Running on Empty, Part V

When the Dollar is Broken, What Does One Do to Not Go Broke? (Guest Post)

Gary Brode of Deep Knowledge Investing was kind enough to share my series Running on Empty with his readers. This afternoon I’ve invited him to offer his thoughts for my readers, focusing on the implications that Running on Empty has for investments in the years ahead. After you’ve finished here, be sure to check out Gary’s own Deep Knowledge Investing for more insight.

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Overview

Contemplations on the Tree of Woe wrote Running on Empty, a three-part analysis of the petrodollar system that was so full of woe that it ran a full four parts.  That’s 33% more woe than had been promised.  Because we thought the series represented the kind of deep-dive analysis that we admire, we asked the Tree if we could print Part I as a guest post.  You can find that piece along with links to parts II, III, and IV here.

Part I of the series explained the origins of the petrodollar system, and noted that it’s the first reserve currency not backed by gold or other precious metals.  We’ve made similar comments about the disaster started when US banks in conjunction with the government created the Federal Reserve, and then took the US off the gold standard in 1971.

Part II of the series explained how the system enabled the Federal Reserve to print increasing amounts of currency and enabled Congress to run increasing deficits.  Because the US could print dollars for free, we did so and sent them overseas in exchange for foreign goods.  This hollowed out the manufacturing base of the US and led to a decline in living standards for many Americans at the same time that the people decrying inequality were pursuing policies that led to more of it.

Part III took on the controversial issue regarding where and why the US deploys the military.  Contemplations on the Tree of Woe describes current and future military conflict based on US  naval power controlling the ocean vs the Russians and Chinese who seek to control the resource and population-rich Eurasian land mass.

Part IV discussed incorrect assumptions by all parties involved in the Russia / Ukraine war.  Most importantly, the Tree concludes that after decades of massive deficit spending, the US policy of printing dollars to fund ever-greater debt is no longer a viable strategy.  The final conclusion is that this strategy is now “empty” and we either need to eliminate deficit spending, to pay for our spending with taxes, or if the US is going to continue both spending and printing, we’ll pay with further inflation decreasing the value of the dollars held by American citizens.

Unfortunately, Contemplations on the Tree of Woe has done detailed research and astute analysis.  Deep Knowledge investing agrees that over the past few decades in general, and the past few years in particular, Congress, the White House, and the Federal Reserve have debased the currency.  I’ve personally laid out the case that a stable currency is a requirement for a free and prosperous people, and pointed out that the anti-Russian sanctions are destroying the value of the dollar as the world’s reserve currency.  This has significant negative implications for US foreign policy and national security.  It also negatively affects the standard of living of most Americans.

Tree of Woe exists to provide readers with sufficient amounts of daily woe.  Deep Knowledge Investing exists to help you earn better investing returns regardless of how woeful the environment is.  We have been invited to write Running on Empty Part V in which we help you figure out what to do about the long-term decline in the dollar, and what to do in a world where the petrodollar is broken.  This arrangement, which supported the US dollar as the main reserve currency, is being replaced with a bi-polar financial world where the power of the dollar is going to be challenged by the ruble and the won.

A Few Points on Parts II and IV

For us, the most important point made in the Running on Empty series is noting that the dollar is no longer tied to gold or any other hard asset.  In The Bitcoin Standard, Saifedan Ammous argues that the key issue in making a currency “hard” or reliable is the stock to flow ratio.  Gold is a hard form of money because it’s rare and difficult to mine.  Each year, gold miners can add only a couple percentage points of new flow to existing gold stock.  Since the creation of the Federal Reserve and the decision to take the dollar off the gold standard, the dollar is the opposite of that.  80% of all dollars in existence have been created in the past 2 ½ years.  The flow of new dollars is a tidal wave that has drowned the existing stock.

The reason this is so important is because every time the Federal Reserve (or the banks that own it) creates new dollars it debases the dollar meaning the value of the dollars you own become worth less.  This is nothing less than legal theft.  Under normal circumstances, the Fed targets a 2% inflation rate.  While this seems reasonable, at 2% inflation, over a 40-year working career, the value of your dollars will decline by 55%.  The beneficiaries of government spending (including the politicians who use it to get elected) do not get these benefits for free; but rather, at the expense of all holders of dollars, and everyone who earns their paycheck in dollars.  This alone is a serious problem, and is further compounded by a current inflation rate far exceeding the 2% target (and far exceeding the official CPI statistics).

The petrodollar and the status of the dollar as the world’s reserve currency have created a world where the US could just export dollars in exchange for goods.  The anti-Russian sanctions have broken the petrodollar and the Saudis have already begun negotiations to accept other currencies for oil.  The Russian have successfully pressured Europe to pay for gas in rubles.  And the other anti-Russian sanctions have handed more power and influence over the international financial system to the Chinese.  None of this is a benefit to the US, to US citizens, or to people who receive their wages in dollars.  For a greater understanding of this point, please feel free to check out this video on the topic.

Enough Complaining – Let’s Discuss What to do Now

Contemplations on the Tree of Woe is correct that this is a bad situation likely to lead to some combination of long-term inflation and declining GDP.  It’s possible that the Fed can engineer another round or two of reduced rates and quantitative easing, but eventually, the bill will come due. Let’s start to go through the things you can do to protect your home and your portfolio from these problems.

Food:  All of the above is going to lead to higher food prices, and in the event of stagflation, economic turmoil, and a government that is going to be increasingly unable to pay its bills, self-reliance can be lifesaving.  The Food and Agriculture Organization of the United Nations is showing worldwide food prices up 23% in the last year, and the US Department of Labor Statistics is finally showing US food inflation in the double-digit range, something we’ve long said is understated.

In addition to all of that, Ukraine is a huge grain exporter, and many of its farmers were either fleeing the country or defending it when the spring planting needed to be done.  Russia is not selling fertilizer to unfriendly countries meaning US crop yields will be down.  Some US farmers are having difficulty sourcing diesel fuel to run their tractors and are planting less acreage.  And some European governments are restricting use of nitrogen fertilizer and saying openly that they expect that many farmers will go out of business.  We’ll leave it to you to determine whether these governments are unaware of what happens when farmers go out of business, or whether hunger and starvation are part of a plan.

All of this is going to increase the price of food.  Now would be a great time to fill a freezer with well-packed meat and fish.  If finances are tight, large amounts of rice and beans, and other canned foods with a long shelf life can be an inexpensive way to ensure you can get through difficult times.  There are also organizations that specialize in ultra-long shelf-life meals that can last decades and provide additional variety.  Mormon co-ops tend to be helpful with sourcing these meals, and my experience is they’ve been welcoming to non-Mormons and don’t ask about religious affiliation.

Other Household Products:  In February of 2020, in a piece telling subscribers we were short the market ahead of the Covid shut-downs, we suggested that people stock up on water, medical supplies, cleaning products, soap, and toilet paper.  Food shortages, and bad inflation can lead to domestic unrest.  Having a supply of these kinds of items at home can be helpful.  If possible, it’s a good idea to try to get extra supply of any prescription medications.

It’s also a good idea to think about things that would make life more pleasant under bad conditions.  For many people, that would be items like coffee and chocolate.  We’d also recommend some things that could be used for barter like high-quality whiskey, sugar, and flour.  Think of all of this as cheap insurance, and if the worst doesn’t happen, you can consume these things yourself over time.

Gold:  This has been the standard for money for thousands of years, and was what backed the dollar during the period when the US rose to world leadership.  There are many ways to own gold.  It’s possible to buy coins and store them at home.  I don’t love that option because I don’t want to have that much of value in the house, but it does ensure access in case of emergency.  It’s also worth noting that you’ll pay a premium to take delivery of actual gold coins.

It’s also possible to have gold stored in a remote vault, but that will come with expenses and no guarantee that you can access it in case of emergency.  If you’re willing to pay a small annual expense, and have exposure to the financial system, there is an exchange traded fund (ETF) with the ticker GLD that closely tracks the price of the metal.

Silver:  This has been the secondary standard of money for thousands of years, and also has some industrial use.  Like gold, silver has a high stock to flow ratio making it “hard” which is what you’d want for long-term wealth storage.  Like gold, you can store silver at home, in a vault, or own it in a different ETF with the ticker SLV.

People I know who study silver closely think the market is rigged.  Because silver derivatives (contracts that are valued based on the price of silver) are large compared to the actual supply of silver, it is possible that the market is manipulated.  I don’t have proof either way, and my solution is to own some silver, and a larger position in gold.

Oil:  There’s been a lot of talk in the financial press recently about the strength of the dollar.  Recently, the dollar hit parity with the euro for the first time in 20 years.  That means you could buy a euro for one dollar.  For a better understanding on what that means for you, check out this article.

The dollar is indeed stronger against other fiat (national) currencies, but with inflation, a dollar is also buying us less in goods and services.  If you’re a foreign exchange trader, the dollar is up.  If you’re an American consumer, the dollar is losing purchasing power.  We’ve been writing about this for months concluding that we’d rather own food, fuel, and shelter than euros.

This, combined with oil supply restrictions, a lack of growth in refining capacity, and supply chain disruptions due to anti-Russian sanctions have led to huge increases in fuel prices.  Our view on this is that we all have the right to be upset when we fill our gas tank, or get our heating bill, but rather than be upset, we’d like to see you make money from the disruption.

We like owning large well-run oil producers with permitted wells.  This way, when you overpay to fill your gas tank, you’re also paying yourself.  If you want to know in greater detail which oil companies we’ve been buying and have owned all year, feel free to check out this video.  We talk about our investment thesis in the space and give specific tickers.  At the moment, a lack of refining capacity is raising prices and hurting demand for oil.  Long-term, we expect increased demand for oil, and believe that OPEC has little excess production capacity.  This means that over time, prices should stay high or increase.

Bitcoin:  The apex cryptocurrency has come down with other “risk” assets, but remains a deflationary asset in inflationary times.  This means that the increase of supply will decrease over time and the stock to flow ratio which is already excellent will continue to improve.  We’ve written extensively on the topic, and continue to believe that investors should at least have some exposure to Bitcoin.  For those of you who are nervous or skeptical about “digital gold”, we understand your feelings on the matter.  Our best response is given all you know about the failure of EVERY SINGLE fiat currency in history, why would you be comfortable having 100% of your assets in dollars?

Buying and storing Bitcoin can be a little complicated for those of you who aren’t technically savvy.  It’s not impossible, but requires some effort.  If you find that to be daunting, you can always buy the Grayscale Bitcoin Trust (ticker: GBTC).  It is backed by Bitcoin and should trade closely with the cryptocurrency.  We do note that GBTC can trade at a premium or a discount to net asset value.  It currently trades at a discount so you’d be buying Bitcoin cheaper than the regular price.  That discount can remain in existence for a long time or even increase so only choose this option if you’re willing to hold the position long-term and if you are able to look past short-term volatility.

Individual Stocks:  At Deep Knowledge Investing we provide research on individual stocks we own.  Some companies will be hurt by inflation and others can benefit from it.  Owning stocks with pricing power can be beneficial, and we own some companies that help consumers reduce their costs instead of continuing to pay more.  We also think consumers will be in for a rough ride so companies that provide assistance to them could also do well.  Corporate earnings that will rise with inflation can themselves be a good hedge against inflation.

Shorting Stocks:  Many investment advisors only talk to their clients about long positions.  We think that’s a mistake.  Many companies have rising expenses due to higher commodity costs and increasing wages.  Earnings estimates for the S&P 500 are going to come down, and that’s typically bad for equity valuations.  We’ve been hedging out all equity exposure since the first week of January, and that’s been the biggest profit producer we’ve had all year.  To limit risk, it’s ok to short indexes like the S&P 500 (ticker: SPY) or the NASDAQ 100 (ticker: QQQ).

Real Estate/Your Home/Debt:  This one is a bit tricky.  We advised subscribers to refinance their mortgages before rates went up, and then warned back in February that higher interest rates were going to make homes less affordable which would lower pricing.  We’re seeing that play out right now.  Keep an eye out for a good deal on a home you’d love and for an opportunity to finance or refinance a mortgage when rates drop.  For almost the past year, the interest rate on mortgages has been well below the inflation rate.  In general, talking on a lot of debt can be risky, but mortgage debt is secured by the home, and is typically long-term.  Both Deep Knowledge Investing and Contemplations on the Tree of Woe think we’re going to see long-term inflation.  Imagine the joy of paying off that mortgage in 30 years with dollars that have little value.  Who doesn’t love beating the bank at their own game?[1]¹

Conclusion

Contemplations on the Tree of Woe supplies its readers with fantastic analysis accompanied by woe and regret.  The creation of the Federal Reserve followed by the abandonment of the gold standard put in place the conditions for politicians to debase the dollar leading to reduction of production and excessive debt.  The Running on Empty series explains how the petrodollar system only delayed the inevitable.  All empires end with overspending, debt, debasement of the currency, and excessive war.  We are following a multi-thousand-year-old pattern and will either chart a new course or suffer the same fate as those who debased their currency as a way of stealing from their own citizens.

Deep Knowledge Investing exists to help our clients earn better returns regardless of how “bad” the environment is.  We try to remain agnostic regarding whether something is “good” or “bad”.  We look through whether an event reflects our political policy preferences; and instead, think in terms of how we can predict the effects of an event and use that to help our clients make money from it (or at least protect themselves from it).  As much as the current environment has been overwhelming for a lot of people, please don’t feel helpless or that you don’t have good investment options.  While the overall situation is negative, there is a lot you can do to ensure you come through this intact, or even with profits.

For those of you who want more woe in your life combined with well-researched analysis, the subscription page for Contemplations on the Tree of Woe is here.

For those of you who want to know what to do about it, the subscription page for Deep Knowledge Investing is here.

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1. Deep Knowledge Investing wishes to apologize to Contemplations on the Tree of Woe for injecting joy into the conversation.  In general, we know the situation is awful, and we understand that helping people be happy is off-topic for the publication.  We regret the error.