One of the many lessons traders learn is to greatly limit their information flow, which is especially tough in today’s environment of information overload. Ironically, those who are just starting out in trading often do better than seasoned pros precisely because they don’t take in lots of information that leads to fear and uncertainty, which leads to making exactly the wrong trades. But there are a few exceptions, and one of them for me is David Nichols and his daily Fractal Market Report.
Here’s a discussion of inflation and the dollar from yesterday’s report that I think is pretty much on the money. The bottom line is that regardless of what you believe about the propriety of the matter, the dollar is a financial instrument that fluctuates in value relative to other assets and financial instruments. Understanding that is essential for making the correct long term moves.
Here’s the article, reprinted with permission…
My discussion of inflation vs. deflation sparked some questions, so
I want to continue on this topic. The reason this is so important is
the fluctuation in the dollar is almost never factored into most
people’s thinking about financial markets.
I’m just going to ramble on a bit on these ideas, as I want to get
this down quickly. I’m not going to document each point I make, or
show charts on everything, as that would be a big job, and I’m just
writing this after the close today. I’d rather just quickly make a few
points, and let this be the starting point for your own independent
rumination and study. You definitely do not have to take my word on
any of this.
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 and not 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.
Let’s look again at the monthly chart 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
just relative 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
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’s gone 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
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
San Diego. 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.
I’m sure this is going to be controversial. 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.