One day a week I write an big-picture investment overview for subscribers to my monthly advisory, Strategic Investment. Today was that day. And since I got in late from Germany, I've decided that instead of writing a sepate set of blog posts, I'll post here what I typically send in the weekly. It won't always happen this way. But today it did. Full time blogging returns tomorrow. Regards, Dan Strategic Investment Wednesday, September 24, 2003 Paris, France The Chocolate Countries ***Bad Dollar, Good Asia ***De Gaulle on Currency Regimes ***The Marginal Treasury Seller and the Marginal Chinese Buyer ***Gold Consolidation and Speculative Unwinding ***Heat Wave Deaths, Ownership, and Stewardship Have just returned from an overnight trip to Bonn to hear a speech from Robert Miles. Miles is an expert on Warren Buffett. He was speaking to a group of German investors about Buffett’s investment secrets and management techniques. A few thoughts below. And by the way, this was my first time through Germany and Belgium. I guess you could say I made a tour of the “Chocolate Countries” in a few days. Belgium I only passed through (although the vaunted high-speed rail system broke down for about two hours yesterday just outside Liege.) But Germany is a country I’m eager to go back to. The mists on the Rhine this morning heading out of Bonn had me thinking of “The Sorrows of Young Werther” and Beethoven (who was born in Bonn) and all sorts of “romantic” associations. Odd to match that image of Germany with the image of the overweight woman in the form fitting leopard skin top who was singing in the Piano Bar at my hotel last night. She fancied old Peter Cetera tunes sung at a slow beat while her husband bashed out the melody on an 80s synthesizer. But the beer was good. Now…on the investment world…and by the way, with our gold stocks and Asian funds we’re in great position to profit from the weakening dollar and the shift of capital flows to Asia. The daily details of the transition are important (and I’m covering those in Strategic Insider). But the more important thing is to make sure you’ve got your analysis of the big trend right and have made the right investments. ***Bad Dollar, Good Asia A practical concern about the G-7’s weekend decision to let the dollar slide against the yen is what will happen to Japanese stocks. I’ve written a fuller analysis in the October issue of SI, which ought to hit the webstands later this week. But there are really two sides to this story, the U.S. bond market and the Japanese equity market. The U.S. bond market got spooked at the G-7 announcement. Bonds tacked on 15 basis points Monday as investors sold off (remember bond yields move in the opposite direction of prices.) It was a double whammy for the bond market. First whammy being that Japan intervenes to support its currency by selling yen and using the proceeds (and its dollar reserves) to buy U.S. bonds. Weaken the yen, strengthen the dollar, keep exports to the U.S. cheap. That’s the Japanese strategy. If they stop intervening to keep their currency weak relative the dollar, as the G-7 wishes, it means they will buy fewer U.S. bonds. The same would be true for the Chinese, of course, if they decided to let the yuan “float” against the dollar. They’d buy fewer U.S. bonds too. This alone would be enough to affect the U.S. bond market. Take away two of your three biggest buyers and suddenly you have to raise yields to pay for your wars. But the second whammy for the U.S. bond market is that a weaker dollar makes all dollar-denominated assets, including Treasury bonds, less desirable. What investor wants to own bonds that don’t pay a competitive yield and are priced in a declining currency? The bond market recovered some today. But don’t count on it lasting (more below). The other side of the dollar question is Japan and its stock market. The Nikkei sold off 4% on Monday, and for good reason. Japan exports its way to prosperity. Letting its currency strengthen makes its goods more expensive overseas, which makes Japanese exporters less competitive, which presumably leads to lower profits for Japanese firms…which equity investors don’t like. Hence, the instant reaction. However, over the long-term, I believe a stronger yen is not a negative for Japanese stocks. It may halt some of Japan’s positive economic momentum in the here and now. But hold on to EWJ and our other Asian funds. These will be the best way for you to profit from the structural rebalancing of the global economy. I know. I know. I can’t just make a claim like that and not prove it. And a lot of the proof will be in your October issue of SI. But to really understand the best reason for being bullish on Japan and Asia…you have to understand Charles De Gaulle. ***De Gaulle on Currency Regimes "There can be no other criterion, no other standard than gold. Yes, gold which never changes, which can be shaped into ingots, bars, coins, which has no nationality and which is eternally and universally accepted as the unalterable fiduciary value par excellence." No, it wasn’t Alan Greenspan who said that. It was Charles De Gaulle. In 1968, De Gaulle knew the dollar standard was a racket that favored American consumers. He said the dollar’s status as the world’s reserve currency was an “exorbitant privilege” for the American economy. He took the American government at its word and began redeeming his paper dollars for the gold in Fort Knox. When De Gaulle did this in 1968, it caused a mini run on U.S. gold that forced Nixon to close the gold window three years later. De Gaulle didn’t restore the gold standard. In fact, by speeding up the end of the Breton Woods agreement, he actually helped usher in the era of fiat money backed by nothing: the dollar standard we live under today. But he showed that it only takes a change at the margin to precipitate the demise of a currency regime. All it takes is one prominent seller to call the bluff behind the perceived economic strength that backs a paper currency. De Gaulle called the American’s bluff by forcing them to cough up gold. Nixon knew that real gold was worth a lot more than U.S. paper, so he shut the whole charade down. Fast forward to today and the dollar standard. What’s the backbone of the dollar standard…? It’s the unshakeable faith the world’s investors have in U.S. bonds. The Administration apparently thinks it can engineer an “orderly” devaluation of the dollar without causing foreign bondholders to sell their U.S. bonds. Currency markets rarely do anything in an orderly fashion, though, especially at the extremes, when one currency regime ends and another begins. Just ask John Major and the Bank of England about insulating a currency from market forces. Nearly 11 years ago to the day (September 22nd, 1992) The Bank of England tried to manage an orderly entry of the pound sterling into the European Exchange Rate Mechanism. But George Soros knew the pound was already overvalued. The market always knows. Soros figured, “Why wait?” He sold sterling in the futures markets, creating supply. Creating new supply has the effect of bringing prices down. The Bank of England countered by raising interest rates to support the currency. A higher yield, it figured, would create demand, offsetting the extra supply Soros was brining on line. Remember, this Bank knew the pound was too strong. But this was to be an orderly decline. Radical adjustments are disruptive. Investors lose confidence if a currency loses too much value too fast. They start selling other assets denominated in that currency. Currency sell offs lead to stock market sell offs. Stock market sell offs lead to lost elections. Soros kept selling pounds though, and by the end of the day, the Bank of England was forced to renege on the rate increase. The Bank was caught in the awkward position of admitting through its public actions that the currency it managed was not worth as much as it had said. And it couldn’t afford to support it any longer. But it was forced to abandon its position because Soros put money behind the opposite position, that the pound was overvalued and MUST correct. Soros made a billion dollars in one day. ***The Marginal Treasury Seller and the Marginal Chinese Buyer Who will be the first to sell the dollar? Who will panic first so as to avoid the rush later? At a certain point, foreign bondholders will not tolerate owning the debt of chronic spender who pays little interest and whose currency is declining in value. Then the selling will begin. It will only take one seller at the margin to initiate the move. The only counter argument I’ve heard against the end of the dollar standard is that global bond investors simply don’t have an alternative to U.S. bonds. Everyone is tied to the dollar’s fate. Too many people have too much to lose from a falling dollar and a sell off in Treasuries. The dollar is too big to fail. But this is exactly the state of affairs when a currency regime ends: things reach a paradoxical state of paralysis. No one can afford to start selling dollars because everyone owns them. But the dollar cannot retain value and be worth owning when the U.S. keeps printing more AND running deficits. No one can afford the end of the dollar standard. And no one can afford the continuation of the dollar standard. The whole dollar standard rests on an unsustainable economic imbalance…that of U.S. consumption and foreign production teaming up to make the world rich and prosperous. The correction of the imbalance in the U.S. is obvious, reduced consumption and liquidation of debt. But it’s the correction of the foreign imbalance that shows us what replaces the dollar standard. The Asian growth model depends on U.S. consumption. Without it, to whom will Asia export? That question is now being answered. Itself. If American’s can’t sustain the pace of consumption, then Asia will have to consume more itself. This is starting to happen anyway, simply by virtue of rising incomes in China and rising standards of living. Perhaps it’s human nature that after reaching a certain level of material comfort, people tend to hoard less and want more. But it’s conceivable that at some point Asian owners of U.S dollar currency reserves and U.S. treasury bonds will decide to take their losses and begin investing in each other and their own consumption growth. The dollar will be shed because U.S. consumption will no longer be the engine of Asian growth. Of course there will still be disruptions in Asia. The Chinese have massive debt. But 19th century America had its own share of financial crises, too (the years 1837 to 1842 saw the REAL first Great Depression, as you’ll see in my lead article for October). Yet the whole time America was becoming the world’s largest producer AND consumer of raw materials and the world’s largest producer and consumer of finished goods. The Chinese economy is so large that an increase in consumption in the margin will be enough to shift the structural balance in Asia and render the dollar a lot less important to Asian growth. There’s a lot more to the story…but you’ll have to wait for the October issue of SI, especially the excellent piece by Marc Faber. Meanwhile, stay long Asia. ***Gold Consolidation and Speculative Unwinding Large speculative gold futures traders have scaled back some of their massively long position, even while commercials have maintained a large short position. Yet gold keeps rising. I think there is a near-term possibility for some gold selling. I’ve made some recommendations in the October issue on how to hedge this. But don’t be confused about my long-term opinion of gold stocks. Even if dollar-denominated assets (U.S. stocks) get sold off, gold stocks should do well. Yes, many of them report their earnings in dollars. But gold stocks are an equity investors’ quickest lifeboat in a sinking market. And if bullion prices rise as high as I think they could, gold stocks should hold up fine. Hold them. And buy even more on weakness. Another good sign is that the gold industry may be seeing the first signs of consolidation. AngloGold and Randgold are in a bidding war for Ashanti. When the gold majors start scarfing up the junior miners, the bull market in gold has entered a whole new phase. ***Heat Wave Deaths, Ownership, and Stewardship Something had been bothering me about Jacques Chirac’s statement that all of France was to blame for the summer heat wave deaths. And last night at Robert Miles’ Buffett lecture I figured it out what it was. Miles said that Warren Buffett’s single greatest nightmare is not a derivatives meltdown or the mass resignation of all his CEOs or crash in the dollar. It’s attracting the wrong kind of shareholder. Buffett wants owners for his company, not traders. He’s looking for partners who commit capital for the long haul. I don’t have my numbers in front of me but Miles said, I believe, that the average Berkshire shareholder holds his stock for 12 years. I’ll check tomorrow. But compare that the average holding period for a Nasdaq stock: 6 months. Or a Dow stock: 12 months. There’s a cost to having a revolving door at your shareholder meetings. It means you must constantly explain your business and justify your management decisions to new shareholders instead of explaining your strategy for next year to your existing shareholders. Buffett would rather his shareholders consider themselves owners. Which got me to thinking about the idea of ownership itself. Ownership, as the saying goes, leads to stewardship. The inverse of this saying is known as the tragedy of the commons. The tragedy of the commons illustrates the principle that public ownership of a resource leads to the destruction or inefficient use of the resource. Use a public grazing area as an example. Under “common” or public ownership, each individual sheep herder is actually incentivized to get as many of his sheep on the range as he can, even if means eating up all the grass. If he doesn’t do it, someone else will. There’s no penalty of wasting the resource and no incentive for preserving it. Since no one person “owns” the commons, each individual is perversely encouraged to get as much as he can as quickly as he can. No cost. And the longer you wait to gorge, the less you’ll get when you decide to quit being conscientious. Now…what does this have to do with Chirac you ask? Chirac and the French establishment used the line that “we are all responsible” for the neglect of the elderly, after it was revealed that over 10,000 French men and women died from the summer heat wave. In other words, the 10,000 deaths are not any one particular person’s fault…”we are all to blame” Chirac was saying. But isn’t this just the tragedgy of the commons in a sociological (or socialist) context? If moral obligations to look after your family or neighbors are “socialized” through government programs, it’s the failure of the institutions and not the sons and daughters of the dead, right? And in France, much of the public outrage was directed at the government. “Why didn’t the government do more?” “Why did the health services fail?” “What is the government’s solution?” No one bothers to hold himself or herself personally accountable. If you’re only obligated to someone “socially,” that is through taxes which you pay to the State, which then is kind and charitable on your behalf, I’d say you’re not really obligated at all. You’ve abdicated your real abdication to others by contracting it out to a third party. You saw some of that in Sweden too, where no one stopped the killer of the Foreign Minister as he walked out of the department store (or even as he committed the crime and took a life in front of passersby.) The press report, which may not be indicative of the overall mood, instead lamented the lack of police presence and pointed out how it would now be necessary for public officials to have more bodyguards. Someone should have done something. Someone else. Does socialism encourage people to disown their moral or ethical obligations to one another? Looks like it to me. By making the State the middleman in our relationships with one another, we get the convenient benefit of not having to actually feed the hungry, care for the sick or give alms to the poor and look them in the eye…yet we get all the pleasure of devoting a portion of our income to a government that does these things in our name. Freedom and self-satisfaction without the obligation of moral responsibility. Pretty enlightened. Best Regards, Dan Denning P.S. It might not even take a bond sell off to see a crash in the bond market. It might just be the falling dollar taking down U.S. assets with it. In that case, bond investors could hold on their Treasuries and hope that they’d at least get some kind of return on them later. But a default is also possible. In fact, it’s what usually happens when a government can’t pay the interest on a sea of a bad debt. Just this week Argentina stuck it to bondholders…again. Argentina is trying to restructure $95 billion in defaulted bonds. The FT reports that the “government proposed a 75% reduction in the face value of the bonds and declined to pay the interest accrued since the 2001 default. In exchange, it offered investors a new choice of three bonds to replace the 152 non-performing securities.” Naturally, bondholders were…not pleased. They claim the Argentines are trying to rewrite the rules. And of course that’s true. That’s what governments always do when they can’t afford to keep the promises they’ve made…they change the rules…devalue the currency, default on the bonds. Just because the U.S. bond market is bigger and integral to the dollar centric world doesn’t mean it won’t suffer the same fate. Ten years from now, it will be the Japanese and Chinese grousing about new U.S. proposals to restructure the defaulted bonds. Perhaps we’ll appeal to the IMF for a loan. Or perhaps it will finally be America’s turn to ask the world to forgive our debts as we’ve forgiven theirs. Copyright 2003 Agora Publishing The Strategic Investment Weekly Update You may not forward, reprint or post any of the material you read here as it contains information exclusively provided for the benefit of subscribers to Strategic Investment . However, brief passages and quotes may be used within the body of other articles and reviews, with proper attribution.