Monday, March 16, 2015

"In investing, what is comfortable is rarely profitable." -- Robert Arnott

SINCE EVERYONE EXPECTS THE U.S. DOLLAR TO KEEP RISING, LOOK FOR THE EXACT OPPOSITE (March 16, 2015): Investors may differ in some ways in their future outlook, but almost everyone around the world today agrees that the U.S. dollar will continue to ascend indefinitely. The U.S. dollar index surpassed 100 during the past week and achieved its most elevated point since March 2003--just about exactly twelve years ago. Gauging the extent of any extreme in the financial markets is inherently a perilous task, as we have experienced some of the most exaggerated extremes in both directions since the beginning of the century. However, we have such a preponderance of data which screams for a reversal that it is worth reviewing the available evidence and reaching a conclusion.

Let's begin with the media's explanation of "why" the U.S. dollar is so strong. Relying on the mainstream financial media to understand anything in the financial markets is hopeless, because they'll put together any story line which seems to fit recent facts, and they'll invent nonexistent cause-and-effect relationships. The most popular current myth about the U.S. dollar is that it has been rising because it's the cleanest dirty shirt in the laundry, and that it's climbing in anticipation of the U.S. Federal Reserve raising interest rates, and that it will continue to move higher because U.S. Treasury yields for any given duration are higher than similar yields in many other countries.

The problem with all of the above arguments, of course, is that entirely different arguments were advanced two or three years ago when the U.S. dollar was rallying. At that time, there was no expectation that the Fed would raise interest rates, and in fact the Fed made it very clear that they would not do so for an extended period. Therefore, the explanation at that time was that the U.S. dollar was rising because the Fed wouldn't raise interest rates. It can't possibly make sense that the U.S. dollar rallied in 2013 because the Fed wasn't going to raise rates, but it will rise in 2015 because the Fed is going to raise rates.

As for the Treasury yield differential argument, a similar explanation was given seven years ago about why the U.S. dollar would keep falling in value--it was allegedly because interest rates outside the U.S. were much higher than U.S. Treasury yields of similar durations. As it turned out, these higher rates abroad caused growth in other countries to slow down, while the low U.S. rates led to more robust expansion. Thus, the differential caused exactly the opposite result of what the media were saying. Instead of continuing to retreat from its all-time nadir, the U.S. dollar in March 2008 began a powerful one-year rally precisely when its yields were the least competitive with those from many other countries. The fact that U.S. Treasury yields are currently higher than government bond yields in many other countries means that the economies of other countries will probably grow more quickly than the United States' GDP growth rate, which will cause the U.S. dollar to retreat instead of rising further.

Here is what I consider to be the most logical explanation of what will occur with the greenback: the U.S. was the first country in the world to do quantitative easing and to adopt a near-zero interest rate policy. Since the United States was first, it was the first to enjoy the temporary economic stimulus created by this scheme. As a result, the U.S. economy outpaced most of the rest of the world, so investors crowded into U.S. assets of all kinds including stocks, bonds, real estate, and the U.S. dollar. Recently, dozens of countries around the world have belatedly decided to copy the United States with nearly identical quantitative easing programs, figuring that if you can't beat them, join them. This will soon result in the economies of these countries enjoying a higher rate of economic growth than the United States, and thus their currencies will appreciate versus the U.S. dollar. In some cases, the current exchange rates have become so exaggerated that their reversals are likely to be powerful--such as for the Brazilian real, the Russian ruble which has already made some inroads, and the liquid Canadian and Australian dollars. Even the much-detested euro and yen will rebound strongly against the greenback during the next year or two, simply because they have become so irrationally oversold.

Is there any evidence to support these contentions? If you go to or , you will discover that for many currencies the current bets by commercials on higher non-U.S. currencies are at or near historic extremes. Commercials are those who are required to trade any given futures contract as a part of their regular business dealings, such as the treasurer of a major multinational corporation like McDonald's. If these executives as a group are betting with increasing intensity on a lower U.S. dollar, then it's unlikely that they're going to be wrong.

Speaking of McDonald's, there is a well-known signal known as the "Big Mac Indicator," which asserts that you can determine what will happen with currency fluctuations based upon how much it costs to purchase a Big Mac sandwich in any part of the world. In those cities where a Big Mac is especially cheap, it's likely that the currency has become illogically undervalued and will soon climb significantly. In those cities where a Big Mac is unusually expensive, there will likely be an important decline for the local currency. Throughout the decades, this indicator has proven to be surprisingly reliable, accurately chronicling the overvalued Japanese yen in the 1980s, the initially undervalued euro at the beginning of the current century, and the overvalued Australian and Canadian dollars in late 2007 and in 2011. Today, a Big Mac is unusually cheap throughout most of Australia, Canada, Brazil, and Russia, while it is near multi-decade highs in many parts of the United States. Only Switzerland tends to be overpriced in Europe, with nearly all other European countries experiencing Big Mac costs which are their lowest in several years when measured in U.S. dollars. This signal has such a reliable long-term track record that its current message is probably worth taking seriously.

The media have changed their way of writing about the greenback. Instead of articles such as "will the U.S. dollar rise or fall in the coming year?" they instead are only interested in debating how much more it will climb and when. There are far more articles of the "better get used to" variety, which almost always proliferate whenever any trend is set to reverse sharply. In failing to appreciate the inherently cyclical nature of the financial markets, commentators will say things such as "you better get used to the U.S. stock market being depressed," which was especially popular in early 2009 when investors should have instead been aggressively buying equities, or "you have to adjust to the new reality of real estate prices continuing to decline," which was stated repeatedly in 2010-2011 before a significant rebound. Four years ago, the belief was that emerging markets would continue to outperform indefinitely and that inflation was an unstoppable force; today, almost the exact opposite outlook for deflation and slumping emerging markets is assumed to continue for many more years. We don't throw away our winter clothing on an especially hot and humid day in July, but that is how investors tend to greet any extreme in the financial markets, by assuming that the recent past will continue into the indefinite future. Since almost everyone now takes for granted that commodities will keep slumping and that the U.S. dollar will keep surging, it's unlikely that this will be the first time in history that the herd proves to be correct and that the inherently cyclical character of the financial markets has somehow been repealed by Janet Yellen.

Tax tip: If you own shares or funds which are trading near six-year bottoms and you are a U.S. resident, you can take advantage of their currently depressed prices if these assets are in your 401(k), 403(b), SEP-IRA, Keogh, traditional IRA, or other non-Roth retirement account. You can convert these shares from your account to a Roth IRA and pay taxes based upon their present low valuations. As these eventually rebound, all future gains will be completely tax free. In the event that these shares don't recover but end up retreating further in price, you can choose to undo your conversion, which is known as a recharacterization. You can then wait at least 30 days, or until the following calendar year--whichever is later--and then convert them again. There is no limit to how many times you can repeat this process, as long as each recharacterization is done on or before October 15 of the year following the date when the conversion had been done. It's like being able to go back in time and "unbuy" something which doesn't go up in price. It's heads you win, and tails you also win. Unfortunately, I do not know of an equivalent strategy which is permitted in any other country.

Disclosure: In August-September 2013, and at various points during 2014 through the first quarter of 2015, I have been buying the shares of emerging-market country funds whenever they have appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares and related assets especially following their most extended pullbacks. I have also been accumulating HDGE which is an actively managed fund that sells short various U.S. equities, because I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, XME, HDGE, GDX, SIL, COPX, REMX, EWZ, RSX, IDX, GXG, ECH, GLDX, URA, FCG, VGPMX, BGEIX, VNM, ZJG (Toronto), NGE, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position since June 2013 to less than 4% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG but I repurchased it following its recent collapse. I expect the S&P 500 to eventually lose about two thirds of its recent peak value--with most of that decline occurring in 2016-2017. The Russell 2000 Index (IWM) has only modestly surpassed its high from the first week of March 2014, while the Russell Microcap Index (IWC) has never surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of past bear markets are doomed to repeat their mistakes.