Of late, the value of the US Dollar has been falling, which has had an inevitable impact upon the price of US stocks. But why exactly has the US dollar been falling, will it continue to do so and should this be something to worry about? Fat Prophets investigate.
For some of us who grew up in the 1970s, the television program "The Six Million Dollar Man" will be a nostalgic experience. Many will remember the show's famous tagline "... A man barely alive... Gentlemen, we can rebuild him ... we have the technology. We have the capability to make the world's first bionic man. Steve Austin will be that man. Better than he was before, Stronger, Faster..."
Of course the bionics and all that rebuilding came at a price. Back in the 1970s it took $6 million dollars to rebuild Steve Austin. Today $6 million dollars wouldn't buy a bionic finger, let alone bionic legs or a bionic eye! In fact, if Steve Austin was re-launched in a new show today, we believe the producers would have to up the ante and call it The Six Billion Dollar Man!
In the report last week, we addressed some of the major inflationary issues facing the US economy and why we believe the dollar will come under severe pressure over the next few years. So now we ask: why has the US Government let the value of the currency fall so much?
To answer this question we need to look back at history. Since 1944, following the famous meeting of the global central bankers at Bretton Woods in New Hampshire, it was decided that the US dollar would assume the privilege of becoming the world's reserve currency.
This status was important because effectively, it meant that nearly all countries in the world would trade with one another using dollars as the medium of exchange. In addition, the central bankers agreed that a gold standard would be adopted by the US Government. This would literally anchor the value of the US dollar to a tangible asset.
Through the gold standard, any country holding US currency could exchange dollars at "The Gold Window" for physical gold at the rate of $35 per ounce. Following Bretton Woods, this system worked well for many years, with the US Government generally exhibiting responsible currency management. Spending was within budget and borrowing was limited. Money supply grew in size, but only at the same rate as the underlying GDP growth rate.
However, with the escalation of the Vietnam War in the 1960s, spending on the military soared and the Government went deeply into debt. To finance the war, money had to be borrowed, and thus the supply of US money in global circulation increased significantly. Countries holding large reserves of US dollars began converting them into physical gold.
This led to a large outflow of gold reserves from the US to countries such as France, which was cashing in its excess dollars at the Gold Window at a frantic rate. The system began to buckle, as the physical gold transfers accelerated.
Alarmed at the rapid dissipation of US gold reserves and frustrated by not being able to effectively fund the Vietnam War, Nixon took the dollar off the gold standard in 1971. This freed the dollar from a tangible anchor and allowed massive borrowing and debt expansion. Money supply within the system skyrocketed.
Inflation rose sharply during the 1970s, driven by spiraling wages and commodity prices. Oil peaked at $40 a barrel in 1980. Gold hit $850 an ounce. On the front pages of newspapers there was talk of the US dollar potentially collapsing.
Then along came Paul Volcker to manage the Federal Reserve. A man ahead of his time, he raised interest rates to nearly 20 percent to wring out and halt the rampant inflation within the system. Defying many skeptics at the time, he succeeded and price inflation subsided. For the next 20 years, prices were relatively stable.
The same cannot be said for the US money supply. The number of US dollars within the global system has continued to expand rapidly. The world today is flush with US dollars, and we believe this partially explains the sharp rise in asset and commodity prices.
Holders of US dollars are converting them for tangible assets. Nations such as China, Japan, India, as well as OPEC members are accumulating US dollars by the trillion. It remains to be seen just how long this will continue as the dollar is continually damaged by the growing money supply, trade and budget deficits and national debt which is climbing towards $9 trillion.
With the decline of the US dollar in recent years, purchasing power abroad has also fallen dramatically. Within the United States, inflation has remained relatively subdued (although the Federal Reserve is becoming more uncomfortable). However the true picture has been clouded by the fall in the dollar.
What does this all have to do with the stock market? In our opinion, the declining purchasing power of the dollar partially explains why the Dow Jones and S&P500 are rising. US stocks are relatively cheaper today for foreign investors. Stocks are also tangible, and in an inflationary environment, are perhaps a better place to invest capital, rather than in treasury bonds or cash.
We firmly believe there are too many US dollars in existence today within the financial system. The world is beginning to awaken to the fact that the intrinsic value of the dollar (if indeed it has any) has been greatly eroded in the past three decades. While we believe further falls in the dollar are highly probable, the Dow Jones Index could rise to between 14,000 and 15,000 in the next few years as the currency continues to depreciate.
In summary, as highlighted last week, our strategy continues to be biased towards large cap, internationally diversified stocks (e.g. Microsoft - note George Soros buying heavily this week), or stocks that produce products where prices are established internationally (BHP Billiton). We also favor the precious metal sector and in particular, gold stocks. While US equities may experience volatility in the near term, the inflationary cycle should drive the market to new highs towards the end of the year.
If The Six Million Dollar Man does make a return to television now, who knows; in a few years he might just be the Six Trillion Dollar Man.