Southwest Ranch Financial, LLC
October 2007 Update
The S&P500 is at 1526 on 30-September-2007

This page can be linked to at   ( www.swranch.net/emails/2007-10.htm ).

The Southwest Ranch Financial Market Alert Timing Model is in the stock market.  Since the last buy signal in February 2003, the S&P has risen 84%.

Year to date, the S&P500 index is up 9.0% and the SWR Balanced Portfolio is up 6.1% (with half the stock market risk.)

  Here’s the year to date performance of the SWR Balanced Portfolio by asset class.

As of 9/30/07

Market Alert Model
The SWR core model is used to time large cap stocks. It’s currently IN the stock market.  Stay invested with proper diversification. A market alert never occurred during the July-August slump because the SP500 only dropped 7.9%. That's simple volatility and never indicated a change in market direction. My models warn of cyclical changes and not normal volatility.

Year Ahead Timing Model
The YAT model is used to indicate periods of buy opportunities within the Market Alert Model’s timing cycle. The SWR Market Alert Model always trumps the YAT model. The YAT model is positive.

Interest Rate Model
The SWR Interest Rate model is negative on interest rates and long bonds.  

Gold Model
The SWR Gold Model is positive on gold.

Market Trends
This month I’ll address the issues of the dollar, gold, inflation and the trade deficit.  If you haven’t already, read last months eletter on the US debt situation.  (www.swranch.net/emails/2007-9.htm )  What follows will build on that.

In the 1960’s the US inflated the money supply and by the 1970’s we experienced stagflation.  Ronald Reagan broke inflation by shifting inflation from money creation to debt creation.  The debt went increasingly offshore and stayed there because US interest rates were quite high and debtors were paid well to hold dollars.  Increased US government spending from debt stimulated the economy. China boomed by selling to American consumers. By the 1990s, everyone was fat and happy. However, the debt cycle continued too long. It was extended by ultra low interest rates from the Federal Reserve. This sucked average citizens into a consumer spending binge. That binge has now turned into a sinkhole. Government debt is growing at unsustainable levels. Consumer debt has hit the wall due to the fallout from subprime lending.  We are at the cusp of major changes.

Since 2000, the US dollar has declined 50% against the Euro, but prices are stable against the Chinese Yuan. For example, my favorite Rustler blue jeans can be purchased at Wal-Mart for $10.88 and the price hasn't budged in years. That's less than half of what Levi jeans sold for 10 years ago. 

China absorbs the cost increases on consumer products sent to America in order to expand its economy by selling into the massive US market.  Expanding employment is more important to China than big profit margins.  They send us stuff, get paid in dollars, buy our bonds and get a measly 4.5%.  Meanwhile, those bulging dollar holdings continue to decline in value tremendously against the Euro.  It is indeed a strange conundrum isn’t it?  Welcome to the wacky world of fiat currencies and central banks. 

These strange activities occur because all the world’s currencies are money without the backing of gold or silver.  Governments can manipulate currency exchange values by changing their interest rates and inflationary targets.  They all do it. People who predict the collapse of the dollar say it will happen because of the printing press economy.  Yet they acknowledge that all the world’s economies have exactly the same system.  In order for the dollar to collapse, some other currency would have to take its place.  Which one would that be, pray tell?  The Euro?  Perhaps eventually the Euro may replace the dollar as the world’s reserve currency.  But, if China refuses to take dollars, they won’t keep their factories open for long.  The Yen?  Not likely. Japan has a higher percentage of debt to GDP than the US. The US has 1/20 of the world's population, but accounts for 35% of world gross domestic product (GDP). Likewise, US stock capitalization accounts for greater than 40% of the world total.

The Transition Away from the Dollar
In a fiat money world economy, central banks can manipulate trade and exchange rates.  However, there comes a point when debt and spending get so out of balance that things have to change. I believe we're at the point where dollar dominance will decline. An orderly transition requires a gradual adjustment of trade imbalances and is doable if everyone cooperates.  It’s to everyone’s advantage so countries probably will cooperate - despite short-term rancor about the pace of change and resulting internal political problems. Eventually, China will adjust the value of the Yuan because internal inflationary pressures and the declining value of their dollar holdings requries it. When China raises prices on my Rustler blue jeans it will be the beginning of consumer inflation in the US. By my analysis, we’re about to enter a rebalancing period encompassing trade and currencies. This process can take two paths and both will result in higher inflation.

Under scenario one, what I call the path of sanity and the one envisioned by Alan Greenspan, this whole process will be very gradual with about a 20-year time frame.  (Skip to the last sentence of this paragraph if economic talk bores you). The first effect will be when China gradually raises prices on exports to America.  They’ll do this because they can’t absorb cost increases from materials and labor any longer.  This will happen soon. It will cause a reduction of sales to America, but higher profit margins for China.  Prices will go up in America and consumption will drop thus helping to slowly close the trade deficit.  We’ll see rising prices, but the Fed will not immediately raise interest rates.  It  will allow the dollar to fall until US exports rise.  When exports equal imports, the US offshore debt will stop rising. The Fed will eventually be forced to raise rates, but not until CPI inflation exceeds 4%.  People will take advantage of higher rates to save money.  Higher interest rates will cause US stock prices to stall out, but will attract cash to dollars thus stabilizing the currency. Foreign governments with trillions of dollars sitting in US bonds will be allowed to shift those assets into buying US companies.  This will stabilize stock prices. The American standard of living will decline due to higher prices.  Since Asia won’t be taking on ever increasing US debt, the government here will have to raise taxes to pay the interest on debt and keep budget deficits from expanding.  Standards of living will move toward equilibrium in the world economy with Asia gaining relative to America. This is all a lot to absorb. Just think of it as rising consumer prices and rising interest rates.

Under scenario two, the US refuses to cut back on the rate of government spending due to strong voter resistance against cutting medicare and other social programs. The politicians don't raise taxes. The US government doesn't reduce its standing armies around the globe because it feels the need to project force to control adversaries. With a huge debt overhang and a weakening currency, this path is not wise. Unless costs are reduced, the US will go the way of numerous other over-extended empires of the past that collapsed due to failed economies. I've documented in previous eletters how countries have gone from superpower to bankrupt in less than 30 years. This includes England, France, Spain, Germany and others. This scenario has happened repeatedly and occurs because of trade imbalances, debt, bad money and military costs. American investors must take precautions against this possibility.

I'm hoping for scenario one, but fear the US leadership will shift only slowly from path two. The reason being oil.

Resource Constraints and Bad Money
We are entering a period of wars over natural resources like oil and water. Oil is going much higher in price due to inflation and supply constraints. This may cause social upheavel and will certainly require profound changes in a US lifestyle so heavily supported by cheap energy. Politically, it will take a lot courage to change government's social contracts with the citizens. Over the last 20 years, any politician who tried was squished at the polls.

The major difference between the historical failed regimes and the present is all the world's economies are now off the gold standard. Gold no longer serves to regulate bad money. Greenspan and the Federal Reserve get a bad rap from some quarters for allowing the stock-housing-debt bubbles to go on for too long. That's not altogether fair. The Fed has two mandates by law. They are: maintain full employment and maintain stable prices. The Fed has no control over how Congress and the President spend money, but must deal with the consequences of executive and congressional action. The economy was spinning into recession after 2001 so Greenspan lowered rates. Bush and Congress then doubled the national debt between 2001 and 2007. It's not Greenspan's fault that Bush decided to start a couple wars and spend like crazy. The Fed lowered rates while reckless liquidity caused money to flow back into stocks and houses and consumer goods. Consumer prices didn't rise much because China wanted those dollars and kept prices low. Greenspan did what he had to do. Inflation didn't show up in consumer goods and we had full employment. However, the dollar declined against other currencies and against oil and gold. From a consumers perspective, prices were generally stable, but internationally we got torpedoed and that will come back to haunt us.

Let’s get the story straight from the Maestro himself, Alan Greenspan.  On the road touting his new book Age of Turbulence, Sir Alan, the master of understatement and linguistic obfuscation, has been talking up a storm.  He says inflation forces are building and interest rates will rise. Rates could go into double digits in the US, but not for a while yet. The inflation damping effect of globalization is receding. At the White House there is no serious economic rigor or intent to move toward sound fiscal policies. He also says the Iraq war is about oil.

The last point is very important. The Iraq war is about oil - a point I've made repeatedly. You can chose to believe it's about Iraqi nuclear weapons or spreading freedom in the Middle East or whatever story they concoct when no one believes the last one. It's about oil. Iraq has about 10% of the world's known reserves and it's high quality.

Connect the Dots
Here's the point of all of this. There are two asset prices governments can't easily manipulate. Oil and gold. Oil adjusts quickly to inflation. Gold trumps even oil and is the premier asset. Let's connect the dots. The dollar has fallen 50% against the Euro during the Bush administration due to US debt expansion. Oil has risen from $30 to $80 and gold has gone from $300 to $700. China will soon start exporting inflation to your local Wal-Mart. Higher consumer prices amid falling home prices and tighter restrictions on borrowing make for a very dicey economy. The government will be forced to reduce the rate of federal spending or we'll end up with hyperinflation. If America doesn't cut back on spending and these resource wars continue or expand, it actually could happen. Like Sir Alan, I believe the future for the US economy won't be as rosy as the past.

Here's what I believe will play out in the years ahead.

1. Gold is going much higher
2. Oil is going much higher
3. Inflation adjusted US stock market returns will be lower than in the past
4. The price of imported goods from China will rise
5. The dollar will continue to decline by perhaps another 30% - perhaps more
6. The trade deficit will begin to close but slowly
7. Inflation will rise in the US and will run perhaps 5% yearly for the next 25 years
8. US interest rates will eventually rise

It will take years to adjust government spending because so much inflation is already cooked in. Investors and especially people living on fixed pensions need inflation hedges. They can't hide in cash.

Get Some Money Into Gold
Longtime readers know I've never been one to push extremist investment themes or advise survivalist hoarding. However, with the US entering a prolonged period of rising inflation, it makes sense to own some gold. I've recommended gold occasionaly since 2003. it was at $325 when I first suggested buying. I never pushed it hard because I hadn't developed a market timing model for bullion until about two years ago. Going forward, I will update my gold model on the website each month. My gold model can't predict how high gold will go. It only indicates when to buy or sell.

People living on a fixed income from a pension may wish to consider owning gold. Most annuities and pensions are fixed and don't adjust for inflation. The purchasing power of a pension is cut in half in 12 years with inflation at 5%. I'd recommend holding 10% of investable assets in gold (ETF or coins) or an amount equal to at least your yearly pension - whichever is greater. So, if you need $30k/year to live on, hold at least that much gold. If inflation cuts your pension by $1500 per year then your gold should keep pace and offset the loss. I don't recommend gold mining stocks or non-bullion gold coins or medallions. I think gold should be held in an IRA using the gold etf GLD. Taxable money should hold one ounce gold coins like the American Eagle which is US legal tender.

Government confiscation of gold is very unlikely unless we enter a hyperinflation or a period of widespread social upheaval. Both are unlikely.

At $730, gold isn't cheap, but I believe it will trend much higher over the next 20 years. We are probably still at the beginning of a long-term gold bull market. I've studied the performance of gold since America went off the gold standard in 1971. Gold did very well in the 70's and poorly in the 80's and 90's. It didn't really come back strong until 2003. Gold rose from $37 in 1971 to $730 in September 2007. Since 1971, gold has provided a compound annual return of 8.5% per year whereas stocks have been closer to 11%. I think future returns for gold will be at least as good as the past and stocks will not do as well. At the present time, I wouldn't be within 10 miles of a long term bond.

Gold vs S&P500
Over the next several years, gold could easily double to $1400. That sounds incredible, but the limited evidence supports this idea. Look at the chart below. It is not predictive of the future and only shows what has happened in the past. I've reconstructed the S&P500 index back to 1900 based on data provided by Professor Robert Shiller at Yale. My chart shows the ratio of the S&P500 index to the price of gold.

In September 2007, the SP500 is 1525 and gold is $730. That's a ratio of over 2:1 (1525/730). From 1900 to1944, the average ratio was about .5 while the US was on the gold standard. In 1944 the dollar became the world's reserve currency at the Bretton Woods conference. The ratio rapidly expanded to over 2. In 1971, with the Vietnam war raging, the ratio declined to .5 due to US inflation. In 1980, the US used debt to expand the economy and the ratio soared to over 5. In 2007 it's still over 2.

While on the gold standard, the ratio was well under 1. When people lose confidence in the fiat dollar, gold rises and the ratio falls like in the inflationary 70's. We're entering such a period again. If the S&P500 stays where it is and the ratio falls to under 1, that means gold could go to $1400. If the ratio returns to .5 or .25 like around 1980, we could see gold at $2000 or $4000 or higher. I know that sounds unbelievable, but it could happen.

The world is entering a period of rising inflation, loss of reserve currency status for the dollar and possibly resource wars over scarce water and oil. I believe we shouldn't limit our perspective to the recent past, but must view possible events over a longer time frame.

I consider gold a unique asset class. It's insurance and sound money. Continue to hold a balanced portfolio, but set aside a safety allocation to gold.

I suspect we're about to enter a long period where swing traders will do well moving money between assets like gold, stocks and bonds. Enterprising investors may want to consider adjusting portfolio allocations to over and under weight asset classes based on market timing signals. My models are very good at catching multi-year cyclical swings. So, don't despair just because Greenspan is sour on the markets or investment newsletters warn of stagflation. It's time to take what we know and put it to use. The next 25 years could be the golden age of the market timer.

Best Regards,
Southwest Ranch Financial, LLC    (www.swranch.net)
Tom Gleason, Manager & Researcher

Author of: How To Invest If You Can't Afford To Lose

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Disclaimer:.
Investing involves risk and the future performance of the models cannot be guaranteed. SWR is not a registered investment advisor and nothing published by SWR should be considered personalized investment advice. Any investment recommendations made by SWR should be made only after consulting with your investment advisor and only after reviewing the prospectus or relevant financial statements.  SWR does not receive any compensation for mentioning stocks, funds, or financial products.