Web Note
The following analysis and charts are hypothetical in nature, but are based on what was, what is, and what may be.

It is early 2005 and for several months, new orders for production have been falling. After a modest bout of Christmas spending, sales have slowed notably in February and March. Leading polls of consumer confidence show little appetite for taking on major purchases such as autos and major appliances. Used car prices have been falling sharply as cheap and easy financing under-pin a preference among consumers for new vehicles. In recent years, credit has been relaxed so that new cars can be bought with almost no down payment and loan durations spanning 8 years. This is in sharp contrast with the 20% minimum down-payments and shorter duration loans seen only 5 years earlier. In March, the latest reports on consumer confidence begin to deteriorate significantly falling 7 points on the Conference Board Survey, with forward expectations looking out 6 months even weaker. Rumors float that several ratings agencies are close to downgrading debt ratings on one of the major U.S. Auto-Makers, citing excessive debt levels on the corporate balance sheet. Bond prices continue a rally, which began at the beginning of the year, as 10 yields fall initially below 4% despite the fact that many top notch bond pro’s wonder publicly whether bond holders are getting fair compensation for extra-ordinary risks. It is also reported in March, that the Bank of Japan and Bank of China were still buyers at the recent 10 Year Bond Auction, recycling trade dollars back into U.S. Treasuries in the name of free and unfettered global trade.

At the same time, The Federal Reserve Board seeks to continue raising interest rates, with Fed head Alan Greenspan, moving the short term lending rate from 2.75 to 3.00% in April, citing a still healthy level of growth near 3.5% GDP, in an effort to “normalize” long term rates. With inflation running at 3.5%, real interest rates are still negative and for most fed watchers, the Central Bank appears “easy” in continuing a pattern of “accommodative” monetary policy. Nevertheless, amid weaker economic data and falling long-term yields, the 10 Year-2 Year spread has narrowed from 250 basis points to only 50 basis points representing a distinct flattening in the Treasury Curve. Unlike prior expansions, where robust employment growth and rising wages trigger a flattening curve, this recovery appears atypical in that growth is slowing while the curve is flattening.

Elsewhere, a report surfaces that the IMF may sell part of its gold reserves to help with 3rd World Debt relief sending Gold prices down toward $415. An early report of Foreign Trade Flows shows that while 84% of January’s Treasury Sales were taken up by foreign central banks, the in-flow of $61.3 Billion was still sufficient to cover January’s Trade imbalance of $56.60 Billion prompting a mild dollar rally. In the United States, personal, corporate and government debt levels are running at never before seen record levels on both an absolute and relative basis. For many consumers, credit card debt payments chew up all remaining disposable income meaning that numerous households live paycheck to paycheck. Where the Federal Government is concerned, huge and burgeoning fiscal deficits have no end in sight as lower tax rates combined with huge foreign defense related expenditures and a slowly growing economy have created a fiscal “black hole”.

On television, “reality” shows dominate the ratings with a new show debuting in which contestants “day trade” technology stocks while being deprived of food and sleep. The winner after 12 weeks gets a million dollars, or 20% of the net gains on a mythical $1,000,000 portfolio, which ever is larger. Other reality shows seek high ratings by forcing contestants into life threatening situations for the chance to win $50,000, while yet another show pits college grads against high school grads to see who can outwit and outsmart the other.

Overseas, in an economy more globally linked than ever before, growth in China continues at a rapid clip as the Chinese Industrial Revolution continues to move masses from agricultural centers to urban centers. China’ s hunger for base metals and all forms of commodities continues to support sharply higher raw materials prices from steel and molybdenum to copper and nickel. Factories hungry from raw materials are manned by a labor force working at rates 1/10th the wages seen in developed countries.

In fact, in some Chinese factories, it has become cheaper of late to manually haul goods around the factory floor using sweat labor, than to run conveyor belts, as conveyor belts guzzle valuable and scarce electricity. In the Financial Times, it is reported that Chinese GDP is growing at 10%, while in March, China announces the acquisition of a medium sized U.S. energy company, and a major producer of Canadian coal. In Canada, coal companies have been among the hottest stocks – many advancing by nearly a 1000% as Chinese demand strains Canadian export capacity pushing up prices to levels never before seen. In Pennsylvania, Hershey chocolate announces a 15% rise in all candy-bars, while Colgate hikes toothpaste by 15% with both companies citing higher fuel prices. Both Nestle and Procter and Gamble quickly match the price hikes.

In Winston Salem, North Carolina one of the last of America’s textile mills has just closed laying off 1500 workers. For many of these workers, the textile job has been a generational heirloom, handed down in some families for over 40 years. Strikingly, economic advisors to the President proclaim that the Ricardian principle of “Creative Destruction” is at work, with a new “modern technology” based work force replacing an outmoded manual labor force. The loss of manufacturing jobs is played down while overall job growth is applauded as healthy. One government economist notes that “afterall the Unemployment Rate has just dipped to 5.2%, a full employment condition”. Yet few economic observers note the continued shrinkage in the Labor Force Participation rate, which now ratchets down to a 17 year low, as more and more workers simply give up looking for jobs. Never before in America’s history has an economic recovery unfolded against the backdrop of a shrinking labor force. Tragically, few people seem to comprehend the altered nature of government statistics, wherein unemployed and under-utilized workers are no longer counted in the unemployment rate, which, in reality is much higher than the widely touted 5.2%. In fact, unknown to most, the “unofficial” unemployment rate stands closer to the rate seen in major European countries such as Germany and France, between 9% and 10%. At BLS, sneaky computer models mythically create jobs every month under the never discussed “Business Birth-Business Death Computer Model”, another disingenuous device never discussed by an uniformed media.

In the stock market, weaker than expected job growth along with weaker economic data is seen ironically, as a “Buy” signal. Stocks gather strength and rally to new and higher recovery highs, with bluechips pacing the advance. With Oil prices hovering near $48 per barrel, high quality energy stocks are the treatment of choice, spearheading the market rally along with makers of Consumer Staples, Basic Materials and Electric Utilities. Rotation has taken place within the stock market as high-flying tech leaders from 2003 have faltered, amid ongoing concerns of decelerating earnings growth and high valuations.

Amid ever deteriorating reports in the surplus of trade, the Dollar has taken solace from higher short-term rates, managing to extend its minor rally while at the same time pressuring Gold from $420 to $410. Gold Stocks, a leveraged bet on Gold prices, have been weak all year and are still hovering near multi-month lows with the XAU near 90. In movie theatres, a strange dichotomy persists between increasingly frightening movies and a renewed popularity in children’s animated films. On one weekends Box Office, the top movie is an X-rated Horror movie aside a “G”- rated children’s story. Meanwhile, China's Lenovo Group Ltd. announces it is seeking to acquire International Business Machines Corp.'s entire personal-computer business, that is, if the deal will clear U.S. national-security regulators.

As the first half of 2005 comes to a close, long-term interest rates have eased from 4.20% to roughly 3.75%, in the process restarting a minor wave of REFI Activity in the West and East Coast Housing Market. In San Diego, home prices hit new highs in Carlsbad, La Jolla and Rancho Santa Fe with many of the homes changing hands on no money down type deals. San Diego’s “Capital Trust Company” reports that “Interest Only” Loans - heavily laden with leverage account for 80% of all new mortgage loans. Yet, in Atlanta and Boston, prices have flattened out while in Chicago, high-end home values have actually declined. Home Building stocks attract more and more attention, continuing an incredible surge on Wall Street where they have been market leaders for the last three years. Several Wall Street brokerage houses reiterate their Buy ratings on Home Building stocks.

In Bond markets, corporate-treasury spreads and emerging market spreads have narrowed even further to record lows as the 2 year-10 year yield Curve has almost completely flattened after the Fed’s third one quarter point rate hike. In the equity markets, leading steel producers have been on rampage gaining almost 35% in the first few months of 2005, with large gains in Base Metals stocks on the back of even higher commodity prices. Both Kimberly Clark and Mead announce 12% price increases for paper products which are also on the rise relating to higher prices for wood byproducts. For the first three months of 2005, it is reported that Average Hourly Earnings were up just 1.5%, the slowest reading in 25 years. At the same time, a Time Magazine article notes record high prices for Beef, Gasoline and Cheese are squeezing consumer budgets. In Las Vegas, a burlesque style Adult Entertainment restaurant opens as the newest Hot Spot in town at the premier of a major new casino. 20/20 runs a story highlighting the love affair Americans have with gambling as Poker ranks high among new favorite past-times.

In China, relatively low rates of inflation have been heating up as overall manufacturing output has been maintained at robust levels. In May, China announces a joint venture with a leading Brazilian Iron Ore Producer and the acquisition of a major Argentine Cattle Ranch. With recent Consumer Confidence polls still showing a deteriorating trend in May, many retailing stocks have come under pressure. Whirlpool announces a second price increase in major appliances as spot metals prices continue to drive up manufacturing costs. Whirlpool also pre-announces a disappointing quarter with the stock falling sharply. Elsewhere, within the stock market, specialty retailers, department stores, leading auto-makers have all seen sales slow and stock prices recording 52 week lows. Separately, it is reported by the American Council on Consumer Interests, that Americans now work thru May in order to pay down their credit card debts which now average nearly $11,000 per household. Separately, it is reported that for 2004, aggregate wages and salaries in the U.S. rose only 2.4%, the slowest level in years and that for Americans in the lowest 20 percentile, income actually fell by nearly 2%.

Second Half 2005

In addition, within the stock market, many high-flying technology stocks have been in pronounced declines, warning of sales and revenue shortfalls. On the NASDAQ, the broadly based Advance-Decline Line is moving closer to 52 week new lows as the NASDAQ lags behind both the DJIA and S&P. Yet all is not gloomy in the stock market, the narrow index of Dow 30 Industrials has just made a new 4 year high at 11,500, and the S&P 500 is still close to 1220. A special CNBC broadcast airs featuring “The Resurgence of Commodities” while at about the same time, Gold Stocks begin to improve, with the XAU Index rallying toward 100.00 and spot Gold trading back to $450. In Peoria, Illinois, Caterpillar Inc., the world's biggest maker of earthmoving equipment, introduces a long-term plan in 2003 to expand in China. Caterpillar exports U.S.-made mining equipment to China and maintains joint ventures there to produce other equipment. The company announces it will build a facility in Qingdao to spur more product development. At the same time, the head of a major semiconductor contract manufacturer, announces that more production will be shifted away from New England and toward “lower cost facilities in Asia and Mexico.” Other semi-conductor contract equipment makers follow with similar announcements leading to a surge in total layoffs.

On the NYMEX, Crude Oil prices are still holding $44 per barrel but have weakened from levels seen earlier in the year near $50-$48 while Unleaded Gasoline prices are still firm with approach of summer driving season, trading near $1.55. With gasoline prices at near record levels, U.S. refining capacity remains strained at 95% utilization rates. In currency trading, the Dollar has been in a quite range as the rally in Treasury Bonds has enticed foreign central banks to maintain a high level of participation in U.S. Treasury auctions.

Around mid-July, second quarter earnings are announced and to the chagrin of many bulls on Wall Street, a full 52% of earnings reports fail to meet Wall Street estimates with many technology companies warning of cuts in capital spending, due to excess capacity and a “tough” pricing environment. Many tech CEO’s confirm that final demand world wide has turned very weak. At the same time, the Dow Industrial make another new high in July, this time non-confirmed by other indices like the NASDAQ and S&P. Suspiciously, financial stocks, along with transportation are all experiencing significant, if not, very sharp declines. A similar phenomena hits homebuilding stock which experience 2 months of crash like behavior. It is noted by one bond manager, that over 40% of the S&P profits now come from the “financialized” economy as CFO’s juggle funds in the arena of corporate swaps.

As mid-August approaches, early reports circulate from U.S.Traveler Magazine, that overseas tourism by Americans is down, a report echoed by poor “load factors” at major U.S. Airlines. Within the Airline Industry, it is reported that high fuel costs and poor available seat miles (ASM) have resulted in even bigger losses causing three time comeback kid, U.S.Global Airways to file liquidation laying off more than 25,000 workers. At this time, Challenger Christmas Grey announces that layoffs in general, are surging and are now near a three-year high. In a seeming contradiction, mythical government employment data shows “job growth” still on the mend. Taking heart for the payroll data, economists on a Blue-Ribbon panel continue to predict strong growth ahead. Yet for many individual families, a pattern of ever higher grocery receipts is colliding with falling wages and rising anxiety centered upon job security. In late August, leading Oil tanker company, Overseas Global Shipping notes that “day rates” have weakened significantly. This report dovetails with a sharp decline in the Baltic Freight Index, which in retrospect, has now been falling quietly for the balance of the last 4 months.

In Taiwan, a meeting is held in late August announcing the opening of the ACD Bond Market (Asia Cooperation Dialogue) (http://aric.adb.org/asianbond/index.htm) where bonds will be traded from member countries including China, Korea, India, Malaysia, Thailand, Singapore and Japan. Only days later, S&P announces that a major U.S. Auto Company has been downgraded from investment grade to junk while both Fitch and Moody’s maintain the thinnest margins of investment grade ratings. At Wal-Mart, a more vocal chorus is growing within the U.S. labor force to unionize labor as in Canada, a more pronounced movement toward Unionization has been heated for many months. On the LME spot-market, robust demand for Nickel and Copper has pushed prices to new all time highs with Nickel now trading near $9.00 and Copper near $1.75. In the August report for U.S. Producer Prices, high metals prices combined with high gasoline prices produce a sharp, uptick in inflation leading Bond yields to rise from 3.85% to 4%. At the same time, economic data in the U.S. shows the biggest decline in 17 years in consumer revolving credit, as domestic spending in the U.S. continues to show signs of slowing. In a number of U.S. cities, a trend is noted of high-end restaurants closing down as fewer people are eating out. Perhaps surprising to many, the U.S. Trade Deficit for August is announced at yet another record, -- despite the slow down of U.S. final demand. As a result, the Trade Gap now lurches toward 6% of GDP, an extreme reading associated with currency devaluations on a historical basis. On the Foreign Exchange market, the August Trade number triggers a sharp break in the Dollar exchange rate with the Dollar Index breaking below medium term support at 81.00. As the Dollar breaks below 81, long-term bond yields press back toward 4.10% with credit spreads widening out for the first time in many months.

In the stock market, U.S. Base metals producers Phelps Dodge (PD) and Inco (N) are on fire, moving to new all time highs as strong spot prices continue to drive record earnings reports. However, other companies are not fairing as well. The mid-August earnings report from Procter & Gamble shows disappointing results, as PG was unable to raise prices and noted that higher raw materials costs had cut into the quarterly bottom line. With the sharp decline in PG stock, and an increasing awareness of the renewed Dollar decline, confidence in stock prices has weakened, and with it, stocks have begun to fall sharply.

By late August, the S&P 500 has fallen into negative territory for the year, trading in the 1120-1140 area, down 6% from December 2003, while NASDAQ is now down nearly 16%, trading closer to 1850. Among technology stocks, semi-conductor companies are turning in some of the worst performances as major produces like Intel sport large and bulging inventories and report shrinking gross margins. At the same time, the quarterly Federal Deficit hits new record highs with some in congress beginning to discuss a reversion to fiscal conservatism. As Gold stocks have been rising in recent days, several Wall Street brokerage houses downgrade mining blue-chips citing excessively high valuations. The shares are unaffected and continue to trend higher.

In other parts of the U.S., angry labor groups form stating that exports to China, have contributed to the loss of 2.6 million manufacturing jobs in the U.S. since March 2001 and point out that the U.S. imported a record $195 billion of goods and services from China during 2004, producing a bilateral trade deficit of about $160 billion. Area’s most affected in manufacturing have been textiles, home furniture, appliance manufacturing, and automotive. Amid increasing trade tensions, the U.S. Export-Import Bank announces that it is rejecting in a final decision, Chinese Semiconductor Manufacturer, SMI Corp’s request for a $769 million loan guarantee to buy semi-conductor equipment from Applied Materials citing multi-examples of Chinese failure to respect intellectual property rights.

As September begins, the Dollar sinks ever lower, with the Euro moving toward new multi-year highs at $1.37, the British Pound at $2.10 and the Swiss Franc at 1.06. At home in the U.S., long term interest rates are now rising steadily with the 10 year Bond yield quoted at 4.50% Adding to the surge in long term interest rates, was a new report just issued by the TICS, Treasury International Capital Data (http://www.treas.gov/tic/)

showing U.S. outflows to Foreign Stocks and Bonds hitting an 8 year high. As the Dollar cascades to new lows, Gold prices firm quickly with nearby Gold contracts notching new multi-year highs at $465, while major gold producers rally strongly from depressed level seen earlier in the year. By the end of September, the XAU, the Philadelphia Gold and Silver Index is now up for the year and trading between 108 and 110, a gain of 9% for the year. In Toronto and Vancouver, shares of emerging exploration companies are performing even better with the TSE Venture Exchange Precious Metals Index up 20% in 2005. In late September, Chinese state owned conglomerates announce the purchase the largest Iron Ore manufacturer in Brazil and a 40% equity stake in a major silver producer. China also secures ownership of a large tract of Canadian Oil leases on the Athabasca Oil Sands.

Early October brings to light new Auto Sales data, showing dismal sales with volumes falling to the lowest levels in nearly 10 years. At the same time, Ford Motor Company extends its $2,000 cash back or New Dell Computer offer which had run earlier in the year by offering to throw in 4 free tickets to Disneyland and a new Nokia Cell Phone for every new car sold. For months, O% financing has been ineffective, leaving auto makers confronted with a sales vacuum. In the credit markets, Ford, the No.2 automaker in the U.S., is written up by Forbes which states “Ford wouldn't have made any money pretax for the last two years through 2003, were it not for its financing arm.” For Ford, slower sales cause credit spreads to widen across its entire 280 billion yield curve from 350 basis points to 550 basis points. On the stock charts, auto shares have now broken down below major support levels and are now sliding toward multi-year lows. In the same report, Japanese auto makers continue to increase their market share sparking anger among anti-outsourcing labor groups with several Japanese auto makers noting severe product shortages due to halted production in South East Asia where steel and nickel are in ultra-short supply. The dismal state of the U.S. auto industry is highlighted even further when ABC News reports that in China, a long running dispute between China’s 2nd largest Auto Maker, Shanghai Automotive and one of America’s largest car makers has been resolved by allowing Shanghai’s subsidiary ‘Cherri Corp’ to knock off cheap $12,000 copies of American designed vehicles. At home, major auto related companies are bleeding red ink and announce the closure of facilities.

As 2005 draws to a close, trade tensions between the U.S., China, and Japan and between Europe and Asia are steadily on the rise. The U.S. Dollar is plummeting toward 1.40 on the Euro and Gold is now trading above $550. Gold Stocks finish the year as the Number 1 performing sector with the XAU above 135, while the S&P and the Dow both finish the year down 12% to 15%. On Wall Street, many are reflecting back on the poor performance in January as a leading omen of a return to bear market conditions in the stock market. Retail Stocks have been the biggest losers in the 4th quarter as chain after chain of major retailers announce store closures and falling sales.

Yet domestically, prices in the U.S. are still on the rise for a wide range of raw materials and finished goods. At the same time, wage growth continues to decline with even bullishly bias government figures reporting an obvious retrenchment. Long-term interest rates have now been rising and finish the year near 5.35%, sparked by a lower dollar, rising import prices for Asian manufactured goods, and sharply higher costs for raw materials. By December, a clear picture of oversupply has emerged in virtually all formerly high-flying Real Estate markets with housing prices actually declining 10% to 12% in numerous markets. To sell a home in most markets now takes nearly 10 months leading some homeowners to cut prices in order to close a deal. Among major banks, a downtrend in earnings is observed as successive quarterly reports are accompanied by an increasing trend of “one time” charges. Invariably, these charges relate to residential real estate now in receivership from defaulted borrowers who overextended themselves when rates were very low and housing prices very high. At the Box Office, animated movies are falling in popularity with a new genre of Horror/Sci-Fi dominating new releases.

As 2006 begins, a second great bear market is beginning to unfold on a global scale. In Japan and Asia stock markets are already down 20% from their early 2005 peaks. Thru the fourth quarter, the Leading Index of Economic Indicators is now down 6 months in a row. In mid-January, 4th quarter earnings are released with only 38% of companies meeting growth expectations while once again, technology shows surprising declines in final demand. In tech-land, a number of CEO’s discuss further cuts in capital spending and perhaps idling even more “spare” capacity with several more companies contemplating shuttering “high cost” manufacturing in the U.S., while maintaining production in the 3rd world. Several high profile CEO’s resign due to the poor performance results.

At the same time, foreign capital continues to exit the United States, where budget deficits remain at record levels. With the Dollar continuing to slide, long-term bond yields are now approaching 6.25%, and across the entire U.S. economy corporate earnings are falling sharply. Day after day, lower dollar values, trigger higher long-term bond yields and falling stock prices. Within the stock market, Energy and Base Metals stocks two of the former bull market leaders are now locked into major downtrends and down 12% to 15% from their 2005 highs. On the LIFFE, Baltic Dry Index futures in a sign of weakening global demand close below 2,200; the lowest levels seen since early 2003 and down nearly 60% from the early 2004 peak. Within the stock market, only the Gold Stocks gain ground feeding off bad news and a weaker dollar. The XAU crosses 165 and in the process scores a new all time high.

First quarter GDP is announced with a contraction of –2%, far worse than economists had expected. In the currency markets, the Euro is now trading at 1.60 to the Dollar with the British Pound at 2.65. Within the U.S., the congress is talking up legislation that will force China to revalue the Yuan or impose import tariffs on all Chinese manufactured goods thereby “creating a more level playing field in the arena of international trade”. On television, a new reality show debuts where angry homeless people are pitted against college graduates on a deserted island to see who can obtain food and survive.

In a case of being careful about what you wish for, the China responds with a 10% Yuan revaluation and a movement to a more “open and flexible” exchange rate. Sentiment runs high that trade imbalances will improve. Around the world, capital begins to flow into Asian currencies and Asian bond markets where daily trading volume is now steadily increasing. In China, the central Bank has been diversifying its reserve dollar portfolio, once over $500 billion by making direct investments in multi-national corporations, investing and/or acquiring a large number of U.S., Canadian and South American raw materials producers. Chinese interests take-over a medium sized Uranium producer in Chile. As the Dollar continues its downward spiral now near 70 on the Dollar Index, commodity prices continue to reach new and ever higher prices in what appears to be a “manic” blow-off type market.

At major credit card companies and other financing companies, delinquency rates are now surging toward a 10 year high. At the same time, personal bankruptcies are at record highs while mortgage defaults are surging as increasing numbers of unemployed workers find rising mortgage payments impossible to meet. With long-term interest rates now pressing 7.00%, a large U.S. automaker announces a multi-billion dollar quarterly loss with the stock plummeting. At the same time, other auto-makers see their share prices collapse with an index of auto stocks now trading at a 25 year low. With collateral impaired, with credit rating agencies downgrade of a variety of auto related debt to junk status. Both companies announce plans for more plant closures and further layoffs. Treasury Junk spreads, once at an incredibly narrow 200 basis point spread, have now widened out to nearly 800 basis points with one bond manager noting a substantial drop off in liquidity in both emerging market debt and nearby corporate SWAPS. At the same time, a major government sponsored agency see its shares come under heavy selling pressure, triggering major declines in the market averages as rumors circulate that GSE mortgage players are losing billions on their derivative hedge books.

Besieged by a flurry of bad news, the Dow and the S&P join the NASDAQ in under-cutting the August 2004 lows with CNBC anchors now openly wondering when the bad news and bear market will come to an end. In the Real Estate market, residential property values in many major cities, especially former boom towns on the East and West coast are now down more than 25% from their 2005 peaks. Yet, the news does not improve as American Consumer Confidence surveys plunge toward multi-year lows. For many, the decision to buy new homes with adjustable rate mortgages has proven a major mistake with the residential real estate market now falling sharply. Easy financing deals of all kinds, from homes to appliances have disappeared. Within the realty business, it is reported that sales have slowed to a 20 year low, and several new fangled mortgage finance companies which featured “reverse amortization mortgages and sub-prime loans” have recently gone broke. Several large home-builders are now losing money due to an increasing cost of carry on large numbers of projects started near the peak of the boom. Homebuilding stocks, leaders on the upside are now pacing the bear market decline. Ironically, one Wall Street analyst notes that as the group advanced with low P/E’s right thru the top, multiples are now expanding during the decline as earnings are falling faster than prices.

At Wal-Mart, many average Americans now join picketing workers who are seeking unionized wages in what is becoming a national boycott of foreign made goods. A new organization, “Americans for ‘Made In the USA’ purchases commercial air time on the major media networks exhorting U.S. citizens to take back their manufacturing jobs. Another bill is floated in congress which proposes building a 1,000 mile wall across the Mexican border to “put U.S. workers back on the job”.

Daily headlines are filling with job losses and poor earnings reports, as many companies find themselves in a profit squeeze, caught between higher material costs and falling final demand. Kraft announces price increases on all cheese and dairy products. Several U.S. economists suggest the economy is slowing down but note that growth rates should soon increase citing the wondrous benefits of globalization. Yet in the bond market, mechanical selling has become self-reinforcing stemming from “negative convexity” issues as many over-leveraged hedge funds are now frantically trying to unwind “carry trade” positions. The unwinding of the carry trade is hurting corporate earnings in a profound manner as for many companies, financial wizardry based on credit spreads supplanted product profit margins as a key earnings driver years ago. Panicky institutional selling is now pressing up yields despite poor economic data with 10 Year Notes pressing 7.50%.

Perversely, Gold, which was once thought of as “only” an inflation hedge, is now the only asset class building momentum to the upside as prices close above $700 for the first time in 27 years. Supporting the rise in Gold prices have been a series of announcements by several smaller central banks, including the Bank of South Korea and the Bank of Taiwan which have announced plans to add on gold positions to hedge reserve depreciation in their dollar holdings. Importantly, Gold is now advancing against all forms of paper money, showing excellent relative strength versus even “defensive” currencies like the Swiss Franc and Kiwi-Dollar. On the NYSE, a narrow group of Gold stocks now show high relative strength versus all other industry groups including base metals and energy, where share prices have been falling for a number of weeks despite still high spot commodity prices. As mid-year approaches, the XAU is still the sole market leader and is closing in on 200. In Canada, a conference on Resource Investment draws nearly 12,000 people into the Civic Center in Vancouver as many smaller exploration Gold stocks are making multi-year highs. One speaker, as widely respected metals analyst, predicts that Gold will soon approach $850, its former 1980 peak.

As the second half of 2006 approaches, stock indices have fallen over 20% from the early 2005 highs, and with many decrying a new bear market, a brief, but sizeable “summer rally” ensues. However, in the technology world, over-capacity has once again become a major issue, and with the release of poor second quarter earnings, CEO’s cite sliding productivity, a competitive pricing environment and weak final demand as components for a continued squeeze on earnings. Price wars between major companies both foreign and domestic have intensified.

In Asia and much of Europe, profit margins are also under intense pressure, causing many foreign manufacturers to begin “passing thru” higher prices in order to maintain stable profits. In the past, these manufacturers would often absorb higher raw materials prices as profit margins would remain high due to strong volumes in final demand. Yet, by mid 2006, massive change is underway and at the U.S. Bureau of Statistics, a three-month decline in the Index of Lagging Economic Indicators is seen as validating the start of a recession. Also around mid-year, China makes an open bid for a major U.S. energy producer Unocal, in a deal valued over $50 billion dollars.

On the U.S. consumer spending front, higher market related interest rates have had the adverse affect of pushing up already high credit card rates, and are cutting off availability of credit through the mechanism of home equity borrowing. The Result: total consumer spending has slowed sharply, -- a trend reinforced by higher import prices coming from Asia. In the latest Trade Deficit figures, new record deficits have been recorded despite a lower dollar and a slow down in overall U.S. consumption. Strangely, the typical trade correction seen through a lower currency appears absent in this cycle owing to the fact that lower levels of imports are now being entirely offset by higher prices being passed thru on imported goods.

With much of the U.S. manufacturing sector gutted in the 1990’s and early 2000’s, dependence of foreign production now looms as a major liability, forcing up consumer prices as higher ‘pass thru’ import prices have intensified the squeeze on real wages for most Americans. Declining purchasing power now reinforces the larger slow down in consumption.

In certain economic circles, it becomes clear that over the last few years, the industrialization of China and the full affects of globalization including development in Southeast Asia, Latin America and India, not only prevented wage increases for taking hold in many U.S. manufacturing and services businesses, but by creating far ranging outsourcing alternatives, crippled domestic job creation and with it, any chance of a genuine self-reinforcing economic recovery. By mid-to late 2006, slumping final demand in the U.S., stemming from an over-indebted, savings deprived, U.S. consumer is causing a high tide to roll in on the sea of global trade.

Asian producers realize that while higher prices will maintain current profitability, there is also a dawning realization that high prices have a limit, as they progressively reduce final demand. In Asia, lower overseas revenues result from higher pass thru pricing and translate into less capital available for the recycling of dollars back into American bond markets. Consequently, U.S. interest rates maintain a strong upward trajectory exacerbating declines in residential real estate and corporate profits.

In Washington, a new bill is introduced calling for 40% tariff on all Chinese imported goods should China fail to immediately allow the Yuan to move to a full floating rate mechanism, as trade figures continue to deteriorate despite China’s 10% adjustment. With growing bi-partisan support, the bill also criticizes China for patent piracy and multiple failures to protect and uphold U.S. intellectual property rights. At the same time, congressional sentiment steps up to block the formerly announced Chinese take-over of Unocal – citing regulatory issues. In Beijing, the burgeoning anti-Asian sentiment breeds resentment leading to a strong counter-statement criticizing the U.S. policies and condemning U.S. fiscal mismanagement. By late 2006, the National Bureau of Economic Statistics announces that a recession has not only begun, but has been in effect for the last 5 quarters dating back to the middle of 2005.

A bitterly cold winter in 2006, presses up Natural Gas prices which act as yet another dampening affect on consumer demand. By early 2007, bond traders are focused on U.S. Asia relations and almost exclusively upon the reports dealing with net inflows of foreign capital. At this time, large and unwavering twin deficits continue to pressure the Dollar forcing interest rates to move higher. Major residential Real Estate prices are now down by 40% in many markets sparking disbelief among commentators and fears of impaired bank loan portfolios. By now, stocks have already broken below their 2002 summer lows and led by a declining NASDAQ, more than 85% of all issues are now below their 200 day moving average. Gold prices are surging again, and closely approach $850. Within the market, even the once strong sectors of Energy and Base Metals are down 25% to 30% as money managers with big losses in technology and small cap sectors see these large and liquid holdings as a source of funds.

In April another discouraging TICS report is released, into an already extremely anxious bond market. The data show an even larger than expected outflow of foreign dollars leaving U.S. capital markets. Long-term rates shoot skyward with the Dollar Index breaking down below 60, plunging to yet another series of new all-time lows. At this point, 10 year Bonds are now yielding almost 9% and a full fledged currency crisis is afoot. At home, many economists now urge the Federal Reserve to push up short-term interest rates despite the “recession” in order to stabilize the Dollar where stability is seen to be of paramount importance. Around Fannie Mae, rumors swirl of massive hedge-book related losses wiping out all of the companies equity and triggering a massive sell off in GSE debt. It is feared that several large hedge funds are also in dire straits offloading bonds into every rally.

On the Comex, Gold is in a runaway advance, now seen as the only currency which cannot be devalued. Gold Stocks are exploding in parabolic fashion with developmental “non-producing” companies leading the advance as ‘hot money’ justifies even higher valuations for these stocks based on the idea that in future years, even higher gold prices will accrue a greater premium to their undeveloped assets. The XAU hits 265.00 and on the Canadian Exchange, daily volume now exceeds NASDAQ volume, with many junior mining companies up over 1000% in the last 12 months while exhibiting huge percentage swings on a daily basis.

For the Bond market, higher Gold prices, and shrinking foreign demand continue to leave prices locked in a steep downtrend. Forced liquidation of over-leveraged hedge funds is exacerbating the decline with long term yields now spiking toward 10% and then 11%. As rates spike, shares of a major auto company collapse under $2.00 on news it will be filing for bankruptcy protection. Headlines dominate the news as mass firings are announced at a number of companies and financial institutions which are upside-down on their loan portfolios. Gold Stocks come off the high with a serious “correction” as the XAU pulls back to 225 from 265.

Seeing the sharp rise in long term yields and collapse of major automakers, heavy margin related selling begins to unfold in the stock market with the Dow sliding over 200 points, 6 days in 7. At 5,500 many fundamentalists believe that the Dow is looking cheap as price to dividend yields are moving closer to historical means. On the flip side, the XAU is now once again rallying moving back up toward its former high near 260, up nearly 300% in two years. Yet, selling pressures abound in the stock market and when rumors of a major derivatives problem at a major bank hit the floor, sellers panic and deluge the market. Soon after, news hits the wires, that foreigners are withdrawing massive amounts of capital from U.S. Banks, a that several large hedge funds are in trouble. The Dow spirals lower, collapsing over 1,000 points in a single day. As the great crash develops during the course of the day, sellers are in full control and are seeking to remove capital from risk at any cost.

Stocks of all types are sold off furiously and even with Gold prices moving up toward $1,500 an ounce, gold stocks are sold off with reckless abandon as the XAU collapses by 100 points; down nearly 36% in a single day. At just over 4,000, the Dow and other blue-chip stock indices are now down 70% from their 2005 highs. For the S&P 500 and NASDAQ, 1993-1994 levels have been revisited with the S&P index closing near 350, while the NASDAQ finished below 700. NASDAQ is now down 75% from its 2005 high and an amazing 87% from its secular peak in March 2000.

As stocks of all types collapse, bond traders recognize the tremendous deflationary affects inherent in a falling market, rationalizing that a negative wealth affect will completely dampen consumer spending and at the same time, import price inflation. Commodity prices are collapsing with copper, nickel, zinc, crude oil and natural gas all down substantially from their 2005 highs and the CRB near 230, its early 2003 low. Adding to the bearish overall tone is the further collapse of Residential property markets where some area’s now report no bidders, and home values down over 60% from the 2005 all time highs. In many areas, homeowners with no equity have simply walked away their properties handing back the keys and filing personal bankruptcy. As a result, while stocks crash and commodity prices tumble, bond prices rally sharply in a historic “flight to quality” move sending long term yields down to 7.80%. Nevertheless, great damage has been done, as losses from the surge in interest rates are now feared in the hundreds of billions of dollars, dwarfing the Savings and Loan Crisis of the early 1980s.

As the market collapses throughout the day, the financial crisis becomes the only news story seen on T.V. Around the world, nervous individuals head for their local banks and begin withdrawing funds. A massive bank run develops as ordinary individuals succumb to the fear of a building financial panic. At gas stations and supermarkets, supplies and shelves are almost empty, as individuals have rushed to spend money on food and gasoline. As the smoke clears for the first great stock crash of the new millennium, the stock exchange is closed, and a national bank holiday is declared. Declining asset values have impaired banking system finances with a major derivative crisis now dominating the headlines. In many foreign countries, markets and banks are also closed as the derivatives crisis has caused the global financial system to seize up. Shortly, it is announced that Federal Reserve, the White House, and the entire G-10 committee will be meeting non-stop during the banking holiday in order to broker a global “bail out” arrangement. As the ministers arrive in Washington, there is a hostile atmosphere, rife with protectionism.

Amid growing threats of riots, after 3 days, limited ATM service is restored allowing individuals to withdraw up to $100 to meet short-term needs while banks remain otherwise closed. On Day 10, amid great anxiety, the President, Fed Chair and a panel of G-7 representatives announce that the Bank Holiday is over. To stabilize the Dollar and stimulate domestic savings, U.S. short-term interest rates have been hiked by 5% full percentage points such that the Fed Funds Rate now stands at 7%. In addition, several new international bank mergers are announced, with a large Japanese bank acquiring a major U.S. Bank, and a large European Bank acquiring a second U.S. Bank. Insolvent hedge funds are unwound and merged by the Federal Reserve. It is announced that markets will soon be reopened and that the IMF Reserve Fund will be used if necessary to stabilize global financial markets by ensuring market liquidity.

As the markets reopen, strong rallies follow and continue in the months ahead. By all appearances, life returns to normal, and in time, a recovering economy and recovering markets begin to restore public confidence. Yet, unwittingly, a new financial era has just begun. The Great Stagflationary collapse of 2007 has sown the seeds for an even bigger debacle, The Greater Inflation. In the ensuing years, economies will witness the rebirth of inflation scaled to soar to levels not seen in a major economy since Germany in the 1920’s. In the 2 to 3 years to follow, inflation would rise modestly at first, and then aggressively later on. Eventually, hyper-inflation would take hold, the direct result of the Fed’s 2007 great banking bailout. Through reflation, and then, hyperinflation, debts on a grand scale would be extinguished using greater and greater quantities of currency debasement. The subject of another report, The Greater Inflation: 2008 to 2015 would pose even bigger challenges for both money management and survival.
Frank Barbera

© 2005 Frank Barbera

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