Investment Indicators from Peter George Issue No. 77

Race to Win

South African 'Pick Six'
- in GOLD and ENERGY

Peter George
Sep 25, 2006

Scripture
'I have seen something else under the sun:
The race is not to the swift or the battle to the strong,
Nor does food come to the wise or wealth to the brilliant,
or favour to the learned;
But time and chance happen to them all.'
Ecclesiastes chapter 9, verse 11

(S.1-5 for subscribers)

6. THE HELICOPTER HAS LANDED
One of the more significant events of 2006 was the arrival on the world investment scene of Alan Greenspan's successor - Fed Chief Ben Bernanke. He was sworn in on February 1. As financial challenges multiply, some have deemed Greenspan's departure fortuitous. Most of the world's economic excesses were actively encouraged under the departing Chairman's watch. The most dangerous - and potentially most damaging - was the Fed's encouragement of a recovery in consumption through the deliberate creation of a bubble in the housing market. There are therefore a host of observers who think it would only have been fair had Greenspan been forced to stay on. He could then have lived with the consequences of his actions. Nonetheless, in the increasingly sophisticated world of FIAT currency management, it may make little difference to the way things are run. Aims and objectives remain unchanged. The 'FIAT Express' is still belting down the track to its ultimate destination - the hick town of 'Hyperinflation' with its concomitant destruction of 'un-backed' paper currencies. Fortunately there is still a little time.

Known as 'Helicopter Ben' for his rash boast of being able to avert recession by dropping $100 notes from a chopper, the man stepping into Greenspan's shoes has work to do in an effort to gain respect. International markets initially struggled to 'feel him out' and get his measure. He himself tried to make his mark by attempting to create a different image. Long tainted with a reputation for being 'soft on inflation', Bernanke has been forced to disabuse those in the ringside seats of world markets by pretending to be tough. He is caught like a hare in the headlights. His every move is watched but he faces two conflicting choices.

6.1. IF HE RAISES RATES - THE ECONOMY COULD FALTER
The trick is about knowing when to stop, and if so, for how long. Led by increasing weakness in property prices, many are convinced US markets will inevitably fall. How hard remains to be seen. One analyst made a simple calculation. Every one percent rise in mortgage rates will cause property financing costs to increase by 17%. In a world of 100% bonds, the burgeoning costs of servicing debt could ratchet property prices down by a similar percentage. It has already started. Also inevitable is the need sooner or later for the US to address its deficits on the trade and budget fronts. Both are still over the top, although as mentioned above, there has arguably been a definite improvement since 2004, in the deficit on the budget front. Personal and national debt levels are nonetheless way out of kilter.

The longer both are ignored, the bigger the pain when balance returns. That would be logical, but more and more central banks give the impression of living in dreamland. They proclaim 'this time its different' and that due to 'changed international dynamics', US debt levels can continue to rise ad infinitum. America's latest Treasury Secretary, Hank Paulson, is a fine exponent of the new credo. Appropriately, the ex CEO of Goldman Sachs has a nick name to fit the situation. It is 'Mr. Risk'. Business Week described his strengths as follows:

".......the true significance of Paulson's appointment. What he'll bring to Treasury, and to Washington, is a more sophisticated understanding of risk and return....Think of Paulson as Mr. Risk. He's one of the key architects of a more daring Wall Street, where securities firms are taking greater and greater chances in their pursuit of profits. By some key measures, the securities industry is more leveraged now than it was at the height of the 1990's boom."

"Goldman, under Paulson's leadership, became one of the most profitable risk-taking machines ever built....By contrast, Robert Rubin, Treasury Secretary under President Bill Clinton, was Mr. Prudent. Rubin also came out of Goldman Sachs, but it was a much smaller firm back then...with limited access to ...public capital markets. That made Rubin far more attuned to the need to preserve and protect capital. Perhaps that's one reason why he pushed for frugality from the very moment he entered government."

Unfortunately predecessor Robert Rubin blotted his copybook by launching America's 'strong dollar policy' back in the early nineties. Succeeding administrations continued the strategy. It has caused extensive and lasting damage to the country's domestic manufacturing industry. Plants have been gutted. Factories were exported lock, stock and barrel, to China. This laid the foundation for America's out-of-control trade deficits. Unfortunately, once factories have gone, even a dramatically weaker dollar is unlikely to bring them back. Chinese workers get paid less than 5% of the average wage demanded by their American counterparts. In the process they acquire American technology for nothing. The closures are set to continue. In Africa the Chinese have adopted an even more aggressive and successful strategy. In a desperate search for raw materials they bring new investment but, in Zambia, when they open copper mines they also bring in their own underpaid, harder-working Chinese labour. From Shapi Shacinda at Reuters in Zambia:

"Any project associated with Chinese money is only obliged to contract 30% of it to domestic companies - in a country with some 80% unemployment."

From an economic perspective one thing is obvious. Either the Zambian worker is overpaid or he is totally unproductive in relation to his Chinese counterpart. It's a hard world.

Returning to America's new Treasury Secretary, Business Week described the extent of Paulson's addiction to debt.

"The appointment of Paulson, Mr. Risk, as Treasury Secretary is at once ironic and completely appropriate. According to CONVENTIONAL ECONOMIC WISDOM, the single biggest problem the US faces is a massive accumulation of debt. Both liberal and conservative economists warn that the bulging trade deficit, now roughly 6% of gross domestic product, poses a danger of sending the dollar plunging and causing a financial meltdown. The federal budget deficit for 2006 will hit at least $300billion. And current projections call for Social Security and Medicare to run up enormous deficits in the long run."

"Yet Goldman actually has leveraged up faster than the government in recent years. In 1999, Goldman had about $1,60 in long-term debt for every dollar in net revenue. In the same year, the federal government had $3,10 in debt, mostly long term, for every dollar in revenue. Today the government has about $3,70; Goldman, around $4."

"Clearly, Paulson isn't scared by debt and risk-taking. That might make him the ideal person to grapple with the US economic and fiscal situation, which is more similar to Goldman's than most economists will admit."

Paulson would rather cut taxes - accepting the certainty of a bigger budget deficit today - in exchange for a boost to economic growth tomorrow. He told German news magazine Der Spiegel last November:

"I still prefer the situation we're in to a situation without a deficit but with no growth."

There is little doubt that neither Paulson nor Bernanke are going to risk a recession by raising rates too far or too fast, but with inflation accelerating, they may have more leeway than markets think. Any 'halt' may simply be a 'pause'. As if in confirmation, latest retail figures in the week ending August 11, were far stronger than markets expected. They initially cast doubt on the wisdom of Bernanke's latest decision to pause the rise in rates. The dollar immediately strengthened against the EURO from 1,29 to 1,27. Then the housing statistics came out. They were down sharply, not yet a meltdown, but close. The EURO once again rallied back to 1,285. Finally the British published their own retail sales for the month of July - down 0.3%. With the slowdown spreading to Europe, the dollar once again rallied to 1,283. This was followed by additional evidence of rising inflation. Paulson then issued his own version of a 'strong dollar policy'. The dollar obediently strengthened to 1,268. One can almost hear the cry: "We're all in this together."

6. 2. IF BERNANKE FAILS TO RAISE - DOLLAR COULD SLIDE
With other central banks starting to play catch-up, US yields could theoretically fall behind in the race to garner foreign funds. The $65billion monthly trade deficit would then stand naked. In the absence of regular offshore inflows - from the likes of China, Japan and Europe - the American way of life would come to an ignoble end. In the absence of a resumption of personal and national saving at home, the party would be over. The dollar would fall. This in turn would lead to a sell-off in long term bonds. As prices dropped, long-term yields would automatically increase. The Fed would be forced to follow suit at the short end, paying more to borrow what they were unable to raise by way of taxes. THIS IS THE CONVENTIONAL VIEW AND THE LIKELY RESULT IS SET OUT BELOW:

The end game under any new Fed Chief can never be in question. The US will print and raise rates in tandem. In order to sustain asset markets, every effort will then be made to keep interest rates and inflation in balance, with the former marginally lagging the latter. Rates can never be allowed to EXCEED inflation by any significant margin. They may LOOK as if they are, but those in the know are fully aware that the 'PPI' books are cooked. True inflation is running way ahead of both 'official figures' and the actual level of interest rates. Truth on the budget deficit is even worse then the truth about of inflation. At a recent economic presentation by a highly trained South African economist, it was alleged that up to $500 billion a year of US spending on defence is being financed 'off balance sheet' through the printing of money. In principle this type of behaviour differs little from the Bush Administration's secret prisoner of war camps. Although in a war situation against Islamic Terrorism, both may be necessary!

6.3. AN ALTERNATIVE SCENARIO - COLLECTIVE 'FIAT FOLLY'
In order to stave off an increasing tendency for the dollar to weaken, nations exporting to the US will be content to continue to accumulate dollar holdings. Where necessary, they will print their own currencies to stave off dollar devaluation as long as possible. They will only tolerate gradual appreciation against the dollar when able to replace exports to the US with local demand. This is particularly true of China. Over the past two years precipitate predictions of an imminent dollar collapse by a string of otherwise intelligent analysts have everywhere come to naught. Neither Buffett nor Gross can dispute this conclusion, nor can the writer himself. Few realized the extent to which the process could be spun out as the international system of FIAT currencies intervened to rescue its own and keep the dollar in play.

The writer addressed the issue of a FIAT money system in an earlier article back in March 2004. His report, No.59, was entitled:

'Currencies in FIAT Folly - face Abyss of destruction'.

The writer predicted that the end result of a FIAT system devoid of 'gold backing' would be the collective destruction of all those currencies participating. In fact, all major currencies are jointly conspiring to maintain a massive fraud. Their paper is worthless and will never hold its value. Those who accumulate paper monies as a means of 'saving' will in the end suffer massive losses. The writer has increasingly been forced to acknowledge that the scheme has taken longer to implode than was originally anticipated. If all co-operate, it will certainly buy more time than the dollar deserves on its own. It has already defied the pessimists.

With the Middle East on the boil there are those, like the former Prime Minister of Malaysia, Dr. Mahathir, who unilaterally wish the US harm as a way of punishing the nation for her support of Israel and increasing hostility towards Islamic Radicalism. Mahathir's strategy is straightforward. He would have dollar holders to switch to using other currencies - the EURO, Yen and Gold - but strictly as an act of vengeance. He might as well include the Chinese Yuan as well. Unfortunately his strategy is foolish and unworkable. It serves no purpose, other than venting a personal hatred for America and desire to avenge the nation's determination to curb terrorism - a terrorism which Bush believes is being cleverly disguised as "God-directed religion".

Most dollar holders are guided by the market, not by politics. At this point a dollar crash is still not a 'given'.

6.4. DOLLAR STRENGTH DEFIES THE 'DOOMSAYERS'
The problem with Malaysia's game of spite is that competitor currencies would rather be left alone. No country fancies the prospect of seeing its currency appreciate against the dollar. Most face the lingering effects of earlier deflation and unemployment. Japan is only now beginning to escape from nearly two decades of recession. She recently risked a 'maiden' rise in rates, then regretted it as inflation figures once again came in negative. China is no different. Despite recent vibrant statistics, the country still suffers from massive unemployment in her rural communities. She is therefore desperate to keep her economy growing at a pace fast enough to absorb another 200m jobless peasants. A premature recession could threaten the rigidly undemocratic political system carried over - largely intact - from the cruel days of communism.

Europe is recovering but only slowly. She has no wish to jeopardize growth and jobs on the altar of a 'popular' and strengthening currency. Despite enjoying the highest growth since the turn of the century, French unemployment remains stubbornly high at 9%. In a recent interview with Le Monde, French Finance Minister Thierry Breton was outspoken:

"Monetary policy makers in Europe must avoid making the EURO stronger because it is FULLY VALUED...a weaker dollar is in no one's interest."

Hence the dollar defies the bears. Only gold is theoretically free to run but even here there is an undeniable threat of clandestine sales from the IMF. Meantime, look at a 10-year chart of the EURO in terms of dollars.

The last three years have traced out a potential 'head-and-shoulders' pattern - not for the dollar, but the EURO! In the event of dollar strength, the picture suggests the EURO could fall sharply from its current 'right shoulder' peak of $1,29, back down to $1,05, a level last seen in early 2003. The latest Islamic terrorist attempt on London Airport, pulled the EURO back below $1,28 and briefly hit commodity markets. The affect could be temporary. Return of strength might well lead to a break above $1,30, back up to the December 2004 all-time high of $1,36. It is too close to call with certainty. EURO strength appears more logical but German growth remains problematic whereas US growth - with the exception of housing and domestic autos - appears relatively resilient. The IMF is predicting a dollar decline of up to 35%. The size of the trade deficit logically suggests a 50% crack will ultimately be necessary, but one no longer lives in a logical world. The manipulative dexterity of Greenspan changed the rules. Time will tell whether the shift is here to stay. Most doubt it, but all could be wrong. See the ECU-$ chart below:

Note the 'Head-and-Shoulders' formation, marked with S,H, and S. Observe the dotted 'Target line' T at the 1,05 level. At this stage such a dramatic decline in the EURO is no more than a remote possibility but one cannot totally exclude it.

6. 5. DOLLAR INDEX - GLOOMIER PICTURE THAN THE EURO
Instead of comparing the dollar with the EURO, take a peek at a chart of the dollar 'index' on the page that follows. The 'index' is composed of a basket of major currencies, ranked in terms of each country's relative size, back in 1973. The EURO still comprises a substantial 57% weighting, but the chart presents an 'inverse' picture. One is effectively turning the EURO chart upside down, and tacking on a further ten years of history - long before the EURO came into being as a single currency. A 20-year chart of this index is set out below. Some interpret it as spelling imminent danger for the dollar. From a peak of 120 in early 2002, the dollar index briefly touched 80 in late 2004.

A glance at the chart will show the extent to which the '80 to 85 range' has served as a major base for the past 20 years. Currently trading around 85, a break below 80 would register an all-time new low and trigger a crash of major proportions. For this reason it may never be allowed to happen. It is certainly NOT in the interests of America's trading partners to allow it to happen.

Should the 'Danger level' hold and form a base, it could once again serve as a springboard for yet another dollar rally.

7. OUTLOOK FOR PROPERTY, BONDS AND EQUITIES
What does a sophisticated FIAT system mean for world markets? It spells a trimming of growth. It will probably bring back STAGFLATION. However, it DEFINITELY REDUCES the risk of recession. Because collective 'printing' is guaranteed, interest rates will more than likely rise in tandem, but the moves will be interspersed with periods of weakness. Initially the pace could be slow and of little concern to investors. Gradually rising rates will be used to tamp down growth in an effort to slow inflation but, on balance, inflation HAS TO RISE. Central banks cannot allow economic growth to stall. To do so would tip the world into recession, if not depression and a debt crisis. Borrowing levels are too high to play 'old-fashioned games' like imposing financial discipline. It's too late and too dangerous. So they say.

Even with interest rates and inflation rising in concert, certain industries will nonetheless feel the heat. The US housing market is particularly vulnerable. Bonds may enjoy a brief respite in a slowdown but longer-term are sure to crash. Bill Gross of PIMCO is calling for a short-term three-year 'bull market' in bonds - then never again. It may be shorter than he thinks. Even if rates are cut to stem a slide into recession, the long-term inevitability of returning inflation could scare investors away from any long-lasting love affair with bonds. The US Treasury recently re-introduced offerings of 30-year bonds. It's the first time they've felt confident enough to do so since September 11. Are they 'FATHER CHRISTMAS'? The writer wouldn't touch them with a barge pole. We will look at them later. The long term downtrend has reversed - except for a 'goodbye kiss'.

7. 1. HOUSING HEADS FOR THE HILLS
If the bursting of the housing bubble is carefully controlled, participants might learn to share a sense of identity with frogs in boiling water. House prices could even rally, as rates are temporarily cut before inflation accelerates again. However, the market will gradually and inevitably meet the countervailing force of rising interest costs to service bonds. Over the medium term it's probably safer to use every opportunity to reduce one's exposure to property. The chart of US REITS (Real Estate Investment Trusts) remains intact, but the 'Dow Jones Home Construction Index' has fallen nearly 50% in the past 12 months. This does not bode well for the US housing market. Leading luxury home builder Toll Brothers suffered more than most, its shares down 57% since July a year ago. For the fourth time since November 2005, they were forced to slash the number of homes they expect to build. The company attributed the downturn to:

'an oversupply of homes on the market as speculators try to unload their investments and potential buyers sit on the sidelines waiting for better deals'.

Compared to the same period a year ago, the company shows new orders down 47%, value of contracts down 45%. In major markets - like Washington D.C. - inventories of homes for sale have almost doubled in a year. Clients are canceling contracts. Builders are walking away from options to purchase land. Chairman Robert Toll explained why this time the reasons were different, and therefore more threatening:

"It is the first downturn in the 40 years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors. Instead, it seems to be the result of an oversupply of inventory and a decline in confidence."

In a similar report, America's biggest home-builder D.R.Horton, told of declining orders and outright cancellations. The dramatic slowdown is not confined to the luxury market. It has spread throughout the country and across all income groups. See the chart of home-builders below, down from 1150 to below 600 in 12 months:

7. 2. INTERNATIONAL BONDS FACE A SIMILAR FATE
Long term bond prices will follow property. Both face slow strangulation as inflation and interest rates gradually and inevitably ratchet higher. For now, and very temporarily, markets are being schmoozed by soothing sounds from the central banks. One exception to rising long term rates might be South African bonds, but not just yet. They could see one, two, or some say even three fifty-point rises in the next six months. For reasons discussed later, temporary weakness in the Rand may persist for another month or so, before the long term bull resumes. South Africa's currency is inextricably linked to gold and the metal remains locked in a corrective phase which may still take a short while to play out. Gold's prospects will be addressed separately. Meantime, study the chart of US Bonds below. It does not look good. The long term downtrend has definitely broken. Yields on US 30-year bonds look set to rise. Observe the line chart BELOW. From 5% at present, rates could target between 6% and 7% over the next 24 months.

After studying the 'line' chart ABOVE, check the 'point and figure' chart BELOW. All 'upside counts' point towards 6,75%, and higher - probably within the next three years.

7.3. EQUITIES DEFY THE PESSIMISTS
The Dow peaked at an intra-day high of 11,750 in January 2000, crashing to 7,200 by end 2002. Since then international 'rallies' in all world markets have pushed far higher than many dreamed possible. Analysts were too gloomy - the writer included. In the interim, equity 'bears' switched to gold and energy stocks which largely kept pace with the bounce in the Dow, in most cases exceeding it. Despite widespread sighs of relief from the general body of investors, industrial and financial shares still face uncertainty. Unless the Dow rapidly posts new highs - pushing up from a current level of 11,500, through its 'year 2000 top' of 11,700 - the bear could return with a vengeance. Despite these risks, in a 'FIAT' environment, markets might surprise to the upside. A friend reminded the writer that in the German hyper-inflation of the 1920's, stock prices soared. That was money-wise. In REAL terms they lagged. Expect a repeat.

There is also the possibility of something unusual happening on the energy front, as discussed in Section 3. This would enable the US to replace imported oil and gas with either a nuclear-driven 'hydrogen economy', a modified form of ethanol, or an entirely new source of energy. Shell has big hopes for turning American oil shales to good account - but not until 2018. Then there are the much vaunted latest 'finds' in the Gulf of Mexico, discussed earlier. Failing that, the US faces an eventual 'day of reckoning'. It must address its twin deficits - both on trade and budget. When that happens, required spending cuts could trigger a prolonged recession. Inflated earnings would then fall across the board as rates rise, consumption shrinks, and savings recover. The nation's debts verge on insanity and the history books are replete with tales of woe from those who sought to defy a simple truth:

Initially it requires tough financial stringency, failing that bankruptcy. Neither is pleasant. There may be selected international equity markets that beat the odds. South Africa's 'All-Share Index' has already made a new high. For most, in the absence of printing, the writing would be on the wall. The best option might be 'stagflation', leading to an extended period of marking time but going nowhere.

Observe the Dow chart below. Failure to push through 11,700 will leave us with a 'DOUBLE TOP'. Once rebuffed, the Dow could head back down to the late 2002 low of 7,200, even lower. It might be safer to look elsewhere than general equities although listening to the commentators on CNBC makes it hard to be 'bearish'. Certainly the economy is holding up far better than expected, given the growing weakness in housing and autos. Maybe the rest will compensate? The writer would rather be in gold and energy stocks. The former will outperform in times of crisis, be they debt or inflation. The latter will outperform because oil supplies are reaching an all-time 'peak'.

8. GOLD AND ENERGY STOCKS LOOK BEST
Given widespread central bank consensus to maintain the 'economic status quo', the alternatives are limited. Inflation will continue to rise - albeit in fits and starts - so will debts, unless major efforts are made to balance budgets. It won't happen overnight.

8.1. AN AVERSION TO DISCIPLINE
Meantime, the public is adamant and politicians oblige. Both are anxious to avoid the unnecessary pain of unwanted financial discipline. There are parallels in the field of education. A while ago an incident took place in New Zealand. Two Chinese children were beaten to death by their parents. The nation erupted in uproar and insisted the government ban parental discipline involving corporal punishment. It was an 'over-the-top' reaction, fully understandable yet completely unbiblical. In all likelihood they will throw the baby out with the bathwater. For subscribers who think otherwise, there are two quotes from the Book of Proverbs. In chapter 13, verse 24, it says:

"He who spares the rod, hates his son."

In chapter 29, verse 15 the words are even more explicit:

"The rod of correction imparts wisdom."

In the international economic arena old-fashioned, well-tried remedies, appear equally daunting. Yet the long term consequences of refusing to accept financial discipline will likely be hyper inflation, combined currency collapses, debt crises and an eventual return to a gold standard as the metal resumes its monetary role. Even without the initiative of central banks, people will seek out gold in a desperate bid to protect their savings. In the interim, and for the next 5 to 10 years:

Commodities and commodity stocks offer a form of 'safe haven' for those wishing to protect their purchasing power. It applies as much to COUNTRIES wishing to preserve and protect the real value of paper currencies making up most of their foreign exchange reserves, as much as it does to individual investors. The actions of major dollar holders like China seeking to build up stocks of raw materials from copper to gold - even bidding for entire companies - will be emulated by the man in the street.

The insatiable demands of China and India combined with an American refusal to tighten the nation's belt, spells increasing shortages and rising prices in the longer term and across a wide spectrum of raw materials and precious metals.

Historically the problem would have been handled differently even if the medicine was highly unpopular. A recent article in the London Times described what happened fifteen years ago in the UK:

"Norman Lamont, Britain's Chancellor in the '90s, was flayed on the altar of public opinion for saying that rising unemployment was a price well worth paying to squeeze inflation out of the system. It was anathema, of course, but economically gold-plated - and the difficult decisions made at the time helped Britain eventually to enjoy its longest period of sustained growth in the past couple of centuries. For the Fed, and the world, a recession may be the price that now needs to be paid to avert a longer-term catastrophe."

The logic of the above argument is unassailable. The real question is whether the Fed has courage enough to act? It is doubtful. The imminent bursting of the property bubble would cause too much pain if allowed to proceed unchecked. Instead, whatever the shortfall in demand for credit, the Fed will likely choose to counterbalance any deficit in spending via the printing of money. It will undoubtedly drive the final nail into the coffin of central bank schemes to suppress the price of gold. The balancing act between inflation and growth must draw to a close. From hereon out, it's 'print or collapse'. Many predict collapse. The writer is convinced the Fed and US Treasury deliberately cancelled the publication of information on M3 money supply figures because they have chosen in advance the softer option. They intend to print whatever is necessary to sustain the US economy. Internationally, fellow central banks will follow suit.

As inflation takes off, nervous savers will increasingly dump the FIAT system and withdraw. Within the foreseeable future, no cautious investor will forego an opportunity to divert a minimum 10% of available funds to holding physical gold. Thirty years ago no conservative Swiss Banker would have dared construct a portfolio without a significant investment in the metal. Those days will shortly return except this time, the practice will become widespread. It won't just be the wealthy who participate. The man in the street will follow.

More follows for Subscribers:

The full report is 66 pages and includes further anlysis of gold and international politics as well as 6 specific recommendations on Peter's top South African gold and energy stocks.

Included is an update on Randgold (RANGY). You can find out more about becoming a SUBSCRIBER at Peter George's website. The address is:

www.investmentindicators.com

Sep 22, 2006
Peter George
tel: 021-700-4880
cell: 082-806-3147
Contact

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