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Minyan Mailbag - Part Deux

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John made some excellent points with respect to dollar exposure to Minyan Duke, whose goals are to reduce exposure to the USD via exposure to equities in other countries. I wanted to add another point or two that I think are worth thinking about.

One of the most amazing characteristics of the last 2 years on a global basis has been the remarkably tight correlation among and between U.S. markets and those equity markets of the rest of the world. Look at equity markets in Japan, Hong Kong, Australia, Switzerland, Holland, Spain, Italy, Germany, France, the UK, Brazil, Mexico, Singapore, and Thailand: each made important lows in late 2002 or early 2003 and has subsequently had a very nice run off those lows. This is the direct result of the global reflation trade engineered by the major central banks across the world. Such a high correlation has never been seen before save for a period roughly in 1925-1935. And what it means for investors trying to diversify away from USD-denominated assets is troubling.

Specifically, if the economic cycles of the world's economies are tightly correlated thanks to this coordinated credit reflation, then the analysis of which asset market to diversify into becomes a matter of determining which other fiat currency is going to go down less than the USD. This is precisely what John pointed out and is a key point to appreciate in the credit-driven, debt-laden, fiat-currency economies that are your options for diversification.

Simply buying an ETF in another country's stock market then won't necessarily insulate you from the decline you would expect to see if you are bearish the USD and bearish U.S. stocks. Other countries' stock markets can go down as much or more than the US markets' indices, irrespective of what's going on with its relative currency value vs the USD. Don't forget, the U.S. accounted for something like 96% of global GDP growth from 1996-2002, making us (and our credit-driven consumer demand) the number one market for the rest of the world.

So if you are USD bearish and U.S. stocks bearish, then you are inferring that the world's primary growth engine (U.S. consumers) is going to be taken away from the rest of the world. In such an environment, if we sneeze, they catch the flu, or worse. And that would be potentially very bad for their stock markets.

Which reinforces John's point about real assets like gold. Holding an ETF in a Japanese, Thai, Mexican, Australian, or German stock index is nothing more than investing in a wholly owned subsidiary of the U.S. economy. That ain't diversification. Gold is.
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