The Good, the Bad, the Ugly

If you think you have seen this movie before, you are right, since this movie has played time and time again throughout history. Other than regular changes to the names of the currencies and the nations, the movie usually ends much in the same way.

Our protagonist, gold (“The Good”), prevails in the end, while as the antagonist, the U.S. dollar’s (“The Bad”) fate is sealed from the start. And what would a movie be without a sidekick, in this case the American Government (“The Ugly”): an often-misunderstood character whose unpredictable actions inevitably have an impact on the outcome of the fortunes of the two central characters.

Unfortunately, the lesson in this story – the US dollar’s unfortunate fate – seems lost with most people today.

There are a multitude of forces at play behind the current bull market in gold. So, I think it misleading, that so much attention is given to the daily gyrations of the gold price, which in turn takes focus away from the true nature of the forces behind this bullish trend.

Commentators, both bulls and bears, are quoted daily on the reasons for that particular day’s price move. Invariably, most attribute the recent moves to either the fear of a messy war with Iraq or the dissipation of those fears. My reaction to all this daily noise – is to ignore it. We are in a secular bull market in gold that is driven by macro-economic events that have little to do with the immediate Iraqi situation. This trend will continue for a number of years, and while the daily ups and downs of the gold price may make bulls suffer anxiety and give the bears opportunity to declare the end of the bull market on a regular basis — the trend is clearly up.

Gold Bull Market: Climbing the Wall of Worry

Remember, every bull market, whether it’s in stocks, bonds or gold, “climbs a wall of worry” in the early stages and it never goes straight up. In addition, gold is especially volatile given its lack of liquidity compared to other financial assets. As an example, witness the 1970’s gold market, which I believe bears many similarities to the current market. It took ten years of dramatic ups and downs before it eventually climaxed with an $800 gold price in 1980.

Gold is the chicken soup of all economic maladies that ail the world. It has taken many years and plenty of abuse to the system to create the necessary environment for the major gold market we are now seeing. The gold price will continue to move higher as the effects of that abuse are recognized and fully understood. The corrective process will be beyond what most people are prepared for. In the end, the standard of living most Americans took for granted will be lowered significantly. The structural deterioration of the system is the end result of such things as an aftermath of a stock market bubble, unprecedented high levels of public and private sector debt, and a U.S. currency whose meteoric rise and subsequent abuse allowed it to permeate into every financial corner of the world.

So although factors such as declining primary production (2002 gold production fell for the first time in seven years), ever increasing de-hedging policies by gold producers (hedge books contracted by 423 tonnes in 2002, almost three times as much as the previous year), a forty-year-low interest rate environment and its re emergence as a preferred asset class (with the underperformance of financial assets, gold purchases for investment purposes more than doubled from 2001 to 2002), will continue to help the gold price move higher, gold’s status as a currency and store of wealth will be the driving force behind its long-term upward trend. Since gold and the dollar have a historical high inverse correlation, the degree to which the importance of the U.S. dollar waivers or falls, will have a corresponding positive effect on the price of gold.

Gold Bull Market: The Best Intentions

I am fairly sure that the folks who brought us such religious ideas as Judaism, Islam and Christianity, did so with the best of intentions. The eventual success of these religions made them so powerful, that the temptation to abuse them was too much to ignore. Similarly, the folks that created the concept of fiat currencies also had the best of intentions as they attempted to smooth, and perhaps even eradicate, the business cycle. But, as with religion, the tremendous success of the currencies, which have represented all of history’s global powers, also begged for abuse.

For a number of reasons, the U.S. dollar has achieved such a dominant status as the premier global reserve and transaction currency, that its abuse as a tool to exercise power goes barely noticed.

By all measures (as against other currencies and commodities) it is evident that the dollar is losing ground..but why? There are many reasons, but in general terms, abuse by U.S. policy makers and citizens alike, allowed it and the system backing it to get so corrupted, that spooked foreign dollar holders began switching into other currencies and gold.

Let’s recap in more detail – the U.S. was the recent host to the greatest stock market bubble in history, which burst three years ago. Even so, like the villain in a B movie, the U.S. stock market continues to resurrect no matter how many fatal blows it receives by way of bad news. Consumers, government and corporate debt have grown to levels totaling well over $30 trillion with only corporations showing any recent signs of restraint. Consumers, the worst offenders, continue to pile it on – having increased their debt load by 500% in the last twenty years and are continuing to borrow at a rate which is ten times faster than Gross Domestic Product growth. For its part, the government, having doubled its debt load to $6.4 trillion in the past ten years, borrowed an additional $750 billion in the past eighteen months alone.

Gold Bull Market: Looking at All the Factors

Also, short-term interest rates are at forty-year-lows, allowing for nothing more than further speculation in stocks, bonds and real estate, while the widening real interest rate differentials are potentially disincentivizing foreign purchasers of U.S. government debt. Throw in America’s aggressive foreign policy (which will help push the federal deficit to almost $500 billion this year), the Fed’s threat to print money as a means to avoid deflation and an annual current account deficit representing 5% of Gross Domestic Product – it doesn’t require much imagination to see why foreign holders of dollars may soon look to the exits.

Let’s look briefly at all these factors, starting with the stock markets. Even though the bubble burst three years ago and equities are off between 30% and 75%, depending which exchange they are listed on, it’s still hard to justify current valuations. With the S&P 500 trading at thirty times earnings it’s hardly a steal.

Worse still, if one factors in the current reality of rising energy, insurance and health care costs (which have all increased dramatically), pension plan losses (once reality replaces the current policy of reporting fictional gains), excess capacity, lack of pricing power, declining consumer demand and how all of these factors impact corporate profit margins, the “E” part of P/E (price to earnings) forecasts suddenly become suspect.

As in the last couple of years, after barely hitting recently downgraded earnings, corporations are ratcheting down their earnings guidance for the rest of 2003, and as usual the analysts are ratcheting down current quarter market forecasts and back loading the higher growth in the third and fourth quarters. With economic indicators such as ISM (Institute for Supply Management), factory orders, retail sales and initial jobless claims worsening, I wouldn’t be surprised if we don’t soon double – dip into recession, foretelling a further drop in earnings.

So why are equity valuations so high? The Fed’s continuing easy money policy fuels the fire, I am sure. And for some reason Wall Street strategists and economists continue to retain credibility with their wacky market and economic growth forecasts. But, I think it has more to do with a change in investors’ attitudes and perceptions. For years, a pervasive media and the spin meisters – who know how to use it, have shaped these perceptions. CNBC in my opinion is the biggest purveyor of optimism in the market place, although they are not alone. You would think it might be difficult to consistently put a positive spin on an endless string of bad economic data.

But by a combination of what appears to be selective emphasis (i.e. no repetition or follow-up on bad economic news and repeating the trivial stuff ad nauseam) and allowing “industry experts” (who all have an interest in keeping investors in the game) to comment and opine on the data, and finally switching to sports and entertainment news on days when the economic news is particularly bad, investors never have a chance to do the right thing..and panic. Instead, investors feel obliged to pile into overpriced stocks with the tenacity of a pod of pilot whales beaching themselves. As for CNBC, who knows, maybe its parent GE will recognize this winning formula and license the format to foreign territories suffering with sagging stock markets in need of a boost.

Gold Bull Market: Coming Down to Earth

Irrespective of all this hype, equities will inevitably come down to earth. The effect this will have on the dollar will be very negative, as approximately $1.5 trillion worth of all U.S. equities are foreign owned. Consider what must be the growing disappointment of, say a European, whose U.S. equity portfolio may be down a nominal thirty percent or more, but is actually down over forty percent in his home currency terms.

At some point he will cut his losses.

That said, it is always difficult to predict short-term market performance and with all the liquidity currently being pumped into the system, it’s quite possible that the U.S. dollar will decline against the backdrop of a stock market rally.

With regards to the debt situation, foreign lenders who own over 40% of U.S. government debt, 23% of U.S. corporate bonds and over 20% of mortgage debt must, by now, be waking up to the fact that the U.S. is a nation of savings-deficient, debt-hooked consumption junkies. Furthermore, it is governed by an administration that is hell-bent on creating $1.8 trillion – according to the Congressional Budget Office (CBO) – of deficits over the next ten years. It may end up even higher as it looks as if current budgeting of U.S. Social Security benefit costs will prove totally unrealistic. Just two years ago the CBO projected a $5.6 trillion surplus in the same period. One might think this kind of swing would raise some eyebrows in the global currency markets.

But, if history provides any clue, it is that eventually there should be a “tipping point”, when the creditworthiness of America will come into question. It is impossible to guess when that day will come even though the cracks are beginning to show. At best we will see a decade-slow deterioration of America’s creditworthiness accompanied by continued dollar devaluation and, at worst, outright panic followed by an Argentina-style (they also had a lack of domestic savings when foreign lenders cut them off) dollar collapse.

There is no doubt that currently America is the most dominant economic and military power on earth. Although the world has seen many great powers come and go, including the Spaniards, the French and the British, America’s influence in all global matters, whether economic, military, technological or cultural, is a phenomenon the world hasn’t seen since the Roman Empire.

Gold Bull Market: Repeating the Mistakes

Sadly, the mistakes that brought about the economic demise of all the past global powers are being repeated with impunity by America’s government and citizens alike. When confronted with these historic similarities, most Americans will likely dismiss the danger, convincing themselves that their current superiority is deserved and permanent. They believe that their system is so advanced and sophisticated that policy makers will always manage to keep things under control.

Even when the system shows signs of strain; they all work feverishly to spin the information such that the masses do not panic. This game of confidence (or otherwise known as a “confidence game”) will continue until something gives. For their part, the masses are happy for the reassurance, even though their gut may tell them all is not well. Since most people can only relate to their own lifetime experience, they will believe when told that the current malaise is a run-of- the-mill recession. Very little attention is paid to the fact that the current system has structural flaws that have deteriorated over the last three decades. These flaws are worsening in an exponential fashion, and still we would rather believe that this is a garden-variety recession that can be remedied with the traditional tools of fiscal and monetary policy.

It is becoming increasingly evident, to some at least, that these policies are not working this go around. When a system is overloaded with debt and over capacity and there already exists a gross imbalance between consumption and production, no amount of monetary or fiscal stimuli (which are meant to inspire demand) will work. Conversely, it makes the situation worse by fueling asset speculation and increasing public and private sector debt.

Looking back, it is difficult to argue that, historically speaking, America was initially a great experiment. The American standard of living is the envy of the world and was achieved by a combination of a political system that allowed and rewarded success by anyone regardless of class, and by a puritan work ethic that didn’t exist elsewhere. Both these characteristics held true for most of the 20th century and started to deteriorate only in the last several decades. This path to economic perdition was a result of an ever-increasing societal shift from production to consumption, and by transformation from a nation that was once the number one creditor to the world to one of being the number one debtor.

Gold Bull Market: At Future Expense

Americans are holding on to their standard of living not as a function of their productivity, but at the sacrifice of the family unit (since it now requires both spouses working to maintain a standard that forty years ago took only one), and at the expense of their own future generations (as the result of the increasingly heavy debt load), and at the expense of the rest of the world (a function of its record and ever- growing trade deficit).

How long the world’s other 5.7 billion people will continue to trade their products and standard of living for U.S. dollars is anyone’s guess, but I suspect that with the Current Account deficit running at $500 billion per year (and expected to rise to $600-$700 billion) and the U.S. government’s printing of dollars and issuing debt at historic proportions, it won’t be for long.

The ever-increasing government fiscal deficits are the result of a system that refuses to sacrifice consumption while its government embarks on a military adventure to reshape the world in its own image. It has to be a historical precedent that a debt-laden government goes to war and proposes to cut taxes simultaneously. Keep in mind that the CBO forecast mentioned earlier does not include the cost of waging a long- term war on all that is anti-American.

Government deficits can only be satisfied by borrowing from either its own citizens (an indirect form of taxation) or from foreigners. Already foreigners own over 40% of the $6.4 trillion in government debt. Add to that the projected accumulated deficit of at least $1.8 trillion – I believe it will be a much higher number, given this year alone the deficit could reach $500 billion – over the next decade plus borrowing for other “capital expenditures” and the total debt becomes a whopping number.

Then assume the same ratio of foreign holdings and it becomes apparent that the U.S. will have a difficult time servicing that debt, never mind ever paying it back in anything resembling current dollars. Of course, the alterative solution is to inflate the debt away by printing more dollars, which is exactly what the Fed has already threatened to do to stave off looming deflation.

Conveniently, the government would repay the debt in dollars that would be worth a lot less than today’s dollars. Again, there is nothing new in this little game. Every global powerhouse in history has played the same game. What is amazing though, is that judging by the dollar’s current value, it seems that very few foreign dollar holders have fully caught on.

God help America the day when everyone catches on.


Frank Giustra,
for The Daily Reckoning
May 27, 2003

P.S. Look for Part II of The Good, The Bad, The Ugly… tomorrow…

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Deflation, deflation, deflation.

The word is getting a workout. A few years ago, almost no one had heard of it. Now it seems to come up on every financial page…and even at polite dinner parties. People say the word without embarrassment…and feel no need to apologize after if comes out. They don’t even have to explain it. Everyone knows what it is.

“Deflation fears” are driving up bonds (and driving down bond yields) say the news reports. Ten-year treasuries rose on Friday; yields fell to 3.30%. So, if you buy a $10,000 bond you’ll earn the handsome sum of $330 dollars each year as your reward for lending the government money. This, by the way, is the same government that is promising to make the $10,000 worth a lot less in the future than it is now. The most recent talk has the Fed “targeting” an inflation rate of around 3%.

Hmmm…you earn 3% in yield while you lose 3% to inflation? And that’s if the Fed hits its target. It might just as well end up a little wide of the mark…with inflation, say, at 5% or 10%. Why would anyone who is not a neo-con…that is to say, anyone who is capable of thinking straight…want to buy bonds on those terms? U.S. treasury bonds have become an investment where the risk/reward ratio seems so steeply tilted towards the risk side that only an economist would want them.

Almost everything looks better. Euro bonds pay twice as much…and the euro is rising. Chris Wood of “Fear and Greed” recommends “nearly every traded currency in the world, with the exception maybe of the Philippine peso” over the U.S. dollar.

And yet, to the Japanese, a 3% yield on dollar holdings looks pretty good. The equivalent yield in Japan is just 0.535%. Or ‘effectively zero.’ But while they earn nothing on the yield, the price of things falls…so they get their profit from deflation.

The Japanese are now buying U.S. bonds. In fact, they’re the biggest buyers. They are trying to keep the dollar up against the yen, say the analysts. Even in a slump, Japanese exporters sell 30% of their wares to the U.S. and need to keep Americans buying.

They also hope to make money from their investments in the U.S. “Substantial further disinflation would be an unwelcome development,” said Alan Greenspan last week. But that is exactly what the Japanese are betting on.

“Our own situation is strikingly similar in some ways to that of Japan a decade ago,” Paul Krugman elaborates. “Like Japan circa 1993 or 1994, the United States is now facing the aftermath of a huge stock market bubble – the Nikkei and the Standard and Poor’s 500 both tripled in the five years before their respective peaks.

“Also like Japan, we face a problem not of sharp downturn but of persistent underperformance – an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization.Whatever reassurances Mr. Greenspan may offer, the staff at the Fed is very worried about a Japanese scenario for the United States.”

The effect of persistent underperformance was deflation. Prices have in Japan fallen about 1% per year for the last 7 years. Bond yields have dropped to near zero and stayed there.

If America follows the Japanese example, bonds will rise further and buyers will look like geniuses. If not, they will look like the rest of us.

Over to Eric Fry, back in New York:


Eric Fry writing from Wall Street…

– US financial markets hung out the “Closed” sign yesterday in observance of Memorial Day.and, like most Americans, we New Yorkers fired up our barbecues, despite the constant “hiss,” “hiss,” “hiss” of a dreary, cold rain dousing our Weber grills.

– Someday, we imagine, warm weather will return to New York. And someday, we imagine, our economy will again bask in the warm glow of economic growth. But an unseasonable and uncomfortable chill continues to linger over the national economy.

– Happily, the stock market’s pyrotechnic display is throwing off a little heat, while also creating an entertaining diversion for the lumpeninvestoriat. As long as share prices rise, investors may indulge in all manner of happy fantasies, like the soothing notion that a weakening dollar is good for the economy.

– It’s true, of course, that a little dollar devaluation — like a little cocaine — provides a little pick-me-up. But overindulgence is as certain as it is destructive. As the dollar’s “manageable” devaluation devolves into something less manageable, the “little pick-me-up” becomes a “big downer.” Eventually, foreigners sell their dollar-denominated assets in order to stash their capital in a currency that is not depreciating day after day. Dollar selling begets further dollar weakness, which begets further dollar selling.and that’s not a pretty picture. The greenback may be much closer to such a dangerous “tipping point” than most Americans imagine.

– “With America more dependent on the rest of the world for foreign capital than at any time in the past 50 years, any disruption in that supply is cause for concern,” the Financial Times reports. “This year both the US current account and the US budget could be in deficit by as much as 5 per cent of gross domestic product, representing a material proportion of the rest of the world’s savings. Indeed, foreign investors’ willingness to supply America with capital at yields of less than 4 per cent is what has prevented the country from plunging into a big recession.” – But how much longer can we expect our foreigner creditors to buy bonds yielding 4%, when those bonds are priced in a currency yielding minus 20%?

– “The non-U.S. portion of the world has a vote on dollar interest rates,” Jim Grant observes in a recent Forbes column. “Because the U.S. consumes much more than it produces and owes abroad much more than it owns abroad, torrents of dollars pour into the world’s payment system. The holders of these dollars have Bloomberg terminals, too, and some fine day they might wake up and sell bonds. Who could blame them?” – Although we Americans have been running a current account deficit for a decade, and counting, we never seem to lack for willing creditors.

– “But there are a few reasons the deficit could be harder to finance this time around,” the Financial Times ominously asserts. “First, the US investment proposition has changed. Three years ago, overseas capital rushed to fund a private- sector, technology-inspired productivity miracle. Now America needs twice as much capital from abroad to fund a large and rising public-sector deficit that has arisen as a result of President George W. Bush’s tax cuts and the war on terrorism.At the very least, foreign investors may be keen to change the terms and conditions under which the world supplies America with capital.”

– In other words, interest rates may rise to compensate for the ever-present risk that the dollar’s value may fall. And it is possible, we imagine, that rising interest rates — triggered by a falling dollar — could exert an un-bullish influence on share prices.


Addison Wiggin back in Paris…

*** “For most of the 20th Century gold has been under assault,” writes our fearless leader, Bill Bonner, in an introduction to a new 3-volume set called The Case For Gold. “A war against it has been waged for the last seven decades. The struggle has gone back and forth… with gold gaining ground in some years, losing it in others. Never has there been any doubt about the final outcome.

“No paper money has ever endured over the long run… nor has gold ever disappeared, or ever lost value against paper money over an extended period. But something extraordinary happened in the last two decades of the 20th century… something that never happened before: For a period of 20 years the Midas metal retreated… while paper currency, primarily the U.S. dollar… rose in value against it. As a result, gold fell far from grace in the eyes of governments, politicians, bankers, economists, Wall Street and Main Street as well.

“But there was a time when Presidents, bankers, economists and philosophers spoke of gold with respect and awe, not just as money, but also as a protector of wealth and freedom.

“Paper money is a great aid to politicians. It makes it possible for them, said President Herbert Hoover, to confiscate ‘the savings of the people by manipulation of inflation and deflation.'”

During The Great Depression, those who wanted a safe harbor for their wealth, turned to gold. Now it appears that deflation, secular recession, runaway inflation and perhaps another depression are on the horizon. And gold once again is coming to the center of the financial arena.

With these rapid changes in mind, we publish a special two part series: “The Good, The Bad, The Ugly” by chairman of Lion’s Gate Films Frank Giustra… below…


Addison Wiggin

P.S. The handsomely bound 3-Volume “Case For Gold” is edited by Lord William Rees-Mogg, published by the London-based Pickering & Chatto and is being hailed as “a first in publishing history”. Our affiliation with Pickering & Chatto allows us select editions at a great rate. If you’re interested…

The Daily Reckoning