Disturbing Trends 2007

The dollar under siege by Michael J. Kosares A critical juncture for gold and the U.S. economy from the author of "The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold" ______________

"[U]nder the placid surface there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it. . . We are skating on thin ice."

- Paul Volcker, Former Chairman of the Federal Reserve

"[W]e live in a globalized environment and in a country which has enormous fiscal and external deficits. So you have to figure out some way -- which I have not done I might add -- to protect yourself if we should have a real currency problem here."

- Robert Rubin, Former Treasury Secretary

From time to time I update this short study - the nuts and bolts of which first appeared nearly ten years ago in my book, The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold. You might think it odd that I would update the same study on a regular basis, but the fact of the matter is that the message (and its value as a primer) hasn't changed since the book was first written.

For the uninitiated, Disturbing Trends explores the primary reasons why the economy and financial markets have become so volatile and unstable. It also exposes the reader to the reasons why gold has come to play such a prominent role in the contemporary investment portfolio. For the veteran gold investor, this study serves as a refresher course on why you added gold to our portfolio in the first place and encouragement to stay the course.

Disturbing Trends is simultaneously one of the least and most popular essays I have written. I get numerous requests for reprint. I also get complaints about its bleak view of the future. As the saying goes though, the turtle never got anywhere by keeping his head in his shell. Likewise, he can't avoid danger without first seeing which direction it's coming from. So bleak though it may be, it also serves a positive purpose as a call to action.

To be sure, those who took their cue from this study and purchased gold have been amply rewarded. When "The ABCs of Gold Investing" first hit the bookstores in 1997, gold hovered in the $300 range. It has been in a steady upward pull ever since. As of this update, it is trading in the $670 range. Price appreciation, however, is a sidebar to gold ownership. The main story is gold's asset preservation qualities.

Thus far the United States has avoided paying the piper for its economic sins because of the dollar's position as the world's reserve currency - what French president Charles DeGaulle called "the exorbitant privilege." Just over the past year though, a growing list of countries have switched course and begun substituting dollar holdings with other currencies and gold in their reserves. Unless something changes, the days of "exorbitant privilege" could be suddenly coming to an end. If so, the dollar will find itself under siege like it never has before.

When former Treasury secretary Robert Rubin tells us (as quoted in the masthead) it would be advisable to figure out some way to protect ourselves against a currency problem in the United States, he is referring to the loss of that exorbitant privilege. He doesn't mention gold, but one can read between the lines. There is every bit as much reason to own gold today as there was in 1997 when this study first made its appearance. In fact, the argument for gold has never been stronger.

"It [this new budget approach] will retire nearly $1 trillion in debt over the next four years. This will be the largest debt reduction ever achieved by any nation at any time."

- President George W. Bush, February 28, 2001

During the four years following that Bush administration initiative, instead of reducing the national debt by $1 trillion, the federal government actually increased it from $5.7 trillion to $7.7 trillion. That's a $3 trillion dollar swing between hope and reality. Now, seven years later, the national debt stands at $8.9 trillion - nearly $30,000 for every man, woman and child in the United States. And there appears to be no end in sight to the fiscal madness. The debt clock ticks non-stop at the rate of about $1.3 billion per day.

I should point out that there is a difference between the "deficit" and "additions to the national debt."  The deficit often quoted by politicians and the mainstream press is discounted by borrowings from the social security fund - a machination meant to dilute the real budget deficit which is the actual addition to the national debt.

Thus the accompanying graph illustrates the real accumulated deficits, i.e., the alarming and very real growth in the national debt.  For a short while in the 1990s, it looked like this troublesome problem might at least be held at bay, but along came the military build-ups in Afghanistan and Iraq, the general war on terrorism, increased entitlement outlays and out the window went any semblance of fiscal restraint. 

President Franklin Delano Roosevelt famously proclaimed that we shouldn't worry about the deficits because we owe them to ourselves. If the government pays interest, he said, we pay it to ourselves. There was a time when that argument might have held water, though to characterize government debt under any circumstances as benign is a bit specious. 

Even so, things have changed. First, we no longer owe it just to ourselves. We owe well over $2 trillion of it to foreign creditors, mostly Japan and China. Second, the effect of the national debt is far from benign. It is the principle driving force behind higher taxes, inflation and the depreciating dollar.  Third, few people know that in its own right interest on the national debt ranks third in federal budget outlays after military spending and social welfare entitlements.

When you blanch at the $50 to $75 it takes to fill your gas tank and suffer food prices running through the roof, think about the national debt. When Congress inevitably raises the income tax, think about the federal debt. When you hear about the dollar plummeting on foreign exchange markets, think about the federal debt. It is perhaps the most insidious, entrenched and debilitating of the disturbing trends threatening the nation and our economic well-being.

U.S. exports and imports were roughly in balance in 1970. In 1992, the trade deficit ballooned to $36.5 billion. By 1995, it had grown to $105 billion. By 2000, it had mushroomed to an incredible $378 billion. The estimate for 2007 is $700 billion or more. Needless to say, this is not what one could call an encouraging trend. Few can remember the last time the United States ran a trade surplus (which was 1975). Fewer still can remember a time when the U.S. did not rely on Asia and Europe to prop up its bond market (a quid pro quo, by the way, now threatened by Japan and China's newfound reluctance to take on more U.S. debt).

Mid-summer 2007 brought some even more discouraging news along these lines. With oil trading in the $75 per barrel range, the International Energy Association warned of a supply crunch developing over the next five years which could send oil prices to record levels. Since the United States imports roughly 60% of its oil, and oil in turn accounts for a significant portion of American imports, we should expect the trade deficit to worsen considerably in the years to come. Add accelerated growth in imports from developing countries like China and India, and you get a sense that the balance of trade numbers could be permanently stuck on a one way street going in the wrong direction. Trade and balance of payments is likely to dominate financial headlines for a long time to come. Alarming growth in the export-import imbalance is another Disturbing Trend sure to wreak havoc with the dollar and investor portfolios in the months to come.

The real rate of return is defined as what remains on savings or money market yields after taxes and inflation are subtracted. A currency which carries a positive real rate return tends to attract capital; a negative or low real rate of return encourages liquidation. In recent months, the British pound, European euro and a range of other currencies have reached milestones against the dollar precisely, for the most part, because those currencies are providing a real rate of return

This past May, the Labor Department reported consumer prices rising 5.5% annual rate. The yield on a typical money market account is currently running about 4.9%. 10-year Treasury paper yields in the 5.1% range if held to maturity. In either case, as you can see, the real rate of return is in the negative without factoring taxes into the equation. Once you factor in taxes at even 30%, the net return comes down in negative territory. In addition, many believe that the Labor Department's inflation numbers are politicized and greatly understated. If so the real rate of return is deeply in the negative. In short, the disappearing real rate of return on the dollar figures significantly into portfolio planning both within the United States and internationally, and looms large among the disturbing trends having an impact on the market for the dollar.

"[T]he greatest risk facing financial markets and the global economy is the opaque, mysterious and complex activities of hedge funds."

- Alan Kohler

Derivatives' growth is a new addition to the disturbing trends table, but the late arrival shouldn't diminish its impact with respect to systemic risk. In 1995, the first year the Bank for International Settlements reported on derivative positions, the notional value en masse was roughly $47.5 trillion. By 2006, that notional value had risen to $415 trillion -- a nearly 875% increase.

The primary problem with derivatives is that so few truly understand the risk exposure they represent, even among the hedge fund managers who profess to be experts on the subject. What's more when things go bad, as they often do in the world of hedge funds and derivatives, the damage can extend quickly to the financial system as a whole and cause massive damage before anyone knows what happened. Ordinary losses can transform to extraordinary in the blink of an eye. There are now over 9000 hedge funds operating in the world financial markets, and an international debate rages as to the whether or not that is a good, or a bad, thing.

When you take into account that adding together the losses at LTCM, Amaranth and Bear Stearns (The Big Three derivative related meltdowns thus far) would not even comprise one tenth of one percent of the estimated $500 trillion notional volume, you begin to get a sense of the ominous danger lurking in the financial system as a whole. Any one of the three meltdowns mentioned above could have been enough as isolated instances to create a generalized panic and meltdown on Wall Street. Meanwhile Fed chairman Ben Bernanke tells us that there are between $50 billion and $100 billion in losses now rattling around the mortgage derivative market alone!

Please note that all three  instances occurred in different markets -- LTCM, Treasuries and  currency; Amaranth, natural gas; and Bear Stearns, mortgage securities -- giving credence to the argument that it is derivatives' instruments themselves which should be blamed for the meltdowns, and not market price action by itself. Floyd Norris, writing in the New York Times about the recent subprime mortgage meltdown, went so far as to say that the years of economic boom "were constructed on sand". The fact of the matter is that the financial landscape is littered with derivative-based timebombs ready to go off at any moment. The problem for investors, both individual and institutional, is that many have lost a great deal of money and don't even know it. Warren Buffett,  the sage of Omaha, put it best: "Derivatives are financial  weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

[...read more here on Hedge Funds and Volatility]

Foreign debt hangs like a sword of Damocles over the American economy. As our table illustrates this disturbing trend has shown the highest growth rate of them all. At this writing, foreign governments, institutions and individuals hold a collectively over $2 trillion of U.S. paper -- roughly one fourth of the national debt. Japan alone holds over $600 billion and mainland China over $400 billion. To suggest a measuring stick, federal tax receipts stand at roughly $2.2 trillion.

It is not just the presence of the debt itself which worries the inner sanctums of Wall Street, but the threat foreign-held debt represents to the U.S. Federal Reserve. Through the purchase and sale of U.S. Treasuries, foreign creditors can force interest rates up when the Fed would like to keep them down and force them down when the Fed would like to keep them up. In other words, the Fed very well may be losing control of interest rate policy. Recently, when the Congress threatened trade sanctions against China, the bond market began declining, thus pushing up interest rates. This foreign influence on Fed policy-making did not exist even five years ago.

There is an even darker aspect to the problem of foreign held debt, and that has to do with the international reaction to the future value of the dollar. If faith is lost, or even weakened to the extent that the trend to diversify out of dollars gathers steam, what is now a trickle of returning U.S. dollars could become a torrent. This, in turn, could trigger an uncontrollable inflation and dollar crisis globally.

Some analysts have pointed out that such an exodus would be farfetched in that the holders themselves would have a great deal to lose by unloading a large portion of their positions. The fact of the matter, though, is that the exodus has already begun. For example, Russia recently announced that it was juggling its reserves to purchase Japanese yen. Several Gulf oil producing states have quietly followed suit and are switching out of dollars and into both the euro and yen. Japan over the past year has actually reduced its Treasury position and Chinese officials recently suggested that its central bank might exchange some of its more than $1 trillion in reserves for gold and oil. Many nation states with large dollar holdings have formed sovereign wealth funds, the purpose of which is to utilize reserves to acquire other assets including hard commodities, natural resource companies and an array of other assets. Analysts often infer that their exodus will be controlled, but the problem with systemic crisis is that the evolution from a controlled liquidation to panic, particularly a panic in the ranks of private institutional funds, can come quickly and without warning. That said, even a slow-motion unraveling, or a simple withdrawal from regular U.S. debt purchases, could have a devastating effect on the value of the dollar.

Would you own a stock that performed like the item represented in the graph below? The dollar is now a currency under siege. The cumulative effect of the disturbing trends outlined here has been to undermine the purchasing power of the dollar. In reality, it has been steadily debased in fits and starts since the Federal Reserve was created in 1913. However, in recent years that steady debasement has taken on a more urgent character due to the combined threats of a shrinking market for U.S. Treasuries and the dollar as the chief reserve currency. Add the current problems in the mortgage markets, which have pushed several major banks against the ropes, and you have the potential for an imminent dollar crisis. We may no longer have to gaze into the distant future for a glimpse of what is to come for the dollar. The day of reckoning might very well have already arrived.

The 1913 dollar is now worth less than 5¢ in purchasing power. The 1945 dollar is now worth less than 10¢. The 1970 dollar is now worth 19.5¢. The 1985 dollar (during a time when we were told repeatedly inflation was benign) is now worth only 58¢. This disturbing trend is troublesome to say the least, but when you consider that the depreciation of a currency, when it comes to inflation, is technically infinite (in other words there really is no bottom), you begin to understand why some have begun to view gold as a permanent aspect to the contemporary portfolio.

To show you how far we've come in so short a time, consider this statement in November, 2002 from Federal Reserve governor Benjamin Bernanke when asked about the tanking U.S. economy and fears of a deflation were running high: "The US government has a technology called a printing press -- or, today, its electronic equivalent -- that allows (the Federal Reserve) to produce as many US dollars as it wishes at essentially no cost." How many of us would have ever imagined a statement like that being uttered by a member of the Federal Reserve? And now that same Benjamin Bernanke has been appointed chairman of the Federal Reserve.

"I still sleep better at night knowing that I hold some gold. If or when everything else falls apart, gold will still be unquestioned wealth. I understand Warren Buffett's Berkshire Hathaway is sitting with $46 billion in cash, which I'm guessing is in US T-bills. But I wonder if Warren himself doesn't have a little box hidden away somewhere in Omaha, and that little box is filled with American gold Eagle coins. Warren's father was a big believer in gold, and some of daddy's philosophy probably rubbed off on Buffett."

- Richard Russell, Dow Theory Letters

At the risk of being judged overly simplistic, let me say that there are three potential outcomes to these disturbing trends:

First, things could improve, or, in a sudden fit of political and economic sanity, stabilize on a course that would lead to a complete recovery.

Second, they could stay the same. In other words, what we've had is what we are going to get.

Third, they could get worse.  The long predicted collapse could actually occur.

If you believe that the first outcome is the most likely, you can stop reading here. You have no need to make any fundamental adjustments in your portfolio. If you are concerned, however, that either the second or third outcomes are most likely, then you will need to make some portfolio adjustments (if you haven't already), and those should center around the acquisition of gold.

One of the more interesting statistics in the accompanying table is the one that shows the stock market and gold turning in nearly identical performances over the thirty-seven year period covered by the study. This statistic might surprise many investors, including gold owners, given the amount of time the mainstream media spends dissing gold ownership, however, the numbers do not lie. What's more, cycle theory tells us that we are in the beginning years of the up-cycle for gold and the down-cycle for paper assets. The economic cycle favored tangibles - real estate, commodities and gold - from 1970 to 1985, and then turned in favor of paper assets in stocks and bonds. In 2002 the bear market for paper assets began as did the bull market for tangibles. If the duration of the past cycles holds true, the cycle top for hard assets should arrive sometime around 2017-2020. The point of taking you through this exercise is to show that gold looks to be about a third of the way through its bull cycle, while paper-based assets look to be about a third of the way in their long term bear market. The problems now present in the stock, bond and derivative markets are symptomatic of that larger trend.
 
If the economy goes retrograde (the third possible outcome), systemic risk, market volatility and economic instability will become household terms. As this economic drama unfolds, look for gold to take a step further and once again assume the role it played in European portfolios during its centuries of turmoil - when gold was a permanent portfolio mainstay and a standard recommendation by conservative money managers.

Keep in mind going forward, that due to declining production and capped central bank sales coupled with rising worldwide demand from a number of sectors (private and public), gold could become difficult to obtain in the event of a crisis. Also, be aware that the entire gold industry is probably smaller than a handful of major stock brokerage offices. It is not equipped to handle the kind of activity that would be generated by something like a stock market meltdown. Last, price should be seen as a secondary consideration if you either don't own gold, or don't own enough. For the reasons touched upon here, know that it is better to move now than to wait and open yourself to the very real possibility of a major disappointment should gold availability dry up.

If you are concerned about the trends described here, switching at least 10% of your portfolio to gold will go a long way toward providing peace of mind. If you have deeper concerns, it would be advisable to move that percentage incrementally higher with 30% as the top percentage diversification. Always, your gold holdings should be managed in a way that insures the preservation and expansion of your total wealth. Once you have achieved your desired goal, you should maintain it as a constant percentage otherwise you jeopardize the safety of wealth you have gained in other endeavors - professionally or as an investor. Do not make the mistake of resting on your laurels, or selling out your position simply because you have been impressed with your profits.

There is good reason for my emphasizing this approach. Consider, for a moment, the investor in Argentina who early in the crisis sold his gold for a hefty, inflation-induced profit. Though it looked good on his financial statement initially, months later when Argentina's economic system collapsed in totality, he found himself standing in line at the bank's door like most everyone else hoping to gain access to his accounts. The temptation to take a profit left him defenseless when the real problem finally manifested itself. I am often asked "How much gold is enough?" I respond with a question of my own, "How much savings is enough?" In the end, gold is simply a form of savings detached from the national currency. Its principle value lies in its unique status as a stand alone asset that requires no endorsement -- an asset that depends upon no individual or institution for value.

The specific types of gold coins you purchase depends upon your goals. Your advisor at USAGOLD/Centennial Precious Metals can help you choose what best suits your needs. In general, if you want basic protection there's nothing like gold bullion or gold bullion coins, such as the U.S. Eagle or Buffalo, the Canadian Maple Leaf, Austrian Philharmonic or South African Krugerrand. If you want to add an extra layer of protection against government intervention in the gold market -- including potential capital controls and confiscation (a possibility during a currency crises) -- you should consider a selection of the lower premium European and U.S. pre-1933 gold coins, such as the U.S. $20 gold piece, British Sovereign, Swiss Helvetia, or the Dutch Guilder, et al which are also liquid and track the gold price.

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For more information on the role gold can play in your portfolio, please see The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold by Michael J. Kosares.