A Weekly Outlook and Analysis of the
Global Investment Climate
November 6, 2000

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Declining Dollar utilities

Message for the wise men of the nation

What you say? The Euro is in free fall, quietly followed by the Canadian Looney, and only slightly louder are the tumbles of the Australian dollar and pound-sterling. Even Gold is getting clobbered. More like declining Euro or gold utility it would seem. I had not realized how much I have taken the term utility for granted, until a recent meeting where I tried and subsequently failed to explain the concept to a friend of mine over {tea} last week. To be sure, it isn't an easy concept to understand. But I will try to help do that today, for it is important to understand what I mean when I say that the aim of US dollar policy is to constantly seek to maximize its total and marginal utilities any way possible. And this is done in order to keep your focus away from the objective exchange value of the dollar.

I will explain the Ludwig von Mises concept of objective versus subjective value a little later, but what I intend to prove is that in the face of generally rising commodity prices (the objective value of a currency) and weak domestic capital markets, the ability of the Treasury to maximize dollar utility (using political tools outside of the confines of economic borders) is compromised. When this is generally recognized, we will "see" a massive inflation breakout in the United States as the subjective value (approximated by the fiat exchange rate) of the dollar gives way to its objective value. Whether the Fed will be able to stop it or not, will depend on how fast Greenspan can revert to his own objective roots and how much resolve he will ultimately have. Mr. Greenspan may not be the right man for the job, especially if he is wrong about the productivity (odds are he is) gamble.

Even though the dollar has been as important to world commerce as water is to human survival, both are equally plentiful (for the moment) and thus without true economic value. We are literally swimming in a sea of paper currency whose only worth is to inflate assets, but as global commerce ebbs (recesses) under its own weight, we are finding that the dollar is not so useful in buying real things. Especially when there are so many more dollars than some of those scarcer, real things. Though I have touched on this before, I think it is important to make this observation clear. While the stock market regularly creates and destroys wealth, it does not directly create or destroy the money supply. Furthermore, while it is in the process of creating wealth it easily absorbs additional dollar liquidity, even while encouraging more money creation. For years, the world has been buying the easily printed dollar in order to shovel it into the perpetually rising US asset markets. This process peaked, however, somewhere in the middle of 1999, according to our data.

Note that while the advance decline lines have been falling since 1998, this only meant that the "broad" bull market began to contract and resolve in a narrower and narrower leadership. We know that fewer and fewer stocks have been rising in recent years, and we know that more and more investors have been losing money since the second half of 1999. We know this anecdotally and we know this by looking at a chart of the gross private savings pool. We also know that by the end of 1999, 80% of the big board was flat to down on the year. What we do not know is precisely when more stocks began to generally decline than to rise, though we would place it somewhere in the middle of 1999... shortly after investors ostensibly began to have a tough time with the market.

We argue then, that the broad peak of the bull market coincided with the peak in the advance/decline line in 1998, but that the "wealth destruction" began one year later, by mid 1999. Some would argue that it began at the beginning of 1999 when bond markets began to fail. Not coincidentally, the price of oil and other commodities began to rise significantly near that point in time, but the US Treasury (endorsed by the Fed) fixed that problem a few months later by buying the Treasuries at the turn of the millennium. What a scandal that will be one day, perhaps when we have a different perspective on today.

Light Crude Oil Futures	30 year US Treasury bond

 

What does this mean? What it means to us is that the optimum economic utility of the dollar has peaked. When US asset markets began to malfunction, the "objective" exchange value of the dollar appears to have become the focus of investors who needed oil. What they found was that they could not get enough scarce oil for their abundant paper any more. Perhaps because the conventional utility of the currency has become less certain, it has begun to influence some perceptions about the unit's ability to function as a store of value, or its future purchasing power. When people begin to ask this question, it can only resolve through a reversion to objectivity, and thus objective exchange values. Ouch. From this perspective, reports of private oil inventory accumulation in Europe might be taken as a confirmation of our hypothesis rather than as a potential "supply" glut.

But what if the Bull comes back
The big bull is putting on a good fight. As exhausted as it is, and still mustering the strength to snap the important blue chip "averages" back above the 200 day moving average. Yet this is far from good reason to get bullish. You will notice nothing new here. In fact, it is the very same type of fight that has been carrying on to keep you bullish ever since about the middle of 1999. Only it is weakening rather than strengthening. Look for yourself:

Dow Industrials	NYSE Composite

Consider the observable fact that the last real meaningfully "broad" stock market rally happened to end in July 1999. Also looking at these averages, observe the three sell offs (excluding the last one), which sliced cleanly through the 200 day MA. The bull responded each time by snapping the averages right back above the "widely watched" trend line. But each rally in the averages took fewer stocks with it.

{Note the advance decline line}

The implication is that the broad market continues to weigh (in fact the broad market is already a primary bear in our opinion) on the statistical averages, yet the increasingly exhausted bull still insists on cheating your perception through the narrow leadership.

This time, the target of its fancy was to give the Dow averages a good jolt. Dow's Transportation issues put in one heck of a rally early in the week, keeping their heads slightly above water, while the Dow Utilities took another run at resistance points. There is enormous confusion in the midst of all of this. Why are bulls buying transportation issues? Because they think that oil prices will come down now? Why, because the economy is slowing down? Those perceptions combined with a slowdown will only aggravate the real issue driving oil prices. And should they be right, why buy the "expensive" Utility issues, which have priced an energy crisis premium into share prices?

In the meantime, the Tech markets and the SP500 have been having trouble not only staying above their 200 day moving average, but in sustaining any rally at all. The bull has seemingly abandoned the technology market all together?

Inside The Market
Mostly, the sectors that have been leading this bull so far this Fall, can be placed into two categories - those which would benefit most from an energy crisis -- oil producers, natural gas, and power/energy providers - and those that have benefited (read past tense) from all of the political noise and bogus promises made during the election campaigns - the drugs, biotech's, healthcare, and aerospace.

As for last week, the industrials got mild support from some of the financials, decent support from Coca Cola, and strong support from Merck and Phillip Morris. But much of the broader support for the industrials came from more than a few relatively mediocre reversions to the mean for some of the stocks in a real downtrend

JP Morgan Co	Philip Morris

Intel Corporation	Home Depot

There was some nibbling in Alcoa and International Paper, but that would only confirm our hypothesis. All in all, the question of leadership is up in the air. I am looking for the drugs, biotech's, and the other healthcare issues to start giving the industrials trouble after the election is over as participants are lined up to sell on the news. As for leadership post election 2000, it will not be in the stock market. It will be in the commodity markets.

Global Markets
The same basic truth holds for the equities picture in Canada and Europe. Both the FTSE (London Financial Times Index) and the Euro top 100 responded to mid October's decisive sell off by pushing their heads slightly back above that 200-day MA. However, both the French and German stock indices look even more bearish than either the FTSE or the EURO 100.

French CAC Index	German DAX Index

And while the same may hold true for the Hong Kong stock market, the Tokyo Nikkei has been leading the way down the abyss.

The interesting thing (to me) is that the Yen has hardly budged, while the Nikkei is down more than 30% since April. Yen spot prices show a better than average bullish bias within an eight month trading range, while the nearby futures appear to want to break out of a falling wedge. I wonder if the dollar would hold as well on a Dow 7400 target?

It's the inflation, stupid
Even though Bill Gross has been buying up the US Treasury bond, the chart seems to have lost some momentum on the week, keeping bond prices well contained within a wedge and yields showing some bullish bias just under the third trend line of what looks like a very bullish fan.

The government regulated precious metals and oil markets are weighing on the CRB a little bit. And I mean a little bit. Oil prices, for instance, have met selling pressure consistently over the past 10 days but have not caved. The bullish bias in the long-term chart is nicely intact.

Gold futures continue to trend lower, apparently intent on testing old lows against the dollar from last summer (before the signing of the Washington Agreement) and on obscuring the obvious dollar inflation against everything else.

From the February peak at around $330 to last week's lows near $263, gold prices have declined 20% while the dollar index has gained roughly 14% against its major trading partners. From the last August (1999) low at around $255 an ounce to last week's (52-week) low at around $263; gold prices have gained a whopping 3%. But the dollar index over that time frame gained about 20% against the currencies of its major trading partners. This is a good thing as it shows that gold prices have been generally keeping up with the rapidly rising US dollar's fiat exchange value.

The strong dollar has again begun to accelerate the declines in other currencies. The Australian dollar and the Canadian dollar have led other developing market currencies much lower over the past two weeks, from Indonesia to Latin America. While the Aussies are known to sell their gold for dollars, on dollar strength, the likelihood that smaller countries have been selling some gold in exchange for dollars to support their own currencies has increased considerably as their currencies go into free fall against the powerfully politicized (imperialistic?) dollar.

Yet the parabolic nature of the dollar's ascent (mainly against other fiat) is out of line with its increasingly bearish (objective) fundamentals. Though support for this rise has come enthusiastically, from Europe over the past five years (Europeans also are guilty of fervently throwing their own plentiful new currency at the American bubble cause), the European Central Bank has signaled that enough is enough last week when it began buying Euros with or without the politically frozen Fed.

This could work in favor of the Euro if the central bank (ECB) stops worrying about whether the European economy can withstand tighter monetary policy or not. The fact is, that it cannot afford to risk the alternative. Watch for signs that the bank moves in this direction, as it will mark the end of the dollar buying cycle.

Economics
Evidence = Truth = Denial (for those on the wrong side of the trade)

Ignoring the wage inflation, Wall Street started the week off with an applause for the previous Friday's set of weaker than expected economic figures, as it reasoned that the wise men of the Fed would clearly react to this evidence, by lowering interest rates soon. From where I sit, it is as though the bull is still begging big Al for some interest rate help. I do not think, however, that it has considered the market consequences to help from the lender of last resort, which subsequently does not work. This is clear by glancing at the various sentiment indicators, which show that stock bullishness remains generally high.

CBOE Put / Call Ratio

Yet oil prices remain firm in the face of threats of US and Saudi "intervention," and wage data show acceleration in the hourly figures. Surprise. In Wednesday's beige book, US regional banks confirmed this anecdotally, with concern for accelerating wages in many of their own districts. Furthermore, there was some discussion about at least one account where a manufacturer was able to pass on its higher costs to customers. The situation ought to worsen as losses in the purchasing power of the currency mount and become ever more visible to the naked wallet of the average American. We'll see if there are any surprises in this week's producer prices. There was also some reference to strong loan demand, and I am very interested in what the consumer credit figures will look like on Tuesday.

But When…
When are all of these things supposed to happen? Why can't they just keep the party going like they have been? After all, they have been doing great so far. Look how wealthy we are.

Well, it is not going to happen. It "is happening." This is precisely what I am really trying to tell people. Right before our very eyes, and the wise men governing our perceived wealth are lying to us about it, if they are telling us it is not happening. Forget about the twenty years of prophecy from the gold industry, calling for it to happen before this day. Unfortunately, the prophets were not good market timers. For example, now they are short. But so what, maybe they have simply been gifted with the wisdom of a logically correct diagnosis, which has proven to be more a burden than a profit (hah-hah).

The point is that the fabric of our current monetary system has been worn very thin. We really do not have to look far beyond an inspection of the conspicuously deteriorating quality of the nation's debt structure, which has been holding together only by virtue of its own ability to continue to grow, and which really represents the fabric of the dollar dominant global monetary structure. We need to explain the incredibly meteoric rise in oil prices better than with some babble about how OPEC can withdraw 3 million barrels a day (from a market which consumes 25 times that each day), which it then replaces, and cause oil prices to more than triple in under two years? Why couldn't they have done it before? They would have lived much better over the past ten years.

The reason is that they did not have the advantage of declining marginal dollar utilities working in their favor, which they undoubtedly have today. That is why it is working this time.

And while Wall Street, the financial media, and the Fed explain this by pointing to either the wealth effect (rising aggregate demand) or supply side imbalances in the oil market, the reality is that the dollar has little objective utility outside its use as a medium of exchange in the field of global finance. The facts should speak for themselves. In fact, it is my contention that significant inflation cannot be avoided now unless a new economic or political utility for the enormous global sea of dollars is to be invented, one that is larger and more effective than the benefit that extremely top heavy asset markets might provide for every additional new dollar printed in the future. Even war is unlikely to increase the global demand (or utility) for American dollars as any war would have to be with someone who doesn't already own too many dollars, yet is important enough that it would encourage global political support and possibly a global stampede into the US dollar.

The Arab community is a convenient target for political aggression because they make it relatively easy to round up global political support against it. And as the experience with Vietnam proved, it is important to gain global political support for such action. For it was the lack of that support which forced increasing calls on US gold in exchange for dollars in 1971.

The irony is in Iraq's proposal to offer crude in Euro's rather than dollars. It is ironic because what I say is so true that it has formed the foundation of Saddam Hussein's attack "on the dollar." Global leaders are well aware of the increasing dollar problem, which is why the US is taking "political" steps to try and prevent Iraq's move. Theoretically, it is in the ECB's and all of Europe's interest to allow Iraq to price their oil in Euro's rather than dollars, but unfortunately for European citizens the subjective value of the Euro is supported more by its dollar position than by it holdings of gold or oil. Even if it were to denounce the dollar publicly, the Euro might survive but the country would be in economic peril.

So long as politicians continue to try and weave all sorts of creative (forced) new utilities for the sea of dollars, they will avoid doing what they must to prevent a devastating loss of purchasing power in the US dollar, including telling you the basic truth about US dollar policy. A truth that Iraq, and others, is well informed about... indeed.

So, what is Marginal Utility?

Marginal utility is generally defined as the marginal 'unit' (an abstract relative quantity) of user satisfaction resulting from the consumption of each additional unit of the good.

Generally, the more abundant is any particular good, the less will be the "marginal" utility of each additional unit than will be for a good, which is far scarcer... even if its total utility is very low. While very abstract, the concept of marginal utility, for instance, helps us to understand why something with so much total "utility" (use-value) such as water can be worth so much less than a diamond, which by simple scarceness commands a higher "marginal" utility. It allows us to understand and better explain the laws of demand.

Ludwig von Mises showed that when applied to money, the concept of value is either objective or subjective. If it is to be objective and therefore useful to us in ways in which most other commodities are not, its ultimate value lies in how much of a good it can acquire. If it is subjective, its value lies in our "perceptions" of its future objective exchange value. This differs from the concept of value as applied to most other commodities, in that the subjective value for most commodities can rest with the value of the use of the good without an objective exchange rate.

As Mr. Greenspan says (paraphrase), "there will always be some sense across time and space for the purchasing power of a currency unit by individuals exchanging goods and services for it." It is strange that in these times, the genius of Ludwig von Mises' work has suddenly become so relevant as to provide us with at least a directional answer to our present monetary conundrum.

The central element in the economic problem of money is the objective exchange value of money, popularly called its purchasing power. This is the necessary starting point of all discussion; for it is only in connection with its objective exchange value that those peculiar properties of money that have differentiated it from commodities are conspicuous.

This must not be understood to imply that subjective value is of less importance in the theory of money than elsewhere. The subjective estimates of individuals are the basis of the economic valuation of money just as of that of other goods. And these subjective estimates are ultimately derived, in the case of money as in the case of other economic goods, from the significance attaching to a good or complex of goods as the recognized necessary condition for the existence of a utility, given certain ultimate aims on the part of some individual. Nevertheless, while the utility of other goods depends on certain external facts (the objective use-value of the commodity) and certain internal facts (the hierarchy of human needs), that is, on conditions that do not belong to the category of the economic at all but are partly of a technological and partly of a psychological nature, the subjective value of money is conditioned by its objective exchange value, that is, by a characteristic that falls within the scope of economics.

An excerpt from The Theory of Money and Credit; Part Two,, chapter 7
by Ludwig von Mises

If you didn't get that, don't worry... try this. Mises describes the concept of utility in terms of a use-value. The basis for what many economists might more vaguely describe as a quantity of satisfaction from the use or consumption of that good. That the subjective value of a good is a function of someone's perception of the good's potentially objective use can equally apply to money (as a medium of exchange for instance), but that with money its use-value is ultimately dependent upon its objective exchange value. This is because part of the utility of money is to provide as a store of wealth. Many would argue that in fact, this is not part but primarily the role of money.

Whereas it is possible for a commodity to have a use and thus a subjective value even without an objective exchange value, it is not possible for money to exist without an objective exchange value. Accordingly, the objective exchange value of the dollar appears to be in steep decline for some of the basic necessities of life, its subjective use-value, which has been primarily in the field of global finance, has deteriorated significantly as well. Which came first? Excess dollar supply came first, but more recently, the evidence suggests that deterioration in the long maturity Treasury bond may have represented the point at which the subjective value of the dollar had peaked and gave rise to an inflation expectation set. As the expected rate of return on dollar denominated assets began to gradually decline, dollar owners found it increasingly difficult to exchange the dollar for relatively scarcer goods, such as oil

So do inflation expectations precede inflation? Yes and No. They may precede the point, at which the inflation becomes less stoppable, but they can never occur with an anchored monetary policy.

Sincerely,
Ed Bugos