WEEKLY UPDATE

October 26, 2010



The dollar has, at least for the moment, stopped falling. In my last update I noted how just 3% of investors surveyed thought the dollar would rally and that this was usually a contra-indication that the dollar was poised to reverse course and start moving higher. Since then the dollar has stopped falling and is trending slightly higher (see the violet trend line that I placed on the chart below). If this trend continues I would expect to see the stock market rally that began in late August to come to an end.

The trend for a weaker dollar and higher stock and bond prices began in late August. I have drawn a white vertical line on the chart below marking the day the that Fed announced their intention to print more money, embarking on another quantitative easing program known now as QE2. The Fed's announcement sparked a decline in the dollar (violet line) and a rise in stock and bond prices.



What does a weaker dollar mean?
When our dollar weakens against other currencies it makes our exported goods cheaper to foreign buyers and it makes U.S. corporate profits on overseas sales look stronger than they really are. A weaker dollar gives our economy a boost and that is one of the key reasons that the Fed is printing more money. The problem is that other industrialized countries are trying to do the same thing.

Currency Wars are Brewing
This weekend the Group of 20 finance chiefs (G-20) met and agreed to let fundamental economic strength determine currency values and to refrain from competitive devaluation of their currencies; in other words, they agreed to refrain from artificially lowering the value of their currencies. Meanwhile finance chiefs throughout Europe, Asia and the western hemisphere are each quietly trying to reduce the value of their currency to reap the same economic benefits that we are trying to achieve.

Should we believe the G-20 finance chiefs' promises that they will stop trying to lower the value of their currencies? The marketplace doesn't seem to believe them. The fact is that the U.S. government is not actively engaged in actions to lower the dollar - but the Fed is. As we all know, the Fed is not a part of our government but acts as an independent central bank to control our nation's money supply. So if the Fed decides to put more money into supply by using quantitative easing our Treasury Secretary can still tell the other G-20 leaders that the U.S. government is not actively bringing down our dollar.

Why does this matter to me?
As investors, it matters a lot. History has shown that a government's effort to manipulate the value of their currency produces only temporary results; eventually a country's relative economic strength determines the longer-term value of its currency. Recent action by the Fed is temporarily lowering the value of the dollar but eventually the strength of the economy will determine the long-term value of the dollar. So, even as bad as our economy is today, it is still stronger than most of our trading partners. Unless our economy suddenly falls off another cliff like it did in 2008, we should expect that the dollar will eventually strengthen against our trading partners currencies and that in turn will determine the fundamental value of our stocks and bonds.

The Week Ahead
Bonds continue to perform very well. This is auction week for the Treasury and so far the auctions have been very well received by investors. Prices remain high and yields remain low.

Stocks are trading quietly this week. Trading volume remains light as investors focus on next week's elections. Moves in the dollar continue to inversely impact stock prices, but one cannot expect much activity until results of the elections are known.

Take care,
Greg

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October 15, 2010



The Fed's rhetoric following their August meeting has been pushing the value of our dollar down and stock prices up. When our dollar falls in comparison to foreign currencies, it boosts the comparative value of our exports. One would expect that if our exports are more attractive in the international market then demand will increase and our nation's factories will start to hire more employees to meet that demand. Below is a chart illustrating the changing value of our dollar over the past year. I've noted on this chart how investors view the value of the dollar at different times and what this shows is that whenever investors expect the dollar to fall further the dollar surprises everyone by bouncing back up.



Why do we care about the value of the dollar? Because ever since the Euro Crisis receded in May, the changing value of the dollar has caused an inverse reaction to U.S. stock prices (dollar falls = stocks rise). If this dollar/stock relationship continues then a halt in the dollar slide would trigger a slide in stock prices. The chart below shows the value of the dollar (black line) compared to the Dow (tan line).



It will be very interesting to see if the dollar can surprise 97% of those investors who expect it to keep falling. I wouldn't be surprised at all to see the dollar bounce in the near term and bring stocks off their recent highs.

Take care,
Greg