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July 03, 2008

Scorched Earth Economy
by David Galland

Here at Casey Research we have been on the record as bearish on the outlook for the economy for some years now. Lest you think that is loose boasting, I can offer proof in Doug Casey's August 2005 article, the dramatically titled "Profiting from the End of Western Civilization".

In that article, he looked ahead and saw the inflation that the government's loose money policies made inevitable. A quote...

"Of particular importance is that the U.S. dollar has been used as a gold substitute for decades by other countries. This has been very convenient for the U.S.-we can create almost infinite numbers of greenbacks and give them to people in other countries in exchange for real wealth. Idiotically, central banks abroad have been holding those dollars as backing for their own currencies.

The amounts involved have grown so immense, and the eventual grim fate of the dollar has grown so obvious, that foreign central bankers are now looking at each other, trying to figure out who will head for the exits first. Many are "diversifying" from dollars into other currencies-which are themselves backed mainly by other paper money, mostly dollars. At some point there's going to be a panic out of U.S. dollars that's going to dwarf any financial event in history."

And in that same article he also predicted the current collapse in the housing bubble that the loose money had made possible. Another quote...

"What's going on now in the residential real estate market is much like the tech bubble, but potentially much, much more serious than what went on in stocks a few years ago."

Jumping ahead 3 years, to today, the unhappy scenario Doug then foresaw is now unfolding. Right on schedule the economy and markets are heading inexorably toward what might be termed the Scorched Earth Phase.

Even a casual glance at devastation now being wrought on the very building blocks of the economy confirms he appropriateness of that term.

For instance, consider the U.S. financial firms, the single largest component sector of the S&P 500. So far, the losses to those firms are approaching half a trillion dollars. And the odds are high that there's much more to come. With the exception of Bear Sterns, the big name financials have been able to cobble together the billions of dollars in additional capital needed to shore up their balance sheets... but they are quickly running out of rope. That becomes apparent when you consider that many of their major revenue centers are now either severely wounded or in the morgue. Last quarter alone Morgan Stanley saw its investment banking fees fall by half and toxic paper sales (ah err, I mean "fixed income") sales and trading revenue collapse by over 85%. And this at a time when these same firms are being forced by regulators to repatriate their off-balance sheet assets... to wit, the aforementioned toxic paper.

Sovereign Wealth Funds (SWF) to the rescue? Not anymore. Those that initially rushed in were seriously burned and many are now on record as staying on the sidelines. But any that might wish to take a second roll of the dice, will only do so if they get much better terms, which is dilutive to existing shareholders.

Meanwhile, the housing meltdown persists and will continue for at least another year or two. Unless, if course, the government gets serious about "doing something"... in which case the downturn could last 5 or 10 years.

Why do I say that? What the market needs most of all right now is for house prices to fall, as quickly as possible, to a market clearing price. The problem, of course, is that thanks to the self-serving exuberance shown by many appraisers during the real estate bubble-mania, at this point nobody actually knows where the bottom is. Another 10%? 20%? 30%?

There really is only one way to find out... let the brush fire burn, as painful as that will be. But as I don't need to tell you, "doing nothing" is not a concept that politicians in an election year are very comfortable with. And so, like trained seals leaping after vote-fish, the politicians will jump though any number of hoops to keep people in their homes even though many can't afford the carrying costs, let alone the mortgages. That only prolongs the pain and increases the government deficits that are at the core of the current crisis.

So, we have a tumbling collapse in the largest component of the stock market, coinciding with a tumbling collapse in the largest component of people's net worth, their homes.

And we aren't even warming up yet.

For a more complete accounting, you also have to add into the mix the intractable problems unfolding in energy patch, including the near-certainty that Mexico, the 3rd largest source of imported oil for the U.S., will stop exporting said oil within 4 to 6 years... max.

Rather than rushing ahead with emergency initiatives to open up new energy sources, the U.S. Congress just emergency legislation to prevent so much as exploring for uranium anywhere near that big hole in the ground, the Grand Canyon. It is this perfect world mentality that assures that the cost of what energy is available, will only get more, not less, expensive. Of course, as energy is required in the production of, well... everything, so the cost of everything will go up.

And that includes, food... which, as I don't need to tell you, has been on a tear of late.

Sure, opportunistic new plantings will help, over time, to moderate the higher food prices... but not overnight. Meanwhile, the cost of filling the old tractor and shipping food to market will keep going up.

So, to the list of serious problems for the economy, we have to add persistent high energy and food prices.

But even those fall short of the KING KONG of the set piece... the collapsing fiat monetary system that helped created the recent series of bubbles in the first place.

In a fiat monetary system the only tangible barriers to money creation are provided by a loss in stakeholder confidence. While the average American is, sad to say, almost completely ignorant of what a fiat monetary system is, let alone the consequences of same, the same cannot be said of the foreign holders of an unprecedented $6 to $7 trillion dollars.

To be a touch more specific, by unprecedented I mean as in "never happened before". While, under other circumstances this fact might evoke a raised eyebrow or a concerned comment over cocktails... going into the jaws of a vicious economic/dollar crisis those foreign dollar holdings become akin to playing toss with a lit stick of dynamite. He who holds the dollars when the fuse meets the powder are in for a very, very bad day.

As a result, the foreign holders are watching the moves of the Fed very closely. Trying to avoid that scrutiny the Fed, like a curbside three card Monty dealer, has come up with some clever sleights of hand, including lending directly to investment banks and swapping Treasury bills for toxic paper. But that has accomplished little more than buying some time; it does nothing to resolve the "rock and a hard place" dilemma.

Which remains as thus: if the Fed raises rates to prevent a sell off in dollars, they'll crush the highly indebted and already struggling populace and, in so doing, unleash a serious economic crisis. But if the Fed keeps rates where they are, or even lowers them, they'll trigger a dollar sell-off and unleash a serious economic crisis.

Either way, the story ends the same: a serious economic crisis.

At this point, our bet remains that the Feds will go to default mode which means cranking up the printing presses into the red zone, letting the dollar move ever closer to its intrinsic value: zero. That they'll follow this route is suggested by two inputs. First, a depreciating dollar means a reduction in the trillions of dollars in obligations now owed by the U.S. government. And, secondly, foreign holders don't vote.

So, we are calibrating our investments toward a serious economic slowdown, but with high inflation. Some people would call that Stagflation. But given the severity of both sides of that formula, the situation may be better described in terms of Scorched Earth. Or, because people seem to find concepts ending in "flation" handy, Stag-flagration.

Businesses and personal net worth will be devastated at the same time that costs run out of control.

How to Play It?

Our strongest recommendation is to position your portfolio in anticipation of higher inflation and, in time, a turnaround in interest rates. The latter is because interest rates, which are still near a 50 year low, can only go up as the inflation rises to the point of banner headlines (at which point, the government is hoping, the economic downturn will have moderated).

In fact, we think the move towards higher interest rates is a trend that will surprise many, but, once it gets going in earnest (and corporate bond yields are already on the rise) last for at least the next several years.

In terms of other investments, it's worth noting that in the last major bull market for tangibles, back in the 1970s, oil was the best performing investment, followed by gold, U.S. coins, silver and stamps.

Today the range of investment vehicles you can use to make the trend your friend is greatly expanded a wide variety of specialized ETFs (though an added layer of analysis is required to sort the strong, well structured, high volume variety from the thinly traded variety of suspect parentage). And while they continue to require patience, the highest quality junior Canadian gold exploration stocks remain one of the most prospective investments you can make. A number of these companies are now sitting on proven big discoveries, but thanks to the stop-start markets, are significantly undervalued. They won't stay that way long.

Whatever you do, don't be complacent at this point. If we are right, then the economic crisis will soon head into its next and most dangerous stage. Certainly, we should feel the heat, and maybe worse, by the end of the year. Therefore, at the very least, you'll want to take measures now to protect yourself. For our own portfolios, we believe that the best defense is a good offense, and so are positioning ourselves in the sectors that will profit, and profit big, as the stag-flagration sweeps across the global economy.

Then it's just a matter of sitting tight and being right.

David Galland is the Managing Director of Casey Research, LLC., publishers of Doug Casey's International Speculator which provides unbiased research and recommendations on the highest quality junior exploration companies.

Casey Research has also recently launched a brand new monthly advisory, The Casey Report, which focuses on the most powerful trends now driving the U.S. and global economy, and how to profit from those trends. As a special introductory offer, when you subscribe to either the International Speculator or The Casey Report before the end of July 2008 you will receive the other free of charge for as long as you remain an active subscriber. Plus, your subscription comes with a full three month money back satisfaction guarantee... so you have nothing to lose when you try these publications today. Learn more about this special offer now.

David Galland
Big Gold

Information contained herein is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained herein is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed herein are those of the publisher and are subject to change without notice. The information herein may become outdated and there is no obligation to update any such information. Doug Casey, entities in which he has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications. Corporate policies are in effect that attempt to avoid potential conflicts of interest, and resolve conflicts of interest that do arise in a timely fashion. No portion of this web site may be extracted or reproduced without permission of the publisher.

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