first majestic silver

The Steve Puetz Letter

Part - I

July 1, 1997

Dear Fellow Thinker:

Much confusion exists between the terms economic and financial. It's frequently said that we live in the best of economic conditions. Joblessness stands at a 25-year low, and US companies are very competitive globally. To this list, Merrill Lynch chief economist, Bruce Steinberg, adds: "The US economy may be in the best fundamental shape of this century. Growth is healthy but moderating, inflation is all but invisible, and earnings continue to rise. Indeed, the latest set of economic indicators could hardly be more favorable, validating our bullish tale of moderate economic growth and low inflation."


Just how good conditions really are, however, depends on whether they are viewed economically or financially. From an economic standpoint, it's true -- things couldn't be better. But, financially, we are already in a disaster. Let me explain.


Webster's defines economic as: "Pertaining to the production, distribution, and use of income, wealth, and commodities."

Production, distribution, and consumption. Those are the functions of the economy. In the United States, some of the major economic indicators are as follows:

  1. PRODUCTION indicators include housing starts, industrial production, capacity utilization, Gross Domestic Product, and total employment (the number of people working at production).
  2. DISTRIBUTION indicators include business inventories (which measures the degree of success in moving goods from producers to consumers) and the following consumption indicators.
  3. CONSUMPTION indicators include auto sales, retail sales, and Personal Consumption data in the quarterly GDP report.
  4. From an economic standpoint, things look great. People have jobs. They are spending the money they earn. Business activity expands month after month. Retail prices are holding steady -- thus CPI inflation hasn't been a problem. This has led many analysts to describe the US economic scene as the "Goldilocks Economy" -- one that's not too hot, and not too cold, but one that's just right.

However, the "Goldilocks Economy" is a creation of Keynesian economists. Keynesians believe that as long as consumers have jobs, and as long as they spend their income, the economy will do just fine.

But, it's a mistake to monitor the economy without also looking at its foundation. It's a lot like buying a home. In either case, it's necessary to examine the not-so-easily-observed foundation before judging the worth of the part easily seen through daily observation.

For the economy, the foundation is financial.


Webster's defines financial as: "Pertaining to monetary receipts and expenditures; ... or pertaining to those commonly engaged in dealing with money and credit."

Almost without exception, the popular press completely avoids discussion of the financial condition of the US economy. They concentrate almost exclusively on the rosy economic scenario. For example, in the bullish Merrill Lynch article cited on page 1, Bruce Steinberg's only mention of financial conditions was in this excerpt:

"Newly released Fed data shows that the savings rate, as measured in the Flow-of-Funds accounts, remained at an all-time low in the first quarter. Indeed, when pension-fund contributions are excluded, Americans actually had a negative savings rate."

Steinberg then attempts to put a bullish spin on this financial disaster by saying that Americans will soon begin to save more. He predicts with these savings, even more money will go into stocks and bonds. As a result, he thinks the financial markets will continue to soar.

In fact, the Federal Reserve Flow-of-Funds data confirms what I have been adamantly stating for many months -- that the United States is engulfed in a tremendous financial mania, and leverage is the vehicle inflating the mania (not savings).

Unfortunately, both history and logic show that any over-valued market must continue to suck in more credit to keep inflating. This implies that for stocks to go up, the US savings rate must become even more negative.

The tell-tale signs of the financial condition of the US economy, however, are the ever-rising rates of bankruptcies. defaults, and delinquencies. US consumers and businesses are increasingly unable to repay loans in the best of economic worlds.

What we have is a "Goldilocks Economy" coexisting with a "Vampire Financial State." Consumers spend every last dollar they have to keep the economy inching forward, while their burdensome debt-loads suck the financial life out of their balance-sheets.

It's noteworthy to add that the rising trend in credit difficulties is stronger and moving with more force than the weak-trend in economic gains. Which of these two trend will win?

Obviously, the US economic structure can not stand up much longer with the national financial foundation crumbling to pieces below it. The trends now emerging support my long-standing prediction: the next major move in prices will be deflationary. More precisely, a violent deflation.

In fact, some mainstream economists are now beginning to recognize this threat. Leon Korobow, an economist and a retired official of the Federal Reserve Bank of New York recently wrote: "Policy-makers may be getting their wish -- an economic slowdown -- as suggested by the weak retail sales figures for May and the revised figures for the two preceding months. But the magnitude of the decline in retail sales is certainly more than anyone would have bargained for and is a clear danger sign for the Federal Reserve. In addition, producer prices have extended their declining trend to five months, and major technology companies are warning of slower growth ahead. Can there be any doubt that the gathering forces in the US economy are deflationary?"

The trend in credit-difficulties gets stronger with each month. The American Bankers Association reported on June 17th that its over-all delinquency index rose once again -- this time for the first quarter of 1997. Previously, bank credit problems were mostly concentrated in creditcards. Now, delinquencies are shooting higher in their car-loan portfolios.

All of this bad debt is only possible because lenders have been increasingly willing to take on greater credit-risk in their competitive bid for new customers. This drive for yield and risk has become all to obvious in the credit-markets.


Jacqueline Doherty gave this account of the speculative tone of the marketplace in the June 9th edition of Barron's: "Bond investors have turned into yield junkies. They're grabbing at whatever yield they can find and begging for more. The signs of addiction began to appear earlier this year. But last week the situation got more than a little out of control. In the global markets, investors clamored to buy bonds of Brazil and St. Petersburg as if they were being sold by US municipalities. In junk-bond land, investors snapped up $1.35 billion of debt from TransAmerican Energy, which is run by a guy who has led not one, but two companies into bankruptcy. And adding to the excitement, investors rolled the dice on the weather. Yes, they bought securities that basically pay out only if hurricanes don't hit the East Coast... The demand for yield has ... kept the party going in the junk-bond market. About $4 billion of junk bonds were priced last week alone. In fact, if new issuance continues at the current pace, volume of new junk bonds sold will easily surpass the $73.6 billion record set last year.... And June's new issuance volume could compete with the record - breaking months of August 1993 and May 1996. The new deals are coming out with incredibly low yields and trading up after issuance, thanks to the cash that keeps flooding the market."

Things Eke, like "Brady Bonds" have become popular. These "US-backed" bonds of mostly Latin American governments have attracted the yield-junkies. These bonds have risen 4-fold since the 1990 bear market. See the following chart.

And the amount of leverage in the marketplace keeps rising and rising. As one example, open interest in listed financial derivative is now just shy of 50 million contracts -- 5 times higher than the post-crash level of 1987. See the chart below.

Ever increasing amounts of leverage being shifted into the riskiest areas of the marketplace are the perfect indication of the speculative nature of the present mania.

One thing is certain. When all of this leverage tries to unwind -- as leverage always does -- the greatest financial crash of all time will explode onto the scene.

Gold weighs 19.3 times as much as an equal volume of water.
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