first majestic silver

The U.S. Economy & U.S. Markets

December 13, 2001

The American delusion over stocks continues. It seems impossible to investors, most of whom have never seen a secular bear market, that we could be in the early stages of a very serious 1970's decline. Of course, we remain convinced that we are in the early days of what Ian Gordon has labeled the "Kondratieff Winter." For those of you who may not be aware of Ian's work, we urge you to read our interviews with this insightful institutional stock broker at our web site at

One thing we know for sure is that stocks continue to get more and more expensive. At the end of this past week, the Earnings Yield (retained earnings plus dividends) for the S&P 500 stood at a paltry 3.18% of which only 1.34% was represented by dividends. What's more, given the decline in American morality and thus honesty, the retained earnings part of this equation is highly questionable given all manner of accounting gimmickry employed these days. Recall that one of the factors that got Enron into trouble was the dishonesty surrounding their reported earnings.

Compared to the S&P 500, at the end of last week, one could buy the 10-year Treasuries and received a yield of 5.17%. In other words, you could a cash return of $5.17 for every $100 you lent to Uncle Same this past Friday compared to a cash return of only $1.34 for every $100 you invested in the S&P 500. Is the remaining $1.84 worth $1.84? Probably not. The theory of course is that companies can re-invest their earnings in the company and get better returns than shareholders could get from dividend payments, especially given that dividends are taxed. That may be true when times are good, but during an economic downturn it is doubtful. Moreover, dividends paid out can be reinvested in other companies which would provide an element of diversification for investors.

The main stream media, for the most part, continues to spout optimistic views on the economy. The thinking is that with the fed pumping up the money supply, with a fiscal stimulus package and with declining oil prices, a turn around in the economy is a forgone conclusion for the market. There is scant evidence of any economic turn around at this juncture. In fact, economic data continue to worsen. So why do all these supposedly wise talking heads on CNBC say otherwise?

Well for starters, the main stream media do their best to keep less optimistic views off the air. Certainly our friend David Tice can attest to that. As long as the stock market was booming to new highs, David was a good laugh for the bears. But once the bear market began, and when Mr. Tice should have been receiving more acclaim for his correct call, he was not nearly as welcome. There are bears out there, it's just that the prejudice against them runs very deep. But for the most part, most people simply WANT TO believe the bull market will resume. So they think what has continued to work so often in recent years, will continue to keep working indefinitely into the future.


On my way back from Reno on Saturday, I picked up a copy of "When Genius Failed" most of which I managed to read on the trip back to New York. This is the story of the rise and fall of Long Term Capital Management (LTCM), by Roger Lowenstein. One of the things that really struck me about the genius management team that ran LTCM was how it failed to use long term data in forming their models. Somehow they thought that data from recent years was sufficient upon which to predict the behavior of markets for years to come.

For example, one day in late August of 1998, swap spreads displayed extreme volatility beyond historical data built into their model. But if these "genius" Wall Street Whiz kids had simply examined data as recently as 1987 or 1992, the extreme volatility of the summer of 1998 would not have been unprecedented. Perhaps the company would not have so arrogantly held on to their losing bets for so long in what proved to be a fatal move, if they had simply applied data from a longer stretch of time. The failure to apply data from as recently as 1992 and 1987, not to mention the 1929 to 1949 Great Depression, allowed the Long Term Capital Partner's mathematicians to think the 1998 debacle was " event so freakish as to be unlikely to occur even once over the entire life of the Universe and even over numerous repetitions of the Universe."


I believe there is an assumption being made not only in the U.S., but around the globe that Milton Friedman's notion that by printing money, economic downturns can be eliminated. The genius Wall Street boys, like those at LTCM, thought this was true and that their derivatives would also help reduce systemic risk.

In fact, there is no doubt now but that LTCM's involvement in the derivative markets INCREASED systematic risk. And now, with regard to the ability of central banks to avoid a business downturn by printing more money, there is growing evidence that doing so does not always work. The policy makers in Japan have been putting the pedal to the metal over the past 10+ years, but to no avail. Japan is definitely in a depression.

And increasingly in the U.S. the economy is not responding to some of the most torrid money printing episodes in American history. Milton Friedman has always ignored the impact debt plays in a fiat currency system. He simply believes you can always stimulate economic growth by printing money. But in a fiat monetary system, you can print money only by issuing more debt. And, as we are finding out in the U.S., since 1950, as our Kondratieff cycle matures, it is increasingly characterized by: A) Increased mal investment and B) An ever increasing amount of new debt required to be issued in order to generate the same amount of GDP. The combination of these two trends are lethal for the economy because it results in a decline national income at the same time money is extracted out of the economy to pay principal plus interest on debt that is growing exponentially.

The result is worsening balance sheets such that even as central banks pump more money into the system by passing entries (buying bonds), demand to borrow money on the part of consumers and corporations or the willingness to lend by banks declines sharply. This is the "pushing on a string" phenomenon that Japan has been experiencing for the better part of a decade and which the U.S. experienced during the 1930's. There are increasing signs now, as Ian Gordon predicted back in 1999, that the U.S. is beginning to experience the same thing. Such is the stuff of major economic declines.

But the brilliant Wall Street Whiz kids are an arrogant bunch. They think they know it all and so does Milton Friedman. No need to look back to the 1930's because they assume they are far superior to their forefathers and erroneously, they think they can, by their knowledge and superiority avoid the same economic declines as that of the 1930's. They overlook the logical comparison of a national economy with that of a family budget. On a macro economic scale, it is not unlike the family where the husband borrows money to gamble in the market or in Las Vegas or to support a drug or alcohol habit. Then as he pays interest and principal on the debt, there is not enough money to buy things for the family like food and shelter.

Friedman and Keynes both argue that since a sovereign government can print money where as a household cannot, that is not a valid comparison. But their argument overlooks the fact that even for sovereign governments, there is a limit to the amount of money that can be printed. Nor do they take into account the fact that debt itself is at some point deflationary and thus must necessarily bring the economy down.

Most significant of all is that the need to print money grows at an ever more rapid pace as the long cycle matures. So it is now that the U.S. is creating money and debt out of thin air at one of the most rapid paces in our history. MZM has grown at a 25.3% clip according to Jim Grant. Wow! But remember, in a fiat currency system, money is printed by creating debt and debt chokes off effective demand as interest and principal payments skyrocket with new money growth. That's simply how a fiat currency or liability money system works.

How much longer can the U.S. fantasy world continue against an enormous growing debt burden and a rapidly rising money supply? We have now had eleven rate cuts, the latest being a 1/4% cut today. The economy is shrinking and the decline may in fact even be accelerating. Profits and profit margins are plummeting as pricing power continues to decline. No sign of a turn around in profit margins for American producers either in no small part because globalization has resulted in China and other poor nations forcing U.S. profit margins down, down, down and jobs are being transferred from the U.S. to those countries. That also is killing effective demand in the U.S. The job picture continues to worsen and there are signs now that the one last remaining strong hold in the U.S. economy, namely the consumers may be about ready to take a dive as well.

Then there is a worsening global economy. Europe, Asia, Canada and South America too. No matter where you look, economic activity is on the decline. Japan is facing the worst decline since WWII. Argentina could become the biggest debt default in history. The global economy is a mess. Where is the rational for thinking a turn around in the economy, never mind profits, is a forgone conclusion as CNBC talking heads insist? I hope they are right, but where is the beef?

Incidentally, with respect to the global picture, I have begun charting the Dow Jones World Stock Index. At the close of last week, it was at 177.32 compared to 210.90 at the start of this year. That represents a 15.92% decline.


In case you have not figured it out, I remain as bearish as ever. Like Richard Russell, I'm bullish on America but not American stocks, at least not now. And I could not disagree more with the contention that in order to be a patriotic American you should buy stocks. That is one of the dumbest things I have every heard and it is so UNAMERICAN! Since when should Americans do stupid things like pay too much for anything they buy and in the process weaken their own balance sheet, their family balance sheet and quite frankly, the balance sheet of the nation? An informed investor and consumer help keep America strong. Stupid purchases do not!

Of course our policy makers are themselves engaging in un-American and very stupid policies that are in effect weakening the financial fiber of our country. Along with a much-needed decline in equity values, a major decline for the dollar is also required if the global economy is to avert an eventual disaster. It is way out of line with respect to trading fundamentals simply because our policy makers have manipulated opinion that the U.S. is somehow such a superior place in which to invest. And they have effected this manipulation by rigging the gold market and concocting and over exaggerating phony story about American productivity.

But natural laws of economics and markets cannot be defied. Intervention will only exacerbates economic dislocations, and thus not only ensures ruination. The longer and more pronounced the intervention, the bigger the eventual reconciliation. The only hope we Americans can have for a continued democratic process is that somehow, the truth about the cause of our problems - excessive creation of money and debt will be understood when our economy falls. Thus far, except for Congressman Ron Paul, there are very few elected officials who understand the damage being done to our economy and our Constitutional form of government by the excessive printing of money. Unfortunately, most often the cry for intervention grows as the economy is pushed more and more out of equilibrium by each successive intervention. Those responsible for the decline - the bankers and their friends in government - are not likely to be willing to see themselves as the cause of our problems.

What ever the future of freedom in America, there can be no doubt that the manipulations of the dollar will eventually result in: a) a major decline in the dollar itself, b) a major stock market crash - to levels much further than we have declined so far, c) a major decline in corporate interest rates as a result of declining credit quality and d) rising interest rates for U.S. corporate debt as foreign money begins to flee out of America. With a full 42% of U.S. Treasuries now owned by foreigners, that may mean that even as we enter an economic decline - perhaps on a par with that of the 1930's - interest rates could rise. We are by far the largest debtor nation in the history of the world!

Because we see the future as we do, we are keeping our Model Portfolio with the following allocations: A) 25% in the Prudent Bear Fund. B) 25% in the Prudent Safe Harbor Fund. C) 20% in junior and senior mining stocks, D) 2% in gold and silver bullion, E) 18% in select energy stocks and F) 10% in select high tech stocks, most notably those companies that can use their proprietary technology to reduce the cost of producing essential goods and services. We may make some adjustments to our Technology Mix at the end of the year and we may also look for some blue chip dividend paying investments to ensure cash flows during the difficult times we are likely to face. But by in large I believe our portfolio is well positioned for 2002. Through 12/10/01 our Model Portfolio gained 6.03% vs. a decline of 13.66% for the S&P 500.

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