The US Economy, inflation, gold and the DJIA

Information is power. Data about the economy is often complex, confusing, and often contradicting. That is because too often the data is looked at in isolation and presented in a vacuum relative to other data. The U.S sconomy is very complex, this is true, but in this modern era one cannot look at only the U.S. data, because that also is too confined and restrictive. The world is now a very international affair, I am sue all would agree. So when one aspect of the economic equation is altered, a chain reaction of events occur that cascade through not only our domestic economy but also that of other countries as well. Sometimes thes changes are so subtle as to hardly be noticed. But when viewed with a greater macro view, often times patterns emerge that can be very instructive for forecasting models.

I am not proposing that CyclePro will cover all angles. It is largely assumed that most readers are already aware of the plethera of data that is alredy available. Certainly if you look deep enough you can find almost anything about anything. But having a piece of data is usually worthless unless it can used in such a way as to provide meaning or at least provoke a deeper question... which then triggers the analyst to dig even deeper raising even more questions. This is an iterative process. Somewhere along the line it is hoped that an image appears that hits you like a ton of bricks.

I have assembled a collection of charts to show a wide variety of data. Some of it is probably available on other websites and others are likely to be rather essoteric. Either way, I hope the collection as a whole presents an image you you can see more clearly where we have been and perhaps where we are going.

I will start off with some of the more basic data. First is the following chart on U.S. inflation rate over the past century.

While we should perhaps discuss the caveats to using government supplied PPI or CPI data, I assume that everyone is already aware that the things that most consumers use for daily activities have been systematically removed from this data over time and is now a mere shell of its original intent. Nonetheless, this chart shows that the current inflation environment is rather low and is near its lowest point for the past 40+ years. One thing that this chart does show is that the inflation rate never stays flat for very long. There are only two directionsthat we can logically go from here, upward (inflation) or downward (deflation or depression). The most noteable deflation/depression times were the early 1920's, of course the Great Depression in early 1930's, and then a delayed reaction to an overheated economy following WW-II. I do not give this data a lot of weight because of the dilluted information, after all how valuable can it be if food and energy have been removed -- basic neccessities of physiological need -- and stupid concepts such measuring not the change in real estate valuations, rather measure things like how much a house could be rented for if it were available to be rented -- or measure not that computer prices have dropped in price but rather how much more productive they are because we're getting more horsepower from the chips for each dollar in cost -- what kind of morons were behind these kinds of revisions to CPI? What it really boils down to is that CPI & PPI are not very good measures for comparing modern data with historical data.

Why show this chart? Because news media often refers to it and we need to have a basis from which to compare other, hopefully more meaningful, data.

Next chart is Personal Savings as measured as a percent of U.S. GDP:

From the depths of the Carter Recession in 1982, there has been a steady reduction in personal savings. Historically, savings have been the life blood of business growth because this is what was behind bank loans to individuals and businesses. Today, this has been altered. Instead of putting money into bank savings accounts, people have opted instead to invest in stocks and mutual funds. This really is not a bad thing, as far as economic growth is concerned because instead of money going through the bank channels for loans, the money goes directly to the corporations from which stocks are purchased; either through directly ownership of stock or through mutual funds who in turn buy the stock. This leaves the individual and small business owner out of the loop. But banks have also evolved such that they can still make loans... instead of relying on savings account money they rely on a tap from the Federal Reserve liquidity spigot.

On the surface, shifting personal savings from banks to stocks seems acceptable. However, the problems come when individuals feel the need or desire to liqudate a portion of their holdings. When savings were largely held by banks, the banks were still able to tap into Federal reserve cash to keep their loan wagon rolling. Now however, when individuals sell enough stock, or at least discontinue buying additional stock, corporations feel the pinch. In a rising stock market, companies are able to grow money on trees by simply issuing more stock as individuals eagerly gobbled them up. Who needed loans when all of the cash you needed was readily available by issuing more stock? When the stock prices begin to fall, companies are less likely to issue more stock because that only exacerbates the lowering of stock prices even further. As a result, company growth becomes constrained. It is almost like they are unwilling to go back to the olden days of seeking bank financing (for which there is little personal savings to promote loans).

The next 2 charts cover Consumer Credit. The first is Consumer Credit per Capita and the second is Total Consumer Credit Outstanding as a Percentage of GDP:

In the Percent of GDP chart we can see that credit pulled back during the recessions of 1976, 1982, and 1992. Even though we apparently just completed a mild recession (really?), comsumer credit during 2000-2003 shows zero signs of contraction. I believe this is one of the early signs that a contraction is yet to occur. The Per Capita chart clearly shows that Americans appetite for credit is growing more and more extreme. ONly the 1992 recession shows a very shallow and short-lived contraction. While this chart does nothing to suggect that the growth of personal credit is changing or about to change, it does show that the growth rate is exponential. This in itself is disturbing because exponential trends rarely last and when they end they often times end badly. One example of this is the current "fad" of home refinancing. There is a right reason for refinancing and a wrong one... unfortunately, most current refinancing is for the wrong reasons. A right reason would be to reinvest home equity into home upgrades or new additions. Refinancing with the intent of buying a new SUV is not only a bad reason, it is a VERY bad one. This is a short-term expense, not an investment at all, such that the life of the refinance loan is often longer than the SUV will last (and with rising gasoline prices, SUV longevity may be much shorter than originally anticipated). Further, the ability to refinance is based almost entirely on the fact that home price values have risen, in many cases substantially, over the years.

This is a lot like the stories we heard of from Silicon Valley about the entrepreneurs who used their paper wealth in their stock options as loan collateral on homes, cars, and other toys. When the Nasdaq turned down in 2000, banks had to ask for more collateral to back the loans or cancel the loans altogether. When the dot.coms closed up, jobs were lost, the paper wealth was gone, the taxes owned on converting stock options to stock still had to be paid, and now they had to walk away from their homes. If the mortgage company took a loss re-selling the home, that became another tax burden for the individual.

In the current refinance arena, too many families are floating along on higher home valuations to support their base mortgage plus refinance loans. What happens if (or when) home prices start to turn down? It is just like stocks in 1999-2000, when investors stocks buying, prices came down, when investors started selling, prices dropped even faster. Real estate is no different. This is a bubble that will eventually burst. The aftermath will not be pretty. The selloff in the Nasdaq erased $7 trillion in paper wealth, the real estate market is much larger.

Some real estate markets are still at lofty heights. Others, such as Houston (still reeling after the collapse of Enron and its aftershocks affected the entire Houston economy) where home prices peaked around August-September, 2003 -- the market has been slowly falling since.

I really see little difference between the guy that leveraged his stock options as collateral verus homeowners using current lofty home valuations as collateral on refinance loans. The only real difference is that the fiasco is history and we can easily see what happened while the real estate bubble is happening right now. I am sure that if you told the guy in March, 2000 that he risked losing everything if the market turned down, he would have thought you were crazy. Refinancers today have the same reaction. Either way, the collateral is based upon assumptions that have little or no basis in reality. Sure, a house may be "worth" a lot right now, but if too many homes in the area are sold at the same time, that "worth" is immediately dilluted. Homes are not liquid commodities, they cannot be instantly sold anonymously, such as stocks on an exchange.

What we are likely to see, and in some markets it is happening already, for-sale prices start off high and after 90-120 days on the market, prices will be lowered, and lowered, and lowered again -- chasing the slowdown in the real estate market.

Once the bubble bursts, many aspects of the economy will be affected. Local and county tax revenues are reduced because property valuations go down. To make matters even worse, what I witnessed in Houston (as I am sure happened elsewhere) the local taxing authority modified the values of land versus buildings and developments. THe tax is based upon the improvements to teh property, not the land itself. So over the 1990's the politicians anounced that property taxes would not be raised... yet I noticed that the value placed on land was systematically reduced while the valuation of the home was increased. Sure the taxe rate was not increased, but because the home value increased, tax revenues increased. With the bursting of the bubble, tax revenue is at risk. This devaluation of home prices will be a slow process, it is always a lagging indicator.

Counties will be forced into making up the shortfall in two ways: raising taxes (after the November election of course) and other revenue generating activies... such as taffic citations. Certainly you have already seen an increase in traffic cops since the beginning of the year. The absence of traffic cops in the past 4-5 years has allowed motorists free rein to abuse traffic rules. Now local, county, and state authorities are capitalizing on this situation of increase revenues. That's right, traffic citations are simply another form of taxation. If they were really concerned about traffic safety they would have had traffic cops out all along the way... because tax revenues were adequate as the real estate bubble inflated, cops were not deployed. Now with a soon-to-be shortage in tax revenues, agressiveness in citing traffic violations will only get worse.

The current total public debt has reached $7 trillion -- that's $23,900 per person (including armed forced overseas) or $63,000 per household as the following chart demonstrates:

The next set of charts show the history of U.S. Federal Budget Deficits (and Surpluses). The first chart shows the life from 1901 through 2003 as a percentage of U.S. GDP. The budget ran a clearly declining channel from its 1948 surplus, the highest surplus of the century. The low point was the early 1980s recession. A feeble attempt to recover into 1990 and then the Bush recession pulled it back down slightly. The Clinton era (with a booming stock market and resulting federal-level tax revenues) turned into a significant surplus... the 2nd largest of the century. The Bush-II recession not only evaporated all of that surplus, but additionally ate away to a deficit not seen since the days of Daddy Bush a dozen years ago. Since this chart only shows through year-end 2003, and 2004 is expected to be a deeper deficit, iy is quite possible that the Bush-II recessionary deficit could test historical extremes. Of course the 1920's was a super-extreme as was WW-II. The next-worse deficits were in the 1930's (as part of the recovery from the Great Depression) and the 1980's as we discussed earlier. If Bush-II defiti reaches 6% of GDP (and many analysts expect) it will be the 3rd worst deficit in the century.

The second chart shows quarterly data from 1947 through year-end 2003 and includes overlayed State (collectively) and Federal deficits as a percent of U.S. GDP (Federal scale on left in orange, State scale on right in blue). What is noteable here is that the states seem to be leading indicators. Since 1970, each time the state surplus peaked it was a quarter or two ahead of the Federal peak -- likewise on the recoveries, the states also lead the way. 4th quarter, 2003 showed a rebound in state deficit while the Federal deficit continue to worsen. Is it possible that the states apparent recovery signals that the Federal deficit may soon bottom and also recover? If that were to happen, many other factors would also have to confirm... so far they have not.

Now we need to go back and recall the earlier inflation chart -- compare the major surplus & deficit events with inflation & depression eras, as in the following chart that overlays the two charts:

Each deficit either followed or preceeded significant inflationary times except, in contrast, the early-1930's depression which preceeded the deficit in the mid-1930's. The frequency of Help Wanted Ads seems to be a much more sensitive indicator of economic health as the follwing chart demonstrates, as compared to quarterly Federal Deficit figures. Right now we are seeing an extremely low ad frequency rate. This, perhaps better than any other statistic, demonstrates the recession of the current employment market.

What is inflation? We all know the technical definitions of inflation -- to me inflation is the systematic deterioration of the purchasing qualities of a currency. Undermining the strength of a currency can comes from many different angles. Of course The Federal Reserve printing dollars at a faster rate than the growth of GDP is the most obvious. Stealth inflation comes about from merchants that keep prices unchanged, yet reduce the size or quantity of the product. For example, it is very rare today to find a 1# bag of potato chips at the supermarket -- they are 14 3/4 ounces (instead of 16 oz). The price per ounce changed, but it is not always obvious because the package to the comsumer appears similar enough to the old package. The following demonstrates that canned corn and diced tomatoes are no longer packaged in 1# cans, instead they are in 14 1/2 to 15 1/4 ounce cans.

Ok, enough of the econ triva poop... Let's discuss what the future outlook may be like and what we might to do benefit from the information.

Perhaps the one question on most CyclePro readers minds is, where are we going and how will it affect my investment in stocks, physical gold & silver bullion & coins, and gold stocks?

To answer that you will have to subscribe to my new newsletter... yeah right. Well so much for the joke...

There are several scenarios that may have promise for the forseeable future: inflationary, hyper-inflationary, deflationary, all-out depression (Robert Prechter), flat or muddle through (John Mauldin), or combinations of these. The most optimistic of these is the flat or muddle through economy as coined by John Mauldin. While I have tremendous respect for Mr. Mauldin's opinions, particularly since he has just recently completed research, writing, and now publishing his latest book "Bull's Eye Investing", (I have not read his book yet, it won't be available until April 15, 2004) I have a difficult time accepting that the (domestic and global) economy will simply "muddle through". If that were the case, there would be little need to exit all stocks and buy gold & silver as a defense of severe marketary gyrations. Instead, we could all simply hold our breath, ride out the volatile market burps, and wait for everything to calm down. In the long-run we should come out relatively unscathed... that is my take on Mauldin's muddle through economy.

I cannot completely buy that outlook. My research suggest quite a different outlook -- I am in the inflationary, to hyper-inflationary camp. But I must also admit that I can very easily see the distinct likelihood of a short-term deflationary period first. I am certainly not in the same camp as Robert Prechter, who you recall continues to hold to his 1995 view that the DJIA will eventually trade BELOW 400. I may be bearish, well ok, extremely bearish. But my outlook is much more optimistic (chuckle, chuckle) in that I simply expect the DJIA to work its way down in stages: the 1st target is DJIA 5000 area, a brief pause, then a further selloff down to the 3000 area, with a worst case scenario in the 2000 area.

To make the same point that I have been espounding for the past several years is the following updated chart of the 200 year history of U.S. stocks (1800-2004) after adjustment for inflation: The longer it takes for stocks to move down, the higher up the slope moves my target. The newest projection for the channel centerline is DJIA 5600 around 2010 and 3300 around 2014. The downslope that I am using to forecast for the timeframe is simply a composite of all other downslopes for the years following when the DJIA touched the upper channel line. The 1929-1932 downslope was very quick, less than 3 years. The 1899 peak took 7 years to make a double touch of the upper channel (with at least one touch of the centerline along the way) and 14 years to reach the bottom in 1920. The 1835 peak took 7 years to touch the lower channel, and 1966 took 16 years. Since we have already witnessed 4 years since DJIA and NASDAQ peaked in 2000 and we are still hanging on to the upper channel line, the 1929 pattern is not a likely scenario.

After the 2nd touch in the 1899-1906 peaks, the market essentially went sideways for 10 years before finally collapsing during WW-I. This sideways move (again worth stressing that this is after adjustment for inflation) is probably very similar to what John Mauldin has in mind for his "muddle-through".

While there are certainly deflationary pressure all around right now, I still cannot jump aboard the Robert Prechter train-over-the-cliff scenario. His outlook of ultimately taking the DJIA below 400 would place it on my chart right above where the 1835 peak is. Not only below my lower channel line, but below, WAY below the worst-case-scenario lower channel line. In fact, since the DJIA is maintained with a survivor-bias (meaning only the healthiest, most viable companies are retained in the index, weaker companies are tossed out once they appear to be holding the index down), this means by the time DJIA hits 400 the true economic climate will be EVEN WORSE than a mere 400 spot on my chart! By the time the DJIA hits DJIA 400, the index will have gone through several revisions to weed out the poor performers and replaced with better quality companies. I say that tongue-in-cheek since Prechters economic climate strongly suggests that there will be no such thing as a "strong" company. Perhaps it is better to look at it in Richard Russell terms who says that the outlook will not be measured by who wins, rather it will be measured by whoever loses the least. Therefore, the Prechter DJIA will eventually be comprised of the least-loser companies.

This does not necessarily mean that all companies will be going bankrupt. In 1929-1932 the RCA company dropped from its high of $114 to just under $3, a loss of -97%. It was still a great company with a great product (remember radio?) but it managed to survive and prosper afterwards. What Prechter's outlook suggests is that companies that are severely leveraged right now will be some of the biggest losers along the way. Prechter's outlook will only allow the strongest and most fit companies to survive.

A quick caveat to that scenario is, when the time comes and the DJIA 400 low is hit, any surviving company will be a great investment opportunity. Unfortunately, since Prechter's outlook is based upon his interpretation that we have already completed a Grand-Supercycle level wave structure (in 2000), then the already-in-progress bear market is at the Millenium level. Meaning, the next series of waves down will not happen over night... it will not be a crash, like 1929 only lasting for many years... rather it will be a series of waves that could take 1/2 century to complete. I probably will not be around to witness it. The best I can hope for are the generational waves, such as the one I have layed out in CyclePro Outlook which should last for another 8-10 years.

My thoughts come around to derivatives trading as probably one of the most likely to get hit the hardest. This covers almost all aspects of commodities trading: agriculture, metals, energy, and certainly finanacial markets. JPMorgan-Chase and the next larger derivative trading banks appear to be vulnerable to a sharp contraction. JPMorgan may have invented the concept of "value-at-risk" for valuing the risk components of derivative trading, but their models do not take into account shocks that exceed a few standards of deviation. All of their testing and first-hand experience have stayed within a few standards of deviation and I believe they feel that a shock of greater magnitude is simply too unlikely to be concerned. And, the few situations that did cause excessive shocks were assisted by the Federal Reserve (ie: LTCM bailout), a consortium of other banks, or the IMF. I have previously discussed in CyclePro Outlook how if JPMorgan-Chase were to suffer a large-enough shock such as a mere 2% loss (of its derivative trading book notional value) through systemic counterparty default would mean a complete vaporization of the company. Because of its size and importance it would probably take longer for JPMorgan-Chase to fail than what happened to Enron, but the final result could very well likely be the same. Once the death-spiral begins, it is very difficult to stop. One company that successfully escaped the grip of the death spiral was Dynegy.

If Prechter's outlook is correct, then well before the DJIA gets down to the 400 area, JPMorgan-Chase will simply no longer exist.

To get back on track, the CyclePro Outlook is the optimistic one... DJIA 5600 area by 2010 and 3300 by 2014. In the same timeframe I expect gold to reach $2000 oz and silver as high as $90 oz. Further, I expect that there will be a super-severe golden bubble blowoff that may very briefly reach up toward $3000 oz -- so quick that only very nimble (or very lucky) traders will be able to participate. By then, rules will be changed to make it more difficult for us mortals to play freely. Inflation will reach double-digits again.

The question that comes to my own mind: is it possible to have deflation first, then followed by inflation? The answer is: absolutely. In fact that is what scares me about what we are seeing right now.

To get an idea of what our possible scenarios may be like, I offer the great inflation-adjusted 200 year history of the U.S. stock market. Plus, I have shown zoomed in charts of the greatest bear markets from 1835, 1906, 1929, and 1966. The 200 year chart uses a logrithmic scale while the zoomed charts show the logrithmic channel lines, but on a flat scale (which shows the exponential curved log lines).

As a brief overview of the top chart, it depicts the complete history of the U.S. stock market from 1800 through present. All of the index values have been adjusted for inflation using 2001 as the base. Notice how the index level stays mainly between the two darker channel lines. In two cases, 1813 and 1982, the index moved to a lower (orange) channel line. Within this history, there have been 5 times when the index has reached the top channel line, 1835, 1899-1906, 1929, 1996, and 2000-2004. Of these topping events, only 1929 and 2000 significantly exceeded the upper line. In every case, once the upper channel line was touched, the index moved to the lower channel line. In many cases, the center line (light gray) provided either temporary support or resistance along the way. The "You are here!" tag alerts to the fact that the current stock market had moved well above the upper channel line in 2000 and has recently rallied up to touch the line a second time. The green arrow slopes downward from the current position to target "Where you are going!". The slope of this line is a composite of each of the other bear market slopes from the previous peaks at the upper channel line. The 1987 selloff is shown, but as you can see, the index was only as high as the channel center line, and the selloff reaction was almost insignificant relative to the scale of the whole chart.

Assuming history repeats, the U.S. DJIA index is expected to eventually trade down and at least touch the lower channel line. The centerline is 5600, lower channel is 3300, and the extreme low channel line is 2400. Because the channel lines are upward sloping, the longer it takes to go through the current topping action, the higher the targets will be. Certainly, if stocks trade mostly sideways (on an inflation-adjusted basis) for the next 40 years, eventually the center line would catch up to the index, and after 80 years, the lower channel line.

For a quick point of reference to Robert Prechter's forecast of DJIA 400, the 1835 peak is approximately at the 250 level. Using the same composite slope line as I used above, a move to DJIA 400 may take 40-50 years to complete.

Each of the bear markets depicted here are discussed in more detail below.

The 1835 bear went from an inflation-adjusted stock market peak of 250 down to a low of 82. The rally from 1813 to 1835 took 12 years and started from the extreme lower channel line -- this is similar to the current market, except we have taken 18 years to reach the upper channel line.

Robert Pechter's deflation scenario calls for gold & silver prices to drop along with all other commodities as people sell anything and everything in an attempt to stay solvent. The following chart verifies that this is possible, but only for a brief period. Keep in mind that the price of gold was controlled by the U.S. government, but by adjusting it for inflation we can see how its barter value varied along the way. I appologize that my data is limited to only yearly. The bear market lasted from 1835 to 1842, yet gold sold off for only the first 2 years, from $277 to $205 - a loss of -26%. Because the data is limited to year-end only, it is quite possible (actually quite likely) that the true peak and true low points were much more extreme.

However, by the time the stock bear market low was reached in 1842, gold had staged a +62% rally from its low.

From the view of inflation-adjusted silver prices (the government controlled price was actually set at a fixed value of $1.29), the peak in 1834 was $15.20, the 1836 low was $11.90 for a loss of -22% and then the rally to $18.64 in 1843 for a gain of +56% from the low.

If a similar scenario occured today, it suggests gold prices could drop from $432 peak (assuming that is the final high for this exercise) to a low of $320 followed by a rally to $518. Silver from the recent high of $8.45 to a low of $6.60 and then a rally to $10.30.

The conversion rate from US Dollars to 1 British Pound roughly confirms the timeframe (also at the year granularity).

The next stop is the 1899-1920 stock rally peaks and bear market. Silver initially moved down from 1901 to 1903 and rallied along with stocks into 1906 and through 1907. Then Silver sold down to 1909-1910. After that there is not a fair comparison because silver was hugely affected by WW-I as well as the mini-depression as can be seen by the price spike into 1920 where silver prices more than doubled. Again, the monitization value of silver was $1.29 so once prices exceed this, people hoarded silver coins and melted them down and sold the metal. To keep that from happening, the U.S. government sold silver out of its huge stockpile to depress the price.

The 1929-1932 depression shows that silver prices fell from 1929 to 1933 and recovered in a rally to 1935.

Perhaps a much better comparison is what happened to a commodity that was not government controlled. For this I turn to Homestake mining stock. Although silver and gold prices were government controlled, the stock prices was not. Therefore it makes for a suitable derivative or proxy for the perceived value of gold.

The following Homestake price chart was obtained from Jim Puplava's Financial Sense website several years ago:

The Homestake chart conveniently begins in 1900 where we can see a decent rally through 1907, then a sharp drop for 1 full year, then a strong rally to September, 1916.

The 1929-1932 depression shows that Homestake only made a very slight drop, immediately followed by a substantial rally into May, 1939. By analyzing the x-y cooridinates of this chart, it appears that the 1929 selloff ended by year-end, therefore the selloff of Homestake stock only lasted about 3 months.

By comparison in 1966, the sell-off only lasted about 3 months also.

The following chart from Gold-Eagle website shows more detail in the 1924-1935 timeframe. Here you can see what looks like a hard rally in July, 1929 followed by a volatile sell-off through October, 1929. This confirms that, while the stock market selloff continued into 1932, the Homestake stock participated in the selloff only briefly (3-4 months), then broke free, stabilized during 1930 then steadily and agressively (when Roosevelt confiscated privately-held gold) moved higher through 1935. Homestake stock peaked in July while the general stock market peaked in September, so Homestake was already in a selloff of its own by the time stocks started their tumble. Therefore, any affect of the general market onto Homestake was limited since Homestake bottomed out in October, 1929 while the general market continued much lower, through July, 1932.

As a side point, in 1929 the Homestake stock low was around $70 per share, yet the dividends were $7 (10% yield!). By 1935 the stock was trading near $500 with an annual dividend of $56 (11% yield). In all, even if you bought Homestake stock at its peak in July, 1929 at about $90 in the 6 years from 1929 to 1935, your stock appreciated +450% plus raking in dividends totalling $135 -- altogether a return of +600%.

The 1987 stock selloff was interesting in that some gold stocks rallied the first few days of the stock selloff (See Newmont Mining - NEM, below) and followed physical gold and silver prices higher. When the stock market staged a "dead cat bounce" rally, Newmont Mining stock acted like a stock and rallied while physical metals dropped in price. When stocks retested their October lows in December, gold had rallied to make new highs, silver rallied to cut its losses in half, and Newmont struggled to figure out which hat to wear but ultimately followed the metal prices higher. Afterward, the metals fell back into their own market pattern while Newmont continued to follow the stock market.

The XAU, which consisted of a wide variety of precious metals stocks, was knocked with the general market selloff, essentially treating these stocks as though they were ordinary stocks (2nd chart below).

In each chart you can compare in detail how Newmont, physical gold, silver, & XAU reacted when the NASDAQ tanked.

The 1997 & 1998 charts are interesting in that the AMEX Gold BUGS Index - HUI simply followed gold and does not appear to have been enticed into following stocks. In each case, gold & HUI reacted negatively when stocks were in their panic modes, but very quickly recovered. At this point in time, physical gold and silver were still in the midst of a 20-year long bear market which automatically placed a downward bias on their charts.

The 2000-2001 chart shows that HUI tended to mostly follow gold prices. In November, 2000 HUI broke away from both gold and NASDAQ an started its historic rally that is still in progress today. Gold bottomed out in April, 2001 and it too is still in its historic bull market rally.

The conclusion of this analysis is that in panic situations it appears that physical gold & silver are likely to take a brief hit. Gold stocks on the other hand, tend to follow the physical gold price more closely. In the actual panic scenario, everything seems to be a candidate for selling. However, if the selloff is more gradual, not a massive panic attack, then physical gold and gold stocks tend to move on their own merits. In each of the cases presented above, the major bear markets for stocks initially affected gold & silver prices, but they quickly recovered and staged a substantially rally while stock continued to move much lower.

Therefore, if the stock market selloff is moderately orderly, quality gold stocks should be only minimally impacted and tend to follow physical gold & silver prices. Lower-quality gold stocks are likely to be treated by the market as mere stocks and participate in the general selloff. In a panic selloff, it appears that nothing escapes the carnage, however, gold, silver, and quality gold stocks recover quickly and in most cases should rally much higher while lower-quality gold stocks and general stocks move further down. It looks as though physical gold & silver are the least losers in this case, followed closely behind by quality gold stocks.

Next we will discuss the standard set of CyclePro spread charts for gold, silver, and DJIA.

Silver & Gold, 200 years, adjusted for inflation:

Gold & Silver as a spread ratio, for 200 years:

And the DJIA as compared by spread ratios to Gold and Silver. The DJIA/Silver chart is a 200-year history. The DJIA/Gold chart shows only the last 100+ years:

Finally, we need to discuss the repeating 3 & 5 year gold cycles:

CyclePro correctly used these cycles to pick the bottom of the "e" wave as depicted in the 2nd chart above. As such, CyclePro called the bottom on April 2, 2001 which was the next day after the lowest low had been made. Wave "e" also completed the larger (pink) wave "B". In the big picture, I see gold trading in a very large 3-wave structure of which wave "C" started in 2001 and should progress much higher, and well above the "A" wave high. Our current outlook is a target of $2000 oz with a possible brief panic spike near $3000 oz. The Elliott Wave outlook after completing the 5-wave series: a-b-c-d-e is usually followed by a very impulsive move in the opposite direction. This is what we are seeing in the current gold chart. While wave "C" will not move up in a straight line, the fact the we are currently in the timeframe for the 3-year up cycle suggest that a pause may be necessary. Is the pullback from January, 2004 to March enough of a pullback? The timing of the January peak is close enough, but the duration of the correction is probably too brief. The March second peak ($432) forms a double top formation. Also, because it is a better fit for the completion of the 3-years up cycle, this is a much higher probability to be the top that CyclePro was looking for. It is still possible that a higher high can be reached in the next few weeks, but from the viewpoint of a 25-30 year chart, a few weeks is almost insignificant.

Also, I believe that the strength and reliability of the 3 & 5 year cycles has ended. I expect to see cycles form, but they are more likely to be skewed away from precise 3 years and 5 years. Further, I sincerely doubt that any selloff in gold & silver will get low enough to come close to test the April, 2001 low. If my Elliott Wave analysis is correct, then a breach of that low will not occur.

As we discussed above, the stock market is extremely vulnerable to an extreme downturn (ie: a resumption of the decade-long bear market that began in 2000). As such, physical gold & silver may be vulnerable to a brief selloff if the stock market selloff is anywhere near a panic. Quality Gold stock are also briefly vulnerable. Lower-quality gold stocks should be largely viewed as general stocks and are more likely to suffer greater losses along with general stocks.

In the big picture view, DJIA is expected to reach the 3000 area by 2010-2014 timeframe. At the same time, gold is expected to reach $2000 or higher. The DJIA/Gold ratio is expected to reach a low of about 1.5 to 1 (thus: 3000 Dow, $2000 Gold). The Gold/Silver ratio is expected to reach a low of about 16-20 (thus: $2000 gold, $90-110 Silver). Inflation should be well into double-digits and high quality dividend-paying stocks should be yielding double-digits. High-quality dividend-paying gold stocks should be paying double-digit yields well before the stock market bottom.

The long term trading strategy remains unchanged... (this is my personal strategy) hold a core position of physical gold & silver until no earlier than 2010 and allow market conditions to dictate. These core holding will not be sold, regardless of what happens to the stock bear market over the next several years. An additional holding of gold & silver will be held but can be used for trading purposes along the way. The higher speculative holdings of lower-quality gold stocks will be scaled back to reduce the downside loss risk of a panic selloff in general stocks. Having cash on hand in this event will be a good thing. In the 2010-2014 timeframe when the core physical gold & silver is to be sold, the proceeds are to be placed into quality high dividend-paying stocks and long-term bonds. This is a good strategy for setting up a retirement fixed-income stream. The stock and bonds will generate income while the market value of the stocks should rise as the general stock market recovers, further increasing the overall net worth of the strategy.


We have only just barely started seeing inflation invade our daily lives. Certainly we have all noticed higher gasoline prices... I am still waiting for my earlier prediction of "$40 crude is an inevitable certainty". We have gotten close a few times. The Federal Reserve has been very busy printing up more US dollars, lowering interest rates, and increasing liquidity in an effort to twart deflation. Any time a currency is inflated, the effect is identical to taxation. Although many holders of Dollars don't see the initial connection, the fact that future Dollars will buy less that what current Dollars will buy is just about the same as if G.Bush ordered the IRS to quietly extract a certain percentage of cash out of every citizens bank and investment accounts. The interesting thing about inflation is that it is tied to all holders of Dollars. The government budget surplus/deficit is directly linked to tax collection, thus everyone conducting business in the US. Holders of Dollars, on the other hand, are world-wide. Even most central banks of the world hold US Dollars... everyone is affected once the currency becomes inflated. In fact, I cannot think of a single country in the world that will not be directly or indirectly affected by G.Bush's current currency inflation strategy. A dozen years ago I would have guessed that China might not be too affected, but the recent trade imbalance has China holding hundreds of $Billions. Even countries that do not trade directly with the US are affected indirectly... for example, most international crude oil is priced in $US, thus anyone using products derived from crude oil is affected as prices rise to reflect inflated Dollars.

Bush's staff has been hounding OPEC to increase production to lower the price of Crude Oil. Yet, OPEC production is pretty much in line relative to where it was a few years ago and taking into account increased demand. The reason crude and gasoline prices are high is not because OPEC is cutting production, rather it is simply because the reduced valuation of the dollar in international trading indirectly raises the price of crude oil.

Inflation is a stealth tax and has a very efficient built-in collection scheme... everyone holding Dollars is affected and everyone's purchasing power is diminished, therefore the collection of this "tax" is 100% efficient. And to make it even better, there is no papework to fill out, no check to send in, no harrassing telephone calls from the tax collector, and the government can continue to print all of the dollars it wants so it can continue a free spending policy.

Again with crude oil... the devaluation of the dollar in international trading and the resulting price increase of crude oil is roughy equivalent to a scenario of a stable dollar but where crude oil has a substantial import tax causing the domestic price of crude oil to rise. Either way, from the viewpoint of the U.S. consumer, the price is higher. This is another example of why I classify inflation as a stealth tax.

G.W.Bush may say no new taxes, but he must think most people are gullible enough to believe it. Unfortunately, he is probably right about traditional taxes. It seems that most people are more willing to allow their Dollars to lose value to inflation than to pay additional taxes, even though the inflation-effect may do far more damage to their purchasing power. Over history, Americans have been brainwashed into believing that a little inflation is actually good for the economy as well as for each individual. The President is playing this psychological-ignorance game to his full political advantage.

In the humorous inflation-effect department, Bill Gates has been knocked out of the "Weathiest Man in the World" competition, simply because of the international devaluation of the Dollar.

Several years ago at the height of the craze, Bill Gates had a paper net worth of just over $110 Billion. There were news bits discussing whether Gates could be the world's first Trillionaire! I wrote a little piece on CyclePro that if Gates could liquidate his entire net worth and invest it in something that returned a mere 5% interest, he and his heirs could spend $11 million per day, every day, and never, ever run out of money.

Now, of course, his net worth has dropped from a soft Microsoft stock price, from $110 billion to only $47 billion today.

Here is a little example of how stealth inflation works: Suppose a 1# loaf of bread costs $2.50. You work at a job and make $10. Uncle Sam collects 25% for taxes. In this situation, your take-home pay is $7.50. Thus, you can go out and buy exactly 3 loaves of bread. Now suppose that we go through a prolonged period of inflation such that the bread is still $2.50 per loaf, but each loaf contains only 12 ounces, you get a 10% cost-of-living raise to $11 (wow!), and income taxes are lowered to only 24% (another wow!). Your take-home pay is now $8.36 (feeling richer are we?), but unfortunately you buy your 3 loaves of bread but still feel hungry and don't know why. This person probably never noticed that the bread loaf was smaller even though the price was the same... no price inflation right? It would take 4 loaves (at 12 oz) to equal the old 3 loaves (at 16 oz). Even with a salary increase and a tax cut, they would still need another $1.64 to buy as much bread as they were able to purchase before. In this extremely simple scenario, during inflation this person would likely believe that they are better off because psychologically they think they are making and taking home more money -- after all the paycheck stub looks bigger. The fact that they cannot buy as much stuff may appear to them as a frustrating problem of person budget. Yet reality is that their purchasing power is much less. A person in this situation will gladly vote for the presidential candidate that promises to increase their salary while lowering their taxes (even though stealth inflation ultimately bites them in the butt).

If it were possible for gold to stage a very steady 1/2% increase each week (about $2 at current prices), the price would exceed $500 this year and reach $2000 by the year 2010.

When planning for retirement using the CyclePro scenario discussed above, here is how I think a typical retirement investment strategy could play out. Assume you invest $200,000 today to by 500 oz of gold at $400/oz and sell it all in 2010 at $2000/oz and turn the proceeds ($1 million) into 30 year bonds (or conservative bond fund) yielding 12%. While inflation will diminish the buying power of your dollars by about 1/2 by 2010, your initial $200,000 investment could return $120,000 per year for 30 years from 2011 through 2040. That means a total return of $3.6 million over 30 years (plus your principle of $1 million when the bonds mature). By today's standards, that would be like trying to live on an interest income of $60,000 per year (because inflation will cause the buying power of the dollar to be roughly 1/2 of what it is today).

Another way to look at it, if you desire to retire around 2010 and feel that you need at least $60,000 per year to live on at today's living standards, then you need to back calculate using the above formula to determine how much to put away today. For example, if you think that gold might only reach $1000 by 2010, then you will need a gold investment of at least $400,000 right now. In addition if you think interest rates will only be 6% at that time, then double your gold portfolio again to $800,000.

I do not mean to try to scare anyone about their retirement planning, but the reality is that it takes a lot of investment capital to guarantee a decent fixed income 10 years from now. Plan for the worst and hope for the best.

My final comment for the day:

The total value of items sold on eBay in 2003 was $24 billion, up 60% from 2002's $15 billion. As the effects of inflation/deflation continue to fester in the economy, expect eBay business to climb. eBay is mostly anonymous and allows person-to-person exchange without actually revealing who they are. This will begin to replace the function of the local pawn shop. Even supposedly wealthy individuals can sell off some of their unnecessary items without detection, something that is very difficult with a pawn shop.

As the federal coffers dwindle expect the IRS to eventually tap into eBay and force it to issue 1099-like statements to all seller participants. At some point, we will have to provide business statements to support our inventory costs to offset the sales. Otherwise the IRS will view all sales as profit, and therefore subject to taxation. It will probably be a few more years before this begins to be discussed in Congressional circles.

Good luck always.

Posted in Online Trading

Leave a Reply

Your email address will not be published. Required fields are marked *