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This could possibly be the most unpatriotic post I have ever written. The dollar is critical to many investment themes within the current RE Macro models, and it’s currently flashing bright red to us. The lynchpin to market sentiment is the financials. As I said last week (see Hedgeye’s Early Look: Rust – 1/23/09), the debate over the status of some financial service firms reminds me of last year’s debate over whether GM was bankrupt or not! Of course, it was bankrupt, and yes, the government is running our largest financial institutions.

In the short run, the ever bigger US Government socialist stimulus plans and government bailout expeditions are going to be good for the stock market. As the government transfers “risk” from the balance sheets of our defunct financial institutions to its own balance sheet, it will be good for whatever financials remain and therefore, good for market psychology. But everything has its price!

Unfortunately, the deterioration in America’s balance sheet has severe implications on how the world views the US dollar. The more we show the world that we are willing to socialize our financial system, the less the US Dollar will be worth. There is a price to pay for the lack of accountability in the US financial system and that will result in a devalued US dollar. Year-to-date the U.S. dollar index (UUP) is up 5% and the S&P 500 has declined nearly -8%. The bulk of the decline in the S&P 500 has been driven buy the -29% decline in the XLF – Financials.

Over the years, mismanaged countries have had to de-value their currency in order to pay for the sins of the past. While there is a psychological impact associated with devaluation as a cheaper US dollar could be perceived as a sign of weakness, a devaluation of the US dollar would boost aggregate demand in the economy. This would help in the effort to fight rising unemployment. In addition, a decline in the value o f the dollar would help increase the value of assets in the US. In the end, an efficient way to clean up the toxic assets inherent in the US financial system is to create a cheaper dollar.

Keith continues to emphasize the fact that stocks cannot go up if the dollar is rising. The market knows that the quickest way to fix America’s problems is to print more of our currency so if the dollar goes down, stocks will rally. At the time of writing this missive the S&P is down -0.7% and the US$ is up +0.75%. This is The New Reality.

Howard W. Penney
Managing Director