I did something really dumb last December... I recommended betting against Warren Buffett, the world’s greatest investor.

Now - normally, I wouldn’t be so stupid.

In ten years of writing investment letters, I can’t ever remember specifically betting against Buffett. (I did wonder why he kept holding stock in Coke back in 1999-2000, when it was so expensive. It’s lost over half its value since then.)

Back in December I looked at the same numbers he did. I did the same homework. However, this time I came to the opposite conclusion. Buffett’s conclusion was that our trade deficit was killing us, and the U.S. dollar had to crash. He put tens of billions into the trade to back up his idea.

I felt so strongly about my conclusion – the opposite of his – that I made it my theme for 2005... “The Buck Stops Here” was my theme this year, meaning that the dollar would stop falling against the euro, and strengthen instead.

So far, we’ve been right. And Buffett is wrong. My subscribers have made good returns. Buffett has literally lost billions. This year, the euro is down by about 13 percent versus the dollar. Buffett’s losing money. That’s why in his latest quarterly report (released on Friday), Buffett said he’d cut his position in this trade by about $5 billion dollars.

What happened? Why do I think Buffett was wrong and we were right (at least so far)? And where do we go from here?

It’s simple. I think Buffett’s got the wrong premise...

Yesterday the latest trade figures came out. Its official: We have the worst trade deficit in U.S. history. If Buffett’s theory was right, the dollar should have fallen. Instead, the euro has fallen, and it’s now at two-year lows.

What’s the explanation here? Dennis Gartman explained it yesterday:

“Unlike Mr. Buffett... and others who wail and gnash their teeth and sell the U.S. dollar relentlessly because of the U.S. imbalance of trade, we pay no attention to the imbalance. The U.S. has been in imbalance of trade for our entire life, and it shall remain so... We only know this: the long-term effect upon the dollar of the trade deficit is zero... nada... nothing... zippo. Spending time trying to correlate a rising trade deficit with a weakening U.S. dollar has been a complete and utter waste of time.”

In the long run, economists tell us, this trade deficit will come home to roost. Of course, to quote the most famous economist - John Maynard Keynes - “In the long run, we’re all dead.”

The point is, while the trade deficit may come to haunt us eventually, we simply can’t trade off it.

The short run is what matters when it comes to currencies. And in the short run, money flows to where it’s treated best. Cash earns 4% in the U.S. and 2% in euros... so money flows – and will continue to flow – into the dollar. That’ll keep driving it up.

“Purchasing power” also matters, but much less so in the short run. The dollar and the euro aren’t far out of line on this one, so I won’t waste any time on it. I’ll simply say that, over time, a pair of Levi’s jeans costs about the same in Paris as it does in Chicago or Tokyo. The key is, “over time.”

The last thing that matters for currency valuations, it seems, is the prevailing trend. The prevailing trend in the euro is down. I sure have no intention of fighting the trend. In fact, I’m sticking with it...

These are the three things (the trend, interest rates, and purchasing power) I use in my 1-2-3 model to size up currencies. Right now, the trend is against the euro and so are interest rates. With that in mind, we’re keeping our bet on the dollar and against the euro.

Mr. Buffett is still betting big against the U.S. dollar, based on the big U.S. imbalance of trade.

We’ll humbly continue to bet against him on this one.

Good investing,

Steve