October 10, 2008

The Beginning of the End
     Peter Schiff, President and Chief Global Strategist

Featured Investment Recommendations
     Our Latest Investment Opportunities

Thoughts on the Financial Crisis
     Andre Sharon, Consulting Research Analyst,
        Euro Pacific Capital

Euro Pacific In The News

Previous Editions of Our Newsletter

While I have warned for years that the United States was headed into the eye of an economic hurricane, nearly every other "expert" from Washington, Wall Street, the press and academia saw nothing ahead but sunny skies. Now, suddenly, there is an overwhelming consensus that absent the Federal mortgage bailout, my dire forecast would have come to pass. While I'm glad that rose colored glasses have finally been removed from so many eyes, the vast majority of these observers are still blind. In truth, the bailout plan substantially increases the threats to the U.S. economy.

When I wrote my book "Crash Proof", I not only predicted that our consumer/mortgage credit-based economy would fall apart, but that the government would ineptly try to repair it. The magnitude of those potential policies formed the basis of my worst case scenario. My fears have now been confirmed, and the U.S. Government is now set to destroy all hope of economic recovery.

Make no mistake; had the government resisted the political pressure to interfere with the markets, we would now be experiencing a very deep recession. But by refusing to let the markets work, policy makers are resisting the only medicine capable of curing the economic disease that afflicts us. The same mistakes were made in the early 1930's, causing a severe financial crisis to morph into the decade-long Great Depression.

The government will now attempt to keep bad loans from failing and real estate prices from falling. Rather then allowing market forces to rein in excess borrowing and replenish savings, it will encourage even more borrowing and drain what is left of our savings pool. Rather than allowing our economy to return to one based on legitimate production, it will continue to encourage reckless consumption.

In the end, by refusing to allow market forces to work their cure, our economy will inevitably die from the disease. Our economy will now face death by hyperinflation, which will cause a complete loss of confidence in the dollar and result in prices and interest rates skyrocketing out of sight. The evaporation of our national wealth will lead to civil unrest, food and energy shortages, and the possible imposition of marshal law. If such a scenario unfolds, what is left of our Constitution will surely be completely shredded.

Although this reality looms as large as anything I have ever seen, investors still do not see the forest for the trees. Convinced that the bailout will actually work, and that foreign governments are derelict for not launching similar plans, global investors are fleeing other currencies in favor of the dollar. Soon investors will discover that foreign politicians and central bankers have acted responsibly. When they do, the current gains seen by the dollar will reverse violently.

Investors seem to be bracing themselves for a global depression that will not occur. Foreign stocks, particularly those exposed to China or natural resources, are trading at the lowest valuations I have seen in my entire career. Fears of a global meltdown are based on the misconception that the U.S. economy is the tent pole for economic activity around the world. The premise of my entire argument is that the U.S. economy, by consuming so much of the world's resources and manufactured goods, and borrowing so much of the world's savings, has in fact been a drag on the global economy.

The enormous global vendor financing scheme is finally coming to an end as the vendors discover that their biggest customer is flat broke. In the short run, our creditors are experiencing some pain because they finally realize that they will never get their money back.

Once the foreign stock markets take this hit, they will be far better poised to grow than their American counterpart. Foreigners will reclaim their productivity and savings for themselves, and will subsequently experience the biggest global economic boom in history. America on the other hand will fare much worse, as we will be left with a hollowed out manufacturing base, dilapidated infrastructure, no savings, and a gigantic Federal Government that will regulate, spend, borrow and print our economy into ruin.

For an updated look at my investment strategy, order a copy of my just released book, "The Little Book of Bull Moves in Bear Markets." Click here to order your copy now. While the "bull moves" I forecast have yet to materialize, I am confident that given time they will. The good news is that now you actually have some time to put my strategy in place at favorable prices and exchange rates!

In our last newsletter, we focused on stocks that we believed were conservative, well managed, good value and paid a healthy dividend. Given the continued volaility of global markets, we think this approach is even more appropriate today. We believe that strong, regular, dividends are the best anctidote to market unpredictability. With that in mind, a few well written sentences from our last newsletter bear repeating.

"In this time of near-panic it is vital to focus on the fundamentals while everyone else runs with the herd. Investors with ice water in their veins, who understand that the world will ultimately shrug off their exposure to the American economy, will be rewarded for scooping up plum assets at bargain basement prices. However, we recognize that when it comes to people's life savings, ice water may be in short supply. As a result, we recommend that during this time of transition, investors consider focusing on conservative stocks that pay good dividends while providing a reasonable degree of insulation from the world at large.

Such companies do exist. And although they may not have intriguing growth potential, they do offer the attractive virtue of steady performance and predictable payouts. By seeding portfolios with many of these "steady Eddies," investors can position themselves to survive the current turbulence. With their income preserved, investors will have the flexibility to move into "riskier" assets once the dust settles and foreign markets regain their upward momentum."

Our research department has found a few more companies we think are worth looking at. Naturally, any company, even the most conservative, can experience volatility and short term disappointments.

Company #1

2007 was a difficult financial year for the entire Canadian energy services industry. A dramatic slowdown in oilfield activity in the fourth quarter following the announcement of proposed increases to the Alberta oil and gas royalty rates coupled with reduced activity levels due to low natural gas prices in North America and a rapidly rising Canadian dollar to U.S. dollar exchange rate caused a significant drop in utilization rates for several energy companies. Among the several companies, one of them has emerged successfully by restructuring its business, selling off an unprofitable segment, paying off its debt and has now become a focused high margin downhole services company.

The outlook for Canadian drilling-related businesses and well servicing has improved with the long term forward outlooks for crude oil and natural gas commodity prices improving meaningfully. Management is encouraged by the recent optimism in the sector and continues to remain confident in the long-term fundamentals for Canadian natural gas drilling and Canadian-based oilfield services. We believe this "new" company with its mergers and divestitures behind the Company coupled with a stronger balance sheet and focused growth areas - service rigs, wireline, and downhole tools offers investors a opportunity to put new money to work. The company's drop in share rice, we believe, is overdone, and we think the current price is an excellent entry point. With C$100 million market cap, 10% dividend yield, trading at just 7x CY:09 projected earnings and close to its 52 week low of C$1.56 (52 week high was C$5.58), we would encourage investors to take a serious look at this Company.

Company #2

This Australian company is a growth story in an otherwise low-growth sector. This growth is possible because its largest single asset, a regulated natural gas pipeline, earns higher than regulated returns with the regulator providing an effective earnings backstop. The company's other assets are regulated natural monopolies that should provide stable predictable earnings in uncertain times. While this company, like most others in the utilities sector, is highly leveraged, rising interest rates have a limited effect on the profit and cash flow available to shareholders. Furthermore, in the context of the potential for an extended bear market, we believe that the earnings stability of this company is undervalued.

Since listing on the Australian Stock Exchange, the company has grown distributions by 7% annually, and we are anticipating distribution growth to continue at 5% annually, both of which are faster than industry comparables. While the company's dividend yield of nearly 10% may not be the highest in the regulated utility sector, this is more than compensated for by the prospect of sustained high dividend growth fully covered by free cash flow. Furthermore, the company's yield will become relatively more attractive in a falling interest rate environment, pushing the stock price upwards.

The company closed at its 52 week high of A$3.55 back in October 2007 and its low was A$2.54 in September of 2008. At a current price of around A$2.75 (US$2.15), the company has a market cap of about A$1.75 (US$1.35) billion and is expected to yield about 10% over the next year.

Investing in foreign securities involves risks specific to international investing, such as currency and political risks. There can be no guarantees of success in pursuing any of the strategies we recommend, or that any of the specific companies will gain in value. Risks 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. While every effort has been made to assure that the accuracy of the material contained in this report is correct, Euro Pacific cannot be held liable for errors, omissions or inaccuracies. Euro Pacific has not independently verified the information supplied by the company, and cannot make any representations as to its accuracy. This material is for private use of the subscriber; it may not be reprinted without permission.

© Euro Pacific Capital Inc. All rights reserved. 1-800-727-7922
10 Corbin Drive, Darien, CT 06840

What happened:

While every cycle is different, they all share pretty much the same characteristics: the system starts looking like a pyramid, with the overwhelming bulk consisting of real capital resting on a solid base. Over time, responding to a variety of forces (discussed below) the pyramid becomes inverted, i.e. involving an-ever higher level of debt holding up an ever-smaller foundation, incorporating far less equity at the big fat top. This is an inherently unstable situation, which can cause the whole edifice to come crashing down for any number of reasons, since increased use of leverage and interdependence between many of the component parts makes it increasingly difficult to isolate and absorb individual shocks. Result: An accident waiting to happen.

What happened this time?

During the past 10-15 years we've experienced decent growth and low inflation. Most people took the good times for granted, coming to believe they were a new norm, and would go on forever. In my opinion they were no such thing ---- they represented an exceptional period, brought about by the very unusual combination of four forces fortuitously coming together:

1. The full fruits of the Volcker-Reagan revolutions in monetary and fiscal policies, which took many years to work their way through the system as they altered the culture of saving, spending, corporate behavior, etc...
2. The end of the Cold War, which released tremendous resources from the public to the private sector
3. The technology revolution, which brought about a dramatic improvement in productivity
4. Globalization, which dramatically lowered prices

As we settled down comfortably into this unique sweet spot in history, human nature took over. People became increasingly complacent, greedy, reckless. Overspending, undersaving, and all the rest, on all levels: personal, corporate, national, international. The pyramid became increasingly inverted and inherently unstable, though only a few realized it.

Architects of Disaster

Even if one accepts the various premises I've outlined above, it doesn't have to follow that the entire edifice necessarily will come crashing down. Nothing can repeal human nature ---- what Keynes correctly called "animal spirits", i.e. greed, selfishness, ambition, the urge to succeed, and all the rest --- but it can be held in check with regulation and sensible monetary policy. In other words, it becomes essential that the monetary authorities not become enablers and facilitators of irrational, stupid, and downright dishonest behavior. The capitalist system works best if risk-takers are allowed to reap the rewards of their activities, but also if they know up-front that they, and they alone, will pay the full price for their failures. We dismantled too many sensible regulations, the Greenspan Fed opened the floodgates of liquidity, and both Congress and Wall Street became increasingly, and symbiotically, corrupt. Those are the architects of the perfect storm. Alan Greenspan has always had a special place of honor in my pantheon of those responsible: by lowering real interest rates to close to zero he practically guaranteed that the scramble to generate return in a context of super-cheap money plus low risk would lead to the creation of insane new financial models. Now Main Street --- the American taxpayer --- is being asked to bail out Wall Street. No wonder the caviar socialists are lapping it up.

And above it all, explaining all, is Freud. I've begun to hear and read a lot about the Svengalis behind the debacle. My thoughtful, considered, response is: undiluted nonsense. Greed and stupidity are universal and eternal, always there and ready to reassert themselves. With no due respect to the anti-American European media, trendy left-wing capitalist bashers, and disingenuous populist conservatives, this is not an American phenomenon. Interesting historical tidbit to help put the present crisis in perspective: Isaac Newton, hardly an icon of emotion and irrationality, lost his shirt in the South Sea Bubble in Britain in the eighteenth century, a phenomenon not unlike the tulipmania that gripped those solid Dutch burghers in the seventeenth. Fearless prediction: we'll re-reregulate, we'll scapegoat, the deals will flow to places where regulations and compliance are a joke, and new models will launch new cycles starting elsewhere but landing here anyway.

What Now?

Only three possible outcomes:

1. We inflate to the level of the debt, i.e. we "fulfill" debt obligations, but in mini-dollars
2. We take the hit, cleanse the system of excesses and move on. Result: deflation, bankruptcies, high unemployment, etc...
3. We disinflate veeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeery slowly, like Japan. Won't happen: the American psyche won't take 16-odd years of no growth. Different cultural mindset: you can't prick a balloon slowly here.

My guess: combination of 1 and 2. I would hope for a bias towards 2. Terrible for many, but healthier for the system long-term. Schumpeter's concept of creative destruction trumps Keynes, in my book. That's life, and progress, with all its faults and flaws.

Investment Implications

Here's my personal list:

1. By all means live boringly in turbulent times. Spend, save, and if you must borrow do it prudently and within your means
2. Inform yourself: listen, read, and observe widely, then use your common sense. There are no experts, only different points of view
3. Distrust most politicians, theoreticians, simplistic slogans, and paper currencies, at least some of the time
4. Diversify your holdings --- geographically, by asset class (ladder fixed income), by sector, by currency, by individual company holdings
5. Right now and until the dust settles, I'm happy to sit on the sidelines (cash) with a significant percentage of my portfolio until I can better measure the expected depth and duration of a global slowdown/recession, contraction of corporate profits, and equity market contraction, which I fully expect to unfold over the next year or so
6. Beyond that period, I expect that the gargantuan world-wide infusion of liquidity will lead to a new wave of global inflation, and a weaker dollar. For that reason I expect gold to appreciate against all currencies during the coming years. For the share portion of gold exposure investments should be concentrated in as safe geographical locations as possible
7. Among sector preferences agriculture stands out. I would take advantage of recent price corrections in this area
8. And wherever and whenever possible, choose high dividend payers, denominated in attractive currencies

Final Thought

Twenty-five or so years ago Mike Milken, the first major financier to harness junk bonds for investment banking purposes, paid a fine and went to jail. Today executives of some of the world's leading investment banking and brokerage firms were reported to be working on improving their golf games and playing poker with their cell phones turned off as their companies were hemmorageing billions. They ran proud century-old firms into the ground, and below, while walking away with hundreds of millions of dollars in compensation.

I asked several people about the logic of this, and the answer is always the same: they did nothing illegal. Neither did their Boards. Stupidity and incompetence are not indictable offenses. You can't legislate morality, and so on.

They're right, of course. Still, one is entitled to ask, "but what about justice? It's outrageous!"

It requires a conscious effort to calm down and reflect on this: the Founding Father writers of the Constitution had it right. With no illusions, they assumed up-front that people are deeply flawed, greedy, corrupt, and corruptible. You can't legislate morality, but you can try to regulate patterns of behavior, while seeking to avoid doing harm. You will never get it exactly right, because it's a process, eternal and never-ending because embedded in the human condition. To expect that one can devise a magic wand to make everything right all the time and in all conditions is a conceit best left to charlatans and intellectuals.

So the party's not over. This particular party is over. But like the final words in Camus's The Plague, new schemes and new models are inevitably being devised consciously or unconsciously in people's heads in response to this crisis, ready for launch at the next round. Be prepared!

This Newsletter is a service of Euro Pacific Capital Inc.