Uncertainty and the 
Dollar Short Squeeze

Unusual period of uncertainty
Isn’t all of life uncertain? The answer is yes. But, every few decades, financial, or economic, uncertainty escalates to a level which generates widespread fear and panic. During those times the financial markets act in unusual ways…ways they will act maybe two or three times per century on average. Today we are in the midst of one of those times, and I suspect there are very few people unaware of it. But I wonder how many people really understand why we are where we are. I want to discuss some of the things I’ve learned about this unusual period of uncertainty. As usual, it won’t be my wisdom, but what I have learned from the experts in whom I have confidence, those I believe the Lord has led me to. As I write, I pray that will be the case. 

For just the last few months, almost every single asset class, including stocks, commodities, and real estate, whether publicly traded or not, has been falling relative to the dollar, i.e. its price in dollars has been going down. (US government bonds have not fallen in price because they are a proxy for the dollar and perceived as a safe haven to which people flee in panics; most other bonds have fallen in price). Why is this happening?

A short course in shorting
In case you are not familiar with “selling short,” here is a quick explanation. Our capital markets are structured so that an investor can buy any publicly-traded security. But he can also sell almost any security, even if he doesn’t own that security. If he thinks that security is likely to go down in price, his broker will arrange to borrow the shares he wishes to sell so that they can be delivered to the buyer. This is called “selling short,” and the investor making the short sale is required to put up a cash deposit with the broker in case the price moves up (against him) triggering a margin call for the amount of the seller’s loss. If the margin calls reach a large enough level, the short-seller can be forced to buy back what he sold. When this happens suddenly, or on a large scale, when many short-sellers are caught on the wrong side of their trades, a “short squeeze” can be created. All it takes is for enough buyers to put in orders, pushing the price up and triggering more margin calls, which in turn triggers more buying, forcing the prices of the securities involved to rise faster and farther than under more normal trading conditions. 

Keep in mind this concept of the short squeeze, which can unexpectedly force many investors to act involuntarily. I’m going to suggest something very similar is happening today, only the short squeeze is in the US dollar. People are being forced to “buy” the dollar. But wait a minute, you can’t “buy” the dollar. No, but you “acquire” the dollar by selling some other asset, any other asset or assets which you own. And why would you do that? Because you run out of money to pay or service your debt, or you’re just scared by the fall in the market value of your investments. 

Think of it like this. When you borrow money, you are creating a “synthetic short” position in the dollar (I first heard this term from Richard Russell). You do it with very good intentions, perhaps to buy a home which you assume will go up in value, or a stock you assume will go up in value, or to increase your standard of living with the idea of repaying it out of future income. Perhaps things go well for a time, then the assets you bought with the borrowed money begin to fall in value, and your income is not enough to service your debts. You are “short” of dollars and forced to sell whatever you have to cover the shortage.

Now switch your thinking to the macro level…our nation. For several decades we have created the largest debt pyramid (both public and private debt) in the history of the world. Mortgage debt has grown completely out of proportion to value. Credit card debt has increased exponentially. Thousands of hedge funds have been created, most of them borrowing additional funds in an attempt to increase their investors’ returns. Some have leveraged their investor’s money as much as fifty times. The debt pyramid has begun to rise exponentially over the last few years. The debt pyramid has created a gigantic synthetic short in the US dollar. All it took in September 2007 was for a few sellers who understood what was happening to begin selling stocks and commodities, and meeting most of the buy orders with sell orders, and the next big down leg in the secular bear market which began in 2000 was underway. Most people didn’t notice what was happening until months later. Prices came down in a fairly orderly way until about May, 2008. Then a lot more people began to notice what was happening to their IRAs and 401-Ks. Not until September, 2008 did the market fall off the cliff and begin the acceleration phase of its crash. By then, the dollar short squeeze had kicked into high gear. 

In March, 2008, I did an in depth review of four of my experts, and what I learned scared me. I reported my conclusions in Letter 19 dated March 13, 2008. The most important conclusions were that all these experts were holding a cash reserve near 50%, and all four felt that stocks were either in a bear market, or had lower prospects than other asset classes. I also said that the secular commodity bull market was due for a correction, and stated that a correction of 25% to 50% could come at any time. I came away from that study with a deep conviction that I needed to make a major allocation change in my portfolio. At the time, I was about 40% in stocks and less than 20% in cash. Over the next few weeks I reduced my stocks to below 20%, and my cash to over 40%. These changes were reported in the letters and portfolio transactions on the web site. This reallocation has had a very significant positive impact on the performance of my portfolio for 2008 year-to-date.

Hindsight is 20-20
I am still thanking God over and over for the wisdom He gave to me through my experts. But neither they nor I knew what lay ahead last March. If I had, it would have been a simple matter to simply sell everything and be 100% in cash today. If I had done that in March, I would be well ahead of where I am today. But that’s not the way it works. All my experts are down, and I am down for the year-to-date. And any other investor who is not 100% in cash is down. That brings me back to the subject of this letter. What should our strategy be based on the assumption we are in the 1st, 2nd or 3rd worst financial crisis of the last 100 years? 

Three to five year strategy
First, here are my major allocations as I write this: Stocks 12.2%; Physical Commodities 53%; Cash 34.1%; Misc. 0.7%. There is so little change in these from the last allocations I reported (November 14, 2008), I am not going to detail the whole portfolio. I made two or three very small transactions, but the allocations are almost identical. I will disclose any significant changes as they occur, otherwise I will wait till year end to publish another portfolio. I’m not motivated to do much of anything at the moment except wait for more clarity. I will lean on my experts for that. Which brings me to my working hypotheses for the 3-5 year period ahead.

Working hypothesis for the period ahead

THE BEAR MARKET IN STOCKS: I doubt the final bottom in this bear market has been reached, but there is no way to know. Interestingly, the technical evidence suggests we are in a rally, which could last for several months, and carry the Dow and S&P 25% to 35% off the recent bottom. After that, we could easily see the lows tested. I haven’t seen strong evidence of a final capitulation bottom. I wouldn’t be surprised to see a 5,000 Dow, but there’s no way to know. Strategy: Since I’m only 12.2% in stocks, I will sit tight. If I had more than 20% in stocks, I would either switch the excess dollar for dollar into the Permanent Portfolio (PRPFX), or use any rally to lighten up. I’d move cautiously in small steps and not try to act too dramatically, making sure my cash didn’t drop below 30%. I don’t have the courage to let that happen right now. Remember: Uncertainty.

THE SECULAR COMMODITY BULL MARKET: Based on Rogers and Maybury (and others), I have a strong conviction the commodity bull has another 8-10 years minimum to run. The 50% correction I mentioned in March has occurred, which indicates commodities as a class are excellent value here. But we have no evidence that a bottom to this correction is in. I am willing to take a few tiny nibbles, but don’t have the courage to do so at the expense of my cash falling below 30%.

AGRICULTURAL COMMODITIES: If Jim Rogers believes agricultural commodities have a better prospect than any other commodities (including gold and silver) or asset class, and that’s what he says, I feel I must take him seriously. And he is buying them even as they continue to make new lows week after week. He says their fundamentals are growing stronger every month, and I believe that is true. I have made some tiny nibbles so far (DAG, DBA and RJA), but they have gone down since I bought them, and there is no evidence of a bottom. Whatever I do, I won’t let my cash go below 30% until there is evidence of a bottom. At the same time, I feel I must have a meaningful position in them some day, but I don’t know how much or when.

GOLD AND SILVER: My faith in gold and silver is unwavering. Based on what the government is doing, as far as I am concerned, all roads lead to gold and silver. The trillions of new paper dollars they are creating out of thin air, along with the debt pyramid suggest to me that after this dollar short squeeze ends, we will have a long period of high inflation, if not hyperinflation. There may be a lag of 2-4 years, so timing is uncertain. As I compare the year-to-date performance of gold with stocks, there’s no doubt which I would choose. I’m holding my gold and silver.
 

GOLD MINING STOCKS: I have a conviction that when the next leg up in gold occurs, the better mining stocks will fly. They have been completely decimated, and could provide huge leverage to the move in gold. There’s no point in trying to select individual stocks. GDX, USERX and TGLDX are all very acceptable vehicles for this play. But never forget that they are speculative and must be included within the limit of your stock allocation.

As far as I can tell the dollar short squeeze is not over. At the moment cash is still king. What an irony! Right at the moment when the dollar is the most sought after asset on the planet, the government is in the process of destroying more of its purchasing power. Sooner or later the dollar bull will end, and people will begin to realize the dollars they acquired by giving up real wealth assets are practically worthless. Some day the government will be forced to take some kind of action to restore confidence in the dollar. This could happen fairly quickly, or it could drag out awhile. I’m happy with my allocation whichever occurs.

I wish all of you a blessed holiday season………………..Jay