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Edinburgh Seminar April 29, 1997 Transcript

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Princeton Economics International, Ltd.

Edinburgh Transcript

April 29, 1997



I would like to begin today with a brief overview as to how we at Princeton look at markets. For those of you who attended last year’s conference I will try to be as brief as possible.


Effectively, our models are based upon world capital flow movements.  This is very important to understand because often politicians and the media confuse capital flow movements with the issue of trade. In reality trade accounts for less than 10% of world capital flows. Most people are shocked at this figure, but it is true. For example, if you consider the Nippon Life company in Japan. If they decided to buy US government bonds and moved just a portion of their portfolio in that direction currently that would equal approximately 15 years worth of trade deficits. The amount of capital that is actually out there today, particularly on the investment side, really dwarfs all the trade numbers. Politicians prefer to discuss trade because it makes them sound like they know what their talking about and the statements always make the press. However, it really has nothing whatsoever to do with forecasting the global economy. If you take the US and Europe in terms of trade, Europe means almost nothing to the US. Mexico and Canada are the bulk of the US trade market. Yet when you look at the same comparisons on a capital flow perspective, Mexico means nothing to the US. Mexico doesn’t buy US bonds, real estate or equities. So it depends upon your focus. If your focus is going to be trade, then I guarantee you are going to get the currencies wrong about 95% of the time. Another important aspect that I think is also creating this global trend towards rising volatility (our computer models show that the rising volatility will not peak until 2003) is that we have not dealt with the ramifications of the last major change in the monetary system back in 1971. At that time we returned to a floating exchange rate system. We are just now beginning to see some politicians in various governments beginning to listen to what we are saying. I gave a lecture in Japan in March and I was quite surprised when the Nikkei Shimbun turned my lecture into a three day series in their newspaper. I believe that the basis of my lecture in Japan was quite important. If you look at the US/Japan trade account for the last quarter you see that the Japanese trade surplus rose 17%. Immediately after the numbers were released the newspapers said that Japan was recovering, etc. However, if you asked a Japanese company if they sold 17% more cars they will tell you absolutely not. In fact they sold 1.5% fewer cars and they are laying off employees. You get two completely different pictures.


The reason for that is the core concern that I have about EMU. This extends back to the mistakes that governments and politicians in particular made when we went to a floating exchange rate system. Today trade is calculated by simply measuring the amount of money going back and forth between countries. We do not have people standing at the ports counting every Toyota that comes off a ship. Consequently, the statistics are formulated merely by looking at capital flows. Now that system did make sense when we were under a fixed exchange rate system because the value of money could not change. Therefore, if you sold $10 billion more to the US from one month to the next, obviously it had to include more goods. Under a floating exchange rate system this is not true. If you look at the controversial trade account between the US and Japan you find that the yen declined by 20% while the trade surplus rose by 17% which showed that they actually lost 3%. The volatility in foreign exchange has become excessive, as we all know. The accounting systems that we had in place prior to the floating exchange rate were all based on the fixed rate system. Virtually every economic statistic that is used today is effectively wrong for this very reason. To make matters worse we have a huge problem in that the statistics that governments put out are either inept or intentionally, politically manipulated. I have been giving lectures around the world for a long time warning people about the problems with the CPI. Often people ask me why I am the only person talking about the problem if it is really as bad as I make it seem. They wonder why the press doesn’t bring these facts to light. I think this example will give a good answer. In 1985 the Chief Financial Editor of the New York Times, Hy Maidenburg, came to my office. I spent an entire day with him discussing the various government statistics and explained clearly to him how they had all been politically manipulated. Even the GDP figures are a good example. When calculating GDP most governments count government employees twice. If you analyze the numbers you will find that total government spending is calculated into GDP and then on the private side they include total personal income. When 1/3 the civil work force is employed by the government, then one of those figures should be backed out of the formula. When we brought these errors to the attention of the appropriate office in Washington and asked them to tell us where these numbers were being taken out of the formula, they couldn’t answer our question and hung up on us. At that time Mr. Maidenburg was around 62 years old, he left my office and said that it was the best story of his entire career. He called me the next day and said that he couldn’t run the story because they paper said it was too controversial.


I received a phone call from Bloomberg last week here in London.  Apparently a report came out of Washington on the Commerce Dept. statistics showing that they were full of mistakes and completely inaccurate. Bloomberg asked me for my comment to the story as I had been the lone voice saying that the statistics were inaccurate. I said that I didn’t really have a comment. I have been saying that the numbers are completely wrong for so long, it was only a matter of time until someone else noticed. They asked if I believed we should have a new independent agency to put all the numbers together. I stated that it would be a step in the right direction, but then we would need to do the same thing on a global basis. GDP numbers are calculated differently in all countries, yet we still compare the statistics.  So in my opinion this is just one factor that is increasing volatility. One statistic comes out saying that inflation is falling and traders buy the bonds and then the next day another number comes out and bonds fall again. The numbers are confusing everyone. As I have seen from portfolio managers around the world, everyone is constantly shortening their horizons. No one has 30 year positions any more. I just gave a lecture in Zurich where I was discussing the end of 1998 and someone in the audience said that was too long-term and he wanted a three month forecast. People don’t even want to look at a one and a half year forecast any more and this is a dangerous trend. I believe it is largely the economic statistics that are contributing to this trend. As I have mentioned in my previous lecture here in Edinburgh, the CPI has been revised fourteen times since 1980. Again, many people have asked me why I am the only person discussing these previous CPI revisions. It is now interesting to note that the latest proposed revision to the CPI is finally making headlines around the world. I have been getting phone calls from people who were very skeptical of my speeches a few years ago now saying that they understand. Greenspan has been testifying before Congress saying that inflation is overstated and should be cut in half, while at the same time he has been raising interest rates saying that the marketplace is too exuberant. Why has he done this? On the one hand you have Greenspan the economist and on the other hand you have Greenspan the politician. It is easier to manipulate the CPI of any country than it is to tell the people that they are receiving too much money from entitlement programs. No Republican or Democrat in the US would attack social security payments directly because they know they would never be re-elected. Accordingly, it is much easier to simply cut the CPI in half and thereby reduce the indexing of all entitlements in the system.


We at Princeton decided to put together our own US CPI index for our clients.  We are simply going to use the individual state indexes. It is very interesting to note that last year New York’s CPI was 7.5%, New Jersey was nearly 7% and Pennsylvania was almost 8%. I would like to know how the Federal CPI can be 2.5% while at the same time the individual state CPI’s have been running at 7.5% on average. This comparison has very important implications because it has fueled the debate as to whether long-term rates are too high relative to real inflation and whether they should come down. I argue the opposite. The only forecaster or analyst that is never wrong is the marketplace itself. If long-term bond rates have been hovering around 7% for years and they can’t come down, the market is right and the indexes are wrong. If real inflation was in fact 2.5%, then long-term rates would indeed stand at 3.5% to 4% but they have refused to fall much below the 7.5% on a sustainable basis. If you look at the individual state CPIs you will find that the market is correct. The Producer Price Index has been running at around 7.5% federally for the last two years in a row. When these announcements are issued we often hear the term “excluding food and energy”. Well food and energy happen to make up 1/3 of a person’s cost of living. The CPI index in the US contains over 80,000 items. Naturally if you want to lower the volatility of an index, you increase the items being calculated. If you look at the core items in a person’s living expenses, you find they are all running well over 2.5%. The property taxes on our Princeton office last year rose 18% in one year. It’s a good thing the CPI isn’t running at 20% because our taxes probably would have rose 40%. We find that tax rates have been rising far above the CPI and, in fact, taxes are running at over 700% just since 1985.


All these things are combining and I think they serve as a good illustration as to our concerns regarding EMU. I think that EMU probably represents one of the single greatest threats to capital investment around the world and, again these concerns are not being taken into consideration. We saw the same thing happen in 1971 when we moved to a floating exchange rate system. The politicians just wanted to institute the system and said they would work out the details at a later date. The accounting systems have never been changed and that is the reason we are seeing the current trade arguments as I stated earlier. So there are many aspects which must be considered. I met with one top G7 official in Zurich a few weeks ago. I can tell you that they are extremely concerned. They have been given a gag order from the politicians. They are not allowed to speak their minds publicly. One of their biggest concerns, which hasn’t even been considered yet, is what happens to the central banking system. Currently every central bank holds a reserve currency of various countries. When you create EMU, what happens to these reserve currencies? You effectively eliminate the vast majority of these individual European currencies as reserves. You then create only one reserve currency for EMU, which is going to be the US dollar. We are trying to help one of the banks at the moment to see if we can place a position with one of our institutional clients in Japan. They need to sell $12 billion worth of yen and convert it into dollars. I have seen some newspaper saying that the dollar should go down because the net amount of dollars needed when you unite a central bank will be less. That may be true, however, they are not talking about all the reserve currencies that have to be sold in the meantime. So what you end up doing is creating a single reserve currency which will be the US dollar.  This in turn is one of the biggest problems that I think exists and it exists also for the US. When I get back to the states I have been requested to return to Washington to explain some of these problems because the US hasn’t yet begun to consider the implications of EMU.  EMU is going through. My friend in one of the central banks says that it is going through “come hell or high water”, largely because the politicians have staked their careers on it, they have set the date and there is no intention whatsoever of delaying just to work out the details. They feel that they can work out the details later and the politicians are not listening to the central bankers at all. If you think that I am bearish on EMU, you should read last month’s report from the Bundesbank. EMU represents a fallacy in understanding. We are dealing with a very significant change, which may lead to the collapse of the EU, rather than strengthening it. The reason I say that is because Europe is going against the trend of the rest of the world. Instead of creating a Europe without war, they will encourage war and the economics will tear everything apart. Yes, even the UK will be at risk breaking up. Scotland here will move to restore its independence by the end of its cycle of 309.6 years from its union in 1707. That gives us a target year of 2016. Creating a single currency in Europe will start to tear Europe apart after the 2007.15 high on our model and will become clear by 2010 moving into the key turning point in 2011.


Prior to World War II and coming out of the previous century, if you look at the economic history of particularly the last two decades of the 19th century you will see that almost every other year is labeled as a “panic”.  In the US this finally came to a head with the San Francisco earthquake in 1906 which led to the financial panic of 1907. Percentage wise the 1907 panic came down faster than 1929 in a shorter amount of time. What was learned out of this panic was very important. The insurance companies were all on the East Coast in  New York and the claims were all on the West Coast in California. So capital moved internally from one region to the other creating a cash shortage on the East Coast. When the government finally realized that the volatility in the entire financial market as well as the economy was being created by these regional disparities, that is when they invented the Federal Reserve. The Fed was originally created with twelve branches and each branch was set-up to run independently and maintain its own separate interest rates. So we had one currency with different interest rates in several regions.  This change produced the highest economic growth period in US history and the most stabile economic growth. The reason why is quite simple. People have often asked me how we could maintain different interest rates in one economy. In fact that was the original purpose of the whole system and why it worked so well.  When there was a natural shortage of capital forming in one region the interest rates would rise and the rates would decline in regions with excess capital. The difference in the rates allowed the free market to naturally arbitrage thereby automatically balancing the regional capital flows and producing a much more stabile economy. Now we ended up with World War II and naturally governments felt they needed to centralize power to strengthen the country against an outside enemy which is probably true. The problem is that after the post-World War II era the politicians on a Federal level never gave the power back to the twelve branches. We then ended up with a “one policy fits all” attitude and this is the very same attitude that is tearing many countries apart and creating separatist movements around the world.  You have the separatist movement here in Scotland, Canada and even in the US. Periodically you may read about the militia groups forming in the US. These groups are forming mostly in the southern US. Why? Abraham Lincoln was President of the US during the Civil War and he was a Republican. The south of course hated the north and President Lincoln, and therefore the south was always Democratic until a few decades ago. The solid Democratic south has turned into the solid Republican south. This change has occurred because the south is very anti-federal government.  They have a just reason for this attitude. Now that we have only one interest rate for the whole country, often raising interest rates to help fight inflation in one region causes economic hardship in another. We see this in Canada. The central bank in Canada raised interest in 1987 to fight real estate speculation in Toronto while at the same time they were forcing farmers into bankruptcy in Alberta. This created a tremendous amount of tension within the country and we see the same thing in the US. All the regions that are becoming very anti-federalist, particularly in the south, are the commodity based regions. These regions are being crushed every time the central bank raises interests to try to lower the stock market. The south is taking the brunt of every rate hike and this is causing a significant rise in anti-federalism in the US and also in many other countries. You can see these same separatists’ movements here in Scotland because of the regional disparities. Canada, Australia, even New York City, we are seeing these same trends everywhere. This is a growing trend because federalism does not work. My concern about EMU is that Europe is headed in the wrong direction. It is not the single currency that is the problem. The problem is centralized control.  Is the new European Union going to raise interest rates because of inflationary fears in Germany and then in turn put farmers in Spain, Italy and Britain into bankruptcy? One policy does not fit all regions. You can still have a single currency. We have had successful single currencies in the past as long as you retain the individual interest rates. Europe is moving into the direction of federalized central control and that is the real danger. Unfortunately, I think that unless the politicians understand this, then the outlook for Europe is not good. If they force this system upon Europe, it will cause Europe to break apart. It will fuel the natural jealousy between countries.   In the US we have been calling this trend the New York / Texas arbitrage.  When New York is booming, Texas is in a depression and when Texas is booming, New York is in a depression. Even in 1932 the bottom of the Great Depression was the peak of the oil booms in Texas.


So this is a natural trend because there are regional differences in every country. The debate here in the UK with Scotland is the same situation. I have been talking about this with many people in London. I think it is a shame, but it represents the problems with elections. Here you have Labour promising a reorganized NHS, etc. which are local domestic issues. On the other side John Major is saying don’t give the UK away. Those regional local issues belong with local governments. They do not belong in Westminster, as is the case in the United States. The idea of a federal government is for federal issues. But of course politicians are greedy. Once they grabbed the power, they never gave it back. If you don’t have a federalized government, then the politicians would actually have to run on statesmanship issues. We saw in the US the Democrats running on many school issues, when actually they have nothing to do with the schools. The Department of Education in the United States only sets the standards and regulations, but the federal politicians always say if you vote for them they will make sure that school classes are smaller, etc. From what we can tell it is these same federalizing problems that are causing major economic changes in Russia. Russia had a strong centralized economy that failed. You have the same problems in China.  A chairman cannot run a company with each office around the world calling to ask for permission to sign a contract. You would never run a business in this manner so why should this system work for Europe? Our concern is that we may be headed towards another serious economic upset similar to 1971 and this potential problem is having serious implications on how capital is already responding. I have been saying for the past few years that the British pound would become the strongest currency in Europe. When I made that statement a few years ago in Germany they all laughed at me. But in fact when you look at the longer-term trends you can see what I mean. Our computer simply takes every market globally and correlates it. You can no longer forecast the Dow or FTSE in isolation. The trend for the British pound has changed and you will see the market move up quite dramatically against the Dmark. This is the first year that we have gone above the previous year’s high and closed above it on this cross rate.




A simple technical chart will show you that the trend of this cross rate has changed. EMU is largely driving the currency trends that we are seeing in Europe. Central banks need to start getting rid of individual currencies and move towards the dollar. We are seeing a tremendous amount of capital coming out of Germany. The Germans have been buying so much property along the East Coast of Canada they have started calling the area “New Germany”.  Many Germans are in the US market buying commercial real estate, etc. Over 1800 German companies have opened offices in the UK in the past two years. The fear in Germany is that when all the European currencies are combined the value will be worth less than a Dmark. This is one of the key issues to understand.


President Reagan asked our company to help in the investigation as to the cause of the 1987 stock market crash. I believe the most important discovery of the commission (which unfortunately was not covered by the press) was the reason for the crash. Of course the G7 was trying to manipulate the currencies, but it was also the lack of news or uncertainty in the markets that caused the crash. We found that many portfolio managers seeing the Dow down 500 points called their brokers to find out what was happening and the brokers said that they had no idea. With the lack of information, everyone’s imagine started taking over. Everyone assumed that something really bad had happened and someone somewhere knew what it was and he was selling, so they should sell also. If the market had fallen due to an interest rate hike, then the managers would have had information upon which to make a sound judgment. We have found that information is less likely to cause a panic. It is the lack of information or news that creates panics. We see this problem with EMU. There isn’t anyone in the world today who can tell you what a Euro is going to be worth because no one knows. Consequently, you are creating anticipation in the marketplace. Accordingly, many funds managers across the globe are deciding that the prudent decision is to move out of Europe until they know exactly what they are going to be dealing with. We can see this same situation beginning to develop in Hong Kong. No one seemed to be very nervous about the hand-over until they heard that 10,000 Chinese troops were moving over. Now everyone is beginning to reconsider his or her position. It is the uncertainty that creates a great deal of volatility. Once EMU goes through and everyone knows what the monetary unit is going to be worth, then they will probably move back. There are too many outstanding issues at this time and, unfortunately, the politicians do not even know what questions they should be answering.  What is going to happen to central bank reserves, how is the banking system going to be set up, is there going to be an institutional market for Euros? All these questions need to be discussed, but the politicians only care about meeting their deadline date. We saw the same attitude in 1971 and the issues have still never been answered since. So the outlook for EMU does not look very bright to us. The politicians never go back to clean up their mess. This is true for all countries. We probably have 1.5 billion politicians on this planet with perhaps only four or five statesmen. Bill Archer, the head of the Ways and Means Committee, is the only person in Washington who I believe is intelligent enough to be President of the US and he is not interested. He understands capital flows. Bill Archer was the only Congressman in 1987 who said that the new tax codes on real estate would cause a real estate crash. As we all know there was a real estate crash in 1987 because the Congress removed the deductibility of interest for second homes and they cut the deductibility on commercial property. Congress created a one way market of sellers without even realizing what they had done. Congress had previously regulated that 80% of the S&L portfolios had to be invested in real estate and after the collapse they wanted to throw the S&L heads in jail for fraud. These politicians have no idea of the ramifications of their policies and they don’t care. In the US the Democrats imposed a 20% tax on boats thinking that it would be a good way of getting money out of the rich. They decimated the boating industry and over 500,000 people lost their jobs. Afterwards they realized that if you bought a new boat you paid their 20% tax, but if you bought a used boat you paid no tax. So they just opened up a huge used boat market. Two years after they had completely wiped out the industry, Congress came back and lifted the tax, but how many bankruptcies did their policy cause? We see this same danger with EMU. There are a whole host of issues that must be investigated, particularly for the financial markets.  As I said in the beginning, 90% of the capital flow movement is investment.


If you take Japan for example, capital is pouring out of a Japan for a very different reason than Europe. In Japan you will find the biggest spread between interest rates and deposit rates. Also, companies that may have an outstanding loan are obliged to maintain the loan even if they have the money to pay it off. We do a great deal of cash management in Japan and currently we are receiving an average of $250 million per month. The companies coming to us for help aren’t necessarily interested in our performance. We are dealing with companies who have cash on deposit collecting 0.1% while at the same time paying 4-7% on loans which they could pay off if they were allowed to. The companies are being raked over the coals and the government knows this, but they do nothing in an attempt to help bail out the banks. So we are converting the funds into US dollars and then managing the hedge.  There is no possible investment opportunity in Japan at this time. No one has any confidence in the stock market, government bonds and the money simply must leave the country.


In 1987 the peak in Japanese holdings of US government securities was 25%. That figure fell to 7% as the dollar fell into 1995 and now Japanese holds 33% of the entire US national debt. That is an unbelievable capital flow swing and that is why the dollar is rising dramatically against the yen. Our computer models are showing that we could go as high as 145. We have resistance around 128.5. Once we close above that level, then our next area of resistance is 134 and then 145. Keep in mind that in Japan the economy is literally in the throws of a depression. There are many strange trends that you really have to understand to be able to figure out what is happening over there. First quarter durable goods sales were up quite sharply and many foreign economists thought that the economy was beginning to turn. We find that this was absolutely false. Economists often tend to think that the average person is stupid. In fact what the economists usually get wrong is that the consumer is often more intelligent than institutional fund managers. For example: when interest rates rose to 17% in 1981 my mother and aunt bought ten year certificates of deposit. They didn’t call me and ask for my opinion, they just knew that 17% was a good deal. Many institutional managers held off for another point and missed out. Often the average person can make a very simple decision while many professionals tend to overanalyze a situation. Most Japanese bought as many durable goods as possible during the first quarter of this year because they knew that a consumption tax was going to be instituted on April 1st. They knew that if they waited until after April, the products were going to cost them 3% more. We now need to see from the next two quarter numbers how much of the durable goods buying has been pushed forward.


Economists made the same mistake with the US market. Many said that as soon as interest rates rose the stock and housing markets would crash. Interest rates have gone up seven times, the Dow Jones has doubled and the housing market exploded. Why? Because the consumer isn’t stupid. The consumers sat back and watched mortgage rates fall month after month. Why should they buy if the price was going to be cheaper tomorrow? However, as soon as rates began to rise they immediately knew that the trend had changed and they decided to buy because they knew it would cost more tomorrow. We can see this same trend with the housing market in the London. Before the election the housing market was up 20%. Why? Because they knew that after the election interest rates would rise.  Inflation is necessary and good in some cases. We find that zero inflation can be just as bad as hyperinflation. However, you need some level of inflation in the middle of the two. Without some level of inflation your home would never appreciate, you would never get a raise and you get market stagnation. In Japan they see housing prices declining and interest rates at practically zero. If you walk around Tokyo you will find many signs in store windows saying “Sale” in English. The Japanese probably don’t even have a word for sale in their vocabulary.  There is very little incentive for the Japanese consumers to buy because they see that prices are still going to be lower tomorrow so there is no rush to buy. The first sign of buying only came about when the people first learned that a consumption tax was coming into effect. The economy in Japan will turn around when inflation finally begins to rise. Consumers will buy when they know the prices could be higher if they wait. So we see that the Japanese economy will most likely begin to change direction around the middle of 1998.


Not only is there no confidence in the stock market, but everyone is making bets over which bank is going to be the next to fail. We just saw another Life company fail. Again, the fundamentals that we were taught in school do not hold true for the Japanese economy due to the different relationship within their culture. Another one of Japan’s biggest problems is their accounting system. A portfolio manager can market his portfolio at cost or market value on a rotating monthly basis. So you end up with many, many funds with the same exact portfolio from 1989. They won’t sell because if they sell they have to admit the loss. So you have all these Japanese companies saying that they just want the Nikkei to hit 26,000 so they can sell and then never touch the market again. In our opinion if the Nikkei takes out 17,000 the market will drop like a stone to around the 11-12,000 area. There are too many weak players and you can’t get a bull market when everyone is already long and waiting to sell for a small profit. You have to clean out these weak players before you can see a substantial rally. I think we are getting close to that period.


There is another issue that I think is very important to understand and that is how the last monetary system has distorted our perspective. People often ask me if the Dow Jones is at a bubble top. The answer is no. The reason is because it is our floating exchange rate system that is distorting our perspective. In 1980 the US national debt was at $1 trillion and it is now $6 trillion; a house in the Princeton/New York area was worth around $100,000 and is now worth around $600-700,000; a Porsche which was worth around $20,000 in the US is now priced at nearly $82,000; and finally, the Dow Jones was at 1,000 and has just hit 7,000. Now if the Dow Jones was hitting 7,000 and the national debt was only at $2 trillion that perhaps would be a bubble top. From all our research, a bubble top is when you can sell that interest and buy twice as many goods. If you actually had the same $100,000 investment in 1980 as you did today and put one in the stock market and one in real estate and sold both, you would have made more money on the real estate than on the stock market. You are still 30% behind 1980 in the stock market and after taxes you’re down even more.


Just as the monetary system before operated where there were natural arbitrages that the free market brought out, you could have interest rates rise to 7% or 8% in one area and the free market would bring the capital back. People would move their money to collect the higher rate and there was no currency risk. Under a fixed exchange rate system, if interest rates were 7% in the UK and 7% in the US, then why buy in the US? There would be no incentive to move your money. But a floating exchange rate system changed this whole scenario. Suddenly 7% in the US with a rising dollar would be worth more than 7% in the UK with the pound declining. Now we are experiencing these currency manipulations and this situation is very important to understand. All we are really dealing with is currencies. Currency fluctuations are really the ramifications of the last change in the monetary system. We are thinking in terms of a fixed exchange rate system, but actually everything is operating on a floating exchange rate system.

Quite frankly, in order to see a bubble top in the US stock market as it was in 1929 the Dow would have to be in the area of around 15,000.  At 15,000 you would be able to sell your stock and buy two houses. You could do that in 1929, but you would not be able to do so today. The biggest booms and busts historically under fixed exchange rate systems are when one particular instrument becomes highly valued over and above everything else in the economy. That is when you know you have a bubble top. If a market is simply going up and keeping pace with all other sectors, then you do not have a bubble top and are simply dealing with the depreciation in the purchasing power of the currency at hand.


Our computer takes every stock market and commodity and looks at that particular market in terms of every currency. From this type of analysis we have discovered that the definition of a bull market is when a particular market rises in terms of every currency. It is significant to understand this definition. If you look at gold last year for example – one of the few currencies in which gold rose around 40-50% was Canadian dollars. There was a very nice rally in Canadian dollar terms but this was mostly because the Canadian dollar turned down. If you looked at gold in terms of yen you will see that it was still going down.  Gold in terms of Dmarks, British pounds or US dollars was also not an impressive rally. But you did see a very impressive rally in Canadian dollars. Accordingly, this was not a bull market – it was a local currency arbitrage. Every currency has some sort of international value and if you devalue your currency by 50% that international commodity will still be double. That is why capital is leaving Japan. At 0.1% money is extremely cheap and it has an international value so why not put it to work elsewhere. The Japanese have simply picked the US market because with the amount of money they have you need a market as large as the US to invest in. Many Japanese are very interested in the Australian market, but unfortunately the Australian market is not big enough for them.


The international movements are important because they are happening at a much faster rate and on a larger scale. In this way, today’s markets are similar to the Great Depression period. As I mentioned before, one of the best books to read is Herbert Hoover’s memoirs which were published in1952. We started collecting a great deal of data so that we could really understand what Hoover was talking about in his book. He stated that …”capital acted like a loose cannon on the deck of a ship in the middle of a torrent.” Capital was rushing back and forth from one currency to another so quickly, they couldn’t form a committee fast enough to even investigate what was happening.


CHART – 100 Years British Pound


When we read statements like that of Hoover’s it is hard to imagine just what type of volatility he was talking about. From the above chart you can see the volatility that Hoover was discussing. You can see that the pound dropped from 4.86 to 3.12 and then back to 5.12 in a two year period. We are only experiencing maybe 25-30% of the volatility of the 1930s and this is why we are saying that we are in a bull market for volatility. We have databases going back a long time. The British pound high against the US dollar was 7.50 in the 1850s. So what we are looking at is a broader increase in volatility. What is interesting to note is that every time we go to some sort of a floating exchange rate system without exception (and we have done it many times) volatility increases.


As I said before – anticipation is everything. When you are on a fixed exchange rate system you don’t have to worry about currency. Capital will not move nearly as much under a fixed exchange rate system because it doesn’t have the same incentive. But when you introduce a currency and the underlying value of that currency can swing 30% or 40% in two years, then your whole investment portfolio changes. Capital is then given an incentive to move around and that is exactly what Herbert Hoover was trying to tell us in his book. As they were worrying about which government was going to default from the gold standard back then, capital was rushing around trying to find stability. As soon as concerns were raised about a particular currency, the capital flooded out and into another market and so on. The pound went back to 5.12 because all of Europe defaulted on its debt permanently with the exception of Switzerland and Britain, which went into a six month moratorium. Although the US did not abandon the gold standard and the US did not default, the pound still rose to 5.12. You can imagine how the portfolio managers felt back then: if everyone else has defaulted, then I guess the US will be next. The fact that the US did not default made no difference, but that shows you what anticipation can do. If you have just seen every Head of State say they aren’t going to default or abandon the gold standard and then they do, are you going to believe the President of the US when he says that his country isn’t going to default? Of course not! That is why the capital was rushing around so quickly. It didn’t know who was going to default next and we are seeing the same threats arising today with EMU. Our computer is showing instead of 40% volatility every 2-2.5 years, we are going to see 50% volatility swings every 2-2.5 years. This in turn causes the portfolio managers to shorten their horizons. Greater volatility poses a significant threat to the stability of the global economy over the next several years.


Many governments have been playing games with the funding of their debts. No President in the history of the United States prior to Bill Clinton has ever funded more than 42% of the US national debt five years or less Bill Clinton has moved 70% of the US national debt five years or less. He has also shifted the debt so short-term that one-third the entire US national debt is funded one year or less. The bad news is that every other government around the globe has done the same thing. Why? With long-term rates at 7% and short-term at 1.5-2%, Clinton decided that he could save a ton of money by funding with short-term paper. Short-term rates then doubled to 5.5% and long-term has basically stayed flat. During the US elections the newspapers were saying that interest rates were down and Clinton has done a wonderful job. In actuality the only interest rates that declined were the mortgage rates which are long-term – short-term rates doubled but no one wanted to talk about that. We are finding the same problem globally and it raises a tremendous risk.


When you are paying 8% on average on your money, you then double your money in less than ten years – simple compound interest. If you analyze Reagan’s eight years you will find that he actually balanced the budget between spending and revenue. However, interest expenditures for that eight year period were equal to $1 trillion and the US debt rose from $1 trillion to $2 trillion. Again the politicians, particularly the left, love to confuse these facts. They say that the debt doubled under Reagan so therefore trickle down economics does not work. But what has happened to the debt since that time. Congress has been raising taxes and the national debt still went from $2 trillion to $6 trillion. So you can’t tell me that raising taxes has had an effect on the debt. The major factor is simply compound interest. You can make as many political arguments as you want and confuse the average person on the street. You see the same debate here in Britain. Tony Blair is saying that the debt has doubled under John Major, etc. I don’t care who the Prime Minister was at the time, simple compound interest tells you that the debt will double and the same thing will happen under a Tony Blair administration. The danger of all this debt manipulation is very easy to find. With 1/3 the entire US national debt funded one year or less, with every .25% rise in interest rates the interest expenditures will instantaneously rise.  Reagan was blamed largely for the mistakes of President Carter because interest rates rose dramatically under Carter, but when you’re funded 70% long-term the rise in interest rates doesn’t affect the economy for four to five years. Now with 70% funded five years or less that means the interest expenditures are going to rise faster than ever before. With 1/3 funded one year or less, expenditures can rise exponentially. We spent over 80 years desperately trying to extend the maturity of our debt to reduce volatility. Now we have a whole new crop of politicians who have decided to try to save money by going in the opposite direction. They are reintroducing the very high volatility that was experienced at the end of the last century back into the economy.


I think Murphy’s Law applies: Anything that can go wrong, will go wrong. That is what we are going to see in the very near future. Politicians across the globe have made many of the same mistakes. Similar to Richard Nixon after the commodity booms just after the floating exchange rate system was introduced, he sold most of the US wheat reserves to Russia. We then experienced two years or drought and wheat rose from $1 to $6 per bushel. We have seen the same mistake again today. The US wheat reserves are again depleted, food prices have been rising and I think wheat prices are going to explode over the next several years.


We are gradually undermining people’s confidence in government and the monetary system and we are creating an era where our computer is going to be correct. We do not see a peak in volatility until around 2003. Now I have just given you a handful of reasons as to why confusion is rising.  Some people think these forecasts are a doom and gloom scenario, however, I disagree. You can’t make money without volatility. The ideal situation is to understand what is happening and be on the right side of the trend. If you don’t understand, then they are going to carry you out on a stretcher because the volatility is going to be significant. With the wholesale funds management that we do in Japan, this past April we are running at around five times the amount of capital compared to last April. I think that the first round of capital coming out of Japan was from the more sophisticated investors who wanted to play the interest rate differentials. Now we are getting calls from many institutions asking for the same type of help. So the second wave seems to be the “me too” wave. Quite frankly I think that this trend is just unbelievable. Also, we see that the sophisticated investors have made their decisions for not very sophisticated reasons. The Japanese are not buying long-term government bonds at this time. They have stayed very short-term oriented. We are probably the largest holder of government Fannie Mae’s in the US on behalf of our clients and we run everything ninety days or less. So they all want to stay short-term because they don’t want to be committed. Also, the Japanese are not interested in real estate simply because they lost money in the real estate market a few years ago. We had a group of institutional clients come to our Princeton office. I showed them an office building right in Princeton. They could have bought the building at around .60 cents on the dollar, fully leased with a AAA company with a 10% yield and they said that they weren’t interested because they had lost money on real estate before. However, they are buying equities and have been since around the middle of the third quarter in 1995. Prior to that time the Japanese were never buyers of US equities. They always kept their equity investment in the domestic market. They previously bought US bonds and real estate and then lost money, so now they are only interested in the US equities. That is what I mean when I say that many sophisticated investors are making decisions based on very unsophisticated fundamentals. They are not interested in long-term bonds because some of the companies that had bought the long-term bonds previously lost up to 25% of their capitalization on foreign exchanges losses because they didn’t hedge the currency. So for all these reasons combined the money coming out of Japan is going directly into short-term paper and US equities. I suppose eventually they will lose money in the equity markets and then the entire cycle will begin again.


There is definitely about an 8.5 year business cycle, but it seems that with every movement of the business cycle the sectors change. So history may repeat, but never twice in exactly the same manner. So over the next several years we see that one of the best investment sectors is going to be in the commodities. I have said that our computer is showing that gold will probably reach the $1000 level going out into around the 2009 year time period and people tell me I’m crazy. Again, adjusted for inflation even using the very understated current CPI, the 1980 high of $875 is close to $2000 in current dollars. So with gold currently trading at $350 we can see that it is substantially well below the old highs. Even to go back to $1000 is not a new high in real terms. Almost every commodity we can look at has already begun this trend. For example, copper has already exceeded its old highs. Crude oil took out its 1980 high – not by much – but it will continue higher. We put out a report last month on some of the crude oil fundamentals. More than 85% of the Alaskan oil fields are used and we have barely five years of crude oil supply and the US last year ended up importing more oil than in many years. We now import around 50% of our crude oil which is right back to early 1970 levels and within a few years that number will reach close to 60% and then drop back down after 2010. Higher prices are necessary to spark exploration and technology advancement. We see the same thing with China. China was a net oil exporter and now they are oil importers. The fundamentals are slowly changing in many of these markets and they don’t get much press. Crude oil is in the process breaking out. It did fairly well last year going from around $15 to $30. Oil then backed off from $28 to $18and then basing around $20. Crude oil should move up fairly aggressively over the next several years and we are expecting that to reach the $65 to $70 levels. Again, crude could rise much higher going into the 2003 period. Keep in mind that $1000 gold in 2002-2003 is not $1000 gold today – it all depends upon the value of the currencies at that time.


The whole issue of commodities is that we look at everything else adjusted for inflation – our wages, houses, etc. – but when it comes to commodities we always think they should be traded in nominal terms. We end up discriminating against commodities so much that in my opinion that is why commodities have distinctively different characteristics in trading than a stock market. Everyone always wants to see stock markets rise, however, commodities should never rise. Accordingly, commodities gets so suppressed to the point that in 1986 every agricultural product and base metal product was below 1932 levels.  So over the next several years commodities will rise dramatically in order to catch up. In my opinion this is why the commodities go down for a long time. Commodity bull markets are usually two or three year periods where they rise dramatically and then fall largely due to our prejudice against these markets.


I think gold is the commodity that historically seems to be the last to rally. Even in the 1970s, wheat peaked in 1974 and the metals didn’t reach their peak until 1980. We can see that the copper market and the agriculturals have already begun their movements up. As to the metals we should see a final low as early as June/July for gold. Quite frankly if gold makes any new low after the June/July period then it will probably drop to around the $255 to $270 early next year and then it will be off and running. We are extremely bearish on silver long-term. The fundamentals in that market have changed dramatically and we have systematically removed all the industrial support for the silver market. 1980 caught the photo industry with their pants down and they had no choice but to buy at $54 an ounce. After that the photo industry invested huge sums of money into developing synthetics which they have now accomplished. Accordingly, they no longer have a need for silver. X-rays have been replaced with magnetic imaging and digital cameras are slowly becoming mainstream. Even Kodak is coming out with an entire line of digital cameras because they know that within ten years film will be obsolete. Accordingly, this undermines the entire silver market.  So going up to $54 and then dropping to $3.50 is normal for silver, but you would never see this type of move in the gold market. Accordingly, support for gold is much stronger on a long-term basis. Right now we see EMU keeping the market down. Central banks have been selling gold to meet reserve requirements and to boost up their budget numbers, etc. There may be some net selling of gold going into EMU. The Bundesbank has also said that they will not rule out additional gold sales. So short-term I think gold is probably headed lower at least into the June/July period. If the Bundesbank does become a net seller by the end of the year then clearly it is going to go down probably to the $250-$270 area by early next year. After that I think gold will be a major buy.


A few months ago we published a list of all the Dow Jones market corrections (in a bull market) for this century. Excluding the current correction, the smallest correction has been 10% while the average has been 15% to 23% and the extreme moves are around the 43% level. Going beyond 43% seems to imply a change in long-term trend, not just a correction. 1987 was approximately a 43% correction and so far we have only accomplished 10% during the current two-month correction. We do see that the market could move back down a bit further if new lows unfold in May, but there is major significant underlying support in the market. There is fundamental support around the 689 to 698 area on the S&P Futures in the unlikely event of declining further. The only question is how these markets interrelate with world capital flows. What we are showing is that the current correction could possibly extend into June/July and then turn back up going into new highs in 1998. If you see any new high after the summer of 1997, the Dow will probably come closer to the 10,000 level going into around June of next year. If we go up that fast, then be prepared for a sharp correction into 1999. Otherwise, if the market has rallies into a June/July high, there could be another test of support this summer. A penetration of the current April low during the later months in 1997 would warn of a June 1998 low with a rally into 2002-2003. Therefore, the two scenarios are a high in 1998 around 10,000 on the Dow warning of a 1 to 2 year correction followed by new highs into 2002-2003. The second scenario warns that a low in June 1998 points to a rally into 2002-2003 with a high perhaps reaching even 15,000.


Despite the overwhelming bearishness about the US market, there is no chance whatsoever of a 1929 collapse or depression. A 1929 economic situation led to a deflationary cycle primarily because government was not the problem. The US was running surpluses at that time and the national debt was a mere $27 billion. As Herbert Hoover pointed out, they couldn’t form a committee fast enough to figure out what was happening. Consequently, the defaults took place. There was no added spending or no real expansion of government because they didn’t have the social programs that we do today. So there inaction led to deflation. Today, we have the opposite situation. The government’s inaction today leads to the social programs automatically renewing themselves. Today everything is automatically geared to inflate out. Today it would take a conscious effort to stop and in part that is what the CPI debate is about. It will take a conscious effort to prevent an inflationary cycle today because that is the default way out. In my opinion, every time governments have fooled with the monetary systems, they have done so for their own personal gain. The monetary change in 1971 took place simply because governments, including the US, were spending without regard to the fixed exchange rate system. The US national debt was expanding and the money supply was expanding to the point that they had simply made so many social programs that all the money supply could no longer be supported by the gold at Fort Knox. Once they realized that they had spent more than they had, they decided it was a good time to move to a floating exchange rate system. Basically, governments defaulted on the gold standard at that point and that is why we have a floating exchange rate system today.


So every monetary change, even going back to ancient Roman times, has taken place only to benefit governments. There are only two ways out for Germany and France: 1) Germany and France are not competitive within the economy. So they would have to go in and take power away from the unions – but that would be the hard road for them. 2) They can simply federalize Europe and make everyone else abide by the same rules and regulations and then they are no longer uncompetitive because everyone else has to follow the same rules. Of course, you cannot build a Berlin Wall around Europe so eventually this will not work.


We also see the same thing that the US went through after its revolution. Prior to the revolution the US had Continental dollars. So many Continental dollars had been issued that they were almost worthless. Accordingly, in 1792 the government effectively created the US dollar and the official exchange rate was 10,000 to 1. Alexander Hamilton made it very clear by offering everyone a deal. At 10,000 to 1 you could exchange your worthless currency and they would give you US government bonds. If you didn’t like that deal the US Constitution said that everyone who held Continental currency would be paid. So you had a choice to either sell or hold. Of course, the US never paid their obligations. You can go to any collectors store and buy worthless Continental dollars. As currencies are changed, governments default on their obligations. All governments have done this at some time in their history. So the real purpose behind EMU is to eliminate the uncompetitive and regulated labour markets, particularly within Germany and France. Also, when you create a single currency all your obligations now have a chance to be redenominated and don’t think they won’t do it. We have done a great deal of research into monetary reforms and every time it is done that has been the purpose. I guarantee that this is going to be part of the EMU plan. Some people say the purpose is to spread the social costs of Germany across Europe. To some degree that can happen.  One currency with independent monetary authority would be the only way to keep the social program obligations localized. However, if you have one monetary policy, one central bank policy and one interest rate policy for all Europe, it will be impossible to prevent deflation from being spread across Europe. EMU is simply a way to readjust all the unfunded liabilities of all the European governments. Quite frankly, I wouldn’t put it past the US from going into some sort of world currency deal and I think that is coming around after the year 2013. President Clinton’s own budget says that Americans will have to be taxed at 80% by around the year 2005-2008 to pay for the unfunded social security obligations of the US. I believe we will see some sort of move towards a single currency and the politicians are going to be more inclined to enter into this type of concept because it will be an easy way to default on their obligations.


When these monetary reforms take place it is usually the tangible asset holders that benefit the most. In 1948 when Germany came up with Dmarks to replace the old Reichsmark I believe they imposed a tax upon tangible assets. So everyone got their 60 marks, but the people that had tangible assets, which were then worth more, they were immediately taxed because they were the people who could survive the currency change.  Even in the US coming out of the Great Depression they devalued the US dollar by raising gold from $20 an ounce to $35. The main purpose of confiscating gold from the American public was to make sure the people did not profit from the government devaluation. Gold was then declared illegal in the US and confiscated so only the government could profit.


So this is what we see in the years ahead. We have published a great deal of research on the world monetary system on our website that you are welcome to visit: (our current website) We have interest rates back to around 3000 b.c. There are few things that man has always kept track of: interest rates, the price of wheat, the value of gold and how many guys died on the battlefield. There are many fascinating aspects of the global monetary system. Why did Julius Caesar revise the calendar? Everyone knew the calendar was off by four days. The politicians appointed a High Priest to determine where to insert the four days. The political corruption that emerged out of that period is quite clear. If your party is in power, the High Priest could insert whatever days he needed. He kept extending the term of office of the current government to the point that by the time Caesar came into power, summer was in winter and winter was in spring. The calendar was completely false due to political manipulation and that is why it was revised.


I testified before Congress in July. They said that they felt interest rate policy should be taken away from the Federal Reserve and put into the hands of Congress and they wanted to know my opinion. I said interest rates would always fall to 1% right before an election and then back up to 9-10% afterwards. Congress would never be capable of administering such a system and that is why the Fed was set up in the manner that it is. It is Constitutionally illegal for the President to even badmouth the Fed Chairman because they knew that if a politician ever had that authority, the economy would collapse.