Well, I don’t think we can call it a run on the dollar yet, but demand for greenbacks isn’t exactly robust these days. Gold seems to have settled in above $1000, roughly 4 times the price at the 1999 low around $250 per ounce; it would appear that folks prefer gold to greenbacks. The government tells me that inflation was quite low over that time frame and while I’d like to believe them, the price of gold tells another story. So does crude oil and just about every other commodity you can think of. So did house prices for most of the decade and I suspect that unless something changes, they will again. There are plenty of economists who will tell you that inflation can’t be a problem right now because we have oodles of excess capacity but apparently the gold and foreign exchange markets are unaware of this idle capacity.

Of course, we can get inflation even when there is a lot of alleged excess capacity as anyone who lived through the 70s can attest. Calculating that output gap proved more tricky than the Keynesians thought back then and I suspect it hasn’t become any easier in the last 30 years. One thing we know for sure is that the unemployment rate is not a good measure of the output gap and we know this because we had high unemployment and high inflation back in the seventies. Mr. Keynes said that couldn’t happen but I’ll take real world experience over theory any day. Besides, living down here in Miami gives me a bird’s eye view of Latin America and if you doubt that high inflation and high unemployment are compatible, I suggest you cast an eye toward Argentina or Venezuela or Brazil or any number of our other Latin neighbors over the last half century. In fact, in Latin America, high unemployment is the default condition for high inflation. Ironically, Brazil, Peru and Chile seem to have figured out the inflation thing just as we seem to have forgotten what causes it all over again.

Anyway, inflation is here and the falling value of the dollar tells me so. Since the Fed has claimed to be more worried about deflation, I guess this must be seen as good news by Ben Bernanke & Co. Certainly, the fall in the value of the dollar is doing wonders for asset prices and I guess for a country deep in debt, that’s a good thing. Stocks continue to levitate, now up 60% since the March lows and a solid 16% since the beginning of the year. Of course, that assumes you are keeping score in US dollars. If you had to convert a foreign currency to dollars in order to buy US stocks, you aren’t doing quite as well. For instance, an Australian who sold Aussie dollars to buy US stocks at the beginning of the 2009 would be down 10% if he sold his US stocks and converted back to his home currency. A Brazilian would be down a bit over 15% and a Canadian is roughly breaking even. A Euro based investor has done a little better, showing a gain of about 7%, but considering the risks, that’s not much reward.

And that should be of concern to the folks over at the Fed. You see, if the dollar is falling in value, it is darn hard to convince investors to keep their capital here. Private investors, foreign and domestic, have been sending capital out of the US for most of the last decade -  except for a brief interlude in 2005 and 2006 when the dollar stabilized- and they don’t seem to be stopping now. If we continue to underinvest, we’ll get a situation similar to what we had in the 70s. A lack of investment means we aren’t creating new productive capacity and eventually we’ll get a supply shock that causes prices to rise. Notice I didn’t say it causes inflation. The rise in prices is the result of inflation; the inflation is happening now and the evidence is the falling value of the dollar.

I suppose this can go on for a while longer, but at some point, the Fed will need to pull the plug on the printing press and stabilize the value of the dollar. If we haven’t used this period of relative economic stability to accomplish anything other than figuring out how to get the CBO to believe healthcare reform can both cost $850 billion and reduce the deficit, well, I suspect we’ll regret it. The stimulus package passed earlier this year sure isn’t getting the job done which explains why there were rumors of a job creation tax credit circulating last week. Apparently, the $787 billion stimulus package wasn’t enough to stimulate hiring but the politicians believe companies would be hiring right and left if they just add a tax credit of a mere 3000 bucks a head. Maybe its just me, but I think it says something about Congress that they’ll pay me $8000 to buy a house, $4500 to buy a car, but only $3000 to hire someone. I’m not sure what it says, but it seems profound in a relative value kind of way.

The key to real economic recovery is the aforementioned investment and so far the Obama administration hasn’t given anyone much reason to invest in new workers or new factories or new companies or anything else. Health care reform, as currently envisioned, is not free and somebody will pay the tab. Whether it is companies who pass the cost onto employees and customers or whether it is individuals in the form of higher taxes, somebody will pay. And until we know who is paying what portion, investment is not likely to pick up. You can’t calculate return on investment if you don’t know your costs. The same is true of cap and trade (or the EPA imposed version of it); until it is resolved, investment will be delayed. And if the cost of either of these two programs is too high, investment may be delayed indefinitely.

The Federal Reserve is doing what is necessary to prevent a deflation that would be very destructive right now. The result is a surfeit of dollars floating around and finding a home in the stock, gold, commodity and bond markets. What the owners of those dollars are not doing is investing them in anything productive. And in case you missed it, that’s exactly what happened for most of the last decade and that didn’t turn out so well. Do not mistake a rising stock market for economic recovery. All we’ve seen so far in the stock market is a step back from the abyss and a revaluation of the dollar. And don’t mistake a rise in government spending - and the subsequent rise in GDP - for real recovery either. The stimulus spending will peak next year and it would be hard indeed for GDP not to rise since government spending is part of the equation. But money spent is not necessarily money spent well.

In the meantime, until the Fed starts pulling the plug on the excess dollar generator, asset prices are likely to keep rising. I tend to think commodities are the better choice, but stocks are obviously doing pretty well too. The one area that is looking shaky right now is the bond market. There’s been a bit of a shakeout in the corporate market over the last week and the long end of the Treasury curve took a pretty big hit too. I suspect we’ve seen the lows in Treasury yields and if that is the case, corporates have probably seen their best days as well.

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Weekly Economic and Market Review

There wasn’t a lot of economic news on the week. The ISM non Manufacturing index rose above 50 finally and is now signaling expansion. Jobless claims fell 33,000 and are back to the levels of a few weeks ago. Claims will need to fall below 500,000 - at least - before we see any net job growth. And lastly, the trade deficit fell a little. Trade is picking up some, but is still way off the highs.

The stock market had a good week, getting back to within shouting distance of the recent highs (and making new ones on Monday before pulling back). I must admit, I was a little surprised by the action in stocks. I expected a little more trepidation before earnings season starts in earnest, but after Alcoa reported decent numbers, the anxiety seemed to melt away. We’ll start getting a flood of earnings reports this week and they better be good because expectations have definitely risen. Unlike last quarter when almost no one expected earnings to be good, the analysts have spent most of the last three months raising estimates on both the top and bottom lines. It will be interesting to see if the analysts have outrun reality.

I’m still looking for some kind of correction but I’m beginning to think it might be more of the sideways, back and forth kind of corrections rather than a quick drop. While the AAII poll of individual investors is once again showing a majority bearish, other measures of sentiment are still a little too optimistic for my taste. A little frustration for the bulls and bears may be in order.

Selected Charts

Stocks rebounded nicely. As I said last week, in a bull market the 50 day MA tends to act as support:

Bonds are starting to have some trouble. I think long term Treasuries have peaked:

Corporate bonds are having trouble too and if Treasuries have peaked, the upside in corporates is capped:

The GSCI is trying to break out of a base. I expect higher prices for commodities as the stimulus spending kicks into high gear late this year and early next year. Obviously, a falling dollar doesn’t hurt:

Gold is making new highs and while there may be a pullback soon, I am inclined to buy the dips as long as the dollar is weak:

And finally, a look at the Peruvian market. I have not made any investments in this market yet; the ETF (EPU) is relatively new.