NEW YORK () -- As any half-awake CNBC watcher could tell you, the precious metals markets have been going like gangbusters for the past few months. Gold has recently topped $650, up more than 50% in just the past year, with the bulk of those gains occurring in the last six months.
The entirety of gold's run, however, has occurred in a strengthening dollar market - an occurrence that has befuddled even the best market watchers. Since the end of 2004, the dollar (as measured by the trade-weighted U.S. Dollar Index) is actually up more than 5%.
This price action, coupled with the dollar's historically strong inverse relationship with gold, forces the question: when will the buck start playing catch-up?
Is Gold Overvalued? It Doesn't Matter for the Dollar
Market pundits around the globe have been batting around this question for weeks. While gold may certainly be overvalued (and I've personally that investors start to take profits), I wouldn't bat an eye if gold moves $150 per ounce - in either direction - in the next three months.
In any event, chances are that the dollar will start to move back toward its relative valuation versus gold. Over longer periods of time markets tend to trade back toward historically strong relationships, such as the inverse relationship between the dollar and gold.
Gold and the dollar have traded out of lockstep for the past year and a half. If we assume that this development is an aberration, then going forward we could expect to see the dollar and gold move back to the relative valuations that existed before they began strengthening alongside each other. Therefore, if gold at $450 equated to a U.S. dollar index level around 80 at the end of 2004, it's unlikely that even a decline in gold back to, say, $500 will translate to an appreciably higher level on the U.S. dollar index than that which currently exists.
In the coming year, I would expect to see one of the following market conditions occur. If gold strengthens, then the dollar is likely to weaken to a larger degree, so as to "catch up" to its relative valuation. If gold stays around the $600-$650 level, the dollar will likely still weaken in order to recapture this relative valuation. Finally, even if gold declines back to $450-$500, the dollar will probably still not strengthen, so as to re-establish its historical relative valuation. In any event, I would not be surprised to see a return to the relative valuations that existed prior to the start of 2005.
Many market pundits were shocked when the dollar appreciated alongside gold - all but wiping out one of the strongest inverse relationships around. Can you imagine how surprised they will be if the dollar and gold decline simultaneously in an attempt to restore the relative valuations that previously existed between the two?
Even Without Gold, the Dollar Will Hurt
Of course, many people will argue that there is no reason to believe that the relative valuation that previously existed between the dollar and gold was the "correct" level. For my part, there's no way to prove the accuracy of this. Even given that, there are still plenty of other reasons to be wary of the dollar.
It's a well known adage that the greatest bull markets climb a wall of worry - and love to 'shake out' the majority of investors before a top is reached. Those who stick by their convictions and 'hold on' for the ride are the ones who profit the most. A prime example of this is the 1987 market crash, which was then followed by exponential gains in the DJIA over the next decade-plus.
The same theory can be applied to bear markets. The dollar rally that occurred in 2005, despite fundamental valuations to the contrary, could be described as just such a "shake out." In short, while longer-term market fundamentals dictate a higher price of gold and a weaker dollar, there will be strong, violent moves to the opposite along the way.
However, there's plenty of evidence to suggest that the dollar's short-term bull could be nearing an end.
The Federal Reserve is likely nearing the end of its cycle of raising interest rates, which will lessen investor interest in the dollar. In the meantime, strong Japanese growth will probably lead to an end to that country's zero interest rate policy, which will should lead to further investor interest in yen holdings. Conversely, the almost continuous growth of the United States' budgetary and trade deficits will not help create new dollar bulls.
But, perhaps most telling of the dollar's coming decline is the waning interest of foreign governments' in dollar holdings. Foreign government participation in U.S. treasury auctions has been declining for several months, and the growing stability of many emerging economies' currencies likely means these countries will need to acquire smaller amounts of U.S. dollar reserves going forward. It is also likely that more fiscally prudent countries will begin to lighten their dollar holdings in order to protect themselves. On April 21, for example, the extremely conservative Swedish central bank announced that it would reduce its dollar holdings from 37% of its reserves to 20% of its reserves.
And, finally, from a technical perspective the U.S. dollar index in perilously close to completing a bear cross of its 50 and 200 day moving averages. (This term is used when the 50 day average crosses sharply downwards over the 200 day average). From a classical TA view, this does not bode well for at least the intermediate term. When this occurred in 2003 and 2004, the dollar index began a period of substantial declines.
How to Invest
Over the past few months, investors holding gold have fared particularly well. Investors currently overweight in the yellow metal should consider taking some profits and cycling into other non-dollar currencies that haven't appreciated to the same extent.
Given the decline of the dollar over the past couple weeks, it's likely the buck will bounce back for gains in near term before renewing its decline. In order to protect against this, investors eyeing foreign currencies should not invest in one lump sum. Instead, put your money to work in smaller parcels, with the goal of potentially averaging down.
The easiest, and most practical, way of investing in other currencies is via diversified un-hedged foreign bond funds. This allows you to avoid the company or industry specific risk inherent in foreign stock picking, as well as avoiding picking specific currencies to invest in. Given the near term world wide rising interest rate environment, it's also practical to choose funds with relatively short durations in order to avoid risking principal.
Some of the better funds to fit the bill include to the Prudent Global Income Fund [Nasdaq:PSAFX], the Franklin Templeton Hard Currency Fund [Nasdaq:ICPHX] and the Merk Hard Currency Fund [Nasdaq:MERKX]. All of the funds have relatively hefty expense ratios above 1%, which is expected given the unique natures of their investments. The Prudent Global Income Fund and the Merk Fund also hold a decent portion of their portfolios in gold or gold-related equities - something that investors who are already overweight gold should be aware of. While the Franklin Templeton Fund is one of the oldest foreign bond funds, it has a 2.25% front-end sales load that I'm not a big fan of.
Ultimately, investors seeking diversification away from dollars would probably fare best by placing bets across a number of different funds with the same mission, since different managers will place an emphasis on different currencies. While there are certainly other foreign bond funds, many of them tend to be longer in duration and place an undue emphasis on emerging market currencies - both of which could ultimately get investors in trouble.
Conclusion
While predicting the short-term movements of currencies is often a sucker's game, making longer-term bets on market fundamentals is undeniably the smartest way to invest. Those who can stick with their convictions and ride out positions that turn against them - as the dollar has done for the past year-plus - will fare the best in the end. Investors should also keep in mind the words published in the recent "Investment Outlook" of bond guru Bill Gross, perhaps one of the savviest mainstream investors in the market.
"Higher inflation, higher personal and corporate taxes, and a lower dollar point U.S. and global investors away from U.S. assets and toward more competitive economies ... Need I say more than to sell U.S. assets and buy Asian ones denominated in their local currencies."
For an investment personality of Gross' caliber to commit these words to paper - at the risk of his firm PIMCO's reputation - is especially telling. Investors would do well to heed them.
