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Poor Man's Gold Monitor
Is the Perfect Storm Near?
Rich Scott & Ramsay Simmons
Definitions

A bubble or mania is a type of investing phenomenon that occurs when investors put too much demand on a stock or sector. Equity prices rise rapidly beyond any accurate or rational reflection of actual worth. There is no connection to the actual performance of the underlying company or sector. Investing bubbles often appear as though they will rise forever, but prices usually will reach a point where they pop and collapse violently since they were not formed from anything substantial. It demonstrates some weakness of human emotion because most of the money invested by the average Joe is lost or dissipates into the wind like it never existed. For example, the stock market collapse from 2000 -2002 lost a total of 4 - 7 trillion dollars.

A crash is a sudden, dramatic drop in value of individual shares of stock and the total stock market as a whole. It generally occurs in a very short period of time. It is attributable to the bursting of a bubble. A situation is created wherein the majority of investors try to flee the market at the same time and consequently incur massive losses. In an attempt to prevent further losses, investors enter into a round of panic selling trying to unload their declining stocks onto other investors. The smart investors who sold near the top of the bubble are the only ones who benefit in crashes by avoiding the panic selling. In a healthy bull market (trend is up) stock markets have normal correction of between 20 to 30%. It is the markets way of keeping common sense among overly enthusiastic investors.

We would like to look at a few of the speculative bubbles and crashes that have occurred throughout history. Although fairly uncommon in the history of financial markets, major speculative bubbles have been known to occur from time to time, often with ruinous effects. We will look at three examples of historic speculative bubbles: the Dutch Tulip Mania (1634-1638), the South Sea Bubble (1720), and the Bull Market of the Roaring Twenties (1924-1929).

Tulipmania

Around the 1500's tulips were imported to Holland. People could not get enough of them! It seems that everybody needed to buy tulips. Houses were put up for sale, horses were sold, and there were loads of all kinds of goods. The list was endless. Everyday life revolved around the buying and selling of bulbs.

Well you know, the Dutch, they found ways to sell bulbs before they flowered. They even made up a futures market. Eventually, they drove the price to absurd levels. Even banks would loan large amounts of money to people to play the game. The whole situation because so intense, people went crazy trying to outbid each other for the better bulbs. 1

Finally, the government of the day decreed that tulips were just another commodity and could not be used for loans at the bank. Everywhere around the country people were forced to sell. This led to a price collapse. Many noble houses were forced into bankruptcy. Unable to keep up with the falling prices, the Dutch government lost income and taxes that led to its demise. Unable to support spending, they lost their holdings around the world. 2

South Sea Bubble - A Speculator's Perspective

Well here it is 1720. I am the son of a wealthy financier in London, England. I have learned from my father to play the market to make money. Over ten years I have saved 500 pounds. Now what? Maybe I'll buy gold, silver or something? I cannot let my savings, just sit there, idle. There has to be a way to make some real profit with this money. 3

I'm going to the city to see what is happening. Making the rounds of cafes near London's financial district has been enlightening. Where to put my money? The newspaper has a good story about the South Sea Company. They have issued a new allotment of shares that sold out in record time. There's interest in this one. I'm going to buy as many as I can.

South Sea has issued another allotment. I managed to purchase four 100 lots for my 500 pounds. I'm in this game. Watching the next few weeks will be exciting. I have made 42% in 12 days. If this keeps up, I will more then double my investment. A month has passed I've made 90%. I have hit the big time.

Well what do you know!!! 250%. I cannot believe it. My 500 pounds has become over 1000!!!!!

In less then 3months, I have more then doubled my money. Ha ha ha!!! Wait? There has been an announcement. The South Sea Company has issued another allotment!! These shares are more expensive then before. Hmmm. What to do? What to do? I'm going to buy! Was able to get seven 100 lots.

It is now mid May 1720. I've just checked my price and it is up over 60%. This 3rd issue was sold out in no time at all again. I wonder if any more will be offered? It doesn't really matter, by the end of May I predict another 100% profit.

Sure enough it's hit the jackpot again!!!!! June has arrived and I'm going on vacation. This South Sea is good to me. Since January of this year I have managed to turn 500 pounds into over 2500 pounds!! I am selling out. There has been a lot of talk of back room antics. I am smart enough to get out when things change. This company is ripe with bad ideas.

South Sea has had its ships seized recently. Still, it offers more lots. There are people buying them and at very high levels. Glad I got out! All summer long I hear no news from the company. Something is very wrong. September is here. The winds are bitter this year. I have got enough supplies to last for the next five years. I am going home.

It was a good thing I left. Every where I saw signs of people who lost farms, homes and all their savings by not selling out at the right time like I did. Thousands have been stripped of all their possessions and many wealthy folk are destitute. Hunger follows them like the chicken pox. My family and I are leaving for the new world in the morning. We will not miss the sorry state of affairs in England. New York should prove profitable. 4

The Crash of 29 - An Average Joe Perspective

The year is 1929. The stock market is booming. It seems that our troubles are over. The average Joe is working all over the place. Things have been pretty good for the most part as I have managed to save a small amount of cash to invest.

Recently in April, I put my money into the railroad stock, Union Pacific. I was able to grab more shares then normal by purchasing on margin with only 10% of my money down. The shares have moved up by a decent amount. It is now June and the markets have taken a break. Many other people have jumped in driving prices upwards toward the moon. I am going to wait a little before selling for a profit. 5

This is going to be a good year. My stocks are still going higher. Maybe I won't sell. I will try to make as much money as possible. Yeah, maybe I will retire. On October 15, 1929, while reading the business section of the New York Times, I noticed a stock chart that looked like a topping pattern had occurred in the Railroad index. This could be something to watch. On October 21, prices still have not dropped yet. There has been some selling at this level but I am going to wait. The following week on October 28, a number of investment houses have announced that they will sell stock in the morning. 6

The next morning of 0ctober 29, selling has picked up and has continued steadily. By noon prices have plunged 40% without any sign of letting up. It is over! The Dow has collapsed! Black Thursday has happened! I have lost everything! A few men have committed suicide. Things have changed forever. The 1930's will be rough on a lot of people. Many have lost it all including their homes and jobs. Life has changed.

Conclusion: Psychology & Market Manias

The same lessons seem to repeat themselves over many decades. It is a wonder they seem to go unnoticed in times of speculation and mania. Conventional measurements of value are snubbed as the professionals of the era verify the genuineness of the bubble or mania. The general public will act as a crowd. One voice will speak and it is one of confidence. The herd mentality builds momentum as the reinforcement of upward price thrust creates increased speculation that builds to a climax before the trend reverses. All three manias or bubbles described above exhibit similar characteristics by investors and the general public. If we use our analysis of previous manias people can gain an understanding of how history has a way of repeating itself. They can take this newfound knowledge to help analyze and put current market activities into perspective.

Common Characteristics of Manias

  • The economy is prosperous.


  • A new concept or technology is introduced that will change the world.


  • People are extremely optimistic and believe prosperity will continue forever.


  • Crowd behavior has a tendency to look for leadership through its own consensus.


  • People are obsessed on becoming rich very quickly. They daydream about future prosperity rather than deal with the real truth until everything comes crashing down on them. They also fear being ridiculed or looking foolish for passing up their one great opportunity in lifetime to get rich quick.


  • The professionals of the era validate the authenticity of the mania. Have you watched CNN lately on business? It really is a false way to lead the public.


  • Valuations have always exceeded conventional instruments by humungous amounts. The P/E ratio for the S&P500 still sits around 23. This is about equivalent to the PE ratio in October 1929 just before the big crash.


  • Credit standards are lowered creating excessive leverage and increased speculative trading activity.


  • "Everybody else is doing it. It must be safe!" or is it? Herd mentality takes over here. It is the belief by the general public that the safest place to be is in the middle of the herd. Why? "It must be safe! " when everybody is recommending and buying it. People become content for the time being thinking that they have made a good investment. Without ever learning how to do research, they do not realize that they are just following the crowd. The result in most cases is that most buy right at the top and end up getting burnt as the trend reverses. For example, Nortel in March 2000.


  • The still bigger fool theory. Investors want to pay ridiculous prices for stocks or tulips etc. because they were sure that somebody else would pay even more for them. This generally is the pattern until prices get so high that no one is willing to pay the price anymore. As a result they plunge.


People are at fault for creating most of the risk in the market place. They inflate stock price valuations into a bubble over a period of time. The general public's unreasonable belief of getting rich quick generally causes a lot of investors to lose large sums of money in market crashes. The nature of the crowd can see calm, rational individuals be overwhelmed by emotion. On a deep-seated level, the overwhelming power of the crowd is usually driven by the fear of being left out or failing when your friends, relatives and neighbours are making a lot of money. Never fight the power of the crowd, but always be aware of how your individual decisions relate to the power of those around you.

It takes time to change perceptions. People have watched stock markets rise since 1982. Once the trend changes, it could take years for valuations to fall to their bear market bottoms. This would be the point where a new bull market can begin. It takes so long for valuations to bottom because investors overreact to good news and under react to bad news. Past perception seems to dictate future performance.

This is verified by a study entitled "Investor Overreaction: Evidence That Its Basis is Psychological" (2000) by David Dreman and Eric Lufkin. Their analysis of investor behaviour illustrates people's perceptions are more important than the fundamentals. They view under reaction and over reaction as part of the same process with the overreaction beginning in the years prior to the stock reaching lofty heights. There will be a very dramatic correction as people who were comfortable with the old trend slowly begin to realize that something has changed but might have lost quite a bit of money in the mean time.

Dreman and Lufkin conclude "that the cause of the major price reversals is psychological, or more specifically, investor overreaction" and that when a price correction comes then the general public tends to under react. Once the damage is done we believe things will soon get back to normal. There is no scaling down of growth expectations. The stage is set for another surprise and more reaction. It apparently takes years for this to work itself out." 7

The Inflation Trap - Pulling It All Together

Bubbles or manias have occurred in each and every century, starting from the 1600's and continuing up to the present. We have defined what a mania, bubble and crash are before proceeding to give a historical overview of Tulipmania (1634 - 1637), South Sea Bubble (1719 - 1720), and the stock market crash of 1929. We are able to draw some very interesting conclusions on the behavior of the general public. As a result, it gives us deeper insight as to how sentiment works during these periods of time.

Our research will show how the inflationary trap might occur over the next few weeks. We believe that once you see the logic it will actually make sense. The thing we have to realize is that nobody can actually predict the exact events that will happen but we can propose a possible general scenario with certain world events as links. We try to read between the lines on the general trends to establish and build a picture of what is going on in the world and relate this back to the trends. There are certain relationships that stand out. Once they are incorporated into the overall picture we get a better understanding that this current rally in the stock markets was just a smaller echo bubble.

The full length of the last bull market run was from 1982 - 2000. Picture a balloon inflating as the stock market picks up steam and sentiment builds on its way to peaking in March 2000. All of a sudden the rally loses steam and people begin to sell as they realize that these stocks are overvalued. Just then a pin pricks the balloon. All of a sudden there is a panic to rush and sell. Only problem is that everybody else wants to sell at the same time. Prices and sentiment plunge as a result.

At the bottom on Oct 9/02, people wondered what happened and figured that the stock market will do what it always has done, have a correction and then proceed higher. Hence, the sentiment of the general public was scared away for a little while but raring to come back when the time was right. Thus, we have the criteria in place for an echo bubble of smaller proportion. As the stock market goes up, sentiment will follow as it always has, with the only difference being that the stock markets themselves never created any new highs.

Pooof! The bubble bursts a second time, only a little more and with quite a bit of damage. Will we wake up to some news one morning that ignites a chain reaction of events? This generally is how bubbles break. Something happens that starts to change the awareness of the general public that some things are not right in the stock market or maybe even the economy. Oops! Will I get caught twice once the panic sets in? Is there a way out? Sentiment is driven lower as fear returns.

The Perfect Storm

A few years ago a movie called "The Perfect Storm" came to theatres. It was about an experienced group of fishermen heading out to sea to make one final catch late in the fishing season. They were unaware that two or three different major storms were about to merge into one gigantic one. They could not get out in time and as a result everybody went down with the ship. We believe that the perfect storm could possibly be setting the stage for all circumstances to come together as one to trigger an exogenous event to begin a chain reaction. An exogenous event according to Bill Carrigan is "an occurrence that may have a negative effect upon a capital asset. The event is not predictable - much like an earthquake or the sudden death of a key executive. The damage to the capital asset, be it a factory or the price of shares, may be temporary, long-lasting or fatal." 8

After researching the information that has been gathered, we determined that such an event would have to come from a run on the US dollar by foreign investors, causing gold to go through the roof and a major spike in interest rates. The general stock markets have been moving sideways after topping in February. Money has been moving into bonds as it always has.

If there were a run on the dollar, the Federal Reserve of the United States would be backed into a corner, creating the inflation trap. He would have to choose between lifting interest rates to stabilize the US dollar or leave them alone to satisfy the bond investors. Ah! But if he lifts interest rates, the bond markets will have a massive sell off. This would trigger bond yields and interest rates to spike through the roof. It will cause bankruptcies to individuals owning houses and corporations with debt fixed to a variable rate of interest and take all stocks down with it. If Greenspan does not lift interest rates to save the dollar then the consequences could be a lot more disastrous. This is what we mean by the inflation trap, no matter which way he turns, he loses. He is forced to lift interest rates as if he were trying to stave off inflation.

Picture, if you will for a second, taking ten decks of cards and building a large card building with them. The cards would be placed on their side just like building the four walls of a house but this house is ten stories high. Think of this as our financial structure. Mr Greenspan knows two cards in the decks. If he pulls the first one, it causes the whole ten story building to collapse. The second one once pulled would only see part of the structure collapse. This choice is equivalent to Mr. Greenspan having to choose to lift interest rates to stabilize the dollar over trying to save the people invested in bonds. Actually, he really makes a decision between some bankruptcies rather than all bankruptcies. There is damage but not as severe as it could have been. Below we are going to introduce you to some of the overall picture before getting into the particulars.

The US dollar began its bear market in late 2002. Why? The United States has become the world's largest debtor nation. Major differences in import/export imbalances (also called the current account deficit (CAD)) have been built up over the years. It now has reached the point where the US owes about one half trillions dollars to mostly Japan, China, and Taiwan or five percent of the total US gross domestic product (Total country revenues). This has historically marked the danger zone for a currency crisis. The US has chosen to deal with its trading deficit by deliberately devaluing its own currency to eliminate the current account deficit (They print money like there is no tomorrow!). As a result this forces other currencies to rise in value (i.e. The Canadian dollar has risen from .62 US to .74 US over the last eighteen months) and creates a concern for countries whose currency is cheap relative to the US dollar. As their currencies start to rise in value, the cost of goods and services that the country has to offer to other countries becomes more expensive. As a result, they become less competitive to the US whose goods and services have become more competitive on the international market due to the drop in value to the US dollar.

Japan is allowing their export market to stay competitive by keeping their currency cheap. The Japanese Central Bank (JCB) can only print Yen and purchase United States Treasury Bills, Notes and Bond as its interest rates are at near zero levels already. This keeps yields on bonds low, which keeps interest rates low in the US and allows Japan to devalue its currency in order to maintain its export market share.

The following quote appeared in a recent article by Robert McHugh Jr. He quoted Richard Duncan, author of The Dollar Crisis, who wrote, "The most aggressive experiment in monetary policy ever conducted is now under way. Japan is printing yen in order to buy dollars in such extraordinary amounts that global interest rates are being held at much lower levels than would have prevailed otherwise. In essence, the Bank of Japan is carrying out the unorthodox monetary policy that the US Federal Reserve intimated it was considering in mid-2003. In other words, the BOJ is creating money and buying US Treasury bonds, which is helping to drive down US interest rates and underwrite US economic growth - and, by extension, global growth.

It is inconceivable that economic policymakers in Tokyo and Washington do not understand the impact that this unprecedented act of money creation is having on global interest rates and economic output. The amounts involved are staggering. Since the beginning of 2003, monetary authorities in Japan have created Y27,000 billion with which they have acquired approximately $250 billion US - that amount is equivalent to more than 4 per cent of Japan's gross domestic product. Most importantly, it is also enough to finance almost half of America's $520 billion budget deficit this year." 9

This gets one to thinking. What would actually happen if Japan decided to alter or decrease its purchases of US debt? If they were to sell, or even stop buying the ever-increasing supply of treasury debt, interest rates in the United States would have to rise or could rise substantially depending on the size of the redemption (total amount sold at one time) and the frequency with which the US debt is sold. If other countries like China and Taiwan were to follow Japan's lead, what would happen? This would cause a run on the US dollar and could spiral out of control if other countries decide to join in. The only way to stop a run on the dollar would be for the Fed to suddenly hike interest rates high enough to send a message out to the investing community that they are serious about stabilizing the value of the dollar. We do not think that Japan would deliberately start selling off large amounts of US treasuries and bonds without a little advance notice. The Japanese are deliberate, like to save face, avoid confrontation, and drop subtle hints about their intentions.

A perfect illustration of this appeared in an article written by John Lee. We quote John, "Three young Canadian backpackers spent one hour planning their day in a tiny sandwich shop at a Tokyo subway station. Keep in mind the restaurant was tiny with very limited seating. It was a busy lunch hour.

While the backpackers were busy figuring out their route, the shop owner stepped out of the register, approached the backpackers and said, "Excuse me, as you can see, we are a small restaurant."

"Ah yes." One of the Canadians answered.

"Yes, but we are a very small restaurant." The owner explained.

The Canadians looked at the owner and one another dumbfounded, before they figured out that the owner was asking them to leave in order to make room to new patrons." 10

The first sign that Japan appeared to be hinting at selling some treasuries and bonds came with the following news article dated Wed January 28, 2004 07:49 AM ET

TOKYO, Jan 28 (Reuters) - "Japanese Finance Minister Sadakazu Tanigaki said on Wednesday he wanted to carefully consider whether to change the weighting of gold in Japan's foreign reserves. Tanigaki told a parliamentary committee he thought it necessary to take a standpoint of diversifying assets in Japan's foreign reserves, which are mostly made up of dollar-denominated assets. "

Then on Monday March 15th, Reuters published the Japanese Central Bank's decision to end currency intervention by the end of March 2004.

"The Bank of Japan is mulling ending its massive yen-selling interventions in the currency market by the end of March, the Nihon Keizai Shimbun reported from Tokyo in its early Tuesday edition.

A few weeks ago, Japanese officials surprised currency traders by suggesting that their long and heavy intervention in the currency markets designed to keep the yen from appreciating too drastically was coming to an end. Make no mistake, said the Bank of Japan; it will still intervene if and when necessary to arrest any sudden or overly sharp yen rallies versus the greenback. However, the signal was clear; an orderly appreciation of the yen was something the BOJ was now resigned to, if not welcoming."

The Japanese Central Bank (JCB) has been politely asking the Fed to raise interest rates to support the dollar. Failure to respond they hinted to the Fed would risk a plunge in the dollar index. JCB even specified a deadline for the Fed to act - the end of March.

In another article from Reuters, Washington shows that it does not take the hints of the Japanese very seriously. "A Treasury Department spokesman on Monday said U.S. policy in support of a strong dollar was unchanged and declined comment on reports Japan might trim its currency interventions. "There is no change in our strong-dollar policy," Treasury spokesman Rob Nichols said at a weekly briefing for reporters."

James Turk delved a bit deeper into the story. In a recent article he stated, "It therefore appears that Japan has made an abrupt about-face. If these news reports are correct, they have decided to stop supporting the dollar with their currency interventions. But why? A huge amount of hot money fleeing the dollar -- to avoid losing purchasing power from the dollar's decline -- has landed in Japan in search of a safe-haven. This money will tend to stay in Japan if the yen remains relatively strong, but it will flee to safer grounds if the yen gets debased along with the dollar.

The warning bell will sound. It will be an indicator that the yen is being debased, and that as a consequence, the hot-money will start fleeing Japan, which is the last thing the policy makers want. So what do they do? Thus, Japan's about-face can be explained by one factor -- the desire to keep the hot money parked in Japan. Japanese policy makers are sacrificing Japan's export industry and perhaps its economy in an attempt to prevent what they believe will be an even bigger problem, an ocean of hot-money fleeing a debased yen." 11

The end of March has come and gone and the JCB has not done a thing. Perhaps it has been because the recent rally in the US dollar. The rise in the US dollar has allowed the Yen to decrease in value. This in turn has taken a lot of pressure away from Japan's export sector to compete. As we speak the US dollar is forming a top and gold is in the process of bottoming. Japan has already hinted that they are going to sell off US debt in advance. One morning in the near distant future we will wakeup to find out that the Japanese have dumped $100 billion dollars of US debt on the market for sale. And the whole thing begins.

When one looks at all the relationships involved, they all seem to stem around interest rates. US interest rates have been held at 1% for more than a year. This is the lowest they have been in 46 years. The only direction is up. Generally interest rates start to rise to slow down the pace of growth in the economy and keep inflation in check. Alan Greenspan has come out publicly and warned that interest rates will be going up in the near future on an incremental or small basis. This marks the first major change in trends in more than two years.

The stock market has not done very well historically against rising rates. We can expect a harsh fall off in the general stock market the moment interest rates start to rise. The general public must understand that this first rate rise will be the first of many. Individual stock valuation levels will start to drop as rates rise thus wreaking havoc in the general stock markets. It is precisely this lowering of valuation levels that creates our current secular (long term) bear market. The general trend is down. Thus we can conclude that when interest rates are dropping stock markets tend to rally.

This is verified by a couple of studies done by James Montier. John Mauldin quotes him in a recent article. He states, "Montier breaks down historic stock market returns into five groups based upon then current interest rate levels and how the market subsequently performs at different levels of interest rates. Before we look at that study, remember that I have shown in previous letters that typically about 80% of the rise of stocks during bull markets can be explained by a rise in valuation or a rising P/E ratio (what some call a multiple expansion). Only a small part of the rise in stocks is due to an actual rise in earnings.

What Montier finds is: Your best chance of multiple expansion is when rates are high not low (quintiles 1 and 2). When interest rates are low, the evidence suggests a risk of multiple contraction or stagnation (quintiles 4 and 5). Low interest rates may explain why we have arrived at high PEs (because investors suffer money illusion), but they say nothing about the sustainability of that PE. The highest returns are for periods of falling rates. When rates are at their lowest, the stock market returns have been the best for the past ten years.

Montier concludes: "Here the fallacy of low rates being good for equities is clearly exposed. Your best chance of high real returns is buying when interest rates are high, not low. Indeed, buying when rates are low has on average resulted in a negative real return over the next decade!"

Let me repeat that: for the ten years following low interest rate environments such as we are in today, stock market returns are actually negative. Not surprisingly, the conclusion is that the best time to invest is when rates are high and the worst time is when rates are low. This is just one more reason to believe that we are in a long term secular bear market." 7

Next we would like to provide you with a little background in bonds. This will enable you to fully understand how huge the bond market really is compared to the general size of the stock market and that a massive sell off in the bond market is enough to take everything else down with it.

A bond is a debt security that represents a loan from the government, a state, a county or municipality, or it can represent a loan from a corporation. It actually is a unit of debt that a borrower sells to an investor. A bond is considered to be a form of fixed income because the interest rate at the time of issue remains fixed throughout its lifespan. For example, say you buy a bond at a par value of $1000 (purchase price of the bond at issue) and it pays interest at a rate of 5% annually. The $50 interest payment will always be the same. Daily changes in interest rates affect the daily market price of bonds. If interest rates decline, the value of the bond should start o rise above $1000 creating a capital gain. Now we a situation in which the investor collects $50 a year interest and a capital gain. Most investors sell their bonds for gains once interest rates have bottomed.

When interest rates start to rise, the value of the bond starts to move down below $1000. Bond investors are not interested in just receiving the $50 annual interest payment anymore as their capital gain disappears. They can make money elsewhere. So they sell causing bond prices to fall and bond yields to increase. Once bond yields start to trend up, interest rates interest rates will not take to long to follow. Bonds can advance sharply in an environment where interest rates are dropping. But bonds can also hit the skids in an environment where interest rates are rising.

The bond market has been fairly quiet since the Fed made the announcement that interest rates would start to lift in the near future. Bond selling will drive down bond prices and drive up yields in anticipation of the first interest rate hike. As interest rates continue to rise, more and more bond investors will get the message and the selling will intensify. The rising interest rates will feed on themselves and result in even more bond selling, pushing rates even higher. One can see how everyone get trapped if there was a large panic sell off in an illiquid bond market. This would lead to a crash as everyone is looking to sell but there are no buyers. This could even lead to the bankruptcies of several billion-dollar corporations because of larger exposure to the derivative market. A few US companies will go down with the bank. The bank will call to collect its debt. If the corporation cannot pay in full it will go down with the bank. For all we know, we could wake up one morning and find out that the company we work for is bankrupt.

The derivatives market has swollen to an estimated $207 trillion and is vulnerable to system failure. Nothing has changed since the Long Term Capital Management melt-down in 1998, except that the total quantity of unregulated derivatives has multiplied. The ability of major investment firms to clear their derivatives positions could be imperiled by a crisis that changes the liquidity characteristics of financial markets. In addition, major financial institutions are more leveraged today than ever before.

David Chapman recently did an interesting article based on the article "The Coming Storm" which was printed in The Economist. David quotes the Economist, "Banks themselves are notorious at building up huge positions in the latest hot market only to discover that when conditions change, often quickly, they wind up with huge losses. With exceptionally low interest rates banks have been increasing their bets in a wide array of areas including junk bonds, derivatives and structured products and of course the above mentioned investment in hedge funds.

As the Economist article points out one of them was the gamble that after Russia defaulted in 1998 it resulted in not only the markets going "berserk" but in the collapse of Long Term Capital Management (LTCM), a very large hedge fund that had to be bailed out by its bankers at the behest of the Federal Reserve. Bank losses were huge and LTCM disappeared but evidence later emerged that this was so huge it almost brought down the banking system if the Federal Reserve hadn't stepped up cutting interest rates rapidly and flooding the system with money to provide liquidity to prevent the meltdown. The resulting massive liquidity injections were then eventually one of the reasons behind the stock market bubble of the late 1990's.

Of course it is when whatever is on the other side defaults then the trouble begins especially if as it was in 1998 big enough. Large write offs were seen as a result of derivatives and loans in the 1998 collapse and again in 2002 as a result of the internet, technology, telecommunications collapse. But banks are in the business because the returns are huge. But with each round of financial disasters that seem to imperil the system every so many years the markets and the economy become more susceptible to shocks. And each time it takes increasing amounts of new debt and money to bail the system out. " 12

This quote from Bill Murphy of GATA shows just how a bank can collapse if it has too much derivative exposure. We quote directly from the article. "As an aside, I worked in the capital markets for about 15 years. One of my interest rate derivative accounts was the largest in the world at the time. Got to know the rate swap traders quite well. One of them left his then employer (let's just say it was a bullion bank that specialized in derivatives) and went to work for another large bank-but to trade bonds and futures. Having diner with him one night and he tells me the swap desk at his new employer (respecting his opinion) asks him to do an analysis of their swap book. He told me he "modeled" their book to show them what would happen if an adverse interest rate movement were to occur. Understand, at this point he's talking about standard deviations and the sort. He was, shall we say, mortified. The crux of his analysis was that if short-term rates rose something in the order of 350 or so basis points in short order- the bank "blew up"." 13

Conclusions

We believe that there is the possibility that Japan might drop $100 billion in US debt for sale in the international market in the near distant future. They will save face by saying that the US should have heeded its earlier warnings. This will cause the US dollar to drop in value (currently topping) and gold to go up in price (currently bottoming). Other countries like China and Taiwan could follow suit in starting to rid itself of US debt, causing the value of the US dollar to drop further. This will continue to force yields and rates up with a real rise in interest rates not far behind.

As the stock market starts to drop further, money will move from stocks to bonds as it always has but some will also move into gold stock because of the recent correction. As the run in the dollar escalates, Mr Greenspan will have to make the choice to stabilize the dollar over keeping the bond market happy. We figure that the Fed will hike interest rates to about 4%. This interest rate spike could create a huge sell off in the bond market causing a few major bankruptcies. As this happens, it will be time to get out of gold because the sell off in the bond market would be big enough to take everything down with it. We have our money in gold and silver stocks until the next peak. Everything else is interest denominated instruments. In the event that there could possibility be an interest rate spike, I have moved all the money in a my pension into a five year GIC or CD to wait out the storm and wait until the markets give a clear direction to invest again. There is nothing wrong with moving all money into a safe instrument such as a 5 year GIC such as I have chosen. I would rather be making 4% in a waiting mode with the possibility of a 50% drop in the global stock market indices. If the markets happen to drop 50%, my 4% gain becomes a 54% gain because I never lost any money. David Chapman suggests holding gold coins works because, by weight, the value is high. For silver, if you have a safe place to store it, physical holding is certainly preferable to leaving it in any financial institution or exchange. Short-term Treasuries, bank CD's (but only up to $100,000 per institution), I-bonds, and TIPS (Real value bonds in Canada) are a wonderful place to sit out any potential storm. Next, we conclude this week's issue with a little help from our friends.


Rich Scott & Ramsay Simmons

Disclaimer
Poor Man's Gold Monitor is a free information newsletter devoted to the education of the Average Joe. The goal is to aid the Average Joe in making better informed investment decisions. Even though we will provide analysis as to the stock picks that we choose, the information here in is not construed as an offer to buy or sell securities of any kind. The main reason is that we are susceptible to making mistakes in the markets just like the veterans that we follow. It is strongly suggested that all investors consult a qualified professional before trading in any security. The information in this newsletter has been obtained from sources deemed reliable but is not guaranteed as to accuracy and completeness.

Bibliography

  1. Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, ed. Martin S. Fridson (New York: John Wiley & Sons, 1996).


  2. Rob Leich, "Tulipmania: A history lesson", Associated Press, April 20, 2002


  3. D. McNeil, "The South Sea Bubble: A Short Sketch of Events", http://is.dal.ca/~dmcneil/sketch.html, October 11/96


  4. Staff of HistoryHouse.com, "The South Sea Bubbl", www.historyhouse.com/in_history/south_sea/


  5. The Government of Canada, "1929 Stock Market Crash: Markets Suffer Worst Losses in Canadian History", www.canadianeconomy.gc.ca/english/economy/1929stock.html


  6. Dustin Woodard, "Black Thursday - 1929", http://mutualfunds.about.com/cs/history/a/black_thursday.htm


  7. John Mauldin, "Is Someone Ringing A Bell?", Gold-Eagle.com, March 16/04


  8. Bill Carrigan, "Could Traders have Foreseen 'Surprise" Event?" Toronto Star, April 4/04


  9. Robert D. McHugh Jr., "McHugh, Financial Markets Forecast & Analysis", Gold-Eagle.com, April 4/04


  10. John Lee, "The Message Behind JCBs Announcement on Currency Intervention", March 19/04


  11. James Turk, "Japan's Abrupt About-Face", Gold-Eagle.com, March 19/04


  12. Bill Murphy, "Gold Pops Big/ Silver Headed for the Moon", 03/08/2004



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