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Taylor on us Markets & Gold

October 1, 2002


No Capitulation in sight. That's bad news

On Friday Reuters reported that despite the stock market turmoil, more Americans owned stocks at the beginning of this year than in 1999, before the bear market began! Wall Street spinners have done an excellent job of selling Americans a bill of goods. Stocks remain hugely overvalued even as the balance sheets of corporations, individuals and local governments continue to deteriorate. That would not be so bad if it were not for an incredibly out of sync global economy, which requires the U.S. to continue to live beyond its means to avoid a global economic collapse. Yet, if America continues to live beyond its means, there is no doubt that the economy will inevitably self destruct and take the world with it. Seems the freight train is roaring down the track and can't be stopped.

Despite this pathetic plight of this situation, Americans have been programmed to act precisely the opposite of what is in their personal best self interest. Like lemmings following one another into the sea, we are content to take at face value what we hear time and time again on CNBC. So, despite stocks being extremely overvalued, almost ½ of Americas households, or roughly 52.7 million as of January, owned stocks directly or through stock mutual funds or retirement plans, according to a survey by the Investment Company Institute and the Securities Industry Association, two trade groups representing mutual fund and Wall Street firms. That's up 7.1 percent from about 49.2 million households in January 1999. So even as the market has lost trillions and trillions of dollars the nonsense about stocks being the best investment continues to be accepted by a population dumbed down for the benefit of Wall Street.

That Americans are continuing to buy stocks is really bad because it means that the bear market, which has already taken trillions of dollars of wealth away from Americans, is still in the very early stages meaning that we have miles and miles to go on the downside. In other words, the capitulation process that CNBC talking heads wish they have seen so they can get on with another bull market in stocks, has not yet even begun! Not only has the psychology of average investors remained naively positive, but so have stocks remained hugely overvalued. The S&P 500 P/E ratio stood at a still very high 31.4 times which compares to a long term median average of around 15 times and levels of around 10 times that are more typical of bear market bottoms. The P/E ratio of 31.4 equates to a EARNINGS YIELD of 3.18% of which only about 1.5% is paid out in dividends. The rest of the earnings yield is contained in the form of retained earnings. And, who knows what that is really worth. By contrast, even though treasury yields have been plummeting in this "flight to quality" bond bull market, 10-year treasuries still offer you a much better deal than the S&P 500. They pay a CASH yield of 3.69%.

Our major objection with including U.S. Treasuries in our portfolio is that we think the bull market in Treasuries may not continue too much longer in spite of the fact that your editor remains firmly in the deflationary camp. Our major concern is that we believe the dollar will inevitably weaken and when it does, a major reversal of foreign savings out of the U.S. is likely to result in a rise of interest rates. When that happens, high and low credit quality debt will enter into a bear market. Stephen Roach Again Pushes for a Lower Dollar.

Stephen Roach repeated again this past week his concern about the dependency of the global economy on the ability of the U.S. to consume more than it earns. Roach pointed out last week that an appropriate policy mix for the global economy would be fore the U.S. to slow down the demand side of the economy while other nations stimulated demand in those countries. In that way, the U.S. could collectively get its balance sheets in better order while relieving some of the deflationary pressures that now threaten to take the U.S. economy down. The problem is, that if the demand side of the U.S. economy were to suddenly stall out before stimulative policies took over in other parts of the world, it would immediately trip the global economy into a very severe decline (depression). And also, short sighted self centered politicians in America are not at all interested in setting forth policies that would slow down the U.S. economy, especially in an election year.

Even so, there is growing concern that the U.S. economy is beginning to slow down and that this impearls the global economy. Last week the IMF focused not on Brazil or some other developing country economy but rather on the U.S. economy. It is clearly concerned that the U.S. demand side engine may be running out of gas even with stimulative policies remaining in place. Thus without them even being aware, there seems to be a growing concern among the ruling elite that in fact Ian Gordon's view of a Kondratieff winter is now in well underway.

According to Dr. Roach, the only answer to this dependency on the U.S. would be to allow the dollar to decline significantly from its current levels. In fact, Roach takes it a step further and says what your editor has been saying for some time, namely that this major global imbalance was CAUSED BY the Clinton strong dollar policy of orchestrated in the mid 1990's. It is most unfortunate that Roach has not yet realized or verbalized the role of the gold rigging exercise as the underpinning of the Clinton strong dollar policy, but at least he recognizes the dollar is overvalued on a trade weighted basis. That's an important start because unless the dollar is valued correctly on a trade weighted basis, America will soon be devoid of any manufacturing. Unless we adopt some currency system that is no longer a commodity but rather a proper medium of exchange based on what goods and services currencies buys rather than capital flows, Presidential Candidate Ross Perot's prediction of the "giant sucking sound" will have completely decimated our nation and its wealth. I believe the giant sucking sound is getting ever louder and that is largely because the dollar, on a trade weighted basis is hugely overvalued. Just look at the industries we are loosing because of the pro-Wall Street strong dollar policy. California farmers being pushed out of their own markets by fresh produce flown into California from New Zealand and Australia for example is putting California farmers out of business.

Hopefully, when the dollar finally plunges and gold rises, a proper analysis of the gold market manipulation will come to light so that healthier polices can be constructed in the future. However, it should be pointed out that China for example, has its currency floating at an unrealistically cheap rate to the dollar so that even as the dollar declines it may do little good to see even capital intensive products from China continue to destroy American industry. On the topic of the responsibility of an overvalued dollar for the world's growing imbalances, Roach had the following to say this past week:

"In my opinion, the imbalances of a lopsided world are a by-product of a fundamental misalignment in relative prices. This shows up in the form of an overvaluation in the world's most important relative price - the dollar. At the start of 2002, our currency team estimated that the dollar was overvalued by at least 15%, maybe more. While the trade-weighted dollar fell by 6% in the first half this year, it has since recouped half that decline and currently stands just 3% below its peak. Moreover, in a climate of heightened uncertainty -- both economic (double dip) and geopolitical (Iraq) -- the dollar could well move further to the upside. That would leave the world's most important relative price as overvalued as ever. Given the imbalances this currency misalignment has fostered, I continue to favor a weakening of the dollar as a major policy initiative of US authorities.

"My suggestion for a weaker dollar has been met with great consternation in official quarters. I have been accused by some of endorsing a strategy of competitive currency devaluation that could lead to ever-treacherous beggar-thy-neighbor trade policies -- smack out of the 1930s. That is the furthest thing from my mind. But I am struck by the obvious: An unbalanced world needs a realignment of relative prices, and a weaker dollar is the most sensible way to achieve this, in my opinion. It also happens to be the one option with the greatest potential to stave off America's deflationary endgame by arresting the ongoing deflation of US import prices. But a rhetorical shift in America's "strong-dollar policy" may not be enough. Aggressive Fed rate cuts, possibly on the order of 75 basis points, may well be required to trigger and reinforce this long overdue adjustment in the US currency. Such an easing would also be helpful in putting a floor on American domestic demand -- yet another advantage in the battle against deflation. Which takes us to the biggest risk of all: Global imbalances are all the more treacherous for a world on the brink of deflation. A lopsided world is in increasingly desperate need of a policy fix. That won't happen, in my view, without a weaker dollar."

Japan Demonstrates the Folly of Keynesian Economics

The week before last, the Japanese central bank shocked the world by saying it would, with money created out of nothing, buy depressed equities held by Japanese banks. In that way, the Bank of Japan would help replenish bank balance sheets. Such is the mentality of the Keynesian economic world we live in. I recall in Economics 101 being taught that it would be a mistake to ever compare a government's finances with that of a family's budget. Governments can print money to finance deficits. Families cannot. What the Keynesians didn't understand, or perhaps chose not to understand, was that even for governments there are limits to the amount of money that can be manufactured from debt, which is how money is manufactured in a fiat (liability) monetary system. That Keynesian notion is untrue for at least a couple of reasons. First, confidence is lost when governments print money without limit as Japan has been doing. It simply runs counter to common sense to issue pieces of paper and pretend they ARE wealth when in fact they are nothing more than a potential claim against wealth that has been created by someone other than the bankers who issued the paper and nothing more than a promise to pay sometime in the future. So it was, the week before last, that following the BOJ announcement that it would bail out Japanese banks by buying equities, that the market issued a confidence warning for Japan. For the first time in history, the Bank of Japan was unable to sell all of a Japanese Treasury issue.

The Nikkei on its way to 5000 as Ian Gordon's Projected

With this most recent round of bad news, the Nikkei headed below 10,000. In fact, with its Friday close of 9530.44, the Nikkei is now considerably below its 10 month moving average of 10,4996.80. As I recall back in 1999 when we first interviewed Ian Gordon, he said he thought Japan was simply ahead of the U.S. and that we would follow its footpath ten years or so later. At the time the Nikkei had fallen from its all time high of around 38000 to around 18000 after rallying from a 1998 low of round 12000. I recall thinking that if the U.S. market was poised for a major decline, then perhaps the Nikkei was a good place for Americans to invest. Ian put that notion to bed real quick in my interview when he suggested that as the global deflationary process began to unwind, the Nikkei would have still much further to fall. As I recall, Ian suggested an ultimate decline in the Nikkei of under 5,000 representing an ultimate decline of close to 90% or approximately the decline of the Dow in the last Kondratieff winter which started in 1929.

And so as events continue to unfold, and as Abby Joseph Cohen continues to suck unsuspecting investors back into an overvalued stock market, the predictions of a little known stock broker/market historian named Ian Gordon has been as incredibly correct Abby Joseph Cohen has been incredibly incorrect. We are happy to say we listened to Ian and not Abby! Most Americans were not so fortunate nor will they be, because the would rather believe a fantasy than a truth that might result in some unpleasant thoughts now but spare them in the longer run.

Last week, Richard Russell made a statement that…" when everyone is thinking alike, no one is thinking." We have seen, during the craziest bull market in history how Americans have blindly and on faith followed the CNBC talking heads like lemmings into the sea towards their financial death. On the other hand, we have seen how it often pays to question authority. People like Ian Gordon, David Tice, Dr. Larry Parks, Congressman Ron Paul, M.D., Dr. Ravi Batra, Bill Murphy and many others interviewed in our newsletter, have demonstrated the wisdom of questioning the dictates of our growing collectivist (read fascist or communist) policy makers.

Oh my goodness! How it has paid. At the end of this past week, our model portfolio was up 53% compared to the S&P 500 which has lost 28% so far in 2002. We remain confident that our strategy of shorting the U.S. equity markets by way of the Prudent Bear Fund, shorting the dollar via the Prudent Safe Harbor Fund, and going long on gold and gold shares is a winning strategy, even though the gold markets may, in this early stage of a new secular bull market cause us to wonder from time to time.

Major Market Summary

Bullish Markets - Gold, U.S. Treasuries of all maturities, and commodities as measured by the Rogers Raw Materials Index and by the CRB. Among the currencies, the Eruo and the British pound are bullish.

Bearish Markets - Virtually all equities with the exception of gold stocks. Also the U.S. dollar and the Canadian dollars are looking weak. The Yen and Australian dollar are borderline cases.


James Sinclair Warns about Gold Project Financings

James Sinclair is a legendary gold investor. I recall listening to his insights during the late 1970's as gold rose dramatically and unbelievably from $35 to $850 per ounce. James has an enormous amount of experience and insight to offer us. So for the sake of those of you who may not have yet read his essay this past week, I am going to summarize it for you and thereafter provide you with my own comments on what James has said. But first, to give you an idea of the authority this man speaks with, here is some of his background:

Mr. Sinclair's career in minerals is based on a long and successful career in finance. He started his career in the late 1950s as an over-the-counter market maker for a NYSE firm, Straus, Blosser and McDowell. Later, he became a general partner of the NYSE firm of Vilas & Hickey and President of their German subsidiary. During that period he was the largest consumer of South African Gold shares in the world. Upon founding his own firm, The Sinclair Group, James was considered to be one of the world's major influences on gold during the 70s. He established a commodity-clearing firm in Chicago where 47 members on the floor wore my colors. The Sinclair Group umbrella developed a Minor Metals (industrial metals & material market maker) dealership in London, a derivative trading group in metals, and various offices in Canada, Switzerland and the US.

When an article was published in the Wall Street Journal in 1980 saying "James Sinclair-Bull takes off his Horns," he began to liquidate his firms, which were vertically integrated around precious metals. During that period James was appointed by the direction of Chairman Paul Volker, then Chairman of the Federal Reserve, to advise the Hunt Family on liquidation of their silver position, as a criteria for the rescue loan arranged by the Federal Reserve.

Thereafter, James established James Sinclair Financial Research SARL in Luxembourg, which was successfully sold to the First Nordic Banking Corporation seven years later. He undertook the Chairmanship of Sutton Resources LTD, whose finances between 1989 until 1994 was personally attended to by Mr. Sinclair's family and later by James and certain of his close associates. Since that time, James personally financed a private company, Tanzanian American Development, which accumulated over 50 mineral concessions in the Archean Tanzanian Greenstone Gold Belt. These properties were explored over 4000 square kilometers using state of the art geophysics applied by Fugro who is the largest such company in the world. After Tanzam completed 12 gold concession transactions with Barrick Gold, Sinclair merged his company into a public company by the name of Tan Range Exploration which now has 14 transactions with Barrick Gold and a total 80 properties primarily in the same location. With Mr. Sinclair having so much depth of knowledge in precious metals financing (43 years of successful investing) and with his experience in doing business with the greatest gold mining company hedger in history, Barrick Gold, I think one should pay especially close attention to Mr. Sinclair who incidentally also agrees that the gold price has been manipulated.

I stopped by Mr. Sinclair's booth at the New York Gold Show this past week and met him for the first time in person. I introduced myself to him and then told him how I had admired his work and insights into the dynamics that drove the gold market upward to $850 in 1980. James began to explain to me how gold mining companies may begin to get into big, big trouble as the gold price begins to rise, depending on the collateral agreements they may have signed with the bullion bank lenders. Because I had to move on to another appointment and because James was, as always in great demand, I had to move on without fully understanding what he was talking about at that time.

After reading a widely distributed essay from James this past Wednesday, I think I know understand more precisely the potential problems for mining companies that Jams is so concerned about. The following example may help illustrate the kind of problems mining companies may run into if they are not careful about the kind of collateral agreements they sign when they take borrow against gold in the ground.

  1. When mining projects are financed, they are done so on a fully collateralized, non-recourse basis. What that means is that the lender may not have recourse to the borrower's balance sheet, but it does have full recourse to the project that it is financing including all of the gold in the ground if that is what is necessary to make the lender whole.
  2. When junior mining companies hold a joint venture position in a gold mine, and when money is borrowed against that asset, most often to fund that mine into production, the junior is most certainly tied into the same deal as the major company. In other words, the junior's position is fully pledged to the lender as collateral just as is true with the senior joint venture partner's percentage of ownership in the project.
  3. Lets say a loan was denominated in gold for 1,000,000 ounces and that the lender also wrote call options to sell 1,000,000 ounces of gold, which the mine expected to produce over a ten year period of time. Lets say the call options allowed the holders to buy gold at $300 per ounce. But since there was no one in the world who wanted to commit to buy gold over a ten year period of time (equal to the mine life), and based on Alan Greenspan's assurances in 1998 that "central banks stand ready to lease gold in increasing quantities, should the price begin to rise," the lender felt secure in writing call options to sell 500,000 ounces in 2002 and another 500,000 ounces in 2003, even though the mining project could not produce 500,000 ounces in years one and two. Afterall it was non other than Alan Greenspan who told the gold bullion dealers that central banks would ensure the price of gold did not rise when gold was around $290. So why not write a call option with a strike price at $300 secured by the gold in the ground of a mining project. After all are not Alan Geenspan's words golden?
  4. But it is now October 2003 and problems begin to crop up in the global economy. Suddenly, as the world began to lose confidence in the dollar, the Chinese, Japanese, Argentines, Brazilians, Russians, Koreans Indonesians, Malaysians and virtually all Muslim countries begin to exchange their dollars for gold. Even a growing number of Americans are beginning to wonder about President Bush and his handling of the economy and the dollar and thus begin to buy gold bullion. Investors began to trade paper dollars in for gold because they inherently understood that gold's store of value was not dependent on the ability of their banks to return their savings deposits on demand. This sudden demand sent the price of gold soaring over the span of several weeks upward toward $600 per ounce. Now remember, the gold lender had an obligation to sell gold at $300. Based on the words of Alan Greenspan and a gold price that had been declining for 20 years, the lenders were confident that any shortfall from the mine could easily be purchased at a price of less than $300 on the open market.
  5. We fast forward to the third Friday of the month of October - settlement day - and the price of gold has skyrocketed to $700 per ounce. The mining company can and indeed does deliver the 100,000 ounces that its projections suggested it could produce. But the lender on the project is obligated to sell 500,000 ounces to the call option holders. And believe me, the holders of those call options are licking their chops to buy gold at $300 when it is selling on the market at $700. So, on the third Friday of October, the mining joint venture partners delivers the 100,000 ounces of gold right on schedule. But now the bank has to go into the market and buy an additional 400,000 ounces of gold for which it will receive only $300 per ounce, thus leaving the bank with a $160 million loss! Moreover, the lender has another 500,000 ounces it needs to deliver at $300 per ounce next year, even though all signs are pointing to a gold price that could very well be headed over the old $850 all time high price for gold.
  6. Panic sets in at the office of the gold bullion lender. (What on earth happened to Mr. Greenspan's promise?) The banks decide to play hard ball with the mining company by exercising their rights under the loan documentation to require a $160 cash payment from the mining joint venture partners. If the joint venture partners cannot deliver the $160 million, the gold lender exercises its right to take possession of the gold mine itself. The shareholders of the public mining companies that joint ventured the project are left with absolutely no value!


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