March 9, 2007

8 Look Out Below
         Peter Schiff, President and Chief Global Strategist

8 Investment Opportunities in Global Stock Exchanges

8 Euro Pacific In The News

8 Upcoming Appearances

8 Previous Editions of Our Newsletter

With last Tuesday's 500 point intra-day dive in the Dow Jones, it appears that the current rally has finally run out of steam. Though the fall of Chinese stocks may have provided the pin, the selling on Wall Street has nothing to do with the price of stocks in China. If you listen closely you might just here the sound of air hissing out of a bubble.

Despite the Dow's nominal new highs set in February, I still maintain that we are in a stealth bear market. If the Dow was priced in Euros, Swiss Francs, Coffee or Gold (or anything besides the non-inflation adjusted Dollar), it would be nowhere near the level it traded at in January of 2000. There are many reasons to suggest that the long term trend for U.S. stocks is down rather than up. Recent data clearly shows that what is left of the U.S. manufacturing sector is already in a recession, and the home building sector is set to implode. With home prices and corporate spending in decline, a recession in the general economy cannot be too far off. Goldilocks is about to mauled by three very angry bears.

If a recession is in the cards, some may wonder why last week's stock sell-off came with equal declines in gold bullion and a nearly 7% drop in gold stocks. Typically, gold benefits from a recession-fueled flight from stocks. However, the market still incorrectly believes that a global economic slow-down will be negative for gold. The reality is just the reverse. As central banks around the world, particular the Fed, will attempt to combat any slow-downs with additional inflation (i.e. rate cuts and money supply expansion). Such conditions are bullish for gold. On Tuesday, skittish investors headed for Treasuries, and bond yields fell substantially. But in an inflationary environment Treasuries will be among the biggest losers. One day the markets will figure this out, and major drops in the stock market will cause investors to sell bonds as well, with the safe-haven money fleeing into gold instead. When this day arrives, those not properly positioned in gold and foreign assets, will not be able to make the necessary adjustments in time. If you have not done so already, make them now.

More surprising than the Dow's sharp decline, or the media cheerleader's efforts to convince investors to "buy the dip," were new policy decisions unveiled by Freddie Mac regarding sub- prime mortgages. The shocker: Freddie will no longer buy loans where there is a "high likelihood" that borrowers cannot meet their monthly payments and which are "highly vulnerable to foreclosure." Talk about closing the barn door after the horse!

Is this an admission that Freddie Mac formerly bought loans that they knew were likely to end in default? They also announced that the higher standards would not go into effect for several months. Therefore until that time they will apparently still buy loans that they know will likely end in default. In addition, by limiting the change in policy to sub-prime loans, it appear that Freddie Mac intends to continue buying prime loans where borrowers cannot meet their month payments and which therefore are also highly vulnerable to default. I guess Freddie Mac wants to make sure all of the horses have left that barn before it attempts to shut that door as well. Incredible.

When asked on CNBC why the agency had waited so long to impose tougher standards, the head of Freddie Mac explained that when home prices were rising, Freddie Mac did not think it was their place to prevent sub-prime borrowers from profiting from the boom. He went on to state that he did not want to substitute his judgment with respect to future real estate prices for those of millions of homebuyers. In other words, since people were making piles of money making bad bets on real estate prices, Freddie Mac did not want to turn down the action. So even though they knew speculative buyers were lying about their incomes and assets to purchase houses they could not afford, Freddie Mac did not want to rain on everyone's parade. So instead of acting responsibly, they simply kept the party going, held their noses, and bought the loans anyway. Unbelievable!!!

Anyone who thinks these problems will be confined to the sub-prime market is delusional. All the same abuses occurred in prime mortgage lending as well. Zero-down, negative amortization, adjustable rates, and no-documentation loans, were not unique to the sub-prime market. There are plenty of speculators with good credit who committed to mortgage payments they could not afford in order to catch a ride on the real estate gravy train. Since sub-prime loans were clearly the most vulnerable, they are the first to blow up. However, as millions of sub-prime buyers will now no longer have access to the real estate market, and the homes that they own go up for sale, many in foreclosures, real estate prices will drop sharply. When that happens, prime loans will unravel just as quickly as their sub-prime counterparts.

Predictably, all of the mainstream market pundits, including Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson, are claiming that there is no evidence that the sub-prime problems are spilling over into the prime market. In the first place, even if they do not spill over, the problem is huge. In the second place, the spill over process takes time. It's only been a few weeks. It reminds me of Wall Street's initial reaction to the first blow-ups in the dot coms. First they said that the sell off would be contained to the real crazy companies that went public late in the game. It would not effect the "blue chips: like Yahoo, Ebay, or Amazon. Then they said only the "B to C" companies would fail, but not the "B to B." (In case you forgot the lingo, B to C meant business to consumers, and B to B meant business to business.) Then they said, OK it's an internet thing, surely it will not hurt tech in general, like Cisco or Intel. Then they said its just tech, it will not spill over into the over all stock market. Get the picture. We have all seen this movie before and we know exactly how it ends.

Stock exchanges are no longer the cozy, private clubs they used to be. Today, many exchanges around the world have gone public, allowing individual investors to become shareholders. In 2006, the New York Stock Exchange ( NYSE ) went public, joining stock exchanges in other countries that were already public. By investing in the stock exchanges themselves, investors can participate in the inner workings and profits of these vast centers of finance and wealth creation.

Until recently, the United States was the overwhelming center of the world financial system. And US stock markets were the undisputed kingpins of global stock exchanges. US markets enjoyed by far the greatest breadth and depth, in terms of capital, liquidity, transparency, strict legal guidelines and protection for all participants, and sophisticated banking institutions and infrastructure. As a result, foreign as well as domestic companies were anxious, proud, and keen to be listed and traded in the US.

No more! Powerful new global forces are reshaping the financial industry worldwide, and, over time will reshape the economic, political, and geopolitical world of tomorrow. And these forces are causing explosive growth in the stock exchanges outside of the US. Here's why.

Globalization and interdependence, not only in products and services, but in international financial flows. Much of the developed world has moved from operating with exchange controls as late as the 1960's to being able to routinely transfer billions of dollars (and yen and euros and yuan, etc…) instantaneously at the click of a button.

Loss of US financial dominance. While the US is still the leading force in international financial markets, it is no longer the dominant one, nor in a position to impose its will whenever and wherever does it want.

Financial Innovation, based on a veritable explosion of derivative-based instruments, hedge funds, private equity deals, etc. Much of this innovation is cross border.

Technological Innovation. Electronic trading platforms are spewing a mind-spinning raft of improvements and innovations. The London Stock Exchange will soon be able to cut the time required to process an order to 10 milliseconds, increase capacity to handle orders four-fold, and display prices within 2 milliseconds of receipt. All this is expected to result in a surge of volume.

Strong growth in demand for financial services, reflecting ageing populations in Japan, Europe, and soon the U.S., increasing the demand for retirement-focused services globally.

Synchronized global economic growth. As a result of all this, the global economy is experiencing the best rate of economic growth in years --- forty, in fact --- without a single major country in recession or serious slowdown.

"World's Assets Hit Record Value of $140 Trillion". That recent headline in the Wall Street Journal, referencing a study by McKinsey & Co. encompassing 2005, pretty much summarizes the end-result of the preceding analysis. All of the money needs to be invested, and global stock markets will be one of the main beneficiaries.

The high cost, and inconvenience of doing business in the U.S. The US has the most strict legal and compliance rules governing its financial markets in the world. The costs and inconvenience of complying with Sarbanes-Oxley has chased away much foreign business form US markets. Foreign companies ask "Who needs this?"

The end-result of these trends has been startling. In 1999, the NYSE and NASDAQ accounted for 57% of the world-wide IPOs.. By 2006 their percentage had dropped to 18%. In 2006 U.S. exchanges ranked # 3 in IPOs, after London and Hong Kong. London is also proving highly attractive for Russian company listings. With its long history as a financial center, Hong Kong, of course, is proving to be an ideal location for launching Chinese IPO's. Unsurprising bottom line: foreign listings on the NYSE peaked in 2002, even as the Dow was clawing its way to new highs in subsequent years. And it could get even tougher for American exchanges to compete, as foreign standards and governance improve.

Around the globe stock exchanges are seeking mergers, alliances, and cooperative arrangements in order to better position themselves to compete in the brave new world of tomorrow. The NYSE expects to purchase Euronext, the pan-European stock and derivatives exchange operator, creating the first major transatlantic exchange. Nasdaq's bid to acquire the London Stock Exchange has been rejected, but that's hardly the end of the story. The NYSE has entered into a cooperative agreement with the Tokyo Stock Exchange; the Chicago Mercantile Exchange and the Chicago Board of Trade plan to merge, creating the world's largest derivatives exchange; the German Deutsche Borse and the Korea Exchange are entering into a cooperative arrangement to share information, staff, and assist in listing of promotional activities in both markets. The Hellenic Exchange is seeking to establish itself as a regional hub; with Cyprus and possibly Bulgaria operating under the same umbrella. Stay tuned. More developments are sure to occur.

Given these powerful global financial trends, we believe that an investment in a foreign stock exchange makes eminent sense. Being smaller and more fragmented than their U.S. counterparts, foreign exchanges are likely to grow more rapidly. As more money heads into foreign markets, and financial institutions diversify their assets out of the Dollar, these exchanges will be major beneficiaries. Some foreign stock exchanges have seen their prices move up sharply recently; others less so. Current valuations are not as compelling as they were a while ago. However, we believe the long term trends are extremely positive. For investors prepared to take a 2-3 year view, we believe that exposure to a number of selected foreign exchanges has excellent potential.

We have highlighted 4 foreign exchanges that we think you should consider. Brief information about each is below.

Exchange #1
This stock exchange has significant exposure to the China trade, and should benefit from China's dynamic growth. Some of the key metrics are:

P/E  33 ( est 2008 )    Dividend Yield  2.4%

Exchange #2
This exchange is located in Europe, and bridges the gap between the dynamic, rapidly growing economies of Eastern Europe, and the developed economies of Western Europe.

P/E  17 ( est 2008 )    Dividend Yield  2.5%

Exchange #3
This exchange has access to a number of smaller, fast growing Southern and Eastern European markets.

P/E  16 ( est 2008 )    Dividend Yield  3.6%

Exchange #4
A leading exchange in an important and strategically located Asian location, providing broad exposure to China and raw materials. Excellent play on China.

P/E  26 ( est 2008 )    Dividend Yield  4.8%

Risks
These include an economic slowdown, or worse, which would adversely impact economic growth, profits, and investment flows; a financial accident resulting from the veritable explosion of global liquidity, increasingly risk-taking and its attendant volatility; a terrorist attack; any developments impeding globalization (protectionism); and currency volatility/weakness.

This Newsletter is a service of Euro Pacific Capital Inc.