;)
By David Nichols in Fractal Market Report for November 16, 2006
In a deflationary environment, the dollar becomes strong, as demand for dollars grows
as assets come down in value. People want to get their hands on cash, as cash buyers
are a scarce commodity, and those with cash are just as likely to wait on a purchase, as
the asset they're considering is losing value with each passing day in this deflationary
environment. In a deflation, dollars goes up in value as just about everything else sinks.
The Fed is scared of deflation, as they have limited policy tools to combat it. This is
also why the Fed targets an inflation rate of 2% to 3% per year --so there's always room
to take interest rates below the level of inflation to stimulate spending andnot saving (In
deflation people become savers of cash, as it's going up in value in relative terms with
each passing day). If inflation is in the Fed's target zone, they have the power to take
interest rates into negative territory in real terms, in an attempt to spur spending and
speed up the velocity of money moving through the economy
One thing we know for sure is the Fed -- and Chairman Bernanke -- are avowed
deflation-phobes. Inflation is their stated policy objective. They want it to continue.
But the problem is this: systematic inflation also systematically destroys the purchasing
power of the dollar.
It's no coincidence that during the Fed's most recent "reflation" campaign the dollar has
lost almost 30% of its value -- and that is justrelative to other currencies, which are also
being systematically devalued by their central banks.
During this reflationary period -- starting in 2001, during the bear market -- gold has
gone from $250 an ounce to a current $624. This also means that gold is doing much,
much better relative to the declining dollar than other currencies, as it's gone up 136%,
and other currencies -- most notably the Euro -- have only appreciated 50% against the dollar (A 30% decline in the dollar is equivalent to a 50% rise in the other currency).
But gold has gone up 136%, so it's apparent that gold has a lot of "gearing" to a
declining dollar. Because of its scarcity, increased demand for gold causes big price
moves, as lots of dollars chase relatively small amounts of gold.
Okay then..... let's get down to what the Fed's inflationary policies mean for you and
me. I think it's fair to assume the Fed will keep on systematically destroying the value
of a dollar. Already the dollar has lost 92% of its purchasing power since the Fed
started in 1913. Remarkably, until the Fed came along, the value of a dollar had pretty
much stayed the same throughout the 1800s. The inherent inflation we all assume is
"part of the system" didn't exist at all until the Fed was created in 1913.
So we have to assume that the Fed's actual policy objective is to create inflation, and to
systematically lower the value of the dollar over time. It's hard to argue with their track
record.
We also know that debt levels in the US are now at record highs. We're swimming in
consumer and government debt, not to mention the untold trillions in unfunded pension
and healthcare liabilities that we've accrued and continue to accrue.
There is absolutely no way we can pay back any of this debt in today's dollars. It's
simply not going to happen. Even if we all gave 90% of our income to pay down the
national debt, we couldn't do it, because we spend so much. The only way to deal with
this debt is to make tomorrow's dollars -- the ones we'll theoretically use to pay back
today's debts -- worth a lot less.
This is also why personally I'm not too concerned about a "housing bubble", even
though there is no end to the hand-wringing these days. That's because owning a house
-- even with a big mortgage on it -- will always be the single best way to hedge against
the systematic devaluation of the dollar.
It's actually a very simple concept to understand. Real estate goes up in value as the
dollar goes down. Obviously there are other factors, most notably speculation and
demographic trends, but the main reason real estate has ramped up so quickly since
2002 has been the plunging dollar.
Let's use the San Diego housing market to take a closer look at this.
In August 2001 -- right as the dollar was topping -- the San Diego Home Price Index
was at 127. Right now it's at 247, so it'sgone up 94% over the last 5+ years. But just to
stay even with the decline in the dollar over this period -- and this is against other
declining currencies, mind you -- explains about half of this gain. I think the scarcity
value of real estate vs. currencies explains the rest of the gains, and this is why real
estate is such a great hedge against the Fed's policies.
It's also worth noting that since the dollar index bottomed out at $81 in December 2004,
housing markets have mostly gone sideways. To me all of this does not seem like such
a big deal. Only in a true deflationary environment will housing markets be in serious
trouble.
If the dollar starts going down again -- and I think it will, because that's what the Fed
wants -- then real estate will start going right back up. But again this price appreciation
will mostly be an illusion. Housing values will again go up in some proportion to how
much the dollar goes down. Owning a house is always going to be the best way to
maintain relative purchasing power in the US economy.
This is why I also purposely took out a big loan back in 2003, when I bought in San
Diego County. I also did a much-maligned interest-only loan to boot. I just can't see the
point of spending even one dollar of today's currency to pay down dollars that are due in
30 years. It doesn't make any sense.
Maybe I learned from my mom and dad's experience with our family house in La Jolla
California. In 1967 they paid $54,000 for 3/4 of an acre in the "Old Muirlands," one of
the most desirable neighborhoods in SanDiego. 30 years later the land alone was worth
well over $1 million, and now it's probably worth $2.5 million or more. It was
completely insignificant to their overall financial situation in 1997 whether they owed
$45,000 on the house, or owned it free and clear.
I think the amount that comes due on my house in 30 years will be a laughably small
amount in 2033 dollars. (I took the mortgage in 2003). If anything, inflationary trends
like this tend to accelerate. Most of the damage to the dollar has occurred since 1987,
when Alan Greenspan took over. I think the next 27 years will see this trend accelerate,
beyond anything we can dream of today.
I read lots of commentary from perma-bears about how the US economy is about to be
destroyed by all of the refinancing and home equity loans taken out over the last 5
years. But I don't get their logic. In an inflationary environment such behavior is
rational. It makes sense to borrow today's dollars and pay back tomorrow's dollars.
If the dollar continues to go down, then everything else is going to go up. That includes equity markets too. It's a very real possibility that the Dow could hit 25,000 and actually be trading at a lower P/E ratio than it is today, and be worth less in real terms
than it is now at 12,250. It's all relative.
This is also how gold and other commodities can skyrocket in value over the next 5, 10,
or even 15 years. To gain any sort of relative wealth in an inflationary environment --
where the dollar is losing vast amounts of purchasing power -- you have to hedge your
dollar-denominated assets with something much scarcer than dollars. Gold and silver are natural choices.
Alright, I'm running out of steam, and it's time to send this out. But I think it's still early days on all of this, and having a strategy to deal with inflation and the dollar is pretty darn important. Hopefully this will stimulate some thought, at the very least.
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Cumprimentos e bons negócios.
Sol Dado