Friday, August 8, 2008

Trees Don't Grow To Heaven

Long ago I learned in an earlier commodity boom that excess breeds its own demise. My boss, a quite brilliant trader, had bought huge amounts of silicon metal back in the early days of the first energy crisis. OPEC was flexing its new found muscles and the world was about to get its first taste of pain at the pump. Silicon metal is referred to as "solid energy" because of the massive energy consumption needed to produce it. He nailed it.

Eventually everyone else in the metals trading industry was pounding on that same nail, but by that time, Jean-Pierre had already decided to convert his strategy into a new eighty foot sailboat. The man knows how to live. Years later when he had taken me under his wing and another product was climbing with no end in sight I learned about crowded trades and falling trees. A boat with all the passengers on the same side is apt to capsize. There are times when you need everyone on the same side, but be ready to move quickly when conditions change.

The US Dollar has been whipped on mightily for the past few years, and rightly so. Our fiscal and trade deficits, our negative savings rate as a nation, and negative real interest rates have not been very attractive to the world at large. Only the dollar's role as the global reserve currency has kept it from getting worse. However now I think it's time to get ready to move back to the middle of the boat.

The economic conditions that have been on every front page for the past year relative to the credit crisis have spread globally. The European Central Bank has long had as its primary mandate the management of inflation. Conversely the Federal Reserve Bank has a dual mandate of managing economic growth and inflation. However, this past week Jean-Claude Trichet, the ECB president gave a press conference in Frankfurt in which he went out of his way to comment that while inflation is still a threat, risks to economic growth are materializing. In a world of supreme nuance this is a statement worth hearing more loudly than the soft words.

One of the primary reasons for the Euro's strength against the US Dollar has been the steady decline of US interest rates while the europeans have held relatively steady. As (or if) that gap diminishes the dollar may undergo a substantial retracement upward against the Euro. I believer the Euro tree is about to fall.

So how does one approach this potential inflection point? We began to underweight commodities earlier in the summer, have kept precious metals allocations low and begun looking more favorably at US domestic equities versus international. This does not mean everyone rushing to the opposite side of the boat, but edging slightly away from our long held preference for foreign equities.

Over the long term, the United States problems look engrained and exacerbated by continuing globalization pressures, the demographics and emerging economies and the shift of wealth away from the US, but there may be a few too many folks on one side for safe sailing at the moment.

John Barnyak
Stonehouse Asset Management