop me a line and let me know what you're
thankful for at:

aussiejoel@the-rude-awakening.com

You can also check out the Rude Awakening website for more
archived articles and assorted ramblings. Simply go to:

www.the-rude-awakening.com

Lock yourself in the room and watch as 3 hours evaporate as
you bath in the Rude Awakening's glow.

Cheers,

jOEL

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And the Markets...

	Wednesday	Tuesday	This week	Year-to-Date
DOW	10,916	10,871	150	1.2%
S&P	1,266	1,261	17	4.4%
NASDAQ	2,260	2,254	33	3.9%
10-year Treasury	4.47	4.43	-3.00	4.43
30-year Treasury	4.70	4.66	3.00	4.65
Russell 2000	683	683	11	4.8%
Gold	$492.87	$494.70	$7.07	12.6%
Silver	$8.12	$8.18	$0.07	19.2%
CRB	314.38	315.50	1.64	10.7%
WTI NYMEX CRUDE	$58.71	$58.82	$2.57	35.1%
Yen (YEN/USD)	JPY 118.74	JPY 118.80	0.39	-15.8%
Dollar (USD/EUR)	$1.1815	$1.1814	-43	12.8%
Dollar (USD/GBP)	$1.7238	$1.7219	-58	10.1%