Monthly Newsletter

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I am imagination. I can see what the eyes cannot see. I can hear what the ears cannot hear. I can feel what the heart cannot feel.

Peter Nivio Zarlenga

This week we saw civil unrest in Europe as the situation deteriorates in Greece, Ireland, Spain, Portugal and Italy. It seems that the man on the street resents paying for the excesses of previous governments. People have been conditioned to expect the government to pay for things like education, medicine and retirement benefits since they paid a significant portion of their income into that government in the form of income tax.


That was the trade off, and now they feel like they've been betrayed. In America the story is a little bit different in that we paid in less tax but received bubbles in return. These bubbles created the illusion of wealth and they made us feel good about ourselves. Unfortunately the biggest bubble of all is debt, used to finance all the other bubbles, and it is about to topple the empire.

The United States experienced a significant change during the Nixon administration. The values that made it the richest creditor nation in the world, that allowed it to come out of the Depression and World War II and prosper, were corrupted by the lies that surrounded Viet Nam. It also followed the assassinations of John Kennedy, Robert Kennedy, and Martin Luther King under what can best be described as suspicious circumstances. The war led us into the realm of debtor nations and in August 1971, then President Richard M. Nixon closed the gold window. This meant that the dollar was no longer pegged to gold and its true value would be subject to political pressures and the whims of a reckless Federal Reserve. These changes came part and parcel with a change in mentality. The idea that cash was king fell by the wayside and fly now and pay later took its place.

The closing of the gold window meant that the US dollar would become the reserve currency of the world. It didn't take US politicians long to discover that they could run deficits and fund the difference with the printing press. In order to draw attention from the deficits the Fed began to manufacture bubbles. It started with stocks in 1981 and spread to bonds in 1986. From there it moved into real estate in 1995 and then commodities and gold in 2001. This was done by generating debt at any and every level. Auto loans, home loans, credit cards, school loans and lines of credit were made available to just about everybody who could sign their name and the Fed encouraged their use. It went to such an extreme that Americans confused debt with assets and began to feel wealthy even though they had no savings and were mortgaged beyond all reasonable limits. The municipal, state and federal governments all did the same thing. The coup de grace came when the financial institutions took all of these loans, packaged them, tied a pretty bow around it, and sold it all to widows and orphans as a "safe investment".

In order to facilitate the transfer of wealth the government used all kinds of institutions such as Fannie Mae, Freddie Mac, Goldman Sachs, Citibank, Bank of America and Merrill Lynch to provide easy money and, at the same time, pass the debt off to an unsuspecting public who thought they were securing their retirement. The end result is what we see below:

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Balance sheets bloated with debt to such an extreme that they must be allowed to mark the price of their bad assets to some obscure, unintelligible mathematical model that isn't worth the paper it's printed on.

Fannie Mae wasn't the only institution that's suffering a debt hangover after the stimulus has run its course. Citibank, Bank of America, AIG, GM and Chrysler were just a few whose balance sheets blew up and found themselves in bed with the government. They all carry large debt that can never be repaid. So how is it that some of them were able to repay their TARP loans? Quite simply the government relaxed the generally accepted accounting principles and allowed them to inflate worthless assets so that they appeared profitable. Then the institution would use the phony results to justify the sale of new stock and bonds to the general public. The proceeds of these sales then went to pay off TARP. In short the problem (debt) was shifted onto the backs of the average American.

Americans are learning the hard way what constitutes a safe investment and what doesn't. We've also learned that the Fed and Goldman Sachs are partners in the largest transfer of wealth the world has ever seen. In very simple terms, wealth is flowing from you and yours to them and theirs.  The weapon of choice is the US dollar and it is being sacrificed, along with your buying power. As a result of excessive printing, the greenback has been in decline for a decade. Right now everybody is waiting for the next wave of quantitative easing and inflation, but everybody is always wrong. Yes we'll get lots

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of quantitative easing, but we've already seen the inflation! Take a look at what happened to the CRB Index between late 2001 and the beginning of 2008. Prices tripled! That's inflation even though the government swept the truth under the rug and published inflation figures that were far removed from the reality of those times. Like all inflations, it ran its course. I believe what we are seeing now is the other end of the spectrum, it's called deflation, and no amount of quantitative easing will change that.

What is certain is that the Fed will print more and more fiat dollars while attempting to hold interest rates at zero. That will put downward

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pressure on the greenback and that is precisely what we're seeing now. Recently the US Dollar Index broke through major support at 80.16 and is now shaping up for a test of good support at 77.03. Furthermore I would not be surprised to see a test of the 2008 low of 70.70 before the end of the year. Right now the dollar is extremely oversold and we'll see a reaction, but both the primary as well as the secondary trend will continue to head lower.

With respect to the interest rates, you should never lose sight of the fact that they are a function of risk. The Fed is mitigating risk by holding rates artificially lower. In a normal world the more a country relies on the printing press, the higher the risk. We've seen bond prices

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rise as investors bet that the Fed continue with its game of financial musical chairs. Bonds rallied continually from their April low to the late August high even though the dollar continued to decline over that period of time. That of course makes investors nervous, especially our foreign investors, so you have to distract the masses. To do that you start a trade war with China and blame them for the decline in the dollar by saying they hold the Yuan at an artificially low rate, when in fact the real problem is the Federal Reserve. The reality is that if you want a stronger dollar, all you have to do is stop printing them. It will turn on a dime and run higher.

This will never happen so that means that risk (remember risk?) will increase at an increasing rate, and since everybody and their brother is long bonds, rates will rise and catch them on the wrong side of the trade. We may be seeing the beginnings of that now with the recent lower high posted last week. By focusing on what the Fed is going to do with respect to rates, they've lost sight of the fact that they own an "asset" denominated in a currency that loses value every week. The 30-Year Treasury closed out the week at 133.38 after failing to move through good resistance at 134.98 several days before. If they fall through good support at 130.80, I believe we'll have seen the highs and bonds will then head down to test the April lows. This of course will be a bumpy road because the Fed has installed itself as the buyer of last resort, but to do that it must print more fiat currency which in turn pushes the dollar lower and increases risk. Increased risk puts downward pressure on bonds and can see a vicious cycle developing with no good end!

Stocks are similar to bonds in that the find temporary support in the actions and statements of the Fed. Evidence of this is found in the Volatility Index (VIX):

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The VIX rises when investors get nervous and buy options as a form of insurance against some future decline in prices. As you can see in the chart above, we have a series of lower highs indicating that complacency is on the rise. As this occurs we can see that the 50-dma is being pulled closer to the 200-dma and a cross under, should it occur, would be bullish for stocks. I have a feeling that complacency will be the death of many an investor!

As far as the stock market is concerned we finally saw the Transports confirm the new closing highs in the Dow after four failed attempts. The Dow's last closing high occurred on September 24th at 10,860.26, then the Transports posted consecutive new closing highs on September 28th at 4,5131.18 and again on September 29th at 4,543.97. On Friday we saw a divergence between the two as the former posted a gain and the latter ended the day with losses. Throughout the reaction volume has been terrible and that indicate to me that the funds

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(big money) are going someplace else. In my opinion there are two ways to look at what is going on: the Dow is trending sideways or the Dow is trending higher at a slow pace. In either case the Dow has reached the top of the range (arrow) and the moment of truth. One point that fascinates me is the fact that the Dow experienced twenty seven 90% days between April 26th and September 1st and zero 90% days after that. I liken it to the calm before the storm.

On Friday the Dow gained 41 points to close at 10,829 and marginally above good resistance at 10,817. On December 31st the Dow closed at 10,428 and in spite of the best September since 1939 it's gained a meager +/- 3% for the year. Most investors trail the Dow when it comes to returns so you've been paid nothing for a lot of suffering while running the risk of a substantial decline. What most investors fail to realize is that the risk of a significant decline is increasing over time. In a country lacking sound leadership and competent fiscal/monetary policy, in a country where spending is completely out of control and distortions are everywhere, you shouldn't expect anything but a bad outcome.

We've seen the beginning of a very special kind of plague that attacks every type of paper asset be it bonds, mortgages, stocks, or fiat currency. The cause of the plague is excessive debt and the only cure is a deep, dark deflation that purges the system of all imperfections. Analysts get on Bloomberg and espouse that stocks are historically cheap but these are people who measure history from the time they learned to shave ten years ago. At present the Dow is selling at 22 times earnings and pays a measly 2.5% a year. I maintain that stocks will be cheap when they sell at seven times earnings and no one wants them. We're nowhere near that point but we'll get there; like gold's rise to 1,372.80, it's just taking longer than expected. I remain convinced that the Dow will move below the July lows this year, and it may surprise the hell out of everyone and do it this month. The "flash crash" was not an anomaly or an error, it was a coming attraction!

So if paper is out, what's in? The answer to that is a one syllable four letter word unknown to the large majority of Americans. The answer is "gold"! The yellow metal gained 10.70 on Friday to close out the week at 1,319.00 and it's become the custom to close above the futures price as well. The demand for gold is quite strong and comes after a lengthy period of consolidation as you can see below:

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You should also note that gold tends to repeat past behavior and we've seen consolidation followed by a strong move higher before. The last time around gold soared 27% once it got up a head of steam, and a repetition of past behavior will take the price up to 1,492.20. As optimistic as that may sound, it pales in comparison to the bullish price target of 1,650.00 found in the Point & Figure chart below:

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I've held a 1,372.80 target for quite some time, but I am now lifting that target up to 1,447.50 and I look for the yellow metal to hit that price before the end of January.

Finally, silver is now looking even better than gold as it rallied 35 cents to close at 22.10, its highest close in thirty years! Both gold and silver have broken above key resistance levels at 1,298.10 and 20.98 respectively, with silver breaking first, and now silver has nothing to stop it until it hits 26.48,  and that's a long way up from Friday's close.

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Here you see the same type of consolidation that you saw in the gold charts, only the run-ups are bigger, and that's because silver is cheaper relative to gold. My price target for silver remains at 26.48 but the Point & Figure price target (not shown) is all the way up at 29.00, and I wouldn't be surprised to see the white metal make it that high.

In conclusion we're now seeing civil unrest in certain parts of the world, and we've seen demonstrations in the US but they don't get the airtime. We are a month away from the midterm elections and it's my hope that the Tea Party can make some serious headway. Then they need to build on it into the 2012 elections. Only then will you be able to make constructive changes; the Republicans and Democrats just aren't up to the task. They're both in it for the money and that was not the intention of the US Constitution. In the meantime we'll have another trillion dollar deficit in 2011 as the tax base continues to shrink. Then we have the war effort which is an off balance sheet event that's never going to go away, and we won't win either. I'm not an expert but I do know that in order to win a war, the nation as a whole has to be willing to make huge sacrifices. The American people aren't up for that as they've grown accustomed to "something for nothing". Fall is here now and I believe will see significant problems, on every level, between now and the end of the year.

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October 03, 2010