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November 20, 2004

The Three Stages of a Dollar Collapse
by T. Stein / S. McIntyre

Our bearish views on the United States Dollar have been formed over years of watching what we view as reckless and incredibly shortsighted policy decisions by the Federal Reserve. The chief culprits of this attack on the greenback have been none other than Alan Greenspan and his band of merry sheep spearheaded by Ben "Printing Press" Bernanke and Bob "Lever up & Buy an SUV" McTeer. We have never been shy about our belief that the most likely outcome to be spawned from the monumental current account deficit, trade deficit, and other enormous debt imbalances in our country is a sharp and severe devaluation in the U.S. dollar. Globally, holders of dollars will seek to diversify into other assets. We have seen a bit of this as the dollar index peaked in 2001 at over 120 and has since dropped to 84.

We thought it might be useful to readers to lay out the various stages of dollar collapse we see coming down the pike. In particular, we will be looking for three divergences in the coming months as signals that the dollar collapse is strengthening and that the gold/silver bull market (still in its early innings) is gaining recognition by the masses, which will propel the yellow and gray dogs even higher. We will hit the highlights of these divergences in an effort to get them on everyone's radar screen. The clear completion of each divergence should be viewed as bullish milestones for the metals.

Divergence One: Gold/Silver to Outpace Foreign Currencies

This divergence may already be getting underway in the most bizarre of sorts. Although the price of gold is up over 12% in the last year in terms of U.S. dollars, it is roughly flat in terms of the Euro and Swiss Francs. The same can be said for gold in Canadian dollars, Australian dollars, and Swiss Francs among others. Non-U.S. holders of gold have in many circumstances not seen any real appreciation in their gold holdings for the last year. Before this gold bull market is over, we believe this fact will change in a big way. From here it seems that highly certain that all currencies, particularly natural resource based economies with central bankers that have a clue, will continue to grind higher against the U.S. dollar.

However, the European Union is again showing signs that at the $1.30 level, their monetary leaders will grab the megaphone and try to talk the Euro down or at least slow its rise. Witness recent comments from European Central Bank head Jean-Claude Trichet, commenting that recent Euro vs. Dollar moves have "tend[ed] to be brutal...brutal moves [are] not welcome." The rest of the talking heads in the Euro zone have echoed Trichet's whining last week. The last time the chorus wrung their hands this loudly, the Euro retreated from $1.29 to $1.16; this time we suspect the market will be wise to the boys crying wolf and the gravity of the dollar's fundamentals will push the dollar even lower and the foreign currencies to fresh new highs.

Interestingly, we believe that even though foreign currencies will make new highs against the dollar, they will begin to drastically underperform gold. The value of gold in foreign currencies will rise, sparking even more buying around the globe as gold is the one asset that is no one else's liability. Unlike its fiat brethren, no weak monetary heads will be complaining about the rise of gold. Sure some central banks will continue to sell gold, but we suspect that as gold becomes their best performing reserve, central bank selling will dry up as well.

The preservation of purchasing power that gold (and silver) offers will again become clear to a nation of investors, which when coupled with the new gold ETFs, should spark a continuation of the spectacular rally in gold that began in 2001. Non-U.S. dollar currencies will do well, but in the end, they face many of the same economic problems that the U.S. does and as such will be far more earth-bound than the precious metals.

Look for the outperformance of gold versus foreign currencies in the next leg of the dollar decline.

Divergence Two: Gold/Silver to Outpace the Base Metals

To date, the metals rally has included both precious and base metals in a similar fashion. Both have gone up by appreciable amounts since their 2001 nadir. Gold is up from its $260 low to its current $437 an ounce - that is a 68% advance. The GFMS Base Metal Index however has more than doubled off of its 2001 low. The GFMS Base Metal Index has risen from 70 to 145 - a 107% increase. Despite being up 68% over the last 3 years, gold has actually underperformed the base metals in aggregate, thanks to meteoric rises in commodities such as zinc, copper, and lead.

The fact that base metals have rallied just as strongly (if not more strongly) than the precious shows that a good deal of the broad metals' appeal over the last couple of years is based on the belief that the emerging industrial powerhouse - China - will suck up all of the world's commodities. There is some truth to that and a lot of base metals were bouncing off depressed levels, but in the end, they are plays on continued robust growth in the world's economy in the next couple of years - something we would not want to bet on. Besides, anecdotal signs point to overcapacity on the horizon in China - at least in the short run.

In the weakening economy/stagflation type of environment that we envision, the desirability of buying base metals as a "robust world industrial economy and China play" is zilch. As such we expect to see the new buyers of gold and silver that will push them to higher levels will not be blanket metal buyers searching for a China play, but rather those that sense the world's fiat currencies are undesirable stores of purchasing power in the current environment.

As the world's economy slows, look for gold/silver to diverge on the upside from base metals as the monetary nature attracts legions of investors.

Divergence Three: Silver to Outpace Gold

We continue to be extremely bullish on both silver and gold. In fact, as gold diverges to the upside from foreign currencies and base metals, it may well do better than silver initially. Over time however, we suspect that the superior fundamentals of silver and the fact that it is a much tighter and smaller market, will ultimately lead it to outperform even gold.

From the two charts below you can see that silver is up 90% to date from its low while gold is up the aforementioned 68%. The two metals have basically moved in tandem to date.

Initial flows out of the dollar will likely find gold to be the easiest non-fiat platform to store wealth. Likewise, the gold ETF has been approved before the silver ETF and will likely help the yellow metal attract the media and individual investors' attention. Silver may well lie below the radar for awhile longer, but eventually its supply/demand picture coupled with its own ETF could propel it to incredible heights.

Please note your authors are long gold and silver and foreign treasury bills, so you should take our opinions with a large grain of salt, given our bias. As the dollar collapse continues, we will be looking for these three divergences: 1) gold outpacing foreign currencies; 2) precious metals outpacing base metals; and 3) silver outpacing gold as all healthy developments in a vigorous and intensifying bull market for Larry Kudlow's "barbaric" relics.

Todd Stein & Steven McIntyre
Texas Hedge Report

Todd Stein & Steven McIntyre are internationally known analysts and editors of The Texas Hedge Report, a market newsletter that highlights under and overvalued securities in the equity, bond, currency, and commodity markets. For more information, go to http://www.texashedge.com

Copyright © 2004-2008 Todd Stein and Steven McIntyre

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