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Where We Stand

The Global Economy

In 2008, the economic crash that I had been predicting for much of the past decade, and that was described in detail in my 2007 book Crash Proof, finally began in earnest. The fallout in the financial markets has thus far been enormous.

Stock markets around the world fell nearly 50% from their 2007 highs. Credit markets nearly froze. The U.S. banking system was on the verge on collapse, saved only by massive and on-going federal bailouts. Losses on mortgaged-backed securities and other debt products tied to U.S. consumers have blown gaping holes in the balance sheets of the largest banks worldwide and have even bankrupted entire countries. Unfortunately, I believe the pain is far from over. In fact, it is likely just beginning.

We are likely experiencing the rumblings of a global economic realignment that reflects the realities of wealth creation and dissipation that have evolved over the past three decades. Contrary to conventional “wisdom” wealth is not created by consumption, but by its opposite. Savings, made possible only by under-consumption, acts as the seed corn for investment and production, and is the root of economic growth and wealth creation. In contrast, wealth is destroyed by government and consumer borrowing and by spending on goods and services that produce no long-term benefit.

Living standards are supposed to rise where wealth is produced and to dissipate where it is destroyed. Like gravity, these forces can only be overcome through tremendous effort. The accumulation of trillions of dollars in U.S. budget and trade deficits, and a corresponding swell in foreign exchange reserves held by Asian central banks, have been the mechanisms which have, thus far, maintained the status quo. But, given the dangerous imbalances these policies create, the global commitment cannot endure perpetually.

I've always maintained that crisis had its roots in the easy monetary policies pursued by the Alan Greenspan-led Federal Reserve, and the strategic decisions of the Asian governments to support the value of the dollar through unlimited lending to the United States. The result was a massive misallocation of resources that inflated bubbles in the U.S. housing and equities markets.

I'm convinced that an economic realignment that reflects underlying economic realities will gain momentum in the coming years. I feel strongly that investors who recognize this trend have the ability to position their portfolios in order to maintain their wealth.

The U.S. Economy

As I wrote in Crash Proof, the deleveraging that would result from the bursting of the U.S. real estate and credit market bubbles would be the cure for, and not the cause of, America's economic ailment. In fact, these violent episodes, however painful, would finally put our economy back on track after years of reliance on credit-driven consumer spending. But what I feared then, and what is even more obvious now, is that the federal government would completely misread the situation and propose "solutions" that would hamstring the free markets, attempt to re-inflate the collapsed bubbles, and completely subvert whatever economic vitality remained. The Obama Administration seems intent on forcing our economy back onto the same track that led us to stagnation.

It appears to us that large swaths of the American economy are headed for bankruptcy and would, in fact, already be bankrupt if not for massive government life-support. However, the public and press do not seem to register that the American government itself is already over-loaded with debt and has no prospect of raising the funds it is currently showering on the economy without resorting to a printing press. For now, America remains afloat largely because our foreign creditors continue to lend. We believe their largesse will be exhausted in the not-too-distant future.

The bursting of the housing bubble, arguably the largest speculative mania in American history, has created many trillions of dollars of real losses for which we need to account before our economy can truly recover. For political expedience, the Federal Reserve, Congress, and the President are trying to delay this reckoning.

To reconstruct the collapsed credit and housing markets, their tools of choice are bailouts, stimuli, tax cuts, deficit spending, and inflation. They are chasing phantoms. Just as FDR's New Deal prolonged and deepened the Depression, the current efforts will magnify the severity of the current downturn and make the ultimate contraction that much worse.

Unfortunately, we feel the most probable outcome is an inflationary depression, which could be more painful than the Great Depression. At that time, the burdens of unemployment and financial losses were at least offset by falling consumer prices. The worst case scenario this time, the odds of which seem to be increasing daily, involves a period of a hyper-inflation which could render the U.S. dollar, and all U.S. dollar-denominated assets, practically worthless. Extreme financial, political, and social unrest would surely follow.

The above forecasts are made with much regret, as we realize that they foretell significant hardships for millions of our fellow Americans. However, we feel compelled to caution as many of our countrymen as possible about the fate that we foresee. We believe that it is important that Americas seek to protect their wealth by moving portions of it abroad, so that in the event the U.S. economy does collapse, it may be repatriated in the aftermath and used productively to help rebuild our economy.

We remain hopeful that dire economic conditions we foresee will at least create a climate in which America can finally return to her constitutional traditions of sound money and limited government, providing a foundation upon which a stronger economy can one day be rebuilt. If out of the ashes of the collapse that I feel lies ahead, the spirit of our founding fathers can rise again, it may one day be possible for America to reclaim her former glory, and once again be that shining city of which Ronald Reagan so eloquently spoke.

The U.S. Dollar

Without question, 2008 saw one of the most unexpected rallies in the history of the U.S. dollar. After steadily drifting downward for much of the last decade, and losing more than a third of its value in the process, the U.S. dollar reacted to the sudden credit crisis in the first quarter of 2008 by staging a stunning rally in which all of its losses of the prior five years were erased.

However, we feel that this rally, which largely fizzled out in the first quarter of 2009, is solely based on fear, not fundamentals. Investors around the world reacted to the financial crisis, sparked by the bursting of the housing and credit bubbles in the U.S., by fearfully scrambling for "safe haven" investments. To a large extent, they chose U.S. Treasuries. The resulting fund flows pushed up the value of the dollar by more than 25%. We feel that this trend will reverse in the near-to-medium term, when foreign investors come to understand the relative safety of their home markets and the danger of hyper-inflation in the U.S.

U.S. Residential Real Estate

Throughout the middle years of this decade, my dire forecasts for the collapse of the housing and credit markets attracted derision and dismissal. In retrospect, it is astounding that the belief in perpetually rising real estate prices could become so completely ingrained in the American psyche. This unexamined doctrine, so assuredly argued by politicians and Wall Street economists, created the conditions by which tens of trillions of dollars were loaned without the slightest regard for risk. These loans, in turn, became the catalyst for the near-collapse of a structurally weak economy.

As I had so often predicted, home prices have not merely fallen, but have plummeted. As of March 2009, national home prices are off more than 30% from their 2006 peaks. In some markets, the declines exceed 50%.

Washington is now struggling to reflate the bubble through a combination of incentives for homebuyers and lenders. Once again, it won't work. Based on analysis of long-term home price trends, fundamental cost analysis, and the realities of excess home inventory and credit availability, we believe that home prices still have far to fall.

The housing industry had become a bulwark of the American economy. Home building, selling, financing, and remodeling created much of the job growth of the past decade. Now that the housing bubble has burst, the air is coming out of those industries as well. Many of the lost jobs will not come back, but will instead migrate to more productive areas of the U.S. economy.

U.S. Stocks
Despite a 50% decline in the U.S. equities markets since the end of 2007, we believe that U.S. stocks remain substantially overvalued given the likely declines in earnings that have yet to be realized by U.S. corporations. As such, we are bearish on the broad U.S. stock market and only find value in certain carefully selected U.S. equities: those companies that are export-oriented and/or commodities-based, primarily in the mining and energy sectors. Although the nominal declines in U.S. stocks may be arrested by the ongoing bailouts and stimuli, the real value of the assets will nonetheless decline with the resulting inflation. This phenomenon will confuse lay investors, and probably most pundits, into believing that a recovery is underway. Our analysts will be indexing any nominal recovery against realistic inflation figures to make investment decisions based upon real economic trends.
U.S. Bonds

In 2008, U.S. government bonds were the best performing asset class on the planet. That rally has continued into 2009. However, we feel that the continued accumulation of U.S. government debt, primarily by foreign central banks, represents the largest and most dangerous asset bubble that we have yet encountered. Given the absolute impossibility that the federal government can repay these debts through any means beside the printing press, it is a certainty that government bonds, which currently offer yields approaching zero, will lose purchasing power before they mature. We believe that the bonds are currently being purchased for political rather than financial motives. These motives can and will change. When they do, the bottom will fall out of the Treasury market, causing a spike in interest rates and a collapse of the dollar.

We also believe that the coming recession will be as severe as anything since the Great Depression, perhaps more so. As a result, defaults by U.S. corporations will increase dramatically. Similarly, U.S. municipalities, whose abilities to raise revenues are dependent on residential property taxes, will also see a wave of defaults.

For these reasons, we recommend that investors maintain minimum exposure to any long-term dollar-based debt instruments, be they treasury, municipal, or corporate. Those holding U.S. dollar-denominated debt instruments should restrict ownership to only the highest-quality short-term maturities. Even those high income investors seeking tax-favored yields are cautioned that avoiding the inflation tax, which stealthily confiscates principal, is more important than avoiding mere taxes on income.

Gold

In a world in which fiat money-substitutes are continually debased by governments around the world, we believe that gold remains the most honest and accountable form of money. When financial uncertainty abounds, it becomes increasingly important to hold assets with value that cannot be diluted by government monetary policy. Gold has been chosen as a store of value and unit of exchange since the dawn of civilization due to its inherent properties: rarity, durability, fungibility, divisibility, and portability.

Ultimately, as the current crisis runs its course, the value of a gold-based monetary system may once again gain favor with productive nations looking to safeguard the value of their savings. In such a scenario, gold would spike in value as central banks became net-acquirers of gold, rather than net-sellers.

Gold appreciated steadily for most of the current decade, ultimately breaking $1,000 per ounce in March 2008. Although prices pulled back by as much as 20% later in the year, gold qualified as one of the best asset classes for 2008. We believe that gold is still in the early stages of a secular bull market. Conservative investors are advised to have a portion of their savings allocated to physical bullion, while speculative investors are advised to own shares of carefully selected mining companies, both domestic and international.

Commodities

Commodities such as metals, grains, and crude oil were driven up relentlessly for much of the past decade due to continued dollar debasement by the Fed and increasing demand for raw materials by the industrializing Asian economies. However, the financial crisis of 2008 fell most heavily on commodity prices, which saw violent price corrections. In many cases, price declines reflected a belief by investors that the global economy would enter a protracted depression which would eliminate demand for commodities. We disagree.

We do not believe that industrialization in Asia will be significantly impaired by the stagnation of the American consumer economy. As a result, we believe that demand for industrial metals, agricultural commodities, and energy staples will push prices back up. For investors, this upward movement will be magnified by foreign exchange benefits as the U.S. dollar loses relative strength against Asian currencies.

Like gold, we believe that commodities in general are still in a major long-term bull market. Therefore, conservative and aggressive investors should seek out respectively appropriate ways to gain exposure to this sector.

Foreign Stocks

As was the case for U.S. equities, global stock markets experienced significant sell-offs in 2008, in some cases outpacing losses seen by the S&P 500. However, despite the precipitous decline in share value, foreign firms show fewer signs of fundamental distress than similarly situated American companies. Although foreign firms that relied heavily upon the debt markets to fund continued operations suffered grievously as credit markets froze, the majority of companies continued to show good earnings.

Combined with the recent declines in local currencies relative to the dollar, we believe that there now exists an exceptional opportunity to invest in carefully selected foreign equities, particularly those that have minimal exposure to U.S consumers or the American economy. In many cases valuations are low, yields are high, and the prospect of earnings growth is favorable. We also believe that foreign stocks, as an asset class, offer potential protection against declines in the U.S. dollar.

Where We Stood
To get a sense of the accuracy of our market predictions over time, please take a look at how we analyzed financial conditions before the 2008 financial crisis became a matter of history rather than conjecture. The outlook below occupied the "Where We Stand" portion of the Euro Pacific Website from mid-2004 through the beginning of 2009.