Contrarian Chronicles: Face up to the falling Dollar
By Bill Fleckenstein
moneycentral.msn.com
Don't let this bounce fool you. A precarious economy, rotten fundamentals and a debt-ridden government that says 'Sell our currency' are a recipe for disaster.
Across the globe, folks are fluent in the language of denial. In Japan, bureaucrats keep their blinders on as they fight off attempts to shake up a sickly status quo. Here in America, a declining dollar is nothing to cheer about (and in fact, an incubating crisis), but just try convincing most people of that. Of course, the process of acceptance hasn't been helped by the fact that the loudest cheerleading comes from the secretary of the U.S. Treasury.
As everyone knows, at the G8 shrimp fest in Deauville, France, two weeks ago, our secretary of debasement, John Snow, pushed the dollar over the cliff when he described its decline thus far as "really fairly moderate." After I heard that remark, I knew it would be bombs away for the currency, and it was, temporarily. (Stocks weren’t thrilled either; the Dow Jones industrials dropped 186 points.) Now, though, the dollar may be in the process of staging its first real bounce against the euro. My hunch is, that's what might be under way.
Though I am in the mode where I expect the dollar to rally for a bit, I think this will be temporary. In all likelihood, it will provide a wonderful juncture for folks to buy gold and foreign currencies. (This is not an idea that everyone should feel bound to pursue. It's something suitable only for those with a prior desire and understanding of what's involved.) I will be doing my best to try to identify that juncture for myself, and should I get an opportunity to take action, I will make readers aware of what I do.
Meanwhile, the implications of the dollar's decline (both thus far and what's still to come) have been lost on most folks. I think it might be useful to lay out the psychological progression, whereby folks' complacence turns to perception of a potential debacle, and what that might mean.
- First they have to recognize that something serious is under way.
- Next, they have to react to that awareness.
- Then, they have to take action.
- Then, we usually see excessive action.
- Then, we see wild overreaction.
This entire sequence is still in front of us, since very few people have even identified the dollar decline as a problem. In fact, I continue to hear the same misguided talk about how a weakening dollar is great for us. That has been completely predictable, as I have noted in the past, because it's what people always say when the dollar starts to weaken.
The problem with greenback-breaking choreography
The problem is, you cannot get your currency to go down a little bit to where you want it and then assume it will stop there. Once these things are put into motion, they always go longer than you think possible, and they always overshoot. I think we have an incredibly dangerous period in front of us, as our financial, economic, and balance-sheet situation is far riskier than the last time we had a dollar crisis, which was in 1987. (The dollar started to fall after the United States and major trading partners decided to push for a lower dollar in the 1985 Plaza Hotel agreement.)
The economy in the spring and summer of 1987 was overheating. Now I believe it's getting set to contract. The world is swimming in dollars. We have a monstrous amount of debt outstanding. The size of our trade deficit, $1.5 billion a day, is just gargantuan. Plus, we've got trillions of dollars' worth of derivatives exposure. So, if you wanted to set the stage for a potential dramatic accident, it's been set.
I can only shake my head at the economic folly of the last seven or eight years as we have tried to speculate our way to prosperity. So many people have been misled into thinking the policies were all good or manageable. How this all plays out is not yet knowable, but it's a given that we face financial and economic turmoil. When one's own government, against a backdrop of precarious fundamentals, stands up and says, "Sell our currency," which is basically what Snow did, it's ultimately a recipe for disaster.
A bubble is growing in the fixed-income world
Over in bond land, that danger has been overlooked recently, with prices staging huge leaps that can legitimately be described as bubblelike activity, and reminiscent of the action in stocks during the mania. It appears to me that there is asset allocation going on, in terms of folks who own bonds selling bonds and buying stocks. That does not affect the fixed-income market at the moment because all the levered-up players there continue to pile into the carry trade (a strategy of buying longer-dated fixed-income securities and borrowing against them overnight on a leveraged basis). But one of these days, the declining dollar will have an impact on the fixed-income market, I would think, forcing interest rates higher. And then all hell will break loose.
Meanwhile, though I think fixed-income is a bubble that is destined to end in an ugly mess, I would caution readers against attempting to short this market. Trying to fight markets when they get into blow-off stage can be very, very tricky. This also holds true for the housing stocks, which have also seen extremely frenzied activity. In the absence of a catalyst -- and in both of these cases, I can find none -- I, myself, prefer to short a failing rally.
Unsettling news about financial reform in Japan
Turning to the news, for those of us who have been awaiting a chance to become bullish on Japan, it was somewhat disturbing to learn of chatter that reform-minded Heizo Takenaka, who runs the Financial Services Agency, might be forced out by the powers that be in the old, decrepit Liberal Democratic Party. This comes via a story in last week's New York Times titled "Japan Bank Regulator Weighs Departure." In his fine summation of the situation, writer Ken Belson says, "Though investors have generally applauded Mr. Takenaka's tough-love tactics, many powerful Liberal Democratic lawmakers are afraid that his proposals could push politically influential businesses into bankruptcy proceedings and increase unemployment."
To take a step back, one week earlier, The Wall Street Journal (in a story called "Suddenly, Evidence That Japan Has Found the Right Playbook") had reported that the Japanese government had bailed out Resona Holdings, the country's fifth-largest bank. On reading this, I thought to myself that finally, the process of clearing the dead wood out of Japan's banking system might indeed be starting to work. In essence, rules created last fall by Takenaka were starting to be enforced. As the Journal story explained, he put into place a "manifesto for reversing the country's deteriorating economy. Takenaka's plan was to force lenders to make changes that had been put off for years. Banks would have to write off billions of dollars of bad loans that weren't being recognized, shore up capital that had been depleted to critically low levels, and get serious about finding ways to turn a profit again."
However, as time went by and not much happened, questions arose on whether he could really pull this off. Then recently, the Financial Services Agency, whose job it is to watch over the banking system, took action on one of Takenaka's rules, which basically enjoined auditors to start doing their job. As the Journal reported, it required "auditors to rigorously audit deferred tax assets, and strictly check whether such assets of major banks are adequately booked." Resona failed to meet the new guidelines, which led to its undoing and subsequent bailout.
Interestingly, Japan's market took the news in stride, with Resona's stock surging 20% the day after the rule was enforced. Folks who are knowledgeable about Japan could not have been faulted for expecting to see some damage to the downside. This might have been a dramatic example of bad news no longer mattering. The Japanese market could have been signaling its belief in the effectiveness of the new regulations to bring about reform.
Quashed by the status quo, for now
Now, the news of a potential exit by Takenaka may call this optimism into question, and it underscores how fragile optimism about Japan can be. Tokyo-based Robert Feldman of Morgan Stanley had told the Journal, "In the past, promises to do something always got postponed. This is the first time that a change in rules is actually being enforced." Also in the story, Steve Roach, Morgan Stanley's well-known global chief economist, said, "This initiative hints that the heavy lifting of Japanese financial-sector reform could at long last be under way. If that's the case -- and it remains a big if -- we then need to look at Japan in an entirely different light."
So, the accent remains on "if." Folks like myself who would like to see Japan on the mend think that Takenaka is doing the right thing, and Japan needs more of it. Unfortunately, others who favor the status quo in Japan continue to wield a fair amount of clout. I believe the mending process is under way and will be completed, with or without Takenaka, but certainly, it's going to be more productive if he remains in power.
Let’s test the stock-shock absorbers
Meanwhile, I will continue to keep Japan on my radar screen as a potential place to invest. What's kept me from committing funds thus far are my concerns that 1) the government lacks the conviction to make the needed changes (witness this latest news about Takenaka), and 2) my fear about what the negative fallout from our bubble would mean for Japan. I would like to see our market and our economy discount the problems that I believe lie in front of us, and see how the Japanese market responds to a dislocation of that magnitude here. Getting that bad news discounted in the Japanese market would make me feel more comfortable about investing in Japan. Whether things will play out in that way and provide me that opportunity, I can't say at this juncture.
As for price, Japan appears to be a bit of a dichotomy. Large-cap Japanese stocks are still quite expensive, but many small-cap stocks are very reasonable. I have not looked at these myself, but my friend Jim Grant has a hedge fund that specializes in small-cap Japanese stocks. He has told me many stories of stocks there that are dirt cheap. If it becomes time to turn bullish on Japan (my guess is that sometime between now and the end of the year could be the time to pull the trigger), I and others have some work ahead of us, in terms of ferreting out stocks to buy. Given that Japan continues to be a story of two steps forward and 1 15/16 steps back, there may be time enough to do that work.
(Bill Fleckenstein is the president of Fleckenstein Capital) |
