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The Pendulum Swings

July 12, 2005

The World, the Economy and the Stock Market in particular, always act like a giant pendulum, swinging from under valuation to over valuation, deflation to inflation, paper assets to hard assets, calm to turmoil. You can let the swings crush you when they reverse or You can ride them to Great Riches, Its all up to YOU.

The Fed's latest interest rate increases ushers in a new era, as the USA changes from the longest period of falling and record-low interest rates to the new era of increasingly higher and higher rates But most Wall Street analysts continue to view the situation myopically, by not looking beyond tomorrows earnings reports and the narrow confines of the stock market. Since I don't have a crystal ball that allows me to see into the future any more than they can, all I can do is fall back on the only reliable forecasting tool that I ever found to be realiable, which is simple Basic Economic Theory. The world is in the early stages of a massive pendulum swing from Real estate Inflation to Deflation, from Financial assets to Hard assets, from relative Calm to out-of-control Turbulence. If you're on the wrong side of this swing, you can get crushed. If you're on the right side, you can ride it to glorious Riches.

The Importance of Interest Rates

At record-low interest rates, millions of Americans are living in a government-sponsored Garden of Eden of no-risk borrowing. With rising interest rates, they will all too soon discover the real world, where borrowing is costly and risky. But this time the normal pendulum swing is much more than just interest rates. It's also much more than the ordinary four- or five-year business cycle. Remember your physics, the angle of reflection is equal to the angle of incidence. The Bigger the Up Swing The Bigger the Down Swing.

From 1982 until 2000, there has been a massive shift into financial assets, especially stocks, while natural resources and hard assets were in a BEAR MARKET. Which lasted for more than 20 years! It was back in 1962 that the Dow first hit 1000 and it then took 22 years before stocks broke out to new sustainable highs above DOW 1000. It also took more than 20 years for financial assets to recover and rise above their 1929 highs.

Now we're in a new pendulum swing, one that started in 2000. Its just 5 years old but the damage done to investor confidence was so severe that the S&P 500 has only recovered half of its losses, despite more than five years of Herculean efforts by the government to cut taxes, mammoth increases in money-supply growth, record-low interest rates and huge budget and trade deficits, plus add a war for good measure.

What I'm really trying to say, is that for at least the next decade, stocks and bonds are going to be trapped in a no-man's land of stagflation, chronic deficits, recurring financial crises, fear, and self-doubt. There will probably be some short good times in between and there will always be individual sectors that shine but another run like the 1990s will not happen for a very long, long time.

Markets are like a three-ring circus. For the past 18 years until 2000, the center ring has been all about financial assets. Now, that ring has dimmed, and the spotlight has shifted to real Estate and the hard assets gold, energy, commodities, natural resources, The bond market is also having its days of glory. But with bonds, as with stocks, you're going to have to be first of all be very patient and then very selective and careful with your timing. The big wave to ride is hard assets.

Is Financial Asset Inflation dead?

People want just a single answer. Is it going to be inflation or deflation? But the world is not black or white and never will be. After analyzing seven inflation cycles and seven deflation cycles, I haven't found one single instance in which the world got through a Inflation cycle without a massive repudiation of debt. So until we see outright debt defaults; by governments, corporations, and consumers, deflation will remain a real and present danger. I think the Greenspan and the FED knows that. and that's why they first panicked and dropped rates to such extraordinary low levels. And it's precisely that fear which is going to drive them to make even bigger blunders. At some point, they're going to panic in the other direction and drive interest rates too high. That is exactly what's going on right now. The FED has lost all of its leverage and they won't stop raising rates until they are satisfied that they have got their leverage back. But that's going to hurt the economy, reawaken deflation, and cause another massive credit crunch. Then, they'll panic again and try to pump in more money but it will be all to no avail. The end result being a weak economy with Stagflation at best Depression at worst.

The stock market is now in a dead zone, trapped between (a) the government-engineered recovery, which started before the economy was allowed to correct the imbalances of its bubble and (b) the side effects of the government's engineered inflation and too low interest rates.

A review of the recent history of the S&P 500

Move number one: In the late 1990s, the S&P 500 surged from 600 to over 1,500.
Move number two: During 2000-2002, it plunged in half.
Move number three: In 2003- 2005 its struggled to recover half of its losses.
Now it's gone dead, at exactly the mid-point between those extremes.
Like a bouncing ping-pong ball, dribbling to a standstill. Or a coiled spring, about to explode into action.

Look overseas! While investors were being lulled to sleep by a meager 7% correction here in the U.S., foreign markets were getting hammered. China's benchmark index is down more than 20 % from its high. India's and Thailand's were down 21%. Taiwan's Index has plunged more than 32%; South Korea's Composite is down 31%. The capital outflows remind me of the 1997 Asian Contagion, but it's not 1997. Back then, we were in a long-term bull market. But Not now. Back then, deficits were not a big issue. Now we have the biggest twin deficits in history ; a $600 + trillion budget deficit plus $750-trillion trade deficit. So we're shifting to:

Move number four: I think that's this one has got to be down. The question is how far?

In each of its last moves, the S&P 500 has reversed 50 % of its previous move. If that pattern holds, the next move down will be 195 points, or 17%. That's the bare-bones minimum. If the pattern does not hold, Then I see the market setting new bear market lows, which will be well over 300 points, or 26%, in the S&P 500. On the Dow, that would be about 3,500 points down from here. Make no mistake: These are no small moves. Unprepared investors will be stung again only worse than last time.

Turning to oil and energy. I'm looking for $3.00 to $4.00 per gallon gas, and $65 + /bbl crude. Its all part of the great pendulum swing. Its not just about the world's oil reserves, that short term, are not getting any larger, its more about refining capacity. The two biggest oil reserve nations (Russia & Saudi Arabia) are being threatened by serious political turmoil, while demand, particularly from China and India is going ballistic. But never forget: It's mostly driven by the unbridled money-pumping machine and trillion-dollar deficits in America.

The bubble in China probably will burst if it has not already done so but the result will only be a temporary setback. China is already making a far swifter-than-expected transition from an agrarian to an industrial society. It doesn't need that many farmers anymore. So millions are flocking to the cities to market the only thing they have left to sell, their brawn and their brains. Last year, China made 50% of all TVs produced, ranking it #1 worldwide ... nearly 66% of all personal and notebook computers, also ranking it #1 ... and nearly 33% of all mobile phones. In the process, they're scooping up raw materials like there's no tomorrow. But make no mistake about it, China will also suffer tremendous dislocations and political upheavals. They will not have a soft landing as no centrally planed economy, even if you call it capitalist, which its not, can possibly make all the necessary correct decisions that are required to run an economy the size of China's.


Demand from China is also helping to drive up gold prices. But the primary driver behind gold is that giant U.S. money pump at the Fed. Last year, the U.S. government pulled out all the stops to cut taxes, slash interest rates, and pump up the money supply. to an astonishing $281 billion-dollar increase in M3 in 2003, $180 billion in the first quarter of 2004, and yet another $108 billion in May of 2004. This is phenomenal. No wonder gold and real estate prices have gone ballistic! Typically, you see that kind of stimulus only after major catastrophes, like 9/11 or the Crash of '87. For it to happen now, in this environment, is unheard of. Something obviously spooked the Fed. Otherwise, why would they have resorted to such ridiculously low, emergency interest rates? By the way it didn't work in the 30's and it won't work now. But now, the Fed has decided that the emergency is over. and Rates are ready to once again rise to non-emergency levels. That alone will double the rates to at least 5% by year end. But it won't stop there as the Fed continues to ratchet up rates in an attempt to stabilize a crashing US Dollar and continue selling our treasury Bills abroad.

Auto loan rates will climb. Mortgage rates, will jump and Credit card rates will spike. Consumer debt is already off the charts.

The use of debt (the Carry Trade) by institutional traders, Banks, Hedge Funds and speculators around the world, with numbers in the TRILLIONS, doesn't even have a chart. They're all sitting ducks for rising interest rates.

Our challenge in this environment, is protecting our selves from risks of a crash while still finding investments that can give some decent upside potential. The first thing I did last year was to reallocated 60% of my assets into short term fixed income governments (Australia, Britain, Canada , New Zealand) with the balance into tangible assets, such as gold coins, and gold and energy trusts .

When financial assets crumble, governments panic. Their power base is directly threatened. To make matters worse, their typical response is to inflate ... inflate again ... and inflate some more. But that just makes it worse, prolonging and extending the swing of the pendulum. That's bad for society. It would be far better for all concerned if we just faced the music and let the stock market and the economy correct itself. The 1919-1920 depression had a more severe drop than it did in 1929 but was able to self correct in less than two years because Pres, Harding refused to allow Hoover to implement all his recession busting plans " The banks got themselves into this mess so let them get themselves out."

History repeats but it's only been recently, that a few economists have begun to examine The New Deal and its effects on the Depression, which actually served to prolong the Depression rather than end it, as most people, politicians and economists of both sides still mistakenly believe.

The government now realizes that there's far too much public and private debt. So, it pumps billions of dollars of stimulus into the economy to inflate the currency and monetize the debt, so as to pay off their debts with cheaper dollars. Its been tried be for, over the past few thousand years and has always led to depressions or what is even worse war and political upheaval. It's classic socialist theory now being applied by supposedly a Conservative Fed Chairman and a Conservative Republican President. Who is kidding whom? Would you believe Greenapan was once a disciple of Ayn Rand, who once advocated a return to the Gold Standard. I don't know why the Democrats hate Bush so much, they could never get a more socialistic acting president and Fed chairman. . Its quite possible that the economy can muddle through for another year or so, at which time we will probably have a replay of the 30's. The Last Clinton inherited the beginning of the biggest boom in history, the next Clinton, will, like F.D.R, inherit the beginning of a depression and she will probably make the exact same mistakes since like FDR, she believes that big government is the solution instead of the problem.


Aubie Baltin CFA, CTA, CFP, PhD.
Palm Beach Gardens, FL
[email protected]


12 July 2005

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