Buy Dollars Wear Diamonds?

We recently added UUP to the portfolio which give some long exposure to the U.S. dollar. The response was immediate from clients who were concerned about the “free fall” the dollar was experiencing and the negative press the dollar garnishes daily and the impact on the state of the American economy. I don’t see it that way and a further review of the facts looks very different than investor perceptions. Truth be told, I don’t know where the dollar is going any more then I know where stocks are going or, for that matter, any of our positions. What I do know is that each position collectively has a greater probability of going up than down at the current stage in the economic cycle. While any one position can be wrong we look at the portfolio as a whole, with the objective of making more money than we start with. What we have demonstrated, by rigorous analysis, is that the overall portfolio is positively sloped. It has high probability of being worth more in the near future with an appropriate level of risk. If I knew where any one position was going with greater certainty, then I would put only that position on and nothing else.

As for the dollar, I think it is misunderstood. I don’t believe the carry trade actually exists. Who would sell the dollar and buy currencies that have a positive carry of around 2% annually when the currency can move more than 2% against you in a day? It doesn’t seem reasonable. Furthermore, the current correlation to equities is not sustainable and in fact doesn’t even make sense that the stock market should go up when the dollar goes down. We are a net importing country. We buy more from other nations than they do from us. That means a weaker dollar makes it more expensive for us to buy foreign goods. While I know that it also makes it cheaper for other countries to buy our goods, the fact is that the net effect should be a negative. The dollar moves more on trade and investment flows than interest rate differentials. At least in the long run.

If you look at the dollar from a longer-term perspective things look a bit different. One year ago the dollar index was at 79.35 (the end of Q3 2008) and the NASDAQ was at 1584. Today the dollar is at 76.80 and the NASDAQ is it 1720 (as of Q3 2009). So the dollar fluctuated down about 3% while the NASDAQ rallied over 8%. I am not sure what the big concern is here. Adding a long dollar position to the portfolio reduced the volatility and drawdown of the portfolio with limited impact on the returns. In fact, when the markets were in a free-fall during Q1 2009 the long dollar offset much of that loss allowing the portfolio to withstand that drop and to participate in the rally with less risk. If we take a look at a longer time-horizon, such as from the two years when the S&P made its high in September 2007, we see even further the downside protection benefits of a long dollar position, as the dollar index was about 80.5 at that point and the S&P was above 1500. The dollar has fallen only about 5% since then and the S&P has dropped almost 30%. So I find it hard to connect the dots of a weaker dollar impacting the markets. Since inflation is one of the main culprits of a currency’s value, interest rates need to be raised to offset the impact of inflation. The core inflation indices are down over the past twelve months so that doesn’t pose an immediate problem. The bulgering debt burden appears to have some in the currency world concerned but demand for U.S. treasuries remains high and rates remain low which would not be the case if debt burden was hampering the credit markets. In the end it’s all about growth and I expect U.S. growth to exceed that of its trading partners. This should support a bottom for the dollar and eventually lead to a stronger dollar. And don’t worry as that can occur with a rising stock market, but it can also occur with a declining stock market. That is what makes this position so attractive.