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All right, so what's the plan?

Richard Russell
Dow Theory Letters
Posted Jun 22, 2005

Extracted from the June 15, 2005 edition of Dow Theory Letters

THE SYSTEM - My civil engineer father taught me always to think in terms of the fundamentals. As a matter of fact, I don't trust any other way of thinking. Here are a few fundamentals that come to mind.

The monetary system we're living under is basically run by the Federal Reserve System. The Fed operates on the basis that average yearly inflation of 2 percent is necessary in order for the system to function. Anything substantially under 2 percent inflation frightens the Fed because with the enormous amount of debt built into the US system, even the suggestion of deflation could trigger a major emergency. Once deflation gets a grip on the nation and in the minds of consumers, psychology can change, consumers will wait rather than buy, and deflation can take on a life of its own. Thus, we come to my old thesis that I haven't written about in quite some time.

The current system demands that we cannot contract or correct - we must "INFLATE OR DIE." You and I as investors, consumers, and survivors (we can be all three) must figure out a way to deal with this system, a system where inflation is a given, a fundamental fact of life.

But now for the first time, something new has been added. China, India and Asia have suddenly entered the global economy, and they confront us with a huge disparity in wages, an enormous, willing work force, and steadily rising skills and technical know-how. Plus, I should add, a fierce work ethic almost unknown in the US and Europe today. Asians don't work for the good life or for luxuries, at this stage of history, Asians (China, India, Asia) work for three meals a day to survive.

The arithmetic in the new global economy is ominous for the west, living as we do under capitalism. And the question arises - how do we survive? How do we survive when one-third of the world is willing to work for a fraction of what we are willing to work for?

The answer is clear, at least it is to me. The earth's economy will "flatten." The standard of living in the West will decline, while the standard of living in Asia will rise. There's going to be what I call "the great equalization." At first it may be subtle, almost invisible, but in due time it's going to burst out into the open. It has to. To my mind, what I say in this paragraph is as sure as two and two equals four.

Currently, the US's so-called "prosperity" is living on the rest of the world's savings. The US needs $2 billion a day of the rest of the world's savings in order to "keep going," and in order to sustain our very high standard of living and consumption. This weird situation is unsustainable, it cannot and will not last.

The disparity must show somewhere. Ultimately it will show up in the form of a weakening dollar. But right now it is showing up in the systematic loss of our manufacturing base. If you've got a manufacturing business, in order to compete today you have to do some, and maybe all, of your manufacturing in China. If you have a service business, you have to at least be thinking about farming out some of your business to India.

This is capitalism in action. Under capitalism you either produce at a profit or you go out of business. And in today's highly competitive atmosphere, you must produce at the lowest cost possible.

After I graduated from college in 1948, I worked for a few years for a very successful textile company. And I can remember the boss fighting like mad to obtain the lowest price possible for our basic goods, which were untreated cotton cloths. The following is something every manufacturer and retailer knows. The money is not so much in the selling price of your merchandise, it's in how low you can buy your merchandise for, or how low the cost is of manufacturing your product. The profit is in the low buying and manufacturing costs, not the selling price. Buy or produce your item cheap enough and you are on your way to making a profit (think Wal-Mart).

Now let's return to your problems and my problems. Our problem is what to do, how to survive in this "new global world." I'm 80 years old. I've saved all my life, I live frugally, I wear black jeans and black T-shirts 90 percent of the time, I own my home free and clear, I don't have many expenses because I've given up traveling, and I don't ride a motorcycle anymore. My biggest expense is that I like to go out to dinner a lot, but I go to modestly-priced restaurants, and I usually skip the wine and the desserts. So I'm OK, because I'm a very modest spender.

All right, so what's the plan? At this time we have some problems. Stocks are expensive today, and they don't hand us much in the way of dividends. You may not believe it, but back 40 or 50 years ago people used to buy stocks for the dividends. You mentioned a stock to your friend, and his first question was, "What does it pay?" I guess my old-timer subscribers remember those exotic times.

Today stocks don't give us much in the way of return; therefore, people buy stocks for appreciation and "growth." Now the question people ask is - "Will it go up?" And my answer is, "Look, stocks are expensive today. The average price/earnings on stocks today is around 20, so who the heck knows if it will go up?" And that, I'm sorry to say, is the correct answer.

My recipe for today's investing problems is that we have to save, we have to buy securities that throw off interest or dividends, and we have to fully understand the "magic" of compounding. I've been talking about income and compounding ever since the primary bear market started in late-1999, and I haven't reversed my stand on this yet.

There's something else we must understand. Do you remember a few years ago when everybody talked about "those 1.3 billion Chinese" as a giant source of demand? We were going to sell the Chinese anything and everything. I warned at the time that the Chinese would be a source of supply, not demand.

With the entrance of China, India and Asia into the global economy, there's now too much of almost everything (except oil) being produced. This is basically and fundamentally deflationary. The central banks know this, and to offset these deflationary forces the central banks have resorted to what they do best - creating oceans of paper money.

How do we protect ourselves against this ocean of ultimately worthless paper? We do it by trading in a portion of our paper for real wealth. That "real wealth" is called gold. And while the central banks' printing presses continue to work overtime, I'll add silver to the equation.

Silver - daily

The latest correction in the precious metals and precious metal stocks may now be coming to a close. Maybe you can see it in the chart above, which is a daily chart of silver. And maybe you can even see it in the weekly chart of gold, below. Note how MACD is just beginning to turn up. Note that RSI is also turning up. Note how gold has held just above its previous reaction low.

Gold - weekly

The precious metals, I believe, are being carefully and quietly accumulated. While the retail public is piling into high-priced housing, I think big money, sophisticated money, is accumulating gold.

But shhhh, don't tell anybody - aw, they wouldn't believe it anyway, so go ahead and tell them.

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Richard Russell
website: Dow Theory Letters
email: Dow Theory Letters

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