Investment Recommendations – see below
January, 2009
“The Rich Ruleth Over The Poor”
“And The Borrower Is Servant To
The Lender”Proverbs 22:7
King Solomon, who was, we are told, the wisest
human who ever lived, wrote these words nearly three
thousand years ago. The truth of them is just as apparent
today as it was then. The ancient Roman Empire also
experienced the sharp end of this principle, as it was their
fiscal irresponsibility, moral and political decay that
brought down the longest-standing empire in human
history. So was the case with the decline of the British
Empire; debt was the chief reason for their fall from world
dominating economic power.
I have on previous occasions pointed out the
many parallels that exist between the recent history of the
United States and that of late-stage Rome, particularly
with respect to debt. When debt becomes unmanageable
and unmarketable to others, inevitable consequences
result. Sadly, we seem to be on the precipice of that very
outcome right now.
Some of you may have heard about the campaign
of the former Comptroller General of the United States,
David Walker, to alert the citizenry to the perils of
excessive debt. I recently viewed a movie that documents
his efforts and to say that it is scary would be the grossest
of understatements. As I pointed out in the last two
newsletters, our debt has bulged dramatically, and has in
the last few months, as it will continue to do in coming
months, expanded even more frighteningly. Yet, my
numbers did not include the entire story. I only referred
to the sum of the confessed national debt, and the recently
added liabilities, which totals approximately 18 Trillion
USD. That is a lot of money, but if you include the
unfunded liabilities for Medicare and Social Security, the
numbers become mind-boggling.
The movie I am referring to should be seen by
every person in this country; more information about it
can be found at: www.iousathemovie.com. Although the
movie was produced just before the pledges and spending
that were done recently, it demonstrates that the national
debt, including the aforementioned unfunded liabilities,
totaled some 53 Trillion Dollars! That is around
$175,000 for every man, woman and child in the country.
Again, this figure does not include the recent 8 Trillion or
so of spending and commitments.
Why, you may ask, do I keep harping about debt?
Well, I assure you it is not to aggravate or frighten you;
rather, I discuss this issue presently and frequently
because I intend to demonstrate that the level of
indebtedness we now have, almost guarantees some very
unpleasant outcomes in the investment world in the not-
too-distant future. That is what I am interested in.
History is clear: A nation that defies the laws of
debt accumulation for too long loses its power. For
example, as is mentioned in the previously referenced
movie, the United States was able to exert political
pressure on Great Britain in the Suez Canal crisis of 1956
by using the threat of dumping its substantial holdings of
British sovereign debt and currency. The leverage
worked, and the ultimate consequence was that the U.S.
Dollar emerged as the de facto world currency,
overshadowing the Pound, and has held that status ever
since (although that may soon end, as we will discuss).
Now, as we rely on foreign nations to buy our
ever-increasing debt, we are putting ourselves in a
position of being the servant, or slave, to our creditors.
As the world‟s largest debtor nation, we absolutely are, to
a major extent, answerable in our actions to our creditors.
This includes totalitarian states that certainly do not have
the same world views as our democratic ones. For
example, we owe a combined more than One Trillion
Dollars to China and Japan. This is a result, of course, of
continuing trade deficits and the direct investment by
these countries in our Treasury instruments. Now, so long
as they continue to hold this paper without any substantial
change, it could be argued that this is causing little harm.
But, suppose they decide to start dumping their
investments in our Treasury paper because, for example,
they fear that the fiscal mess we are in will torpedo the
value of the U.S. Dollar? Or, suppose we have a political
Of course, as we go forward in this financial
crisis, not only will we have to continue servicing the
existing debt, including the foreign portion depicted
above, but we will also be adding huge layers to our
national debt in the next few years. The fiscal 2009
deficit is already confirmed as being at least $1 Trillion!
Is the U.S. immune to the laws of debt?
Well, as we warned would be the case over the
last couple of years, the U.S. consumer proved they were
definitely not immune to these principles and the
mortgage debt collapse we predicted has sent the world
into financial chaos. Now, a grossly indebted Federal
Government (not to mention state and local governments
that are teetering on insolvency) intends to borrow and
spend its way out of trouble. Had we not doubled our
national debt in the last eight years, perhaps there would
have been some latitude to provide enough fiscal stimuli,
safely, to arrest the economic decline. However, since we
did add massively to our debt, particularly from 2000 to
2008, we have little chance of not exceeding the debt
threshold in our attempts to revive the economy. Ask
yourself the question: Is it reasonable to think that the
disagreement with China, such as has occurred before?
Could they use the leverage of threatening to sell their
holdings to sink the value of the dollar? YES.
cause of the disease (debt) can also be the cure for the
disease? I don‟t think so.
Just why, you may ask, do I think we have
reached some magical level of debt that is unsustainable?
Well for one thing, we have now eclipsed the highest
Debt/GDP ratios since the Second World War. At that
time, with the U.S. just an emerging industrial power, and
with the massive spending needs related to the war effort,
it was not surprising to see debt as such a large percentage
of output. But now, with the national debt at the end of
2008 totaling over 10 Trillion Dollars, and with GDP
somewhere around 14 Trillion Dollars currently (we know
this will be shrinking over the next number of quarters) it
is easy to see that the Debt/GDP ratio is approximately at
71%! Add to this calculation the expenditures planned
and not included in the reported national debt of 10
Trillion Dollars, and it is quite likely we will soon see a
national debt that significantly exceeds annual GDP.
Is it logical to assume that a country can, for long,
sustain a debt burden such as above? No, I do not believe
so. It would be very much like an individual
accumulating credit card debt in the aggregate that
exceeds their yearly income. Soon, as many have already
experienced, such an individual finds it impossible to
keep making the required payments. Then, bankruptcy
looms. With a nation, there are other measures available.
Magic? No, Open Market
Operations!
As I mentioned, unlike an individual, a sovereign
nation has alternatives when it finds itself spending more
than it takes in. Of course, in the case of the United
States, this has been going on for decades and that is why
we find ourselves with the massive amounts of debt that
we do. Some of you have asked: What exactly does the
Federal Reserve do to create money? The answer is not
quite as difficult to understand as is the question, “How
can you create something from nothing?”
The Federal Reserve, as the Central Bank of the
United States, controls the money supply and sets official
interest rate targets. Without going into too much detail,
which some of you may not wish to bother with (if you
would like more information about the Fed, their website
at www.federalreserve.gov has considerable information
available) I will endeavor to simply explain how the Fed
is able to create money „out of thin air.‟
When the Federal Reserve desires to increase the
money supply in the banking system, the Federal Open
Market Committee conducts what are called open market
operations. The FOMC, intending to inject liquidity into
Source: Federal Reserve Bank of St. Louis
The above depiction of the rate of change of the
Producer Price Index for Finished Goods speaks
volumes to the issue of whether or not we are now in a
very strong deflationary environment. I intend to deal
with this subject much more thoroughly later in this
the system, will purchase securities from banks via the
Federal Reserve Bank of New York. Previously, the Fed
would only purchase Treasury securities but now, with the
financial crisis intensifying, we know that they will
purchase almost anything: student loan portfolios,
mortgage backed securities, commercial paper, and iou‟s
(just joking) to name a few. When the bank receives the
credit for the purchase of the instruments, the intent is that
more money will be available to be loaned. The securities
themselves are now on the Fed‟s balance sheet and so, for
all practical purposes, the money supply has been
increased by the amount of the securities purchased.
Notwithstanding the above, the creation of the
Troubled Assets Relief Program (TARP) operated by the
Treasury Department has not yielded the results hoped
for. This is because banks, unwilling to commit the same
blunders that got them into the trouble they are in, are
reluctant to loan monies as before. Furthermore, those
that are qualified to borrow are leery about doing so
because they wonder about the prudence of borrowing to
expand in a declining economy. This all relates to the
issue of the velocity of money, which we have discussed
in the past. In certain environments, such as the
deflationary vacuum we presently find ourselves in
(precipitated by the credit bubble burst and exacerbated
by the worldwide economic contraction), the amount of
money attempted to be pumped into the system is not
necessarily consistent with the outcome desired. The
emergence of this environment is, I believe, now very
clear.
piece, and specifically how we can profit from it, but for
now, please notice just how quickly prices are declining.
This is due to demand destruction with respect to
producers, as consumer demand for finished products
has deteriorated in the face of recession, and, of course
the natural effect of the contraction caused by the
bursting debt bubble. This is exactly what we have
been expecting, and the clear emergence of this
environment assures us of great opportunities ahead.
Whew, I‟m Feeling Much Older
These Days!
No, I am not talking about physical effects of
the market on my individual health. I am very familiar
with hectic markets and dramatic changes. What does
make me feel quite a bit older is that, according to the
computer models developed by Goldman Sachs, the
credit crisis we are living through is only supposed to
occur every 100,000 years! Now, I do have a lot of
historical data in my records, but it doesn‟t go quite that
far back! Amazing, isn‟t it, that a company such as
Goldman could make such an inaccurate and frankly
laughable (and arrogant) forecast? Yet, again, there are
always ulterior motives at work in the investment world.
The reality is the banking, investment banking
and mortgage community had to make the likelihood of
disaster with respect to the nonsensical lending
instruments seem so infinitesimal that rating agencies
would affirm and then investors would snap up their
Structured Investment Vehicles (SIV‟s). They claimed
that with the risk of these mortgages and other paper
spread to investors around the world, there should never
be a significant problem. However, they made one
crucial mistake. The pyramid they built was upside
down, with the entire weight resting on the very shaky
and weak foundation of those with a demonstrated
inability/lack of reliability to pay back what they
borrowed. So now the financial community is suffering
and will be heavily regulated by those who have no
business being in business (some of these Congressional
leaders encouraged this borrowing to give the „right‟ of
home ownership to everyone---it should never be a right
but rather an opportunity that people can work towards
realistically), and we, the taxpayers, will be left holding
the bill.
Now, the very same financial geniuses that are
responsible for this catastrophe are claiming to have the
answers for what lies ahead. Can you trust their
forecasts? Well, when you consider their inevitable
conflicts it seems unlikely. They (the majority of
financial advisors, brokers and analysts) are all tied to
the same fundamental approach: you should be
primarily invested in stocks at all times. This way,
whether the market goes up or down, they make money.
For their investors, however, it is another story entirely.
So, to remind you of what I said would be the
outcome, I am including here a couple of direct excerpts
from the January 2007 and 2008 newsletters. Again,
anyone willing to look objectively at the facts at the
time should have been able to come to the same
conclusions; yet, as I said, very few did because they
mostly had ulterior motives to drive their outlooks. I do
not, and so I can freely say whatever I believe will be
the case.
January 2007
So, to sum up, unlike other expansions that
were long-lasting and sustainable for valid economic
reasons, this so-called expansion was merely a
borrowing binge based on valuations that were driven
up by artificial means. Since the economy depends
upon consumer spending for fully three-quarters of its
activity, it is not difficult to see that when the consumer
slows their spending---not because they want to but
because they will have to---economic activity will grind
to a halt. This is precisely what causes recessions in the
modern economic environment and with the level of
debt in place, and the shock an economic downturn will
deliver to the consumer, it is not unrealistic to expect a
deflationary depression to emerge.
January 2008
So, to sum up this section, I wanted to try to point out,
not just by referring to my model’s readings, just how
dangerous the stock market really is right now. It is
telling us, technically, that it is on the verge of collapse
and certainly the underlying economic fundamentals
are saying exactly the same thing. This is what I have
been pointing out for considerable time. Yet, as is often
the case, the inevitable outcome has been delayed by
some unprecedented and rather desperate measures by
the Fed and others. Certainly, the blatant attempts by
many financial firms to delay reporting the severity of
the impact of their holdings in the toxic mortgage area
will be scrutinized more and more as their financial
health continues to deteriorate. So too will the fallout
be great when the rating agencies, quick to grant AAA
investment grade status to a basket of junk because of
the fees they earned, are forced to significantly
downgrade not only the holdings of many of these
financial institutions but, even more ominously, the
major insurers of a lot of Bonds and other investment
vehicles.
End of Excerpt Inclusions

What Lies Ahead?
Early last year, I noted that I expected four great
themes to emerge: collapsing stocks, tumbling
commodities (especially oil), surging Treasury Bond
Prices, and a rising U.S. Dollar. Obviously, all of these
came to pass, but the Dollar did not perform quite as
well as expected so far. This, I believe, will soon
change. Please observe the following chart of the U.S.
Dollar Index, which represents its value versus a basket
of world currencies.

Dollar begins to decline as massive spending

promises erode credibility in its long-term
value.

U.S. Dollar begins to rally strongly as the

financial crisis intensifies, leading to a flight-
to-quality mentality.

Dollar stabilizes as other world

economies decline sharply,
diminishing interest in their
currencies, and deflationary
forces build.

US Dollar Index Daily thru 1/12/2009

I realize some of you may be wondering why I am
forecasting a rise, at least for a while, in the value of the
U.S. Dollar, particularly considering the gloomy debt
picture I painted earlier. It is a fair question and I am sure
that ultimately the outcome for the Dollar will be exactly
as the debt argument would dictate---much lower. Yet,
we must operate in real time and for now, the Dollar is
regaining upside momentum because, as the rest of the
world sinks quickly into recession, it is still considered the
world‟s reserve currency. In fact, many of our trading
partners who rely on their exports to the U.S. are suffering
even more than we are in the U.S. So, for now, I believe
money will continue to flow into U.S. Dollars, especially
since we have identified the clear emergence of
deflationary forces. In a deflationary environment, since
most prices are falling, the relative value of the world
reserve currency rises. So long as the U.S. Dollar remains
the de facto world currency, we should see it rise as the
deflationary forces strengthen worldwide. However, as I
have said, we must remain aware that once the inflation
emerges that will undoubtedly develop due to the massive
spending plans in the works, the Dollar will collapse and
will likely lose its status as the world reserve currency.
As to which currency will take over that status, I cannot as
yet say. But, it would not surprise me to see the Yen
emerge in that role as the Japanese economy is very
similar to that of the United States when the Dollar
became the world reserve currency. Japan, as the U.S.
used to be, is the world‟s largest creditor nation; they
eschew debt as individuals (as Americans once did), and
they have large personal savings (so did Americans in the
not-too-distant past). Furthermore, the same relationship
exists between the U.S. and Japan now as did in the past
between Great Britain and the U.S. when the British
Pound was about to decline from world dominance: The
Japanese have massive holdings of U.S. assets, and they
have no debt. They export huge amounts of goods
worldwide (as did the U.S. at the peak of its
manufacturing dominance) and have huge reserves. They
are, as the title of this piece said, the lender to the world in
many ways.
So, to sum up this section about the Dollar, here
is my straightforward forecast: The U.S. Dollar will
strengthen significantly as deflationary forces
intensify. Then, at some point in the future (once the
model identifies the real beginnings of a spending
induced inflationary cycle) it will sharply decline and
eventually be replaced by some other currency as the
de facto world currency.
 Gold
Gold Daily thru 1/12/2009
Obviously, the price of gold is greatly influenced
by the value of the U.S. Dollar, since like many
commodities, gold is mainly denominated in USD. If the
Dollar strengthens substantially, generally speaking, gold
will decline. Similarly, when the Dollar weakens, gold
benefits. As we look out into the future, it is very
important to understand the implications for gold, and our
approach to it as both an insurance policy and as an
investment.
As you may know, I have recently given my tacit
approval to the accumulation of physical gold utilizing 5
to 10% of your portfolio. I made it clear that I could not
make an all out recommendation to view gold as a pure
investment just yet---not until we get an inflation reading
in the model sometime in the future---and that over the
short term gold could decline. We know that the long run
prospects for gold are excellent, however, as it seems
inevitable that the spending binge to bail out the U.S.
economy will ultimately translate into strong inflation.
Yet, we must look at the overall picture very
carefully. While it is true that the U.S. is spending to
stimulate, so are many other countries in the world. The
Euro zone is spending just as aggressively as we are and
interest rates there have been reduced dramatically. The
same thing applies to many other areas of the world. So,
if our spending is simply relative to others, we may not
see a reaction for some time. I know many have said,
“Why wait to buy gold if you think it is going higher in
the future?” My answer is that I have noticed a distinct
lack of long-term perception amongst investors whose
portfolios are in a nasty short term negative position! I
believe we should wait until we get further clarification in
the model to begin to aggressively accumulate gold as an
actual investment theme.
If you observe the above chart of gold, you can
see that I have drawn in a couple of parallel lines. These
lines define a fairly clear downtrend channel which has
been in existence since the summer when many
commodities began to peak, including and especially oil.
As you can see, there have been a couple of occasions
where gold has moved up to the upper trend line and was
repulsed. This also happened recently and it looks very
much like gold will move now toward the bottom of the
downtrend channel. If that is the case, we could see gold
quite a bit lower over the next few months, as the
deflationary forces mount, and so I do not think it
behooves us to get too aggressive in accumulating gold
just yet. We are already, if I am correct, preserving our
purchasing power by virtue of our holdings in U.S.
Dollars for the time being and when things change, we
will have already shifted our stance.
Therefore, here is my second forecast, for at least
part of this year: Gold will not shoot higher as one
would expect in a spending environment because the
deflationary forces that have been unleashed will, at
least temporarily, overpower the stimulative forces
that are being brought to bear. Later on, gold will
advance mightily but only after we receive an inflation
signal in the model.
 Stocks and Deflation
DJIA peaks
September
1929 @386
50% retracement
takes DJIA back to
297 as of April 1930

Deflationary spiral signal emerges in model

Crash of
1929 takes DJIA finally
DJIA to bottoms July
195 by 1932 @ 40!
November

DJIA Weekly --- Late 1929 – 1932

As I have pointed out on numerous occasions, a
deflationary environment is not very friendly to many
investment classes. This is true as well for stocks. In a
strong deflationary situation, which would be defined as a
deflationary spiral and which would result in such a
reading in my model, stocks generally collapse. This was
certainly true during the very deflationary environment
which followed the initial crash of stocks in 1929 and to
which we refer as The Great Depression.
As you can see in the above chart of that era, I
have notated the chart with some important points. First
of all, you can see that after the crash of 1929 the DJIA
was able to rebound from its initial lows in October 1929
by a factor of about 50% of the decline. It reached its
rebound peak in early 1930 and if you review the history
of that period, you will find there was a lot of optimism
that the worst was over and that stocks were headed
solidly higher for the foreseeable future. That certainly
was not the case.
As is apparent, after the DJIA had its 50%
retracement rally it began an almost straight down
collapse, eventually taking it from the rebound level of
nearly 300 to its ultimate low of 40! This represents an
additional decline of more than 86% of the value of the
DJIA. Furthermore, it brought the cumulative decline of
the DJIA from its peak in September 1929 to its low in
July 1932 to a stunning almost 90%. That is the power of
a deflationary spiral, which began in early 1930 as
indicated by my model (in historical fashion).
Now, I have been carefully monitoring the
situation with respect to deflation and my model over the
past few months. As I have been expecting, and as we
have previously discussed, deflation is taking hold in a
very ferocious manner. Since Producer Prices are a
component in my model, it is entirely possible that we
could see the confluence of a deflationary spiral reading
with a critical mass reading. This would insure the most
dramatic of declines, I am certain. Unlike past times
when news circulated slowly and investors had limited
ability to move in and out of investments quickly, we now
have lightening fast trading and news dissemination. This
could mean a drop in stocks, (if these readings emerge as
they very likely will) such as has never been seen before.
Investors around the world, in a very compressed
timeframe, could sink stocks worldwide in abject panic.
We will have to monitor the situation very carefully, as
such an environment would be devastating to most
investments and fabulously profitable for those of us
properly positioned.
Do not think that such a scenario could not unfold
and that it would be impossible. I am sure you would
agree that a lot of what we have seen this year would have
been deemed impossible as well, just a few short months
before.
 Deflation!
Producer Price Index (Finished Goods) Monthly Year/Year Change
As I was expecting, we have, as of the December
PPI data released yesterday, seen the first emergence of
actual falling prices in this data for a long time. This
means that the likelihood of spiraling deflation is much
higher, particularly since energy is such an important
component of this data series and the direction for energy
prices is probably much lower. So, what does all this
mean to us?
I have explained in the past that I use the PPI
Index for Finished Goods as a measure of wholesale
inflation, based on the monthly change from the previous
year‟s level. This way, there can be very little
manipulation in the data and I can be confident that the
readings are accurate. If you notice the very last bar in the
chart, representing December 2008, you can see that it has
moved to a negative on a year-over-year basis. Since
prices, as is evident in the chart, were climbing at a rate of
10% year-over-year just a few months ago, chiefly
because of the influence of oil, this negative reading
represents a very dramatic change in trend. This is why it
is so important.
Now I must hasten to say that we have not yet
seen the outbreak of a deflationary spiral which would be
recognized by the model. Yet, I would not be surprised to
see this develop soon. So, we can safely say that this is a
very dangerous environment for stocks and for most asset
classes. Although the Government and the Fed are
frantically attempting to re-inflate to stop this progression,
so far their efforts have been ineffectual. I do not believe
they will be able to halt this progression before we see a
deflationary spiral emerge, because the pressures
generated by the bursting of the worldwide debt bubble
are simply too enormous to overcome immediately.
Therefore, we will be evaluating the proper
deployment of our capital based on the environment at
hand, not on what will emerge sometime in the future.
This means that we will soon be re-entering the short side
of the stock market, expecting to see prices decline
consistently as the deflationary forces strengthen. As you
can see in the above chart, when Producer Prices were
negative in a good part of the 2001 – 2002 period, it
corresponded to sharply falling stock prices. Remember,
however, there never was a deflationary spiral signal at
that time and yet stocks still fell sharply. I am sure you
can imagine the pressures on stock prices if (which I
expect) a true deflationary spiral does develop. If this
occurs shortly after, or concurrent with, a critical mass
reading in the model, we could see prices fall in very
similar fashion to what happened in the early 1930‟s as
previously depicted herein. So, we must be realistic
enough to realize that sometimes all the King‟s horses and
all the King‟s men simply cannot put a broken system
back together again, at least not very quickly.
I alluded to the fact that oil, a chief component of
the PPI series above, was likely to continue to fall and add
pressure to price declines. I believe it is entirely possible
to see oil fall all the way back down to its pre-credit
bubble level. This would be back to the price levels of
late 2001 at least. As you can see in the following chart,
that would be quite dramatic.
 Light Sweet Crude Weekly
Rarely have we seen such a dramatic collapse in
the price of anything as is depicted in the above chart of
crude oil. From the summer, as you can see, it has moved
virtually straight down, losing some 75% of its value from
its high! This is a clear indication of powerful demand
destruction brought on by the recession in the United
States, and then having spread throughout the world. This
is exactly what we were expecting, but the rate at which
this decline has occurred has even surprised me. It
means, I believe, that the aforementioned deflationary
forces are more powerful than any we have ever seen,
possibly even including the Great Depression era. This is
very ominous indeed.
Bonds
Although we made a great deal of money in U.S.
Treasury Bonds, beginning all the way back to late 1999, I
know some of you have wondered why we are currently
not in Bonds. As you know, Bonds have spiked higher in
price recently, as the flight to safety mentality has gotten
intense. Yet, we still have to weigh risk and reward in our
investment stance. Although Bonds rallied strongly in the
latter part of 2008, I was concerned that the massive
spending plans by the U.S. might influence investors
around the world to dump their Dollar-denominated
holdings as a reaction to the potential for emerging
inflation. I feared there could be a bloodbath in Bonds if
this developed. So, we chose to focus on shorting the
stock market and then in preservation of capital by being
invested in Treasury Bills, while we await our next
campaign into stocks and other areas.
That said, I believe Bonds will still be a very
profitable investment in the near future, once the
deflationary forces really take hold. I would not be the
least surprised to see Long Term Bond yields fall to the 1-
2% level as this all plays out. With strategic investments
in Bonds, perhaps at slightly lower prices than they are
currently, this would translate into fantastic profits. So, I
assure you, Bonds are still going to be one of our favorite
strategies as the events we are expecting play out.
There are a lot of things happening at breakneck
speed. Yet, with the assistance of the model, which has
accurately forecast most of what has transpired, I am
confident we will be able to navigate these currents
effectively and profitably. As we go forward into the
New Year, let me say how much we appreciate all of you,
and that I am dedicated to protecting and growing your
capital as we go forward.
I will keep you posted. Take care.
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