We Bet Your Money Is Invested Where It SHOULD Have Been

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If your assets have done well the last dozen years it is very likely those assets will do poorly in the time ahead. This is because you likely have the wrong asset allocation for the policy shift happening.

The world is complex and complicated. It is made up of many moving parts, especially many different economies, governments and central banks. There are numerous sets of economic and tax policies around the world, and policies really matter. Government policies determine all asset prices by defining the rules of the game and altering the supply and demand for products, labor and capital. This changes the relative supply and demand for different asset classes. Monitoring and understanding shifts in policy tell us not only what to invest in, but when to invest. Since policy shifts are more powerful and durable than most people realize, asset classes may be in or out of favor for long periods.

We always strive to find the "just one thing" that will help dissolve this apparent complexity. While industry experts and the financial media thrive in this state of complexity and confusion, they offer investors very little in the way of simplifying the world to improve decision making.

One way we have found to simplify the complexity is to understand that the value of the U.S. dollar is the "just one thing." All U.S. policies (tax, regulatory, foreign and monetary) affect the value of the dollar. In our view, monetary policy is the most important policy since it has the largest impact on the currency's value and its consequences are the hardest for citizens to escape. Most of us must act exclusively inside of the currencies of our respective countries. We have all heard the Wall Street line, "Don't fight the Fed." But what does that mean? Is the Fed tightening, easing, tapering, etc? What is that doing to the value of the U.S. dollar? While understanding exactly how monetary policy works can be very difficult, it is fairly easy to decode which way the monetary policy wind is blowing by watching one simple metric, the price of gold. The price of gold is the most powerful "footprint" of the most powerful policy - monetary policy.

Here's how it works. First, remember that the price of gold in U.S. dollars is not really the price of gold itself. Rather, it is the value of the U.S. dollar priced in gold. A rising gold price is another way of recording the falling value of the U.S. dollar. Ultimately, even poor measures of inflation like the CPI will reflect changes in the price level, but the very sensitive price of gold detects this minute by minute.

We have often said that if we could only have one data feed and needed to manage money, that data feed would be the current and past price of gold. If you can determine the direction of the dollar by watching gold prices, then you can correctly identify which way the wind is blowing for all other asset classes. We will use U.S. Equities, as measured by the S&P 500, as an example. A pattern emerges when we look at gold prices and the S&P over the past six U.S. Presidential cycles. When gold prices rise (value of the dollar falls), the S&P does poorly. The weak dollar presidencies of Carter, Bush 2 and Obama saw gold prices rise by 321%, 223% and 80%, respectively.

In these weak dollar periods the S&P flatlined. Under Carter's weak dollar regime the S&P returned roughly 10%. From 2000 to present under the weak dollar regimes of Bush 2 and Obama the S&P returned roughly 11%. We call these periods "red zones." Conversely, when gold prices are flat to down (value of the dollar is stable to rising) the S&P does extremely well. The strong dollar presidencies of Reagan, Bush 1 and Clinton saw gold prices fall by 27%, 19% and 19%, respectively. During this strong dollar period the S&P 500 flourished and rose roughly 1,400%. We call these periods "green zones."

Notice that the pattern of returns here is not driven by political party but rather by the strength of the nation's currency. Importantly, a stable/strong U.S. dollar is not just desirable to achieve good stock market returns. A good stock market is a measure of other very good things such as employment, incomes and output. It is for the sake of these other measures of prosperity, not the stock market alone, that one should wish for a strong/stable currency.

In "red zones" where the dollar is weak, it is not worth investing in U.S. equities. Overall returns are poor while the risk of losing capital is high. It is no coincidence market draw downs are more frequent and larger during "red zones" when the value of the currency is weak and/or erratic.

If one accepts the clear data that a stable/strong currency is preferred, then it becomes clear that the critical job of any central bank should be to achieve that stable/strong currency. To accomplish this a central bank must match the supply of and demand for the nation's currency. For example, the demand for U.S. dollars is subject to many forces, including changing policies outside of the U.S. When the supply of U.S. dollars exceeds demand, as it did on balance from 2001 to 2011, transactors flee dollars for other things. If the central bank (the Federal Reserve here in the U.S.) does not decrease that supply of dollars to match demand then they create what we call an "inflationary mismatch." Investors flee the dollar for other more reliable assets such as gold, commodities, real estate and their surrogates.

Conversely, when the world demands more U.S. dollars, for whatever reason, the Federal Reserve needs to accommodate that demand. If the Federal Reserve does not accommodate the increase in demand they create what we call is a "deflationary mismatch" where the value of the dollar will rise very rapidly and press down the value of sensitive commodity prices. You can think of this "deflationary mismatch" as a margin call as transactors dump assets to acquire dollars. In each of the last three years the Fed has created one of these "deflationary mismatches" by not supplying enough dollars to meet the increase in demand for dollars coming primarily from global investors fleeing troubled countries, especially in Europe.

We, like the vast majority of others, worried excessively about the inflationary consequences of the Federal Reserve's Quantitative Easing program. This was the correct worry until about two years ago when "Footprints of Policy" in the gold market signaled that inflation was no longer the main concern. While everyone was worried about runaway inflation and excessive money printing by the Federal Reserve, the price of gold began stair stepping down (value of the dollar rising) from a peak gold price of $1900 down to $1500. This alerted us that the dollar supply/demand balance that had been a one-way inflationary escalator since 2002 was shifting. It is important to note here that we do not think this change from a weak dollar to a stable/strong dollar was intentional by the Federal Reserve, but merely a consequence of mismatching supply and demand.

More recently the increase in the value of the dollar (decrease in price of gold) has accelerated. Gold has fallen sharply from $1500 to below $1300. Again, this may only be the Fed's annual mismatch, but we believe it is possible and even likely that this reflects something much larger and more important. It does not reflect a specific change in Fed policy, but it does reflect that when considering all policies at work, the U.S. is the least bad place to invest global capital. Global capital is seeking a home in U.S. dollar based assets.

If the policies that are helping spur this dollar demand, such as better tax and regulatory policies, are further improved, then we may look back on this time as the beginning of a virtuous circle. What we mean by virtuous circle is that better policies lead to a stronger currency which leads to more economic activity which leads to a stronger currency which leads to more economic activity and so on. This, of course, puts the lie to the popular misconception promised assiduously by politicians and journalists that a weak currency expands exports and brings jobs back to the U.S. Without taking you through the classical economic theory, your common sense tells you that if this idea were true then countries like Argentina and Venezuela would be rich, not poor. A country cannot devalue its way to prosperity.

It is way too soon to predict this stable/strong dollar future, but it is now a possibility. Had one been following the footprints of gold rather than listening to pundits talk about monetary policy, investors would have been alerted that the one-way escalator of a weaker dollar ended two years ago.

If what is occurring is part of the transition into a virtuous circle of a stronger dollar and stronger economic growth, we can expect several things. Government revenues will increase faster than expected, and demands on the social safety nets will fall. We can grow ourselves into the national debt instead of trying to devalue it away with a weaker currency (the vicious circle).

The consequences for investment returns are significant. The asset classes that do well in a virtuous circle with a strong currency are very different from those that do well in vicious circle with a weak currency. In fact, the rank order reverses. Those asset classes that did well during the last decade of weak dollar policy should go from the top to the bottom of the relative performance tables. Current market disruptions may be reflecting this transitional period as investors struggle to switch their portfolios out of where they should have been (for a weak dollar) into where they should be (for a stable/strong dollar).

Another way to think about it is that the prudent investment action during a weak dollar environment is very different from the prudent investment action during a stable/strong dollar environment. In a weak dollar environment the goal is to protect, as best as you can, the real value of your assets. This is done by investing in real assets or in companies that are surrogates for real assets. There are entire sectors, assets classes and countries that do well in this environment. For example, commodity export countries like Brazil, Australia and Canada do well. Asset classes like commodities (gold), collectibles, fine art and real estate as an inflation hedge do well. Sectors of the economy that are driven by commodity prices like energy, basic materials and mining do well.

In a stable/strong dollar environment the goal shifts from trying to preserve the value of assets to growing the real value of your assets. This, by nature, shifts the focus from the past to the future. Long duration equities and companies whose growth is in front of them, not behind them (these used to be called "growth stocks"), are preferred over companies who use their capital to pay out dividends. There is also a shift towards small and middle cap size companies. Investment in the portfolio hedges of the weak dollar environment are replaced by investment in the equity markets of countries whose improving policies are creating a stronger currency. We must point out here that one does not want to own straight debt that will be damaged by upward normalization in interest rates.

Remember, you are responsible for your assets if this shift is happening. The investment industry is backward looking and, quite frankly, there aren't many investment professionals who have managed assets in a sustained strong dollar environment. One would need to go back more than a dozen years to even remember what that is like. Further, there are almost no managers that remember what a bond bear market is since the current bond bull market began in 1982 when U.S. Treasury bonds yielded 16%. It is crucial that you do not become tranquilized, because if the shift from weak dollar to stable/strong dollar continues, it is highly likely that you do not have the correct portfolio for what may be already here. This does not mean you don't have the best fund or fund manager. It does means that you may have the best managers operating in asset classes that fail in a strong dollar environment. Asset class selection dominates investment returns, and currency strength determines the rank order of asset class results.

James Juliano and Russell Redenbaugh are partners at Kairos Capital Advisors.  

 

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