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26-May-09
Weak Dollar = Strong Commodities
As discussed in my weekly newsletter EPIC Insights, economic textbooks teach us that money should be both a medium of exchange and a store of value. Its use as a medium of exchange is straightforward. As long as two parties agree that they are exchanging items of value, they do not care what actual form the currency holds. From wampum to pieces of paper, if value is perceived exchange occurs. When it comes to money's role as a store of value, things become more complicated. For centuries, money has been backed by some tangible asset, namely gold. However, when President Nixon closed the gold window in the 1970s, we embarked on a new path-that of fiat money.
Fiat money is backed by nothing other than a country's willingness to accept it for payment. With a guarantee that consists of only a promise, it is questionable how a fiat system can replicate a tangible asset as a store of value.
For nearly 40 years, people have ignored this problem as central bankers managed the supply of fiat currency, markets moved higher, wealth was created, and living standards improved. Now all of that is changing. As central banks worldwide print more currency and governments increase their debts, fear of an increasing money supply has called into question the future of fiat money.
As a pure example, consider the U.S. dollar. The U.S. dollar serves as the world's reserve currency. The U.S. dollar has often been seen as a safe haven in an uncertain world. When markets were imploding last fall, the U.S. dollar raced higher as investors sought a secure place for their money. Now that flow is reversing. Fearful of mounting budget deficits, a Federal Reserve (Fed) that will continue to increase the money supply, and a political climate that is anti-capitalistic, the dollar has entered a free fall as investors flee.
One way to determine both the path and duration of a downward move in the dollar is to use technical analysis. Weekly charts illustrate that the dollar has created a head and shoulders top that points to lower values. A head and shoulders involves a rally within an existing uptrend (blue line) to create the left shoulder, a decline followed by a rally to a new high to create the head, and a final decline and rally which fails to top the recent high thus creating the right shoulder. Given their complex nature, head and shoulders are unique patterns with great predictive powers. Having carved one for the U.S. dollar, we should expect it to decline at least an additional 5% over the coming weeks.
Fibonacci retracements show that any additional dollar weakness will lead to a likely retest of the 2008 lows. Were this to occur, we should expect a decline closer to 10%.
Expecting dollar weakness, we must now determine an investment approach. Some will look to companies with large foreign exposure, while others will consider currency ETFs. I will take a different approach by focusing on an asset class that will perform well when the dollar weakens, but that also diversifies our existing portfolio risk: commodities.
Commodity prices are influenced by factors ranging from economic growth to the weather. However, a weak dollar trumps all else. With most commodities priced in dollars, dollar weakness has little effect on demand as well as little effect on the actual cost to a non-U.S. commodity user, but it does cause huge swings in prices. When the dollar drops, commodity prices increase. From a risk-management view, commodities have low correlations with other asset classes and provide risk reduction when combined with an existing portfolio.
For retail investors, many ETFs provide commodity exposure. I prefer the Powershares DB Commodity Index Tracking Fund (DBC). Based on the Deutsche Bank Commodity Index, DBC is diversified across energy, metals, and agriculture to provide broad-based commodity exposure. Using this ETF allows the investor to focus on the general direction of the asset class instead of trying to determine which segment of the market will do better than others. Looking to profit from a falling dollar while reducing portfolio risk, I recommend a position in DBC as this week's fundamental trade.
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