Australian Copper Bullion

Joseph Brusuelas, Chief Economist

The upcoming week will be defined by two closely linked US macroeconomic data that will frame the debate about which direction the economy is poised to take during the latter half of 2008. Yet, these two data are likely to paint two very different portraits regarding the condition of the economy. On Thursday the market will observe the preliminary estimate of economic growth during the second quarter of the year, followed by the publication of the July non-farm payrolls the next morning.

According to Bloomberg, the current market consensus anticipates a 1.8% rate of growth, fractionally below our forecast of a 2.1%. Given the bear market rally that we have observed over the past week, there is little doubt that the 08:30 AM EDT release on Thursday morning will provide a fairly solid case for equity bulls who are claiming that a bottom is in the process of forming in the market. Demand from the external sector could approach 2.0% and personal consumption should hold steady at a 1.0% rate of growth. The contribution of government spending should remain quite solid, but our forecast implies that the combination of the decline in residential fixed investment and a reduction in inventories should combine to reduce overall growth by 1.1%. Due a strong rise in demand for net exports and the stimulus inspired rate of personal spending, the data does tend to suggest that the risk to the report is to the upside. We would not be surprised to observe an initial print as high as 2.6%, with subsequent revisions back to the downside during subsequent estimates towards our 2.1% forecast.

However, once the dust settles and the market begins to look at the source of growth and is able to evaluate its sustainability a different picture may emerge. What permitted personal consumption, which accounts for nearly 70% of overall growth, to obtain a rather anemic rate of growth, was not a resilient consumer, but the well-timed fiscal rebates. To be blunt, it was not a consumer hungry for a return to the malls, but government spending, which was behind a second straight quarter of weak growth in personal consumption. As the June retail sales data illustrated, the impact of the stimulus checks has begun to wane and there is very little going forward to support spending.

That very potent fact will be on vivid display the following morning when the July non-farm payrolls report is published. Unlike the previous days headline data, the data from the labor sector will not be construed as positive, but will be focused on the potential drag on future consumption. The current consensus forecast expects a net -70K jobs will be lost, which is little better than our forecast of -93K for the month. We think that the combination of downward revisions to recent payroll estimates and losses in goods producing, manufacturing and the service sector should push the headline towards the -100k mark for the first time since the downturn in the economic cycle began.

Our forecast for the US economic growth path for some time has been that output would resemble a “W.” We expect that Q2′08 represents the middle apex in what is shaping up to be a classic double dip economic downturn. Our growth forecast implies that the market should observe growth in the third quarter to check in at 1.1% and the final three months of the year to observe a 0% rate of growth, with an outsized risk of a negative print. Moreover, we do expect that the rate of unemployment will advance to 6.0% by the end of

the year and further job losses to add to the -438,000 jobs lost thus far in 2008. Thus, what on Thursday may be the source of much celebration among equity bulls, by Friday morning may not seem so compelling. In fact, by mid-day on Friday the recent bear market rally may fade into a classic bull trap. To our colleagues that are making the case that the economy is in recovery and now is the time to jump into the market and purchase equities we have one question; what will support consumption six months out once the stimulus power of the rebate checks evaporates?

July 25, 2008

Joseph Brusuelas
Chief Economist
Merk Investments

Adrian Ash
BullionVault
24 July 2008

“…Just like everywhere else, Indian consumers face the problem of too much money chasing prices too high and becoming worth less each day…”

IT’S HARD TO OVER-EGG the importance of Indian jewelry demand in the physical gold market.

Between 2000 and 2007, gold jewelry sold in India accounted for one ounce-in-nine sold worldwide. One ounce in every five wound up as an Indian import (its domestic mines produce less than six tonnes per year), ready to be hung off young brides as 24-carat dowries or worked into bracelets and necklaces for the international market.

The single-largest gold bullion consumer, India’s own final demand outweighed the next largest market – China – by almost 57%.

But Chinese gold buyers have now caught up in 2008. Or so says the latest data from the World Gold Council. The switch isn’t only due to surging Chinese demand (up by 15% year-on-year between Jan. and April). It comes because Indian gold sales have collapsed – down 65% in the first six months of 2008 from ‘07 according to the Bombay Bullion Association – as consumers balk at record high prices.

“The underlying drought in Indian demand should have analysts up at night,” reckons Jon Nadler at Canadian refining and metal-dealing group Kitco. As Kitco’s senior analyst, you might expect him to be chewing double-doses of Nitol as a result.

“Who will absorb the metal that the sub-continental buyers are evidently unwilling to consume at current prices,” Nadler asks.

And it’s a fair enough question.

Our best guess-timate here at BullionVault – working off the data provided by our friends at Virtual Metals in London – says Indian gold demand this year could be on track to fall as low as 250 tonnes, well below half the average of 2000-2007.

What might this mean for world Gold Prices? Four caveats apply:

• Diwali – the Hindu religion’s festival of lights – falls in October after the harvest ends (more on this below). It marks India’s peak gold-buying period;
• The drop in world jewelry sales led by Indian consumers comes in terms of physical tonnage; the Dollar value of world purchases actually jumped by 20% between Jan. and April compared with last year.
• Global investment demand continues to surge, with Turnover Doubling for UK Gold Dealers and new purchases rising sharply (both by volume and value) across south-east Asia and the Middle East;
• India’s private citizenry is no different from the rest of the planet right now, in that they can’t move for strong reasons to keep buying gold.

Strong reasons to Buy Gold? First, just like everywhere else, India suffers the problem of money. Much too much money.

The quantity of Rupees in circulation has more than doubled since 2003. So-called “broad money” supplies (M3) have risen 10 times over since the start of the 1990s.

That makes each Rupee in your pocket worth less every day. Inflation in the cost of living is now running above 11% year-on-year, more than twice the Reserve Bank of India’s target.

But even with interest rates set at a six-year high, the real returns paid to cash – the real rate of interest after inflation – remains sharply negative for Indian savers, way down at minus 3.4% annually. That’s even worse than the negative real rates now paid to US cash holders (minus 3.0%).

The Rupee’s steady decline on the currency markets therefore looks set to roll on. It’s steadily sunk against pretty much everything else over the last four decades…clawing back 15% of its value against the US Dollar since late 2002 only because the Dollar has fallen still faster.

Second, both Fitch Ratings and Standard & Poor’s this month Downgraded India’s Sovereign Debt, leaving it just one rating above “junk”. Fitch’s outlook on government bonds denominated in Rupees went from “stable” to “negative” thanks to “a considerable deterioration in the central government’s fiscal position…combined with a notable increase in government debt issuance to finance subsidies not captured in the budget.”

Fitch expects India’s fiscal deficit to reach 4.5% of GDP next year, up from the current 2.8%. Throw in the debt issued to subsidize consumer prices via India’s oil and fertilizer companies, and the ratings agency sees the underlying deficit at a huge 6.5% of the economy or even higher.

Third, the Bombay stock market has proved a great place to lose money so far this year, down almost 30% since reaching an all-time peak at the beginning of January, the worst performance of the four “BRIC” economies (Brazil, Russia, India & China) in 2008 to date.

Indeed, “if you had invested 10,000 Rupees in the Sensex or the Nifty [stock index] one year back,” write Gaurav Pai & Ashish Rukhaiyar in the Economic Times, “your investment would have shrunk to about Rs 8,800.

“However a similar amount invested in gold would have grown to over Rs 15,000.”

Still, at least the Bombay Stock Exchange (BSE) has so far avoided the riots that broke out across the border in Karachi, Pakistan, in the middle of July. Down by 35% inside three months, the plunging Karachi Stock Exchange (KSE) needed police and the army to defend its offices on July 17th from a 1,000-strong mob of Panicked Investors.

(Bombay did get heated scenes in parliament this week, however, when members of the opposition began waving round huge bundles of cash, claiming they were Bribes from the Ruling Congress Party ahead of a crucial confidence vote…)

“I’ve lost all my savings,” said one Pakistan stock-holder to the BBC’s local correspondent. “I am upset because I am constantly losing money and there is no one ready to help me,” said another.

“For me, this is just a murder for my economic future,” said a third after seeing his life savings – worth $5,000 – blown up. And here’s the rub.

“It’s the uncertainty in the financial markets that is propelling gold upwards,” as Devendra Nevgi, head of the Quantum Gold Fund says from Mumbai. Indian and Western investors alike might want to keep that in mind. Because, whatever the aesthetic or festive attractions of owning gold bullion, its role as the No.1 safe-haven asset remains.

“Despite India’s emerging middle class,” wrote Laila Manji in Virtual Metals’ Yellow Book of May 2007, “the rural poor account for two-thirds of annual gold purchases. Small-scale farmers have traditionally used spare cash to invest in small pieces of gold jewelry because, in the face of economic and political uncertainty, they favor gold above paper assets.”

That’s why the vast bulk of jewelry sold in India doesn’t fit Western ideals of fine metal-work. Heavy bracelets and “marriage necklaces” weighing up to half-a-kilo (15 ounces) or more are often stringed together using 10-tola bars – smooth, round nuggets of gold each weighing 3.75 ounces (117g).

Ten-tola bars are heavily traded across India, Pakistan, Singapore and the Middle East. More than two million nuggets of this “TT” gold are believed to be cast or minted each year. “Practically, its portability makes it easier to keep safe and secure than cash,” Manji goes on, “and – even if they overcame their suspicions of paper assets such as equities or government bonds – most of India’s rural population either lack sufficient capital or access to banks to make that feasible.

“Much of India’s informal credit system is backed by gold, and, of course, religious and cultural attachments, not least the idea that gold given to women as a wedding gift remains her own property, are strong.”

Put another way, it’s crucial to grasp just how the vast bulk of gold jewelry buying in India – and across south-east Asia – qualifies as “investing” rather than “for adornment”. Farmers put their post-monsoon profits into gold because they don’t trust the Rupee to hold value (and rightly so). Families hold bullion in the form of rough, heavy jewelry, selling small pieces when needed but laying down savings for wedding dowries, local investment or property purchases. And even as the un-banked sector of India’s population slowly begins to shrink, fully 61% of adults in rural India still don’t have a bank account. Some 40% of urban citizens are without formal banking, too.

This doesn’t guarantee a sudden return of strong Indian buying, of course. But it does help explain a big difference between Indian investors and Western gold-buyers in how they respond to moves in the Gold Price.

“India is a market well known for its price sensitivity,” notes the latest Gold Investment Digest from Natalie Dempster at the World Gold Council.

In particular – as a comparison of volatility and gold consumption soon shows – India’s gold buyers just hate increasing their holdings when the price keeps jumping around.

Total demand recovered a four-year high in 2005 as price volatility ebbed. It picked up again after slumping in 2006, rising 4.5% last year as the violence in daily price movements slowed.

Most crucially – and most unlike Western investors buying any bull market (be it shares, real estate or government bonds) – Indian gold owners like to buy on the dips, rather than piling in whenever the price moves higher. That’s why, all through this decade’s 225% rise in the Rupee gold price, the floor for new buying has quietly moved higher.

“Physical buying in the domestic market improved on Wednesday as Gold Prices fell below the psychological level of 13,000 rupees and the rupee strengthened,” according to B.N. Vaidya & Associates in Mumbai.

“There is a huge demand,” agrees Prithviraj Kothari, head of Riddisiddhi Bullions Ltd. “In the last couple of days alone 10 tonnes may have been sold all over India.”

“They are buying coins and bars…mostly 100 gram bars for investment,” says Jitendra Kantilal, a trader in the Zaveri Bazaar in Mumbai. “There is a lot of appetite for prices at lower levels,” said another dealer to the Economic Times.

“At $915 an ounce, there would be huge interest.”

And why ever not? Buying low, selling high is the way to make money. And analysis from the Quantum Funds in Mumbai notes that, during this bull market so far, Buying Gold in mid-summer has delivered an average 15% gain for Indian investors by the following New Year.

Adrian Ash

Formerly City correspondent for The Daily Reckoning in London and head of editorial at the UK’s leading financial advisory for private investors, Adrian Ash is the editor of Gold News and head of research at BullionVault – where you can Buy Gold Today vaulted in Zurich on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2008

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.

Adam Hamilton

For the most part, this summer has not been kind to precious-metals investors and speculators. While gold did rally rather sharply from mid-June to mid-July, up 12.6%, it could not challenge its $1005 March high. And soon after this retest failed it plunged $47, 4.8%, in just 2 trading days this week.

And silver hasn’t fared much better. As usual it paralleled gold’s mid-June to mid-July advance with its own rally, a healthy 16.3% surge. But this really wasn’t all that much better than gold’s own run, discouraging silver traders looking for outsized gains. And then this week silver mirrored gold’s fast selloff with a steep 5.8% plunge of its own.

But the sickly PM stocks make gold and silver look like superstars by comparison. Despite incredibly high gold and silver levels historically, the flagship HUI PM-stock index just can’t gain any traction. From mid-June to mid-July it rallied 18.2%, offering meager 1.4x leverage to gold. This is pathetic compared to bull precedent. Then this week the HUI plummeted 8.3% in 2 days in sympathy with gold’s selloff.

Naturally this poor gold, silver, and PM-stock behavior is generating great concern among traders. Given the sorry state of the US dollar and all the financial-market turmoil, why isn’t gold rocketing higher? Why is silver just grinding listlessly sideways way below its March highs? And why are these metals’ elite miners trading at October 2007 levels today? Back then gold only averaged $756 and silver $13.70, far lower than today’s prevailing prices.

What the heck is going on here? Are the precious-metals bulls in trouble? Not at all. Provocatively, the summers are virtually always slow for gold, silver, and the PM stocks. After studying these markets for many years, I’ve come to call this period the PM summer doldrums. Most of the time, even within the most powerful bull markets, the PMs spend the great majority of summer grinding sideways in consolidations.

Because of this phenomenon, back in late May we shifted our speculation focus to other areas for the summer months. On May 31st in our new June Zeal Intelligence newsletter I warned our subscribers about the coming PM summer doldrums. As this summer dawned I wrote, “The hard truth is that June and July are just not a great time to expect meaningful gold and silver rallies.”

“In light of this precedent, the most prudent course of action from a probability standpoint is to lower our PM expectations for summer 2008. If you add any PM-related positions, don’t expect too much out of them until autumn. Don’t get discouraged if your existing PM positions drift sideways to lower. When gold and silver grind listlessly, often the PM stocks will slowly drift lower as impatient traders sell.”

So if this lackluster summer action has surprised and discouraged you, it shouldn’t have. Slow sideways-to-lower summer grinds are par for the course in PMs. This is one of the great benefits of being a student of the markets. By studying past behavior, one’s expectations for future behavior can be tempered to align much more closely with probable outcomes. And if you’re prepared, then you can’t get discouraged.

In this essay I’ll show you why I warned our subscribers about the PM summer doldrums in advance and shifted our short-term speculations to other arenas when summer dawned to avoid dealing with this grinding angst. Once you digest these charts, your own expectations for summer PM trading will probably be radically tempered as well.

In order to reveal the summer doldrums graphically, I designed some new charts for gold, silver, and the HUI. I started my analysis for each in 2000, the year in which the HUI bull was born (though gold’s started in early 2001 and silver’s in late 2001). I looked at each summer for all three in 2000 as well as every year since.

Realize that in the financial markets, summer runs from Memorial Day to Labor Day, June through August. This is when the kids are out of school and many traders are vacationing, leading to lower volumes across nearly all financial markets. In addition to these June-to-August market summers, I tacked on one month before and after for context. As you’ll see, June, July, and August are indeed the classical PM summer doldrums traders need to be wary of.

In order to compare all these summers visually, I needed a common scale that transcended the whole price range of these entire PM bulls. So I individually anchored each summer at an index point of the close on the last trading day of May. I set this equal to 100. So if gold rallied 5% above its final close in May, it would hit an index level of 105. If it fell 5%, it would hit 95. This approach makes all summers perfectly comparable in percentage terms.

For 2000 to 2007, I rendered each summer’s indexed results in yellow. While these lines look like a mess of spilled spaghetti on the charts, this is fine for this essay’s purposes. We want to see the general summer trends across all years simultaneously as well as any outlying extremes. These 8 summers’ yellow lines are then distilled down and averaged into a single red line. It really reveals the doldrums’ prevailing trend.

On top of all this, I superimposed one final indexed line in blue. This is the summer-to-date performance in 2008. By comparing this line to the previous 8 summers’ individual and collective performances, we can really see how summer 2008 is tracking relative to precedent. The PM summer doldrums are very real and quite demonstrable empirically, and all PM traders need to be aware of their implications.

This chart is really amazing. Since April 2001, gold has been in its most powerful secular bull witnessed since the 1970s. Over this period of time, the Ancient Metal of Kings has nearly quadrupled, up 291.7%. Investors and speculators, including us and our subscribers, have made fortunes in precious metals since 2001. Yet as this chart shows, virtually none of these stupendous gains accrued in the summers!

Note that all the yellow lines, every summer between 2000 and 2007 indexed to 100 as of the last trading day of May, clustered in a tight trading range. Throughout this whole bull, gold’s summers have been largely limited to plus or minus 6% swings from late May’s levels! While there are a few temporary outlying areas, after all these years of bull precedent traders really shouldn’t expect too much from gold in the summers. It usually just grinds sideways.

The red line averages the indexed gold summers between 2000 and 2007. Note that it is very tight, ranging from -2% to +1%. In addition, it is pretty much dead flat, hugging the 100 level closely in June, July, and August. This average is gold’s expected bull-market path during the summer doldrums. Thus you can see why I warned our subscribers in late May not to expect much from gold this summer.

Interestingly, gold’s recent sharp rally from mid-June to mid-July 2008, rendered in blue, actually ran well above trend. This was much higher than I expected. Nevertheless, we were gaming gold’s summer trading range in Zeal Speculator. I recommended GLD calls in mid-June (low in the range) that we ended up selling in mid-July (high in the range) at an 87% realized gain. So even as gold drifts sideways, traders can buy low and sell high within its summer range.

With gold running so far above trend this year, it shouldn’t be surprising that it has corrected sharply this week to get back into trend. The PM summer doldrums are a tough master that is seldom cheated for long. Gold will likely continue lower into this range in late July and early August. Provocatively, to hit the -6% lower part of its typical range this summer, gold would need to go as low as $835! Although I really doubt this will happen this summer, if it does it is not abnormal at all relative to this bull’s precedent.

These doldrums may seem bleak, but the purpose of summer consolidations is to build a high base for gold’s powerful autumn rallies. In September you can see these rallies launching in this chart, and they are very apparent in full gold seasonal charts as well. Strategically, the summer doldrums lay ever-higher foundations for the autumn gold buying spree emerging after Asian harvest and running into the Indian wedding season. So in a broader context, the PM summer doldrums are nothing to fret about.

As the king of precious metals, gold’s behavior colors all PM sentiment. Silver and PM-stock investors and speculators always look to gold for trading cues. If gold isn’t thriving, neither will silver or PM stocks. And since silver and the PM stocks are essentially speculative proxies on gold itself, it is not surprising that both silver and the HUI tend to mirror gold’s listless summer grind.

Silver in particular virtually always follows gold. Stretching back to at least the 1970s, you just can’t find a meaningful silver upleg that wasn’t spawned by a parallel gold upleg. Countless gold and silver charts reveal this indisputable market history with crystal clarity. Thus it is not surprising that as gold drifts in the summers, silver generally follows it. Without gold’s lead, silver speculators rarely get excited about buying.

As silver is far more volatile than gold, its summer-doldrums trend is not quite as clean-cut. Nevertheless, the center-mass trend based on silver’s indexed summers between 2000 and 2007 is definitely down. 5 of these 8 summers spent almost all of their time in the downtrend rendered above. And none of the 3 outliers could spend more than 2 months at a time outside of this prevailing downtrend.

While gold’s red summer average line meandered around 100, silver’s actually grinds under it. The red line above runs between 95 and 100 indexed. This means, on average, silver is usually grinding slightly lower rather than just flat during the summers. And this is logical. If gold is flat, it isn’t generating any PM excitement. And without gold’s lead, silver sellers can overwhelm buyers causing its price to drift lower.

Interestingly July 2008 was also silver’s best summer performance yet, carrying it above trend. Since it blasted so far out of its typical range, once again this week’s sharp correction shouldn’t be too surprising. Probabilities are high that silver will need to head back down into its typical summer trend before this summer draws to a close. If it merely grinds sideways this summer as usual, silver has plenty of short-term downside left.

Although gold only had one outlying summer, the sharp June 2006 downside which happened during a major correction following a euphoric upleg climax, silver had three. It shared gold’s June 2006 correction of course, but also saw upside outlying years in 2003 and 2004. Both started in July at very low absolute prices. In early July 2003 and 2004 silver was running $4.55 and $5.90 respectively. Like any long-beaten-down asset, silver was more likely to surge suddenly early in its bull since it was so oversold.

Interestingly 2008 is the first upside-outlying summer we’ve seen since 2004. I know this silver surge was driven by gold’s own surge, which I suspect was sparked by the sharp financials-led selloff in the general stock markets and concurrent US dollar selling. But the key point is once gold retreated, silver did too. So if gold continues grinding lower into its typical summer trading range, the odds are high that silver will dutifully follow like usual.

While gold and silver have both been above trend this summer, the HUI has not. PM-stock traders are very discouraged, partly because so many had such high expectations going into this summer. Most have probably never heard of the PM summer doldrums so this sideways action is likely crushing their will to keep playing the game. Yet as this chart shows, the HUI’s lackluster behavior this year is quite typical of the summer doldrums.

The HUI’s summer-doldrums pattern is more variable than gold’s or silver’s. In June and most of July, for every summer since 2000 the HUI has traded in a flat summer range between -11% to +11% of its final close in May. Translated into today’s HUI levels, in 2008 this range runs from 375 to 468. And interestingly this summer the HUI has traded between 397 and 469 on a closing basis, which is right in line with precedent.

But then in late July and August, probabilities shift significantly. During half the summers from 2000 to 2007, the HUI continued grinding sideways in its summer-doldrums range. But during the other half, the HUI has blown out of this range to the upside and the downside in equal measure. 2003 and 2005 saw upside breakouts in late July and August, while 2000 and 2002 saw downside breakouts. Other than 2003 though, a young major upleg, all these breakouts soon retreated back near or within the -11% to +11% summer range.

On an average basis, the HUI tends to run flat in the summer too. Its red line generally meanders within a few percent of flat in both directions from the final HUI close in May. It also tends to get a bit weaker in late July and a bit stronger through August. This implies that our current HUI selloff may run for another week or two before we start recovering a bit. Most of the yellow lines slide lower in late July, a period of sharp seasonal weakness.

So as these charts reveal, the PM summer doldrums are a very real phenomenon. And this is even during the exceedingly powerful secular bulls in gold, silver, and the HUI that have unfolded since 2000. This analysis certainly does not suggest that the PMs can’t rally in the summer, just that probabilities are stacked against any significant rally. Traders would do well to remember this heading into future summers.

If your expectations are properly set heading into summer, then you won’t suffer any psychological damage from the typical lackluster grind. Prudent PM investors and speculators write off most of the summer, accepting the near inevitability of the drift. Then in late August they start buying aggressively in anticipation of the usual autumn gold rally driven by Asian buying. Most of these PM bulls’ gains have accrued between September and February, the highest-probability-for-success time to be long.

As a student of the markets, I’ve been aware of this PM-summer-doldrums tendency for some time. I love studying the markets not simply because they are fascinating, but because this research helps me understand when probabilities are most in my favor to open or close real-world trades. While deep market research takes countless hours and isn’t for everyone, you can easily share in the fruits of our labors at Zeal.

We publish acclaimed monthly and weekly newsletters that integrate all of our ongoing research into uncovering real-world trading opportunities for our subscribers. For a relatively trivial subscription fee, you can put many years of trading experience and endless hours of market research on your side. Subscribe today as we start heading into August and preparing to deploy new PM positions soon ahead of the usual major autumn rallies in gold, silver, and the PM stocks.

The bottom line is the precious-metals realm virtually never does well during the summer months, even within the strongest of secular bulls. For a variety of global supply-and-demand reasons, gold tends to drift sideways in June, July, and August. Since gold’s behavior heavily colors sentiment for everything PM-related, silver and the PM stocks parallel the yellow metal in lackluster summer consolidations.

But if you expect these PM summer doldrums, and trade accordingly, you can be really well-positioned for the big autumn rallies spawned by a surge in gold buying out of Asia. Managing one’s PM summer expectations down to low levels is crucial for PM traders’ psychological well-being during these slow months. Thankfully this slowest time of the year seasonally is followed by the best seasonal time.

Adam Hamilton, CPA

July 25, 2008

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Copyright 2000 - 2008 Zeal Research (www.ZealLLC.com)

John Browne
Senior Market Advisor
Euro Pacific Capital

In recent months, even the most blindly optimistic forecasters have come to grips with how our banks and investment banks took wildly imprudent risks that will result in horrific losses.  The resulting sell-off in financial shares has tempted many investors to scoop up these companies at apparently fire sale prices.  Wise investors should resist the temptation, as the pain for financials is just getting started.

Although voices of prudence were dismissed at the time, these banks’ risks were leveraged largely through “off-balance sheet” mechanisms that generated massive financial rewards for the financials while keeping the losses supposedly at arm’s length.  The resulting windfall yielded $26 billion in bonuses for Wall Street in 2007.

The tolerance for the risks and leverage was based upon the widespread belief that real estate prices were set to rise without correction.  We now know that this was a fairy tale.

Soon, gullibility gave way to greed, which soon led to fraud, and the sub-prime world was born.  It was camouflaged by means of securitization, in the form of Collateralized Debt Obligations (CDO’s), sometimes packaged within triple “A” bundles.  This so-called “toxic waste” was passed on to unsuspecting financial institutions around the world.  The hidden virus infected the entire vast international financial system.  Soon, the credit markets tightened, threatening first their own financial crisis and then, with their reduced lending ability, an economic recession.

When the Treasury/Fed team moved to rescue Bear Stearns and, more recently, Fannie Mae and Freddy Mac, the $5 trillion-plus burden of risk was neatly transferred to the American citizen.  This week, the Wall Street Journal commented on Nouriel Roubini, the New York University economist.  He aptly observed that it was “the price of a system that privatizes profit and socializes losses.”  People could be excused for protesting strongly against such political policies as outrageously un-American.

The rescue of Fannie Mae and Freddy Mac, in particular, generated a wave of buying amongst the so-called “bargain basement” financial stocks, off some 80 percent from their highs.  This optimism was based largely on the belief that the taxpayer would be forced to rescue the banks.  But the banks are not the only financial institutions in trouble.  The home lending and credit boom provided a feast for all manner of other speculations.  Credit cards lenders became very aggressive as did auto lenders and lenders to students.  Even businesses borrowed in order to participate in the great consumer credit boom.

These categories of lending are vast, in sum, amounting to several trillion dollars.  All financials are exposed, but the degree of infection is not yet fully understood.  Soon, even the government must wonder how much more taxpayer “rescue” the $14 trillion U.S. economy can afford?

As the recession takes hold, borrowers are heading for stringent times, especially those with large, high cost credit card debts.  Likewise, their lenders, including many regional banks, are likely to experience massive loan defaults.  Then, there are the insurance companies who have invested much of their own reserve funds in real estate.

In short, investors should become urgently aware that banks are not the only financial institutions that will be adversely affected by the severe economic conditions now looming ahead. 

Before being tempted back into buying financial stocks as “bargains”, investors should assess carefully whether or not the government will be able, either financially or even politically, to extend taxpayer obligations to underwrite the entire financial industry.

Finally, investors should estimate what the long-term cost of government support will be in terms of higher taxes and the hyperinflation that will cause the further debasement of the U.S. dollar.  How will they further inhibit future economic recovery?

While the true extent of the problem is hard to estimate, it is a certainty that the U.S. dollar is likely to remain under downward pressure.  Gold is likely to experience strong upward pressure as high inflation leads into hyperinflation and systemic financial risks become increasingly manifest, offsetting the downward pressures of recession.

July 24, 2008

For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read my new book “Crash Proof: How to Profit from the Coming Economic Collapse.”  Click here to order a copy today.

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