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The Blue Ocean Portfolios blog covers various financial and investing topics such as retirement, investing, indexing, financial advising, and more.

Another Big Short?

The Big Short Book CoverLast night while browsing through our family’s Netflix account, I stumbled across a movie called “The Big Short,” the movie rendition of Michael Lewis’s bestselling book of the same name. As typical with our modern society, the film is laced with needless vulgarity but no nudity or violence. This movie is based on true events leading up to the collapse of the housing market, Bear Sterns and Lehman Brothers back in 2008, and how only a few investment managers had the foresight, guts and intelligence to figure out how to short (or to bet against) the housing market. For two years leading up to the 2008 financial crisis, these fund managers were wrong, dead wrong. Many of their clients and investors were bailing out on them because of their bet against the US housing market. This movie depicted how difficult it is for any fund manager to maintain their conviction when the market keeps moving to the contrary. It can be maddening!

Leading up to the 2008 financial crisis, the banks, government, regulators, economist, central banks and academics completely discounted the possibility that there could be a housing bubble. This bubble was caused by easy credit policies. Banks and mortgage originators were incentivized to make loans and then package them off to FNMA or FLMRC; transferring all of the risk of the loan and keeping all of the rewards for the origination. This crazy system was started under the Clinton administration and went into high gear under W Bush. What could possibly go wrong?

For the past four years or so I have been increasingly concerned about the US Dollar. From 1792 through 1971 the US Dollar was legally tied to a specific amount of gold or silver. This was called The Gold Standard. Then in 1971, through an Executive Order signed by President Nixon, the US Dollar was taken off the gold standard. This event, along with the establishment of GNMA, ignited the inflation of the 1970s. I remember my Dad being worried about inflation at the dinner table when I was in high school in the mid-1970s. 40 years ago the prices of everything kept jumping higher and higher, a scary time that is long forgotten for most of us.

Ever since 2008, the monetary policy of the Federal Reserve and other central banks have been busy deliberately and systematically increasing the money supply, while at the same time the fiscal policy of the US has been purposely incurring deficits and ramping up the national debt to $20 trillion. But very few people seem concerned about the possibility of inflation.

  • The Federal Reserve? No inflation in sight.
  • The politicians? Both Hillary and Trump don t seem a bit worried; "we can’t go broke, just print more dollars!"
  • The smug academics like Paul Krugman of Princeton just laugh at the threat of inflation as if it’s some sort of whimsical monster under the bed.

Just like back in 2006 and 2007 nobody seems remotely concerned about the possibility of inflation, a US Dollar bubble. And just like in 2006 and 2007, the markets seem to ignore the actual economic data that is sending smoke signals of what to come. It is not a matter of IF inflation will arrive sometime in our lifetimes, it is a matter of WHEN and HOW sever this inflation storm will be. Should we all be concerned about what a dollar crisis will have on our spending budgets? Should we be concerned that few if any politicians seem to be worried about the possibility of a currency crisis?

Some of us may find this chart of the Monetary Base just a little scary since the increase of the outstanding currency increased about 4x since the 2008 financial crisis.

Monetary Base Chart

 Even the Wall Street Journal reported on the Fed's preferred measure on October 30th **click here or on the image below to read the full article.

Wall Street Journal Article

The next economic crisis will be different than 2008; we just do not know when it will arrive and how bad it will be. The easiest way to short the US Dollar is to have a meaningful allocation in commodity index funds. There are also other, more exotic strategies like short US Dollars ETFs, like UDN (PowerShares DB US Dollar Bearish). Those vehicles have never been stress tested in real life. It is very important to stay diversified in order to protect against any type of economic crisis that could come our way.

If you have an interest in the mechanics and emotions leading up to the 2008 financial crisis, then “The Big Short” is definitely worth viewing. If you are justifiably concerned about the dramatic increase in monetary base, then it is important to maintain a meaningful allocation in a commodity index fund.


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