How Bad Will This Get? The US Dollar.

March 17, 2008 by Joe Ponzio

When the markets are flying high, value investors tend to sit back and let things happen. When they crash, we must start looking for opportunities – dissecting information, scouring annual reports and proxy statements, and evaluating which companies will survive and which ones will die. (That’s why I haven’t been around as much lately. Sorry.)

Most “regular” people don’t look beyond the stock price as an indication of how things are going – today’s opening price versus today’s closing price is an indication of how things will progress. Most “analysts” have something to sell, so the recovery is always just a quarter or two away (unless they’re eternal bears – then the crash is just a quarter or two away). And then there are the realists – the Warren Buffetts, et al. – that say, “Here’s the truth. Don’t like what you hear? Sorry, but it’s still the truth.”

The Dollar Will Likely Get Weaker

Odds are good that the US Dollar will likely get weaker. What’s happening now is the result of years of poor economic management. We have long been importing much more than we’ve been exporting – to the tune of $712 billion last year.

[Non-US readers: Keep an eye out for this in your home country – the same problems will result in the same results, only the names change.]

All those corporate profits that could have been made in America – that could have provided more jobs, higher wages for US workers, and a stronger stock market – have been made overseas. Foreign companies flourished, but our people made the same wages. As foreign demand increased, supply tightened (as it usually does) and prices began to rise.

The Problem: US wages did not rise as quickly which means things started getting more expensive. Inflation kicks in.

The US Dollar Slippery Slope

Much like credit card debt slowly accrues (I already owe $750. What’s another $30?), we headed down a slippery slope. The more we bought from overseas, the more supply tightened and the more foreign prices (and profits) grew. As foreign prices grew faster than US after-tax wages, foreign products became more expensive in the US.

One might think: Simple solution – buy American. Not so simple. Foreign products were still cheaper than their American counterparts. When choosing between being a good patriot and feeding the family, the choice is painfully simple for most.

As inflation creeps up, US products become even more expensive and foreign products become more attractive. During economic bubbles, most people ignore the data and base their buying and decisions on hope. I’ll buy this house today because it will be worth more next year. Based on what? I’ll buy stocks and mutual funds now because they’ve been going up. And? Wow! A 3% ARM? Give me 110% of my home’s value! It will work itself out. How?

Most people will jump from tech stocks to real estate to emerging market stocks (through mutual funds or otherwise) and then spend their future profits because they are perceived as cash in the bank. Most people are bad savers and even worse investors.

How does this fit in? “Most” people drive our economy, and they have put us on a slippery slope.

Thank Uncle Sam Too

Of course, you can thank the pinheads in Washington as well. By 1999, we were importing 28% more than we were exporting, a figure that had jumped 60% from the previous year, and that continued to grow in percentage and real dollars over the next eight years (as high as $759 billion in 2006).

So focused on other things and blinded by the real estate bubble (Hey, everyone has a house. This is great!), our government did nothing to curb the problem (e.g., increase taxes on imports, implement better trade policies).

They let history repeat itelf by allowing our economy to get into trouble like in the mid-1980s – a situation that resulted in higher inflation (near and well above 4%) from 1987 through 1992.

How Bad Will It Get?

In November and December, Wall Street was calling for a turnaround by the end of the first quarter of 2008. Oops. Then they said “no later than Q2.” Not likely. By late April, they should be calling for a reversal for the end of the year. (Think they have something to sell?)

In reality, our problems extend far beyond the next quarter. This mess needs to work itself out. To do so, we will likely suffer some 5%+ inflation for a while as we try to export more or import less. Less imports means we have to buy American at the higher American prices – hence, higher inflation. If we don’t do this, American wages will remain flat or drop and inflation will quickly grow out of control.

The credit mess needs to work itself out. (Later this week, I’ll talk about how stupid and irresponsible that Bear Stearns, Merrill Lynch, and crew have been for the last ten years.) Regular Joe American who can’t pay his mortgage today ain’t gonna be able to pay his mortgage at the end of higher-price, higher-inflation 2008.

I won’t try to predict the direction of the markets over the next six months. I’ll simply say this:

  • Expect high inflation for a while;
  • Expect to see some severe market swings – up and down;
  • Expect to see trouble in the overseas markets if we do tighten up our trade policies;
  • Expect to see trouble in US markets if we don’t;
  • Expect to see the US Dollar strengthen if we do tighten up our policies;
  • Expect a weaker dollar if we don’t;

Are our problems “fixable”? Yes. Still, it won’t happen in a quarter or two. We went through a trade problem like this in the mid-1980s and it took three or four years of fixing before we entered the boom of the 1990s. By that logic, our next boom would start around 2011 or 2012 – and that’s only if we can solve these more severe problems in the same timeframe.

What This Means For Your Portfolio

Your greatest asset right now is your earning power. As inflation climbs towards your expected investment returns, your actual investment returns will approach zero (or go negative) on an inflated-dollar basis. You can combat this in one of two ways:

  1. If you think volatility and risk are one in the same, you need to be looking globally at bonds.
  2. If you are a non-conventional investor, you should be looking for great businesses, but know that your workouts will likely be your big winners for now.

You won’t be able to “top-tick” or “bottom-tick” the markets so you shouldn’t be focusing on one simple bond issue or investing entirely in workouts (or buy-and-hold stocks).

What This Means For F Wall Street

You’ll likely have noticed that I haven’t been as active on F Wall Street lately. It’s not because I don’t love you or that the market has me down. Quite the opposite – I am busy as hell ripping apart filings and looking for opportunities. (And I do love you.)

When the markets were flying high, I had all the time in the world to write posts for an hour or two a day. Trying to maintain that pace in this market would be detrimental to our future returns.

I won’t be paying much lip service to the economy or markets because today’s hiccups and stumblings have little bearing on how we invest. I’ll do my best to offer some noise-free input, but take it with a grain of salt. At the end of the day, the markets will do whatever the gamblers force it to do on a daily basis; great businesses will grow and their prices will follow.

Remember to ask yourself: Which company will be making more money five years from now than it is today, and am I stealing it today no matter what the price does tomorrow? Which deal is virtually certain to close, at what price, and when?

A Note From Joe Ponzio

This section is for comments from F Wall Street visitors. Do not assume that Joe Ponzio agrees with or otherwise endorses any particular comment just because it appears or remains on this website.