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Taylor on us Markets & Gold

The Paper (Financial) Markets

October 15, 2002

Stocks Remain Extremely Expensive. Avoid the Bear Trap
Investors may have seen the value of their stocks decline by $8.4 trillion so far this year but despite this huge decline in value they remain more expensive even that in 1929. At the end of this past week, the GAAP P/E ratio was an alarmingly high 32.5 times for the S&P500.

We want to remind you once again of the enormously successful strategy of ignoring stocks when their earnings yield is lower than the yield provided on 10-year Treasuries. As a measure of just how awful the corporate environment currently is in America, the S&P earnings yield is still considerably below the 10-year Treasury yields. As we pointed out in a past issue, Michael B. O'Higgins demonstrated that investors could have done far better by being OUT of the stock market during the 1980's and 1990 and being in bonds. Amazingly, $1,000 invested in the O'Higgins process in 1972 would have grown to $415,302 by the end of 2001. By contrast that same $1,000 invested in the Dow would have grown to a still respectable, but far less scrumptious $31,736.

The key to the disciplined approach, which we wrote about in prior issues of our monthly newsletter is to approach the markets by systematically buying it when it is cheap and staying out when it is expensive. O'Higgins compared the S&P Earnings Yield noted above with the 10-year Treasury. Not only are earnings for stocks near an all time low, they are still low in relation to Treasuries. So strictly applying the very successful O'Higgins approach, we must largely ignore the stock market, though we have made a couple of minor exceptions.

Systemic Fiat Money Risk is on the Rise Good as the O'Higgins approach has been, Mr. O'Higgins himself understands that it has some shortcomings. In fact, O'Higgins understands that our fiat money system itself is now in danger of self destructing, which is why he is on record as saying he thinks the gold price is headed to levels in excess of $1,000 per ounce. With the system falling apart, there is only one solution for you as an investor and that is to opt out of the fiat currency system by buying the antithesis of fiat money, namely gold and gold shares.

Opt Out of the Fiat Money System ASAP from:

  • Your Pension Plan
  • Fiat denominated Assets in General

Based on what you have been told in the past, you might reasonably expect your pension fund will be there for you when you finally reach retirement age. After all, wouldn't something as serious as a pension plan be invested prudently and conservatively? It may not represent the highest possible nest egg available, but it would certainly be invested in something safe and secure like AAA Corporate debt, or sovereign debt of credit worthy nations, high quality debt instruments, or perhaps the bluest of blue chip corporations that have been so healthy they have not missed a dividend since prior to the 1930's. I always assumed that was just the way pension funds were run so that my basic financial needs in old age would, along with social security would be met.

That assumption prior to the roaring 1990's may have been valid. But remember, caution was thrown to the wind during the 1990's because after all, none other than that candidate for deism himself, Alan Greenspan promised that the old laws of nature, as they pertain to the economy at least, no longer existed. And a popular myth circulated by Wall Street through the 1990's was that equities were no more risky than bonds. And so, over time, the pension funds began to also throw caution to the wind. They bought into the big lie, that our fiat currency system was sound, just like 99.5% of all America did. So now, as our equity values melt away toward zero, our entire financial system, which of course includes our pension funds are in trouble.

In his September 3 rd article titled, "The Fantasy of Fair Value," my good friend, and contributing writer/analyst for the Prudent Bear fund, Marshall Auerback, pointed out how pension fund performance assumptions are capitalized such that those who are more aggressive in their assumptions have been equally blessed by their auditors as those who are more honest and conservative. And so, with bonuses riding on short term performance for CEO's, Marshall notes that "….Its no surprise, therefore that many chief executives opt for assumptions that are wildly optimistic, even as their pension assets perform miserably. These CEO's simply ignore this unpleasant reality and their obliging actuaries and auditors bless whatever rate the company selects. How convenient: client A, using a 6.5 percent rate, receives a clean audit opinion - and so does client B, which opts for an 11 per cent rate."

The trouble is, as Merrill Lynch pointed with stocks now down for a third straight year, the pension funds of hundreds of top U.S. companies will be under funded at the end of 2002. What that means for the more fortunate workers is that their companies will remain in business and as such be able to make good on their pension fund commitments. But to the extent that companies are under-funded, they will now need to expense future funding sot that corporate earnings may be drastically reduced. But as the Kondratieff winter bears in upon us, the big question is how many firms will be able to survive and as such meet their pension obligations whether or not they are under funded.

Merrill Lynch estimates that the traditional pension fund, also know as defined benefit plans, for 98% of 346 S&P 500 companies are expected to be under-funded at the end of 2002. Those companies make up 70% of the S&P 500. On aggregate, the pension funds of these 346 companies are expected to be under funded by $640 billion - or 69% of the total assets in their pension plans, according to a Merrill Lynch analysts study. Excluding post-retirement funds, pension funds are under-funded by $323 billion at the companies, a sharp drop from an over-funded position of $0.5 billion at the end of 2001. At the end of 2000, the reverse was true: The funds were over-funded by $215 billion. Given our view that the decline in stock prices still has a long ways to go on the downside before this bear market is over, it is possible that we are now only seeing the tip of the ice berg in terms of bankrupt pension funds. Remember the demographics are now becoming increasingly onerous for America as a whole as a huge number of Americans are about to begin to consume their pensions even as the value of these investments continue to decline with declining equity values. Lord only knows what political ramification all of this will have on future generations of Americans especially since the abortion of 35+ million American babies means there will be a much smaller tax base from which the government can transfer wealth from a producing to a consuming sector of our economy.

Invest in your Own Pension Fund ASAP
There would of course be a solution for pension fund woes, if pension fund managers were able to do a little independent thinking. As I told the audience at Calgary, what we are now facing is systemic risk. And what we have to do to successfully survive this system wide risk is step outside of the fiat currency system that is in deep dodo. The only way to step outside of the currency system is to exchange the currency that is in trouble, namely dollars and other fiat money for gold which retains value no matter if banks can return deposits to their subscribers or not. You must step outside of the fiat currency system by trading your paper for gold. Trouble is, I do not know of a single pension fund manager who understands the need to buy gold as an insurance policy against systemic risk. When the Fabian Socialists and Keynesians took over our university economics departments, they indoctrinated investors very well not to look at gold when the system begins to break down. Somehow the establishment deluded themselves into thinking that if only they could trash gold or get it out of our system, fiat money would be successful. They did not understand that gold serves as an honest protector of the common good. No doubt, more than 99% of all pension fund managers, being indoctrinated with Keynes, hold his very unwise views on gold. But given the absence of gold as a discipline against the rampant creation of fiat money from thin air, we are beginning to see what economic hell awaits a world awash in paper that has been irresponsibly manufactured from endless amounts of debt. Somehow that debt has to be serviced. But from what cash flow will it be serviced given trillions of dollars lost as a result of printing press induced mal investment of the 1990s.

Still pension fund managers are "a go along to get along" group of people as are most corporate types. They are more interested in keeping their jobs than in being sure your pension fund is there for you when you need it. And they have been taught not to think independently but rather to march in goose step fashion with the ruling elite. Blindly, our fund managers have out of ignorance accepted the notion that a managed fiat money system is always better than one chosen by the market. The vast majority of pension fund managers do not wish to risk their comfortable corner office nor risk being labeled "anti'-American" because they buy gold. As a result of their blind obedience to Caesar, they may manage to hold their cushy jobs a while longer, but their pensions funds, which have not been prepared to withstand systemic risk will go down with the Titanic.

But You Can Protect Your Assets Against Systemic Risk.
So what can you do? Aside from investing in gold outside of your pension fund, depending on your age, you might do what your editor did several months back. I had a very small pension fund with Credit Lyonnais, for whom I worked in the early 1970's. It was worth only about $20,000 earlier this year. But when I turned 55 years old earlier this year, it was possible for me to withdraw it and place it in a self managed IRA. And so that is exactly what I did. Once invested in my IRA, I bought the Prudent Bear Fund, the Prudent Safe Harbor Fund, a couple of senior producing gold stocks and some shares of NCE Petrofund. By so doing, I stepped outside of the system buy exchanging a currency system that is ostensibly a lie (paper money) for another that is money in truth, that being gold and for short positions against the dollar and U.S. stocks. So far, so good. And I think the profits from this move have really only just begun.

My recommendation to you is to be courageous and go for it. Don't worry about what your banker tries to tell you or what your friends say. Think independently and if you come to the conclusion I have come to, namely that our existing fiat monetary system is in trouble, opt out of this mess and protect yourself against the impending massive decline in the value of our dollar and the global fiat money system as a whole.

Gold Protects Against Deflation as well as Inflation
Aside form the pension problem, corporate earnings for American firms remain disappointing, and Japan is sinking deeper into a depression, just as Ian Gordon had predicted in our 1999 interview and subsequent updates. And, the U.S. economy is still being sacrificed on the strong dollar alter of Wall Street in a losing attempt to try to perpetuate the lies and fantasies the late 1990's Wall Street orgy. But those days are over so you must protect yourself against plunging income during the deflationary Kondratieff. If you are in a building that is on fire, you get out of there as soon as you see the fire cannot be contained. It is clear to me the deflationary pressures of the Kondratieff winter are becoming every more severe which means there will be no escape for people who remain in the fiat money system. The only way to protect yourself is to get out of the building. To opt out of fiat money into real money, namely gold.

Can gold do well in a deflationary environment? You bet it can! There are two examples to prove the point. First, in the 1930's when prices were plunging Americans began to demand gold in exchange for paper money. This became such a problem the Hoover's Secretary of the Treasury warned the President that unless this stopped, the U.S. Treasury would have no more gold. Shortly after taking office, Roosevelt signed into law a bill that would forbid Americans from owning gold under penalty of $10,000 fine and 10 years in jail. Secondly, we have seen recently the surge in demand for gold by the Japanese people who are fearful that their very pathological banking system threatens their ability to access their savings when they need to do so. Accordingly they have been buying gold, which always retains its intrinsic value because its value is not dependent on the ability of others to honor their liabilities.

More Evidence of Deflation
Speaking of the Kondratieff Winter, more fuel for the deflation proponents (of which yours truly is one) was provided last week in an essay by Stephen Roach, Chief economist at Morgan Stanley. Mr. Roach sited powerful evidence that the service sector is now beginning to deflate. With close to 60% of the U.S. economy now a service economy, and with the service sector not being subject to international competition, most economists have always expected this factor to shelter the U.S. against any prospects for overall price deflation. But it seems as though the new information technology is causing the service sector to turn more and more into a competitive international market place and thus subject to the same kind of horrendous competition that commodities and manufactured goods producers are facing.

Given that market declines usually last about 1/3 as long as bull markets, we can look for this bear market to last at least another 4 or 5 years. But even then, there will not be any quick return to the roaring 1990's stock market. Rather, as is typical in the Kondratieff spring, the new cycle will start off very slowly, because citizens, remembering the recent past will exercise extreme caution, even though there will then be far less reason for doing so than there is now when many markets remain severely inflated. How will we know when the markets have hit bottom? Only half in jest, James Grant once remarked that we will know when the equities have hit bottom when CNBC goes to a 24 hours soccer format. In truth, the equity bear market will be over when a tiny fraction of folks dare even think about owning equities. If history is our guide, we will then be able to buy the highest quality stocks in the land and receive a 5% to 10% annual dividend return. But we are getting ahead of ourselves. We have another 4+ years to wait for the bottom (less than 2,000 on the Dow) to finally be met.

With the really in stocks this past week, we have seen a correction of the very bearish trends for stocks and a bullish trend for bonds, commodities and gold. We believe the primary trends remain in place, those trends being a bull market in gold, commodities and bonds and a bear market in the dollar and equities. Gold and bonds returns should not, over the longer term, move together. In fact, gold is negatively correlated with bonds, though not as significantly so as with equities. We think gold will continue in a bull market and bonds will reverse into a bear trend when a continued decline in the fortunes of the U.S. economy begins to result in foreign investment leaving the U.S. When that will happen is anyone's guess, but should we begin to face an unprecedented 4 th straight year in equity declines in 2003 and a continued lackluster economy next year as well, we do not see how a final capitulation in stocks and robust bull market in gold will not take place next year.

Bullish Markets: gold, commodities, and U.S. Treasuries of all durations.

Bearish Markets: The XAU, silver, all major equity indices and the U.S. dollar. If gold is supposed to do so well why is the XAU languishing at this time? I think the reason the XAU, which is comprised of the larger gold mining stocks has broken down is because mutual funds are selling these stocks, rather than those in the major indexes to meet fund redemptions. Selling the index funds would in fact help drive down the established issues and thus increase bearishness in the market.

Also, I think Richard Russell makes a good point when he suggests gold has to deal with deflation prospects. Until it becomes apparent that they fiat system is itself breaking down, the case for owning gold during deflation may not be compelling. But note the dichotomy between gold bullion which remains bullish and the XAU which has recently turned below its 200-day moving average. As for silver, we have never been absolutely convinced that it will do well in a deflation. Unlike gold, silver performed poorly during the 1930's. It is after all much more of an industrial metal than is gold. Yet it does hold most of the same virtues that gold holds that makes it a suitable money. We remain less convinced that silver will perform as the Kondratieff winter takes a firm grip on our lives.




John Exter's Inverted Financial Triangle
In an interview with a favorite stock broker of ours, namely Ron Gilchrist earlier this year, he told us of the inverted financial triangle concept devised by John Exter. John tutored Ron Gilchrist early in Ron's stock brokering career. John Exter is one very rare creature. He is a former central banker that believes we should build our monetary system on gold. What makes this even stranger is that John was a member of the Council of Foreign Relations, which is an anti-gold, pro collectivist, pro-fiat currency organization that is in your editor's view at the very heart of what ails America. But that's an issue for another day.

What made me think of John Exter was a reference to his inverted financial triangle concept last week by Richard Russell. Richard pointed out how gold is the only asset that cannot default. As such it is at the bottom of the inverted triangle while assets of the highest risk are at the top of the inverted triangle. Financial assets at the top are the first to self-destruct.

So at the top of the inverted triangle are the equity markets, which have to a great extent already begun a process of significant self-destruction. Some $8.4 trillion of wealth has already been lost from equities. Next to fall are the debt markets and we have begun to see lower quality issues now defaulting at levels not seen since the 1930's. According to Ned Davis who spoke on CNBC last week, an amazing 40% of junk bonds are now in default. Davis noted on Ron Insana's show that a normal default rate is 2%. A 12% rate was about as bad as junk bonds had gotten in the past. So the 40% default rate represents major, major problems in lower quality debt instruments. Next to decline will be higher grade paper followed by government debt itself. Finally, Treasury Bills and bank deposits will begin to evaporate and all that will be left standing will be gold. That is why gold gains value even faster than paper in a deflationary environment.

So, even though paper money itself may gain purchasing power in a deflation, the system upon which it was manufactured comes tumbling down as the debt load can no longer be serviced. This in fact has begun to take place in Japan. Investors are not sure their deposits will be available to them when they go to take their money out of their accounts, so they continue to exchange their yen for gold, which is one reason gold has performed well this year.

This is the environment described by Ian Gordon in our 1999 interview with him. By all indications, the deflationary collapse of a Kondratieff winter is now unfortunately advancing very much in line with what Ian forecasted in our interview. By the way, if you like, you can read our 1999 interview with Ian Gordon at

The Incas thought gold represented the glory of their sun god and referred to the precious metal as “Tears of the Sun.”
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