Two summers ago, I went on an Alaskan Cruise with #2 daughter. One of the highlights was flying by helicopter to several glaciers. Seeing the huge valleys these glaciers had dug into the bare rock of massive mountains was impressive.

In today's investment world, there is another glacier that is beginning to slowly move down the mountain. It also has the potential to leave a huge valley when it departs. I am referring to the trade deficit and its effect on the dollar. We have visited this theme before, but looking at the investment scene today, I think it is one of the most important stories around. Plus, I was pointed to a Federal Reserve study which may shed significant light on what will happen and when to expect problems as our trade deficit grows.

Then we will look at more reasons "Why Investors Fail ." The response from last week's letter was extremely positive. If you did not read last week's e-letter on "Why Investors Fail ," you ought to go back to the

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web-site archives and do so.

Prediction? What Prediction?

One of the problems economists and analysts have in making predictions is that there are just so dang many variables, all of which are tied together in ways which are not totally obvious. This is why so many predictions are just plain wrong. Most economists get lost in a forest of data, looking at this tree and that bush, but never dropping back and trying to get a picture of the whole. I have no explanation for why they (we?) forget our wrong predictions so quickly.

Today, we are going to look at the trade deficit forest. Gloom and doomers have been predicting the demise of the dollar for years, based upon the trade deficit. Obviously, Armegeddon has not yet arrived. But now, I hear a knocking sound at the door.

(Thanks to Stephen Roach and his buddies at Morgan Stanley for much of the data in this letter. Unless I note otherwise, statistics are from them.)

The trade deficit is running roughly 4.3% of the GDP. It is projected to continue to rise to 6% in 2003, which will be almost $2 billion per day. That means foreigners will have to exchange $600 billion+ of their currencies for dollars in order for the dollar to stay as high as it is. This is unsustainable, and as we will see below, is likely to topple the dollar sooner rather than later. But "how soon" is the question.

Those who are not worried about the trade deficit and the dollar point out that foreigners have a seemingly bottomless appetite for dollars, and that as long as the dollar and the US remain as the safe haven of choice, there is little reason for alarm.

But when you look into the recent trends of the actual sources of where we get those foreign investors buying dollars, it is easier to be concerned.

When we buy foreign goods, we convert dollars into the currency of the country where the product (or service) is made. When a foreigner wants to buy something in the US, he must get dollars. An imbalance in the flow of currencies is what makes the value of currencies go up or down. It is supply and demand in its rawest form. If more people want dollars, then the dollar goes up.

But how can the dollar be going up when we are spending so much more than we are selling? It is because foreigners are taking those dollars and buying US companies and US stocks and bonds. Also, foreign central banks, especially Asian central banks, use the dollar as a reserve currency. It takes dollars to buy oil, and with oil going up, foreign nations must convert more of their currency to dollars in order to get oil.

One of the largest sources of dollars was from foreign companies buying US companies or setting up production facilities in the US. In the period 1990-95 average annual European dollar flows from mergers and acquisitions (M&A) was only $10 billion. In 2000, Europeans invested over $600 billion in the US. Taking away US investments in Europe it was a net $214 BILLION to the advantage of the US. If I have the calculations right, that alone financed half of the trade deficit.

As I pointed out a few weeks ago, announced merger and acquisitions for February were just $7 billion, down sharply from January which was $23 billion. Last year there was $90 billion announced for the first two months. This is a HUGE drop-off.

You would expect that this drop would put pressure on the dollar. But the dollar is up 2% on a trade weighted basis. Why? Because Asia has increased its dollar holdings substantially in the past few months. "Net US inflows from Asia (excluding Japan) totaled $17.3 billion in November and another $19.8 billion in December, the strongest two-month surge on record. In December alone, the region accounted for 42% of total US inflows, with China and Hong Kong the primary sources of capital. The late-year surge in inflows from Asia ex-Japan pushed the regional total to a record $111 billion for the year, more than double the level of the prior year. " (Morgan Stanley)

Read that paragraph again. Now, let's look at one of the reasons why Asia is buying dollars.

Competitive De-Valuation Raceway

Long time readers know that one of my favorite analysts is Greg Weldon. (He writes 3-4 long newsletters a day, which I consider must reading. The cost is $400 a month. He does a gold and metals letter which is just $150 a month. If you are a gold or metals commodity trader, you should get his letter. Drop me a note, and I will see you get a two weeks free trial.)

One of Greg's main themes is "The Asian Competitive De-Valuation Raceway." By that, he means that Asian countries keep lowering the value of their currency against each other vis-a-vis the dollar, so as to be more attractive to the US consumer. Each country is worried that if their currency gets too strong, that the other Asian currencies will have an advantage.

How do you lower your currency? You create more currency than is demanded or is needed. You buy dollars for your central bank reserves, and invest them in US government bonds.

This race has been going on for years, with one country after another pulling into the lead. It seems no country has been willing to let their currency get strong.

That is not good for their consumers, of course. That means US products and services cost a lot more, and hurts our exporting businesses. It is not good for their lifestyles or savings.

Why do they do this? To keep their exports up, which is what they believe will eventually bring prosperity. As an example, this week, the head of the Thailand central bank gave a short speech about his countries problems. Weldon notes he used the word export five times in those few sentences, or 12% of his whole speech. He is clearly worried, as Thai exports were down 8% again last month. He is focused on exchange rates, and especially the way that the Japanese yen has dropped much lower than the Thai baht. It would be hard to be bullish on the Thai currency in the face of those remarks.

Now, here is the heart of the matter. If each of those Asian countries thought they could all get a stronger currency against the dollar, they would be for it. It is not that they want a strong dollar, they just don't want their currency to be stronger than the other Asian currencies. If the dollar were to show weakness against all the Asian currencies at the same time, they would not object.

Could that happen? A Fed study seems to indicate it can. Fed economist Caroline Freund did a study on what happens when the trade deficit gets too big in developed countries. (You can read it yourself here.)

Here are the highlights: On average, when the trade deficit widens to over 5%, the currency starts to drop. It typically drops 20% over three years, as the trade balance recovers.

GDP growth slows down by about 3% from the year prior to the current account peaking. If Morgan Stanley is right about the deficit rising to 6% next year, and the Fed study says that before it goes to 6%, the dollar will begin to adjust down, then that means we are talking about later this year, give or take a quarter. If you lop off 3% from this year's GDP, that would mean we would be back in recession next year.

Of course, it's not that simple. Because the data the Fed study used had a wide variance of actual results, using an average to make a prediction is a random choice.

But I think you can make some generalizations. The study suggests the dollar is in for a tumble over the next few years. It could start soon, or be delayed for a year, but the ultimate result is pretty clear. This will slow the economy down, with the biggest slowdown in the first year of the drop. The study shows this is also likely to push up short term rates in the process.

All nice and neat, isn't it? We can see what is going to happen, make our investments and reap our profits. Except.

Except that there are a few other variables. The study was done on a variety of nations. The concern I have is, "How applicable is that to the United States?" We are the currency of choice - the safe haven in times of storms. Even as the Asians were exiting the US stock market after 9/11, they were buying US bonds.

With all due respect to our European friends, with the exception of the Swiss franc, and up until the Euro, most of the countries upon which this study was based could not be considered safe havens.

Further, each of these currency depreciations take place in the context of global trade, and global trade expectations. A rising view of the US economy by the rest of the world is bullish for the dollar. If the US slips back into recession, that could change quickly. Throw the recent trade skirmishes (we are not into trade wars yet), and the picture gets more volatile. Add the current instability in oil prices and the Israeli-Palestinian crisis and the picture gets very murky.

Finally, the Japanese have seemingly embarked upon a planned decimation of the yen. 150 or Bust seems to be the motto. With some of the truly insane policies they are pursuing, holding it to 150 may be optimistic. If that is truly the case, I doubt whether the other Asian countries would allow the yen to get that much cheaper against the dollar than their currency. Asia is still fixated on the American markets, rather than trying to spur their own consumer markets to greater buying.

It seems to me that like heavy snows packing more ice into a glacier, making it more powerful, we are watching a build-up of pressure in the currency markets that could get ugly.

The longer the dollar stays up, due to Asian countries buying our bonds, the more an eventual downward pressure will build. The larger the current account (trade) deficit grows, the more pressure on the dollar when it does begin to tumble.

When, you ask, will the dollar begin to drop? I don't know, for all the above reasons. But I increasingly am coming to believe it will. The Fed study seems to suggest we are close to that point. FYI, for curious minds, the dollar dropped 37% in the last currency adjustment following 1987.

I have a hard time believing the dollar is going to get much stronger against the Euro and its related currencies. More aggressive investors might consider shifting some assets to the Euro. You can open CDs in the Euro or other currencies at Everbank right here in the USA. Find out more on their information page.

Muddle Through Rules

In the past few weeks, the earnings picture has been ugly. Unemployment seems to have stabilized, although manufacturing jobs are still trending down. New lay-offs are in the works. The markets rise and fall. But consumer confidence is up, as are factory orders.

All this just keeps re-enforcing my view that we are in a Muddle Through Economy. The resumption of the go-go years of the 90's is not in our immediate future. There is nothing necessarily bad about that, except that investors trained to respond to bull market bells are likely to be disappointed.

I note that bonds seem to be behaving better, even as the market falters.

By the way and before you ask, the whole dollar scenario out-lined above is bullish for gold.

More Why Investors Fail

Gavin McQuill of the Financial Research Center sent me the full $5,000 report called "Investors Behaving Badly." He was the author and he did a great job. I read it over the weekend.

I reported last week how the report showed investors chased the hot mutual funds over the last decade. The higher the markets went, the less likely it was that they would buy and hold. Investors consistently bought high and sold low. Investors made significantly less than the average mutual funds did.

The thing that struck me as I read this report is that all the data was from periods prior to March 2000. I would expect more churning after the bear market crash in the NASDAQ, but this study shows that investors were becoming increasingly short-term as the bull market went to new heights. McQuill focused on six emotions that causes investors to make mistakes.

1. "Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon." This is part of a whole cycle of denial, anxiety and depression. Like any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.

2. "Myopic loss aversion (a.k.a. as "short-sightedness) - a fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective." Basically, this means we attach too much importance to day-to day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor behavior.

Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.

3. "Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.

4. "Overconfidence - People's tendency to overestimate their abilities relative to individuals possessing greater expertise." Professionals beat amateurs 99% of the time.

In sports, most of us know when we are out-classed. But as investors, we somehow think we can beat the pros, will always be in the top 10% and any time we win, it is because of our skills and good judgement. It is bad luck when we lose.

Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the "Holy Grail" of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities.

5. "Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.

We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long-term. They think long term is 2 years. They do not understand that it will take years - maybe a decade -- for the process of reversion to the mean to complete its work.

6. "Representativeness - the tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article this week in the Daily Reckoning. He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue that came from a new country which had never been represented on the cover before, the stock market of that country has always risen over a four year period. This year, it is time to buy Argentina stocks. Frye evidently did not do a correlation study on the size of the swim suit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.

Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern. McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it was more likely that Suzy would be a librarian or work in the financial services industry will choose librarian. That would be wrong. There are vastly more workers in the financial industry than librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are likely to be English majors.

Southern California and New York

I will be speaking at an investment conference in Palm Springs the 28-30 of April, and in the LA and San Diego area for the next two days. I will be glad to meet with clients or prospective clients at that time. I will also be in New York (mid-town) June 2-5 speaking at the annual Hedge Fund Forum on the topic: "Facing the Hedge Fund Issues of the Future." I will have plenty of time to meet with you there as well.

We (my bride and I) spent the weekend in Sedona, Arizona. That is one of the most beautiful places I have ever been. Clearly, the beauty distracted me from my golf game, which was as ugly as it has ever been.

But, Spring is in the air, and the crack of bats are heard in Arlington. Sunday I will wander with my son into the Ballpark, and once again wonder why didn't we buy better pitching. It is an annual Texas ritual. Someday, there will be a World Series here. (That would be, by the way, a good example of #3 above: cognitive dissonance.)

Have a great week and get out and enjoy the Spring with friends and family. There is never a trade deficit with friends.

Your spring-time optimistic analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

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