Yesterday I took part in a roundtable discussion with some seriously smart, articulate money managers, two of whom are putting their clients into foreign stocks. Well-run companies with nice dividends in fiscally-sound countries will outperform, they said. And a rising euro or yen or yuan will actually be a great thing for their countries when the dollar really starts to tank, because a rising currency will make these countries far richer. Their companies will be able to buy up foreign assets and their consumers will become engines of growth as they snap up increasingly cheap food, cars and toys. 

It all sounds so…civilized, this smooth transition to a world in which the U.S. is no longer central and other countries can consume enough to more than offset the loss of U.S. demand. I played devil’s advocate a bit, pointing out the downside of a plunging dollar for the rest of the world and opined that maybe other stock markets would suffer a bit along the way. But roundtables being what they are, the conversation moved on and I didn’t a chance to make the point all that forcefully. I’ve spent the rest of the day playing the argument over in my head, and far from being convinced by the smooth-transition thesis, I’m more sure than ever that a plunging dollar makes foreign stocks (other than gold miners) nearly as risky as their U.S. counterparts.

In fact, far more likely than a smooth multi-year adjustment process is a series of discontinuities. A bunch of hedge funds blow up and U.S. stocks fall hard, to which the Fed responds with a rate cut. Derivatives start to freeze up and the Dow drops 1,000 points, leading the Fed to cut rates again and sending the dollar to fresh lows. The falling dollar pushes up long term U.S. interest rates, causing financial stocks to plunge and leading the Fed to buy up long-term asset-backed bonds, thus whacking the dollar again. You get the picture. To each new crisis the response is the same, and the pressures on the dollar and U.S. stock prices grow. With the U.S. in turmoil, the stock markets of our trading partners fall, partially in general sympathy, and partially because their soaring currencies are shutting down whole export industries. With the euro at $1.75 (up from $1.40 today), New Yorkers aren’t buying much French wine. With the Canadian dollar at $1.25 (up from $1.00), Californians aren’t visiting Vancouver. And with the Japanese yen and Chinese yuan soaring, Americans in general are squeezing another year or two out of their old game systems, big-screen TVs, and cars. European and Japanese consumers buy a bit more at first, but they lack the shop-till-you drop, put it all on plastic and worry later kind of élan of their recently-departed American counterparts. So European and Asian factories start to close, and voters lose their jobs.

Most of these countries are democracies, more or less, and their governments respond predictably, with rate cuts and tax cuts and higher spending. But these “competitive devaluations” backfire, as the bond markets at long last realize that in a fiat currency world, there is literally no limit to how much paper a panicked government can print. Falling currencies beget higher interest rates, mortgage lending dries up, and it’s game over for stocks. Whew.

Anyhow, as all this is running through my head, I pull up a chart of the FTSE/Xinhua China 25 Index, an ETF that tracks Chinese blue chips, and am wowed by the way it's doubled in the past year, even as the subprime crisis has been hammering the U.S. and U.K. financial sectors.

Then I found the following chart in a Financial Sense article by Tedbits Newsletter editor Ty Andros. It depicts the Shanghai Composite index of Chinese stocks, which has had a nice couple of years indeed. You don’t even have to know what a chart this steep depicts. It’s an automatic short just on principle.

So just a few minutes ago I bet against China (and against the smooth transition theory) by buying some ’09 FTSE/Xinhua China 25 put options. I’ve been happily short U.S. banks and homebuilders for a few years now, but this is my first stab at predicting the secondary effects of the dollar’s collapse. Back in a few months with an update.

BUY GOLD AND SILVER ONLINE AT GOLDMONEY