Adam Hamilton November 10, 2000 3874 Words
Europe is endlessly intriguing. From the mythos that bore its very name, to the current state of affairs in the patchwork conglomerate of nations that comprise it, Europe never ceases to titillate and fascinate.
Europe’s namesake was the fair maiden Europa, from ancient Greek mythology. Europa was the beautiful daughter of Phoenician King Agenor of Tyre (modern day Lebanon) and Telephassa. One morning, as Europa was gathering flowers by the seashore, the ever amorous king of the gods Zeus saw her and was immediately smitten by her fantastic beauty. Not wanting to frighten Europa away, Zeus assumed the form of a great white bull, and approached her on the beach. Europa was awestruck by the gentleness and majesty of the white beast, and as the bull enticed her she climbed on its back. With his cleverly planned trap sprung, Zeus leaped into the Mediterranean and tore westward, eventually landing on the island of Crete. Immediately after she had disappeared from Tyre, Europa’s brothers began to search for her. They consulted an oracle and were told to give up their hopeless effort, as the gods themselves had Europa. When the bull and Europa arrived at Crete, Zeus shape-shifted out of his bovine form and ravaged Europa. She would eventually bear Zeus three sons, Minos (founder of the Minoan civilization on Crete), Rhadamanthus, and Sarpedon. This early myth is immortalized to this day, as a maiden riding a great white bull is an official symbol of the modern European Union.
The spiritual roots of modern Europe were sown later by the mighty Roman Empire. At the zenith of its power, Rome controlled most of modern Europe. In countless military campaigns, Roman armies advanced as far north as central England. The Roman Emperor Hadrian even visited the Roman outposts in England around 122 AD and commissioned a great wall to be built (now called Hadrian’s Wall) that would bisect the island to cut off potential invaders from the north. The legendary power of the Roman legions was simply awesome.
Roman power began to wane a hundred and fifty years later. In 284, Emperor Gaius Auerelius Valerius Diocletianius divided the Empire in two, granting his friend Maximian rule of the western part of the Empire. In 455, fierce Germanic tribes sacked the once impregnable city of Rome, signaling the beginning of the end. In 476, the Germanic Chieftain Odoacer deposed the last Roman Emperor Romulus Augustus, and the Empire broke into pieces and disintegrated.
Since the demise of Rome, the common goal of most of the notable local rulers of Europe of the last 1500 years has been to recreate the mighty Roman Empire, to unite Europe. Most of the “pieces” of the former Roman Empire have had their bid at European dominion, but they have all failed. The first “French” attempt failed only thirty years after the death of the great Emperor Charlemagne in 814, with the Frankish Empire imploding. Spanish hopes of re-uniting Europe under Spanish rule were dashed in 1588, when the English naval fleet routed the legendary Spanish Armada off the south coast of England. The French had yet another shot at European hegemony in the early 1800s, but that attempt met a bitter end when Emperor Napolean was crushed by a disastrous series of battles culminating in Waterloo in 1815. Italy was a source of perpetual intrigue and meddling in world affairs virtually constantly since the fall of Rome, with the power of the papacy in Rome ebbing and flowing through the centuries. Italy was never able to unite Europe under Italian rule, though. In the late 19th and early 20th century, the sun never set on the British Empire. Although England ruled the waves around the world, it was unable to bring Europe together. England saw its power deteriorate dramatically after WW I, which was the first of two great German bids for European (and world) domination. German Kaiser Wilhelm II failed in what became the first World War, and the second attempt collapsed only a few decades later under Adolph Hitler in World War II. History is teeming with unsuccessful attempts to rebuild a neo-Roman Empire out of the ashes of the old.
The closer in one zooms on the European history of the last two millennia, the more radical and fanciful the ideal of the European Union appears. Racked with virtually endless war, strife, fighting fiefdoms, and local warlords, a unified Europe seems as improbable as the endless promises of “peace in the Middle East”. Yet before our very eyes, a neo-Roman Empire has coalesced out of centuries of virtual chaos and near anarchy.
The latest attempt at unifying Europe is a half century old. In 1951 the Treaty of Paris established the European Coal and Steel Community (ECSC) as a multi-national entity. Pro-unified Europe planners realized that normalizing international trade relationships for heavy industry was a crucial first step for a future economic union. In 1957 the Treaty of Rome established the European Economic Community (EEC) and the European Atomic Energy Community (EURATOM). In 1958, the European parliament was established, although it was largely a powerless figurehead organization at the time. In 1959, Belgium, the Netherlands, and Luxemburg formed a single BeNeLux block for trading purposes. In 1967, the ECSC, EEC, and EURATOM commissions merged into the “European Community”. The nucleus for the modern European Union became the BeNeLux countries and France, Germany, and Italy. (France and Germany together?!? Have they no history books?) In 1973, Britain, Ireland, and Denmark joined. Greece followed in 1981, while 1986 saw Spain and Portugal enter the Union. In November 1993 the incredibly important Maastricht Treaty was signed, which rendered the Treaty of Rome obsolete. The explicit goals of the new treaty were to establish a European political union, a common defense, a common foreign policy, and ultimately a monetary union. The Maastricht Treaty, in many ways, abolished national sovereignty and called for a single unified state, “The European Union”, rather than a federation of sovereign nations. Austria, Finland, and Sweden joined in 1995.
To the amazement of the entire world, the European neo-Roman Empire arose from the ashes like a phoenix, in an incredibly short period of time. In January 1999, one of the primary Maastricht Treaty goals was realized when the Euro single currency was born. It was introduced to the world with much fanfare. The western media, in its infinite wisdom, declared that the Euro would be the “strongest currency ever” and was a “big threat to the dollar”. When it was launched a Euro would buy a little over US$1.18. Now, a mere 22 months later, the Euro hovers in the gutter slightly above US$0.85, for a stunning (for a currency) 28% loss.
Like the currencies of all western nations, the Euro is 100% fiat, backed by nothing but the good faith and credit of the European Union. Claims abound that the Euro is “backed” 15% by gold, but that is technically not true. The European Central Bank has gold reserves, but it does not allow one to walk in off the street and trade a stack of Euros for 15% physical gold at any time, like a true gold-backed currency. A REAL gold-backed currency offers immediate and unlimited redemption for gold. The ability of people anywhere to convert paper into gold at any time for any reason is what makes gold standards so strong and resilient. A true gold standard provides a currency with intrinsic value as a rock-sold alternative to a creative fiction built on government promises.
A few analysts at the time of the Euro introduction bucked the trend and forecast the Euro would be in immediate trouble. Europe has around 460m people and 9 official languages. With its bloody history in mind, it is hard to imagine that these disparate cultures can agree on anything long enough to float the ultimate fiat currency. Most currencies are based on the good faith and credit of a single government. The Euro is based on the fanciful notion that ALL the governments in the Euro bloc will cooperate and work together to make it a success. So far, this hasn’t been the case. While the Euro was cratering in the last 22 months, the unaccountable socialist bureaucrats in Brussels were busy acting like good socialists… stealing from the productive to give to the nonproductive (after they took a cut to feather their own nests, of course). Rather than concentrating on critical issues, like the Euro, the meddling regulators were busy passing laws REQUIRING mom and pop bakeries to use only certain recipes for chocolate and regulating the size of the holes in Swiss cheese, for example. In the meantime, the European Central Bank sat on its hands as the Euro sunk like a millstone in the ocean. Even worse than not trying to buttress confidence in their starving baby, the ECB made statements that greatly reduced global confidence and trust in the ultimate fiat currency. Even while the Euro was making new lows, the ECB announced it would not defend the Euro.
While the Euro debacle has proved entertaining to observe for some outside the Euro block, it is rightfully a deadly serious matter inside of Europe, where hard-working citizens are watching their Euro denominated savings and investments dwindle in value rapidly. In order to escape the roller coaster madness of the Euro, tremendous amounts of European capital flowed into US equity markets. We believe the influx of flight capital from Europe to the USA from the middle of 1999 or so, when Europeans realized the Euro was not all it was touted to be, was a crucial component in fueling the NASDAQ bubble. The price of every stock on the NASDAQ is determined by free-market supply and demand. When dollars are chasing more stock than current owners are willing to sell, prices rise. European investors began to convert vast amounts of Euros (and other local currencies) into US dollars. Euros were sold in the foreign exchange markets for dollars, further driving the Euro price lower and fueling the beginnings of a major dollar rally. Many of these dollars found their way into the NASDAQ, which was the hottest market on the planet in late 1999 and early 2000. The tremendous forces unleashed by the floundering Euro had the simultaneous effect of attaching a rocket booster to the NASDAQ, levitating the dollar, and punching the Euro in the gut.
So how are the European NASDAQ investors doing? Are they making money or losing money like the Americans? In this essay, we will briefly explore how the NASDAQ is holding up from a Euro perspective. We will also muse on the implications of a Euro rally on the American equity markets.
If you own Euros (or any other currency, for that matter) investing in the NASDAQ is a piece of cake. All you have to do is covert your Euros to US dollars, and then throw the dollars at the gaping maw of the insatiable NASDAQ. When you are ready to exit, you sell your stock for dollars and convert your dollars back to Euros. Profits (or losses) can arise on TWO fronts when investing in a foreign market, however. First, the NASDAQ itself moves up and down, creating unrealized gains and losses in US dollar terms. Second, the Euro itself moves up or down in relation to the dollars. For example, imagine converting Euros to dollars and buying a US stock, the stock rises 25%, and you sell. You have realized a 25% return on the stock in dollar terms. Now, imagine the dollar rose in price against the Euro (or the Euro fell in value) by 20%. Every dollar you convert back into Euros now is worth 20% more Euros! Your total gain after translation is the stock gain of 25% in dollars plus the translation gain of 20% in Euros. Currency fluctuations can have a HUGE effect on returns for investors speculating and investing in foreign markets.
In order to see how these two dynamics are currently interacting for European NASDAQ investors, we ran hypothetical scenarios from four starting points. Four graphs are presented below, each representing a different entry point for European investors. Two data series are presented on each graph. The red line is the normal NASDAQ in US dollar terms, the same index shown on the evening news. The blue line is the NASDAQ in Euro terms. Both the NASDAQ and the NASDAQ (Euro) data series have light dotted lines superimposed on them. The lower dotted line represents the return of the NASDAQ as of October 2000 since the initial investment, and the higher line represents the negative return from the NASDAQ series top to the end of October 2000.
We will begin with the assumption that some farsighted Europeans had read their history books, understood the nature of fiat currencies, and immediately converted Euros to US dollars on January 1, 1999, the day the Euro was introduced, and bought into the NASDAQ. How are they faring?
Pretty darn well, so far! In US dollar terms, the NASDAQ (red) has managed a 53% gain since January 1999. From its top in March, the NASDAQ has lost 33% as of the end of October, but American investors are still ahead if they have been in for 22 months. From a Euro perspective, due to the rocketing dollar and/or collapsing Euro, the NASDAQ (blue) has performed far better than for native US dollar investors. The total return in Euros since the currency was born is a stellar 112%. From the top in March, the European investors have “only” seen a 24% loss, which is far better than the native US dollar NASDAQ. Still holding huge gains, the Euro NASDAQ investor who bought in January 1999 is likely not too worried about selling yet.
Now let’s assume the European investor began to sense trouble for the Euro in October of 1999. The currency had been trending lower since its inception, and the Euro had flirted dangerously with US$1.04 a couple times in the summer (down from US$1.18 at birth). Our hypothetical investor sold Euros for dollars on October 1, 1999 and bought into the NASDAQ…
For American investors, buying into the NASDAQ in October 1999 would have yielded a return of 23% as of the end of October 2000. Not too bad, but not fantastic. As we observed in the previous graph, in native USD terms the NASDAQ has lost an ugly 33% of its value since its March top. In Euro terms, the falling Euro makes the investment appear much brighter from the perspective of a European investor. The NASDAQ (Euros) is sitting at a 54% unrealized gain as of the end of October 2000, a very healthy thirteen month return by virtually any standard. As we also observed before, the European investor has seen a 24% erosion in the value of his or her holdings since March. Not good, but far less painful than the American investors’ experience.
What if the European investor had waited until March to jettison his or her Euros, buy dollars, and ride the NASDAQ wave? In March, EVERYONE in the world KNEW the NASDAQ was going to 6000 in a matter of months, KNEW the US economy was ready to takeover the planet, and KNEW the productivity miracle had ushered in the long-fabled era of perpetual prosperity for all. (snicker … chortle) Oh, and the “business cycle was tamed” and “inflation was dead”. (laughing out loud) We know from history that the majority of investors tend to buy in at the very top of mega bull markets. Let’s assume our Euro investor’s defenses were finally burned through in March, and he or she succumbed to temptation to chase the bubble…
In USD terms, folks who jumped in the NASDAQ fray in the beginning of March have seen a 30% loss in their portfolios, with the aforementioned 33% loss from the top. In Euro terms, European NASDAQ investors fared quite a bit better. They saw their position drop 20% in terms of Euros from March 1, and 24% from the early March NASDAQ top. And what of NASDAQ 6000? Where are all the analysts that were paraded on bubblevision in March like a flock of learned elders heralding “this was only the beginning” of the coming boom? They are still there, continuing to spout their nonsense that ignores fundamental market realities, and they are now PRAYING for a mere NASDAQ 4,500 finish this year. The ironic part is that they still have any credibility whatsoever with the average investor… another topic for another essay.
For our final perspective of the NASDAQ through Euro-lenses, let’s imagine our hypothetical Euro NASDAQ investor delayed and finally joined the melee already under progress in May 2000. The NASDAQ was at 4000, and the investing public was ensured that 4000 was “absolutely a bottom” by the sages on bubblevision…
Amazingly, the Euro actually showed a rare display of strength in the early summer of 2000. It bounced from US$0.89 on May 1 to US$0.96 on June 13 to US$0.95 on July 5. It did not resume its southward migration below $0.89 again until August 28. In the past couple months, however, the US dollar embarked on a sharp and bubble-like rally, once again putting the Euro under heavy American fire from across the pond. For a graphical view of the recent dollar spike, please review the first graph in our recent essay Einstein, Gold, and the Dollar. The European NASDAQ investor who pulled the trigger in May would have seen his or her position actually lag the American NASDAQ for four months, although the recent dollar gains have yet again throttled the Euro lower. As in all the previous graphs, the Euro NASDAQ’s return has exceeded the US dollar NASDAQ return. For the American investor, the NASDAQ has seen a 15% loss since May, and a 21% loss since the interim high in July. The Euro NASDAQ investor currently has only a 10% unrealized loss in the NASDAQ since May, and has seen a 19% loss since the interim Euro NASDAQ top, which incidentally appeared in September and does not coincide with the US dollar NASDAQ top.
Many contrarians around the world have been perplexed wondering why foreigners continue to finance the NASDAQ after its implosion. The NASDAQ denominated in Euros we have just reviewed helps to illuminate that important question. Foreigners have not begun to exit the US equity markets en masse because their losses have been partially offset by the raging US dollar strength. The rare and prudent early NASDAQ foreign investor is still sitting on substantial gains, and the more typical “follower” NASDAQ foreign investor has seen his or her losses cut dramatically in local currency terms.
The currency translation gains also illustrate a MONSTER systemic risk for US equity markets. With a US$1b per DAY trade deficit, the United States is desperately dependent on foreign capital inflows to finance American consumption. SO FAR, this has not been a problem, as foreign financiers and investors have been more than happy to play the outperforming US equity markets. As losses mount and the dollar begins to weaken, however, there is the real possibility of a rapid and widespread sentiment sea-change among foreign investors. Even a 10% drop in the fundamentally overvalued US dollar could pose a huge problem. A mere 10% would cut gains in local currency terms of early foreign investors in US equity markets almost in half, and it would ratchet up losses of late foreign investors tremendously, in many cases causing them to exceed American losses in the US equity markets.
If the psychology of the foreign investors who were so instrumental in the massive anomalous NASDAQ returns of the last year shifts, and they begin to sell, a brutal vicious circle could be set in motion. As the bleeding edge investors liquidate first, the NASDAQ will be pushed lower. They will immediately convert their US dollars into another currency, pushing the US dollar lower. Other foreign investors will see the NASDAQ AND US dollar dropping simultaneously, and they will hit the eject button. They will sell their stock, convert their US dollars back into their local currency, and the circle will become self-reinforcing. The potential damage a mass foreign exit of US equity markets would wreak on a dropping US dollar is difficult to exaggerate. The implications of this scenario are staggering.
In the last few days of October and the first few days of November, the dollar ominously began to weaken. Bitter anti-American gadfly Saddam Hussein rammed a proposal through the United Nations that allows Iraq to accept Euros instead of US dollars to settle its massive crude oil exports. Iraq exports 2.2m barrels per day of crude oil, or a few percent of total global daily demand, so big bucks are at stake. If other OPEC nations, most of whom like the United States little more than Mr. Hussein, begin to follow suit, the possibility of a sharp dollar panic arises. Potential exogenous factors like these coupled with extremely negative fundamentals for the dollar are beginning to converge creating a substantial probability of major discontinuities in the global currency markets this winter.
If the dollar drops more than five or ten percent, the NASDAQ will have a big bulls-eye painted on its back with bright red barn paint. What is an investor to do? A falling dollar, tumbling NASDAQ, and rising Euro would all exert tremendous upwards pressure on the price of gold. Trading at 28 year real lows, gold is at rock bottom from a fundamental valuation perspective. The longer the metal trades below replacement cost and global demand greatly exceeds global mined supply, the more explosively bullish its fundamentals become.
In the last 1500 years of bloody history of Europa, many families were miraculously able to preserve capital through constant warfare, governmental failure, and currency debacles. The fact that there is any capital at all left in Europe after over a millennium and a half of strife is a wonderful testament to the wisdom and foresight of the European people. As stock markets burned, currencies were debased, and governments plundered at will, how did prudent Europeans preserve their hard-earned wealth? NOT by investing in overvalued equity markets, believing the popular hype of the day, or believing in the “good faith and credit” of the innumerable collapsed governments which litter European history… True wealth was protected, nurtured, and grown with GOLD, the ancient metal of kings. Those who possessed it built dynasties, and those who did not were forgotten by history.
As one of the very few non-paper investments with timeless intrinsic worth in a fiat world, gold has an unassailable track record in protecting and enhancing wealth through periods of uncertainty. Gold has stood trial by fire through every financial/political debacle in world history, and has won every single contest. The five most dangerous words for investing are “This time it IS different”. Is this time different? Has gold been permanently evicted from its ageless throne? Not a chance! As world markets continue the painful process of unwinding five plus years of unprecedented speculative excess, gold WILL once again rise to seek its true value.
Adam Hamilton, CPA November 10, 2000