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The Tenorio Research Year End Market Review

December 31, 1997

Current Fundamentals

"Fundamentals that you read about are typically useless as the market has already discounted the price, and I call them "funny-mentals." However, if you catch on early, before others believe, then you might have valuable "surprise-a-mentals.""Ed Seykota Interview in "Market Wizards", Harper Collins, New York, 1993, by Jack Schwager.

What are the fundamentals? The US remains in a long term expansion without inflation while the world as a whole remains out of synch. This asynchrony of major world economies has persisted since the 1970's. Both within nations, internationally, and across the spectrum of industries, some have been up while others were down.

Because of the strong US economy and relatively high interest rates, the US dollar has swamped every other investment consideration in the past few years as it did in the run-up to the G-7 Plaza Meetings of 1985. The so-called "yen carry" has become the "everything carry" as it has been very profitable to borrow any currency or commodity, sell it, and buy dollar bonds with the proceeds. Thus all currencies and most commodities including gold have been pummeled. Dollar-induced disinflation on the verge of dollar deflation.

Then we have the spectacle of the "largest" creditor nation, Japan, with eight of the ten largest banks in the late 1980's on the cusp of becoming a "small" creditor nation with its banks imploding. (Has it ever made you wonder if "commercial bank" is an oxymoron? What other "industry" can print money, lend it at 8-18%, and go bankrupt every ten years? And for a new reason each time?)

There is ample evidence that the withdrawal of $20-30 billion from Thailand by Japanese banks over the past two years set the stage for last summer's collapse in that market. Granted that it was an accident waiting to happen, but absent the Japanese need to repatriate funds to cover other losses, it may well have been substantially delayed or averted.

Throughout Asia (and Europe and America?) US dollar-denominated loans will be coming due for countries whose currencies are down from 20-70% from the date of the loan agreements and will therefore not be payable. Already murmurs from Thailand are heard about repaying dollar loans in yen, but the fact of the matter is that most of these loans will be purchased for a few cents on the dollar by J. P. Morgan and/or Goldman Sachs and repackaged for distribution as "Brady II". (Goldman Sachs is already buying Japanese loans secured by prime properties.)

Another important fundamental is the rapid rise to eminence in Asia of the International Monetary Fund (IMF). The purpose and mission of the IMF is, of course, to make the world safe for US (firstly) and W. European (secondarily) capital.

The public image of cabals and conspiracies is of secret confabs of famous men who keep it all under wraps. But the IMF has been quite open and cheerful about its work. All the recent press releases and talks have been as clear as day: the function of the IMF in Korea (and Asia generally) is to dismantle the traditional closed Korean economy and allow access to JP Morgan , Goldman Sachs, and Citicorp. (Unspoken but obvious is the fact that much of Korean industry will be bought cheaply by US and Euro multi-glomerates.)

Most Americans, if they think about it at all, would agree with this approach which confirms American hegemony and control. Most instinctively understand that it is only by purchasing cheaply from others and enticing them to accept our IOU's that they can continue to live so well, especially after having their personal economic power broken since 1980. A strong dollar and Tbond is our strength, as the Germans used to believe. (And will "again" after they have France, Italy and the UK effectively controlled under the EMU.)

As the year ends the debates rage on over the impact which the Asian debacle will have upon the US and world economy. Many observers feel the impact is modest given the small contribution to GDP of American exports to Korea and SE Asia. Gross Domestic Product impact estimates range from a negative 0.5% to a full 1% ultimate effect for 1998.

The specter of markedly reduced exports to the region with whom the US has its greatest trade deficit coupled with a flood of even cheaper imports is sobering. The fact that many of these imports will arrive with a lower price tag due to currency devaluation is partially offsetting except where competition with US industries (autos, construction e equipment, tools) causes market share shrinkage for the Americans.

Clearly Korean and Asian manufacturers in general will be crimped somewhat in their ability to finance the on-going state of the art technology race, particularly in computer chips and electronics. The best that many corporations in Asia can hope for is for their bank loans not to be called. New money for product upgrades is unlikely for some time to come. This will benefit American competitors.

And so we come back once more to the most significant fundamental: the US dollar. Given that the dollar is the international reserve of choice, that most international trade is denominated in dollars, and that most international commodities are traded in dollars, the status of the dollar at anytime tends to be "trend-generative." If the dollar is weak, it is shunned and becomes weaker. And when it is strong it gets stronger since there is no reason not to hold it and it is safe to bet that it will get stronger.

The game between national central banks and speculators is often called "cat and mouse" but it resembles more closely lion and baby gazelle. Neither wants to get out in the open all alone and be eaten. The speculators refuse to take the lead to stem the tide. If the tide is to be attacked (one is reminded of King Canute), the speculators insist that the central banks and treasuries of the world take the lead and spend some of their money.

In recent years there has been very little concerted international central bank intervention in the currency markets. There have been occasional official "regrets" that the dollar is so strong, or modest jaw-boning attempts, but little more. At the same time the focus in the US has been the Federal Reserve's own game of whether or whether not to raise short term rates. This has only served to reinforce the notion that the dollar will remain strong.

Each of the post 1980 international crises which looked likely to lead to a credit collapse or true deflation has occurred at a time of dollar strength. It is noteworthy that the current crisis is occurring with the dollar at much lower levels than in either 1982 or 1985. The trade-weighted US Dollar Index is now just under 100, whereas in 1982 it was above 110, and in 1985 got as high as 165. There are, of course, several ways to look at this phenomenon. In the end, however, it is clear that deflationary pressures are not nearly so strong as in the 1980's crises and that the current pre-occupation with potential deflation is overdrawn.

Nevertheless, the thriving US economy with its positive interest rate differential has created and sustained the profitability of selling anything and everything in order to buy dollar T bills, notes, and bonds. Longer term readers will remember the D.T.T.I. ("Down the Tubes Index") which measured the success of this approach in dollar strength (yen weakness), US stock and bond strength, and gold and CRB Index weakness. D.T.T.I. has been in an extended and major bull market since early 1995 when G-7 fears of a dollar meltdown led to the current conditions.

One of the victims of this regime has been gold. As discussed earlier, it has been advantageous for producers to borrow gold at a quite modest interest cost, sell it, and use the proceeds for new mine development some of whose output will go to repay the loan. Miners avoided both high interest rates and the need to dilute shareholders' equity as they would with new stock issues.

However it has also been profitable for some central banks and for many hedge funds to do likewise. It is not only profitable for the funds to borrow in yen to buy US stocks and bonds. It is also profitable to borrow gold to sell for funds to do likewise. And especially so when there is steady and heavy selling of gold by central banks.

Except for the spectacular rise in the dollar from 1982 to1985, the range has been between 80 and 105 for most of the past 25 years. As this is the "usual and customary" range and the dollar is close to the upper side of this range, we may expect it to be defended at some point. And given the current media and financial industry pre-occupation with potential deflation, which I see as overdone, we could see an earlier rather than a later move. The turmoil in Asia increases the awareness and sense of urgency amongst the G-7 leaders. The next meeting is scheduled for February and preliminary talks have taken place in Washington this month amongst the US Treasury, Federal Reserve and White House and German Finance Ministry's Herr Waigel and IMF's M. Camdessus. Thus the Seykota "surprise-a-mental" fundamental could be an attempt to turn the dollar back early in the year.

The best way, from a political standpoint, to put a brake on the dollar would be a rate cut of ½% or more at the Federal Reserve's FOMC meeting on February 3-4. This is totally unexpected and would have maximum impact in many markets.

Dress Rehearsal

We find ourselves late in the secondary disinflationary phase of the Kondratieff cycle. One of the perplexing issues for Kondratieff analysts has been how to fit the two 20th century stock market crashes (1929 and 1987) into the picture without permitting them to upstage everything else. It is true that absolute price lows in both stocks and in commodities were reached in 1932, but it is also clear that 1932 was neither the end of the depression nor the Kondratieff wave trough. Then too the occurrence of the 1987 crash, the momentous financial market event for this generation, 55 years after the 1932 bottom has served to reinforce the notion of 1932 being the end of a cycle. This notion would put the previous Kondratieff cycle low of 1896 only 36 years before, nearly 18 years early.

If, as I believe, the 18th and 19th century cycle troughs of 1788, 1842, and 1896 were valid bottoms in economic activity (and in these instances before national central banking also of stocks prices), the logical place for a final bottom or end of the next cycle was in 1949. We know that 1935-37 was a recovery both of stocks and of commodities which then failed into 1942. Despite price controls during World War II, price pressures were evident in the war economy. These pressures were felt in 1946 but they abated and a final fall, in what was then feared to be a resumption of the depression, occurred from 1946-1949. Thus I believe that 1949 (53 years after 1896) was the true end of the cycle, and that it was distorted somewhat by the depth of the 1932-33 crash lows in both stocks and commodities and the massive reaction to it by the Roosevelt government.

The implication of this line of thinking is that we are near but not at the end of the current cycle which could last until 2003 to 2004, 54 years after the last final bottom. While I doubt that all commodity and wholesale prices will make lower lows then than at the primary low in 1985-86 (although gold has just done so), the odds are that we will not see the major liftoff in prices previously expected at this time. Since the peak of the next cycle would not be expected until about 2028, an early return of virulent inflation in prices has never been in my cards, only a slow and steady increase for several decades, unless a major devaluation of the US dollar were forthcoming.

Just as prices in 1949 came nowhere near the lows of 1932-33 (or 1937-38), we need not expect a replay of the mid 1980's in agriculture and energy. A look at the chart of page 10 (complete report) shows how the shape of the Kondratieff cycle has changed post 1932, and why we will most likely not see a secondary bottom of the severity of 1842 and 1896.

My opinion therefore is that a price recovery in commodities will soon be underway which will see gold rise, perhaps synchronously with an effort to return the US dollar to the bottom of its range of recent decades; but that will be a tempered bull remaining under cyclic pressures for as long as another four to six years. And if things should go very wrong along currently popular lines, disinflation could persist into that later time frame.

Despite the fundamental pressures from Asia mentioned earlier, all items on the long term "wish list" for American markets remain in various stages of fulfillment: Cold War over, defense costs down, Federal deficits reduced substantially, tax rates down, interest rates down, producer costs down, inflation down, unemployment down, labor peace, dollar up, US leading in leading industries, competitors weak.

Since the current consensus is for continuing disinflation or even true deflation, any concerted government or market attempts to reverse fortune would be seen as bullish not only for stocks but also for commodities and wholesale prices as in the run-up after 1932 and 1942. Thus the chart of gold on page one (complete report) could play out with a final wave E of ABCDE from September 1980 completing early this year, or having that leg re-lettered as wave "a" of C with B running from 1985 to 1996 . In this alternative count, wave "b" of C would start soon and run up for one or more years before the final decline into 2003-2004 begins.

The Tenorio Research Year End Market Review is published by Tenorio Research, Dr. Thomas Drake, editor, also the publisher of Gold FaxLetter. This Gold Eagle edition is excerpted from the 25 page complete edition.

Softbound or emailed Adobe Acrobat .pdf file versions of the complete report are available for $25 plus postage (for hard copy). Credit card or check order to MMA Publications: 1-248-626-3034. Please specify version required.


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