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Selecting Asset Classes - Through the Process of EliminationBarry Downs Going back almost forty years ago, the handwriting was on the wall for the eventuality of the world's money credit system and especially the US dollar, the world's reserve currency, and in turn the American economy. Year after year and decade after decade, the US pyramid of debt has grown and by a year ago had reached the $53 trillion level. In a world where nothing grows to the sky, including a country's debt pyramid, it became a foregone conclusion many years ago that debt and leveraging would eventually reach an unsustainable level for the size of the economy. A debt crisis of some magnitude would then unfold and in the US debt based economy, big trouble would ensue. In 2004 we published an internet article identifying a US as well as global real estate mania. Like all other manias throughout history, we forecasted that the American version of the real estate mania would end badly. The rest is history! The real estate market turned down in 2006, and real estate prices are locked in a classic regression to the mean which we predict won't end anytime soon. It was not really until March 2007 that Americans began to realize that their American dream was evaporating, and since then real estate prices have declined 20%. The present real estate bear market is only slightly worse than the 1969-1970 real bear market, but the greatest decline in new home prices in the last 150 years was the 68% decline which occurred from 1929 to 1932. When we say that the real estate depression won't end anytime soon, we point to the fact that, historically, real estate bear markets have ended when the average time it took to sell a new house dropped to three and one half months. Currently it's taking nine months to sell a house. What was unknown at the time of our bearish article on the real estate market in 2004 was that just the most egregious of the real estate debt, the sub-prime portion, alone could usher in a credit crisis and credit freeze in the entire US financial system plus precipitate the demise of many of America's biggest and most venerable financial institutions. In the late Spring and Summer of 2007 the sub-prime chickens began coming home to roost with the announcement that Bear Stearns was suffering horrendous losses from its sub-prime activity. Six months later the situation had become grave for Bear Sterns, and the Federal Reserve had to provide a $29 billion bailout and merger with JP Morgan Chase to save Bear. Since that bailout this past March, the Fed has extended nine emergency rescue efforts comprising a term auction facility, international currency swaps, a primary dealer credit facility, a term securities lending facility, an outlay to JP Morgan Chase to handle Lehman Brothers debt, the AIG bailout, a commercial paper funding facility, equity stakes in commercial banks, and a facility to Fannie Mae and Freddie Mac to purchase $40 billion per month of risky mortgages. All those Federal Reserve outlays alone top $5.58 trillion. And then there is the US Treasury's emergency economic stabilization act of 2008, hope for homeowners act of 2008, Fannie Mae and Freddie Mac outlay, and the economic stimulus act of 2008 which total another $1.4 trillion. With the unprecedented series of bailouts already announced and with the relative ease in which the politicians and bankers got the population to acquiesce to all the scary socialistic measures, the stage has been set for future bailout action to whatever extent the authorities choose. There is one aspect of the US financial system which, we believe, will remain unchanged and that's the relationship between the Federal Reserve and the country's commercial banks. The Fed can make unlimited reserves available to the banks, but the Fed can't make banks lend to get money in the hands of consumers and businesses for stepped up spending to create economic growth. Banks are already awash with bad loans and know that an additional proportion of their loan portfolios will also go bad. Banks, therefore, are not terribly interested in expanding loan portfolios. Also, potential borrowers are already struggling with their existing debts and are not in a position to go further into debt, which will be needed to pull the economy out of its current tailspin. Bottom line: the Fed is currently pushing on a string and is likely to remain in that predicament for some time to come. By the Fall of 2007 the securities markets has figured out that a credit crisis was engulfing not only the American financial system but the entire world. The US stock market topped out in October and on a 52 weeks basis is off 30% as measured by the Dow Jones Industrial average. As the US economy looks like it will finally sink into an official recession, corporate earnings have nowhere to go but down over a wide range of industries. Aside from the rare special situation stocks, based on what we expect to be deteriorating earnings, are anything but rare values. We, therefore, see the primary bear market extending for quite some time and becoming a secular bear market. In the debt securities market, increasing defaults among the illiquid debtors in the debt pyramid will make the bond market a risky place to obtain interest income as the potential for loss of capital or even default will remain on most investor's minds. The commodity market, in retrospect, topped out a few months ago and is also no longer a place to look for preservation of capital or growth potential at least for the foreseeable future. However, should the cumulative government financial intervention create a big inflationary wave, commodities are expected to recover and that includes crude oil. We are long term gold bulls, because of the eventual demise of the entire paper money system. Gold is the world's only real money but unfortunately is in a betwixt and between situation at the present time. Gold is a superb inflation hedge and becomes the best chaos or default hedge when paper asset classes are suspect and declining. But, the world and American economy is presently experiencing inflationary and deflationary pressures simultaneously. We believe that it is deflation that will ultimately send gold to thousands of dollars an ounce, but until we arrive at net deflation, i.e., falling costs and prices across the board, mass defaults and chaos are unlikely to occur. We expect gold will remain range bound until the financial crisis produces real fear. In the meantime smart money will likely acquire the physical metal, on weakness, to diversify out of paper assets. That's happening presently and there has developed an actual shortage of physical gold, as a result. We now get to the asset class, which we wrote about in 2006 and 2007, and it is not necessarily correlated to the stock, bond, and commodity markets. That asset class is the world's foreign exchange market which dwarfs the world's combined debt and equities markets in terms of turnover. In any 24 hour period, the equivalent of $3.5 trillion turns over on the world' s foreign exchange market which makes it the biggest most liquid of all markets in the world. Because of its size and liquidity, the foreign exchange market has been attracting the most attention from professional money mangers seeking to diversify their portfolios away from equities, bonds, and commodities. Turnover volumes in the foreign exchange market are expected to only increase in the period ahead as the global economy's on-going economic sea change becomes more intense and further threatens conventional wisdom investments. Professional money managers and private investors, who had been wise enough to diversify into the foreign exchange market, have seen their overall performance buffered from the compressed destruction in the stock and bond markets over the past few months. The foreign exchange market however, can be an intimidating place especially because the world's commercial banks, which are the traders in foreign exchange market, have typical minimum accounts of $ 1 million and there are no guarantees against losses. For any long term foreign exchange investment program to be successful, a strict risk management approach is needed to protect gains and, of course, protect original capital. Because we believe a well managed foreign exchange investment program will be among the safest and most profitable investments in the period ahead, we have identified select managers with proven expertise and insight into the foreign exchange market. The foreign exchange market is likely to experience rising levels of volitility, [volatility] but with strict risk management parameters, capital building opportunities will be unlimited. Barry Downs Ronald Gilchrist Messrs. Downs and Gilchrist are consultants in domestic and international money and have spent a combined total of 84 years in the study and application of monetary economics and investment analysis. As money managers they discovered the foreign exchange market, as an asset class, many years ago and have positioned their clients to take full advantage of that expanding market 321gold Ltd |
