Since we last talked of the forces coming together to create a Super Cycle in Gold that will carry to $1,257 Gold a number of factors have converged in time nicely to bolster the position and prospects of Gold investors. Before progressing, let us note that our optimism is primarily aimed at Gold bullion/coins as the Gold stocks appear to be well ahead of the fundamentals, though that discussion is for a different time. What more could Gold investors want? We have (1)U.S. inflation bottoming, (2)a leaderless Federal Reserve, (3)a currency that has peaked, (4)hedgers and shorts finding themselves in a difficult situation growing worse by the day, (5)a U.S. Housing/Mortgage Bubble about to pop, (6)another step in the Pan-Eurasian Islamic War and (7)Gold trying to take out the previous high. Not yet a 12-step program, but certainly enough steps to appease most discerning investors.

Let us ask the question one more time. What more could Gold investors want?

The first chart, U.S. INFLATION SITUATION, shows recent developments on U.S. inflation. As we have discussed before this graph has two inflation series plotted. The first, indicated by the squares, is the Naive CPI released by the government each month, and used by the Federal Reserve to rationalize their policies. The second is the Median CPI produced by the Federal Reserve Bank of Cleveland. This latter measure is probably a better measure of the central tendency of U.S. consumer inflation.

Let us first note that the Naive CPI, on a year-to-year basis, appears to have put in place what most would consider a double bottom. Second, that measure has moved above the most recent short-term high. Were this series to be a stock we would conclude that a bottom has been put in place and that it is likely to move higher.

The Median CPI, the preferred measure of U.S. inflation, continues to run well above the Naive CPI. As reported previously the difference between these two series can be used to create buy and sell signals on the Naive CPI. Buy signals continue on the Naive CPI, and we expect it to move materially higher.

That the U.S. central bank, like so many around the world, has less than exciting and inspiring leadership now seems fairly obvious. Discretionary and visionary monetary policy, as practiced by the Federal Reserve, was not too many years ago billed as the "vaccine" against all economic ills. Rather than a "vaccine," contemporary monetary policy seems no more than another discredited theory. Certainly the divinity of the practitioners is no longer considered dogma.

We need only look around for examples of the failure of monetary policy. The Japanese stock market is around a 19-year low, and off about 80% from the high. The U.S. stock market bubble has burst. Down about 80% from the high the NASDAQ 100 has demonstrated the "new" economy had, like Microsoft products, more than a few bugs remaining to work out. Most of us will never see the NASDAQ indices recover to their highs in our life times.

During a past century Jackson Hole, Wyoming was a favorite gathering place for desperadoes, bank robbers and other undesirables. For that reason a meeting for the purpose of assessing the success of the Federal Reserve would seem to be appropriately located. Recently it was the location of a meeting of the best and brightest of the formulators of U.S. monetary policy with the intent of recounting their successes.

The Chairman of the Federal Reserve reviewed their actions during recent years. According to reports, the Chairman claimed the reason the Fed did not act to halt the stock market bubble was that the existence of a bubble was not certain. Further, that had they acted to halt the bubble a recession might have developed. How to response to such utter nonsense without being tacky? As Thumper's father said, "If one can's say nothing nice, don't say nothing at all." All that probably can be said is that every man has his day, and sometimes that day has passed.

The great news in all this ineptness is that the Federal Reserve does not yet believe a Housing/Mortgage Bubble exists in the U.S. With that view on their part we probably are safe in assuming that a U.S. Housing/Bubble does indeed exist, it will certainly pop and the U.S. economy will plunge into a deeper recession. Few forecasting sources are as valuable to an

investor as one that has developed a tendency for being consistently wrong on major matters.

The graph titled U.S. MORTGAGE APPLICATIONS contains two series. One of those is real transactions, relating to the purchase of actual houses. That line is the squares and uses the right axis. Another line is made up of circles and represents mortgage applications to refinance existing mortgages. These transactions are not real, but are simply the swapping of financial paper.

As is readily apparent, mortgage applications for real housing transactions peaked last year. That development is showing itself in the lackluster trend in real housing transactions. Data from the National Association of Realtors indicates that the sale of single family homes remains below the level of August 2001, prior to 9/11.

Prices are also showing some deterioration. Of the four geographic regions on which the NAR reports, median prices in the West are at the lowest level since March. In the South and Midwest median prices are at the lowest level in three months. Only in the Northeast are median prices still rising. Is the air starting to leak from the bubble?

Weakness in regional housing prices is showing through in the momentum of national housing prices. A graph, U.S. HOUSING PRICES Y-T-Y CHANGE, shows the declining momentum in the rate of change in U.S. housing prices. Remember that a change in momentum always precedes a change in the absolute measure. Trend lines have been added to that chart to aid in monitoring the breakdown of momentum.

The net worth of U.S. households has fallen below the level as the end of 1999 due to the collapse of equity prices. Now U.S. households face the growing risk of a drop in housing prices and a further reduction in their net worth. How will they respond to the double whammy of stock and housing prices falling? Will they keep spending? Are defaults on mortgage debt likely to rise? Are the bonds of mortgage financiers as secure as many believe? Are Fannie Mae and Freddie Mac truly immune to economics?

Much like the stock market bubble most of what is going on are financial transactions with little connection to real activity. What connection that exists is that the refinancing has put extra cash in the wallet of consumers, which they have spent. Like all "pseudo" economic activity a limit exists to this false economic boost. According to the BIS Quarterly Review, September 2002, 92% of mortgage backed securities had coupons over 7% at the end of 1997 while only 26% currently fit that category now. The edge of the economic cliff is coming and Greenspan Bubble II is about to meet its fate.

The consequence of all this pseudo economic activity is that an economic cliff is approaching. Falling over that cliff is the destiny of the U.S. economy. A second more serious recession is coming and the U.S. dollar will be one of the casualties. A sound economy is built on real economic activity not swapping financial paper.

Space precludes a discussion of interest rates and the complex dynamics of the bond market at this time. The collapse of equities and the mortgage bubble are creating a bond bubble. Bond prices are at great risk at the present time. Owners of government debt can not expect to win. Some of today's investors believe that government debt is a safe haven. History shows this to be a completely wrong headed view.

In addition to the pressure on interest rates from a collapsing dollar and the mortgage bubble popping is the need to finance the War. While many issues relate to the War, one that cannot be avoided or argued is the cost. Wars cost money, some for the shooting and some for the occupation. Estimates suggest that Iraqi Conflict II costs will run in excess of $100 billion per year. In the graph, U.S. GOVERNMENT DEFICIT, is the current and projected minimum U.S. government deficit.

The current U.S. government deficit is running in excess of $400 billion. Because of the creative accounting used by the government only part of this amount is reported to the public. A good portion is hidden in the Social Security "Trust" Fund. By the end of next year the U.S. deficit could be running at over $600 billion. The size of the deficit may be rising to the level obvious even to those wearing economic blinders.

The list of choices for financing this deficit is really quite short. The money can be borrowed, the Federal Reserve can monetize it or the debt can be sold to foreign investors. In recent years the U.S. has relied on foreign investors to recycle the current account deficit back into U.S. government and private debt. That the U.S. can rely on foreign investors to finance the deficit is a dangerous assumption. If the dollar, pictured in the graph U.S. DOLLAR, continues to act like it is in a bear market they may be reluctant to provide cheap debt financing.

The consequences of this financial dilemma are generally not good. If foreign investors grow reluctant to recycle the current account deficit back into U.S. debt the dollar's value will fall and interest rates will rise. If the Federal Reserve monetizes the debt a greater risk of inflation and a lower dollar will follow. Again the potential for higher interest rates arises.

Higher interest rates would further collapse the Housing/Mortgage Bubble hastening the arrival of deeper recession in the U.S. These events all lead down one road, one that leads to serious economic problems in the U.S. The path to a lower dollar seems inevitable, as the Federal Reserve seems to have painted itself in a corner. A lower value for the dollar and a higher dollar price for Gold now seems inevitable.

Investors, given all the media coverage, certainly can not forget the coming event in Iraq. The coming event is however only another Battle, Iraqi Conflict II, in the long running Pan-Eurasian Islamic War. Consuming some more space on the coming Battle might be interesting. Jumping to those conclusions that are reasonable regardless of the results of the coming Battle would be most productive.

U.S. forces will occupy Iraq for some time after the Battle ends. Little argument seems to exist over the likelihood that U.S. troops will be there for a long time. The costs of that occupation will be part of the higher deficit that is coming. A financial burden of material size to the U.S. does now seem inevitable.

The widely accepted presumption is that materially lower oil prices will persist into the future after the end of the Battle. Such a view just might be overly optimistic. Many times the troops were to be "home before Christmas." Conjecture on the direction of oil prices after the Battle begins, and ends, are all uneducated guesses more akin to picking a lottery number. Combining the forecasts of the Pentagon and Wall Street analysts, contrary to most such combinations, does not generally result in a higher information coefficient. In short, we know not the likely path of the war and therefore do not know the likely path of oil prices. What we do know is that uncertainty is higher and that the risks of something going wrong will be higher.

Faced with these uncertainties and the horrendous U.S. bear market, investors are shifting massive amounts of money into bonds. Not since NASDAQ 5000 have so many investors pursued an investment with so much money. Investment disappointment is again the probable outcome of this herd like shift. The U.S. bond market is not a case of if something goes wrong but rather when something goes wrong. An alternative to this bond binge does exist, but the sales forces on Bay and Wall Street can not seem to find a way to make outrageous fees on Gold. Charging fees for making money for customers would seem to be more desirable than charging fees for losing money.

Gold continues to be the better choice among the investment alternatives, as our last graph demonstrates. However, too many investors are not differentiating between Gold stocks and Gold. Gold stocks are not Gold. Gold stock mutual funds are not Gold. While that is not a new message, many investors have not yet discovered Gold. Gold's current superlative performance is likely to be a trend that will persist into the future as the foundation for Gold's appreciation is now well documented.

In closing, we note that Gold stocks have under performed Gold for four months, after reaching an over valued level relative to Gold. The matter of Gold stocks under performing Gold will have to await our attention till a later set of comments. Investors need to explore why Gold stocks are under performing Gold. Additionally simple tools to avoid the "Gold stock" trap would be helpful. While Gold stocks have substantially outperformed most equities, the recent inability to out perform Gold itself should be a concern to all investors.

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Ned W. Schmidt,CFA,CEBS publishes THE VALUE VIEW GOLD REPORT, a monthly review of the developing Gold Super Cycle. His major report, "$1,245 GOLD", 150+ pages with 70 charts and graphs, is essential reading for investors wanting to understand the coming Gold Super Cycle. A Media Special is being offered which includes both for a substantial savings, or only $99. This offer can be ordered by contacting Ned at nwschmidt@earthlink.net or by clicking on this button.