1st August 2009

report 1st August 2009

This issue: A calm interlude - buying LVMH China - learning the art of bubble economics (here) Cycles - a new pretender to Martin Armstrong (here) US house prices - recovery likely short-lived (here) Gold - more insight on what’s really going on (here)

Raiders of the false dawn A calm interlude - buying LVMH My analogy has been that our central bankers and politicians in the UK and US are taking us on the economic equivalent of Captain Willard’s journey up the Nung River in the movie, Apocalypse Now. If you indulge me in this analogy, the question is where are we now? In the film, the gun boat emerges from swirling mist (how apt) and Willard (Martin Sheen), sitting on the bow, sees some buildings up ahead. This is the famous “French Plantation scene” and is the film’s calmer interlude. It was cut from the original movie release, but reinstated in Francis Ford Coppola’s “Redux” version (thanks for this DVD to David V. in NYC). Assignats - led to the French hyperinflation of the 1790s

Source: usagold.com

Contact/additions to distribution:

Paul Mylchreest [email protected]

During dinner, the French patriarch, De Marais (played by Christian Marquand) discusses the French defeats in World War II, in Nigeria and, in particular, at Diem Bien Phu, which led to the withdrawal from Indochina, the separation of Viet Nam into the North and South and, subsequently, the disastrous US intervention. There is a poignant moment where one of the diners asks Willard why the US can’t learn from French mistakes? (the lesson of the excessive issuance of assignats leading to the French hyperinflation of the 1790s also came to mind!). The next morning, Willard is back on

the boat and the mist is even thicker. So much so, that “Chief” wants to stop because he can’t see where he’s going. Willard pulls rank and on they go. In the last Thunder Road, I argued that the heavy-handed intervention of politicians and central bankers was pushing us into a “distorted Kondratieff Winter”. What I meant was that in the normal course of events, we would experience a deflationary depression for 10-15 years while debt and excess capacity were purged. However, the intervention, i.e. offsetting inflationary policies, are so extreme that the evolution of events will be far more complex this time, with more twists and turns along the way. Making money is very difficult at the moment and even the “Trader Wizard”, Bill Cara, is finding the going so tough he is heavily in cash and watching from the sidelines: “the risks are just too great. When you see a cash flow stable Microsoft drop -10% in a day or a McDonald’s -5%, how can anybody commit 100% of their capital to such a market environment. I know I cannot.” I have to invest more aggressively and I’ve put some of the cash I had on the sidelines back into the market both a bit before and after the Dow Theory. buy signal which was triggered on 23 July 2009 when both the Dow Jones and Dow Jones Transportation Index broke through their previous peaks (on the 12 and 11 June 2009, respectively) in the current rally. That’s not because I trust this rally, rather I can’t afford to be left out of a rising market to any significant degree. As well as adding to my heavily overweight positions in gold/silver and technology stocks, I bought shares in luxury goods group, LVMH (albeit with a 6% stop loss), after it announced its first half 2009 results last week. Why a trade in luxury goods? It struck me that a combination of the recent return of the “bonus culture” to parts of the financial sector, the possibility of a bubble developing in China (discussed further below) and the likely response of the ultra-rich to the recent stock market rally all bode well for this sector in the current quarter. At the same time, Japan, which is the biggest market for luxury goods (> 20% of the world market), should benefit from recovery in China, its largest export market. Japanese department store sales have seen double-digit declines in every month bar one since last December and surely some improvement is due? LVMH.is the world’s largest luxury goods play with major brands such as Louis Vuitton, Moet & Chandon, Hennessy (cognac), Christian Dior, Marc Jacobs, Fendi, Donna Karan, Givenchy, Tag Hauer, etc.The H109 results were marginally worse than expected due to margin weakness in Wines & Spirits and Watches & Jewelry – it looked to me like analysts underestimated the operational gearing in these divisions. Despite the worst recession since the Great Depression, organic sales only declined by 7% as the group saw market share gains across most of its brands, especially Louis Vuitton. Fashion & Leather Goods, which accounted for 64% of group operating profit, reported organic sales growth in local currencies of 1% overall with 18% growth in Asia – a remarkable performance in my opinion. By the way, according to Vogue UK’s August 2009 issue: “The fashion gods have spoken: this autumn, it’s all about the shoulder.” I read it. “black dominates, along with urban gray. However, indigo tones – from smoky teal to luscious purple – are the shades that mesmerise.” In the second half of 2009, LVMH’s management is expecting more market share gains due to “numerous product launches” and further expansion in emerging markets. LVMH has one of the largest exposures to emerging markets in the luxury goods sector – 32% of sales are outside the US, Europe and Japan, including 24% in “Asia ex-Japan”. Hennessy is the biggest selling cognac in China. At the same time, LVMH is aggressively cutting costs – down Euro163m in H109, equivalent to 10.6% of H108 operating profit from recurring operations. It would be even better if they could do more on inventory management. In PE terms, on c. 17x 2009E and 15x 2010E, the stock is only trading in line with the sector average, excluding the very highly rated Hermes.

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On the subject of luxury goods, my interest was also piqued by a small piece in Saturday’s Daily Telegraph noting that: “The price of Chateaux Lafite and Latour, the two most celebrated claret houses, is surging as new investors develop a taste for fine wine. Wine is in for a bumper year say dealers, thanks mostly to Chinese buyers.” In relation to wealthy Chinese buyers, Simon Berry of wine merchants, Berry Bros & Rudd, is quoted as saying: “They really like the big names – Lafite and Latour.” LVMH has its fair shares of big names in its stable of luxury brands.

China – learning the art of bubble economics While I remain bearish on the prospects for the US and UK economies, the key question on everybody’s mind is whether China is heading into a bubble. It certainly looks like it to me notwithstanding some restraint by the authorities being inevitable. The economic recovery in China is purely a monetary phenomenon – driven by the government’s stimulus package and aggressive bank lending. While we all know that there are caveats regarding Chinese data, the reported Q209 GDP growth figure was 7.9% and 7.1% for the first half of the year as a whole. Growth must be picking up strongly because China’s power generation rose 5.2% year-on-year in June 2009 after declining by 1.7% during the first six months of this year. The worrying aspect was the make-up of the H109 GDP growth. Of the 7.1% growth, 6.2% was driven by investment, 3.8% was consumption and net exports contributed minus 2.9%. At this point, with plenty of spare capacity already, it might be preferable to have the numbers for investment and consumption reversed. What’s more, the amount of newly started fixed asset investment projects doubled in H109, implying a lot more investment is already “baked-in”. Two other data points have prompted much discussion: BB Chinese bank lending went ballistic in June 2009 with 1.53 trn yuan (US$224bn) which was double the May figure. This led to the highest rate of money supply growth in 14 years with M2 growing 28.5% year-on-year; and BB China’s foreign exchange reserves increased by US$177.9bn in Q209 to US$2,132bn. This was a massive increase from the previous quarter’s US$7.7bn and is far bigger than the aggregate of the country’s trade surplus and foreign direct investment implying “hot money” flowing in from overseas. As Doug Noland of the Credit Bubble Bulletin pointed out: “the most recent quarter exceeded even the US$154bn increase near the height of the ‘hot money’ bubble period back in early 2007.” While they set the alarm bells ringing, an email sent to Michael Pettis of the China Financial Markets (and a professor in Beijing) blog from a fund manager is a must-read. The fund manager had just returned from looking at real estate in Guiyang, the major city in the Guizhou province in Southern China. While this relates to one major city, it is hard to believe there aren’t other examples – but here it is: “I thought I’d seen insane excess in the past – 200 thousand square meter malls completely empty next to apartment complexes with 40 thousand units and 30% occupancy rates, etc. etc. But what we saw over there is rather hard to fathom. It seems the Guiyang city mayor had the same idea as the Shenzhen mayor – to move the old downtown to a piece of undeveloped land.  Of course Guiyang has a quarter the population and probably a quarter the per capita income of Shenzhen.  They built sprawling new government buildings about a 20-minute drive north of town. And then the residential high rise projects started going up. From driving around the area, we figured well over 100 20+ storey buildings.

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What was most distressing was that the development has been totally uncoordinated – a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms of farmland well north of town. Every building we got close enough to see was either incomplete/under construction, or empty. Our tone gradually went from ‘Haha, another one!’ to ‘Oh my God, another one.’ We conservatively guesstimated that we saw US$10bn of NPLs (non-performing loans, Paul) in one afternoon.  The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction.  Back in the city proper, every neighborhood we saw was a convulsing mess of buildings being torn down, new ones being built, and unfinished high rises starting to crumble.”  The Chinese central bank has tried to soothe concerns with the Assistant Governor, Li Dongrog saying two weeks ago: “we will strengthen monetary and credit management to ensure stability in the financial sector.” The overwhelming expectation of analysts is that the Chinese government will act to rein in excessive lending but, as Pettis says, there is division of views: “Although I am often surprised by how eagerly foreign commentators have embraced the Chinese fiscal stimulus story and see it as a great, shining success, I am happy to say, mercifully, that in China there is a lot more skepticism.  There seems to be a serious debate among Chinese policymakers over the stimulus package. The debate lists, on one side, people centered on the PBoC, the CBRC and the National Bureau of Statistics, who are worried that the stimulus may be exacerbating Chinese imbalances.  On the other side are people in the State Council, the Ministry of Commerce and in the provincial and municipal leadership who are more worried that any half-heartedness will lead to a significant rise in unemployment.” I’m sure there will be some policy tightening, but I think it will be taken in baby steps in true “Greenspanian” fashion. As mentioned above, the governor of the People’s Bank acknowledged the very uncertain outlook and the authorities will be very wary of further social unrest. Here is an interesting report from Platts on

27 July 2009: “Jianlong Group has been told to abandon takeover plans for China’s state-owned Tonghua Iron & Steel Group after a company executive was beaten to death Friday as 3,000 steel plant workers protested job cuts, a provincial government official told local media Monday. Jilin province’s Development and Reform Committee has ordered Jianlong to halt its restructuring plans and told mill workers to return to work, the official said. Jianlong official Chen Guojun was killed when a brawl broke out after Tonghua workers were told to expect job losses during a meeting with a delegation from Jianlong, a private company based in Beijing. It was the second time Jianlong had launched a takeover bid for the state giant and many feared the company planned to drain state assets before following up with cost-cutting measures, including redundancies, in northeast China’s old industrial heartland.” That shows just how desperately China needs either to increase domestic consumption (good for luxury goods!) or has to hope for an improvement in export markets like the US – but reduced imports were a “benefit” – helping the US to report better-than-expected Q209 GDP of -1.0% last week (the main reason being government spending in Obama’s “USSA”). Down the road, it is highly likely that we will have to worry about bubble economics in China and knockon implications for the global economy, but not for now. Unlike the US and UK, China has the reserves to pursue a very aggressive stimulus-driven recovery without bankrupting itself for a lengthy period. There are also some possible early warning signs that bubbles could emerge in other nations. For example: BB Bank lending in Brazil rose 19.7% in June versus the previous year. The figure of US$679bn was a record; and

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BB New mortgage loans approved in Hong Kong in June rose 36.5% from May to a record HK$38.4 billion ($5 billion) in June;

Cycles – a new pretender to Martin Armstrong Despite all the talk of rising stock markets, stabilising real estate prices and Chinese bubbles, we shouldn’t forget that the central bankers and politicians are fighting a desperate battle against the downward “gravitational pull” of massive debt-deleveraging across the developed world. This was only too apparent in the US Q209 GDP figure from last Friday where consumption (70% of GDP) fell 1.2% which was twice the expected decline. More original work suggesting that we are far from the end of the current down cycle has been written by Stephen J. Puetz in his new book, “The Unified Cycle Theory”.

Stephen Puetz’s new book



Source: Amazon

I’ve said before that Martin Armstrong’s “It’s Just Time – the decline and fall of the United States? The global financial system? Or capitalism?” is probably the finest piece of financial analysis that I’ve ever read. Armstrong’s Economic Confidence Model and his other cycles predicted the 1987 crash, the onset of Japanese deflation in 1989 and the onset of the current crisis as well as many other key financial and economic events. I hadn’t heard of Stephen Puetz but recommend his book which I’m part of the way through. While Armstrong has his core 8.6 year Economic Confidence Model, Puetz has a 6.36 year economic fluctuation/recession cycle. While they might seem very different at first sight, there is some similarity at their core. Before looking into them in more detail, it’s worth just noting when each of them predicted the peak in the current economic cycle: BB Armstrong’s 8.6 year cycle peaked on 27 February 2007; and BB Puetz’s 6.36 year cycle peaked on 24 January 2007. So they predicted a peak in the cycle within a month of each other. The emergence of the sub-prime crisis arguably surfaced with the announcement by HSBC on 7 February 2007, i.e. slap bang between the two, of an earnings shortfall in its US subsidiary due to rising delinquency trends in sub-prime mortgages.

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Looking at Armstrong and Puetz’s cycles in a little more detail: BB Armstrong’s 8.6 year cycle is composed of 4 x 2.15 year cycles, Puetz’s 6.36 year cycle is composed of 3 x 2.12 year cycles, i.e. they identify a shorter term “building block cycle”, if you like (my term), which is only 1.4% different in both cases. BB Armstrong’s 8.6 year cycles build up in group’s of six into a 51.6 year cycle. Puetz’s cycles always build up in units of three – so three units of 6.36 years build into a 19.08 year cycle of financial panics and bear markets. In turn, the 19.08 year cycles build up into a 57.24 year cycle of economic depression. BB Both Armstrong and Puetz acknowledge that their cycles of 51.6 years and 57.24 years, respectively, are similar to the 50-60 year cycles identified by Kondratieff. I find it very interesting that both Armstrong and Puetz identify almost identical cycles of just over two years, i.e. 2.15 and 2.12, respectively. It was the discovery of this cycle which provided the foundation for his work as Puetz explains: “The basis for this research started with my discovery of a 2.1 year cycle that dominated stock market activity over the past thirty years. I wondered if this cycle could be connected to various cycles already discovered by others. The core of the Unified Cycle Theory arose from three ideas. First, the concept that all waves appear as components of larger waves came from the Elliott Wave Theory. Second, Edward Dewey’s (who set up the Foundation for the Study of Cycles, Paul) observation that cycles often appear in harmonics of three was employed. Third, the theory used cycles already identified by the Foundation for the Study of Cycles.” I’m still only part of the way through Puetz’s book so I haven’t got an in depth understanding of his whole thesis yet. However, he also identifies interesting longer term cycles such as a 171.72 year cycle of severe economic depressions. The resulting weakness he argues “subjects nations to both external attack and massive civil discontent”. The current 172-year cycle also peaked on 24 January 2007 which hardly bodes well. Last time it peaked in 1835 marked the collapse in railroad stocks, the longest bear market in US history and was followed in 1861-65 by the American Civil War. Turning to Martin Armstrong, I should mention that his cycle work is multi-dimensional and goes well beyond the 8.6 year core Economic Confidence Model and its related harmonics, e.g. 51.6 years, etc. For example: BB There is a six year “intensity” cycle which runs parallel to the 8.6 year cycle and can cause “giant” or “rogue” waves when the two interact. BB A 37.33 year “monetary crisis” cycle which peaked in 2008 – spot on given what happened with Bear Stearns, Lehman et al – and usually leads to fundamental changes in the monetary system itself (when gold has typically performed very well as I’ve argued previously); and BB There is a 224 year cycle of “political change” which, taking the American Revolutionary War in 1775 as the starting point, peaked in 1999 (was this the peak of the US as a super power?); But cutting to the chase, what does Armstrong and Puetz’s cycles work say about the outlook? They are both bearish, a view which I’m in agreement with: BB As highlighted in a previous Thunder Road, the current downturn predicted by Armstrong’s 8.6 year core cycle does not reach bottom until June 2011. Additionally, the next peak in the six year intensity cycle is 2011, so 2011 could be a very “dark ride”! And we have to get there first. BB Puetz’s 6.36 years, 19.08 years, 57.24 years and 172 year cycles all peaked in January 2007. As he says: “The Unified Cycle Theory projects massive deflation for decades to come...more than likely, an economic depression started during July 2008 (with the break in commodity markets). And will probably exceed the Great Depression in severity.”

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As I’ve said before, Bernanke, Geithner, King, Darling et al are trying to defy economic gravity. Whilst hoping otherwise, I’m not optimistic that they offset the downward “gravitational pull” without destroying their respective currencies. Puetz gets this: “once a civilisation passes its prime, monetary authorities debase their coinage to sustain their spending programs. In modern times, central bank credit creation equates to the coinage debasement practiced by ancient, declining civilisations. In both cases, monetary systems disintegrate in ways that provided shortterm benefits at the cost of long-term stability.” Puetz acknowledges that his cycles work doesn’t always predict stock market and economic events precisely, but he’s usually fairly close from what I’ve read so far. Puetz’s work predicted a stock market high in December 1987 – so two months after the timing of the crash. Where his work seems to have been weakest is in regard to the Great Crash of 1929. While Armstrong nailed it almost precisely if you project his model backwards, Puetz’s 6.36 year and 19.08 year cycles peaked in September 1930, ten months after the Crash. His 57.24 year “depression cycle” peaked in 1949 and I haven’t yet got my mind round his explanation for the deviation yet. There is fascinating stuff in Puetz’s book on how geomagnetic changes influence behaviour and financial markets. I noted in a previous Thunder Road how several financial panics have corresponded with peaks in sunspot activity. Here’s an interesting quote from page 64: “on the first full moon after a solar eclipse, a panic-phase begins. A panic phase usually lasts two weeks – ending at the time of the next new moon.” As you probably remember from the TV news, we had a solar eclipse on 22 July 2009 with the best views being from South East Asia. Checking the full moon dates for 2009, the next one is due on 6 August 2009. Out of curiosity, I checked whether there was a solar eclipse last year and there was one on 1 August 2008, followed by a full moon on 16 August - so there should have been a “panic-phase” lasting through to the end of August. Lehman Brothers went into collapse on 9 September 2008 when the Korea Development Bank declined to invest in the bank. Still, that’s not too bad as a predictive tool. Let’s see what happens in the coming weeks.

US house prices – recovery likely short-lived The US housing market was the catalyst for the current crisis and, after 33 consecutive monthly declines, the latest Case-Shiller data published on 28 July 2009 for May showed that the 20-City Index rose by 0.5% on April. This wasn’t particularly surprising after the decline in the previous month was almost negligible at 0.6%. What amazed me was that the cheerleading anchors on CNBC didn’t make more of it. Maybe they were told to be downbeat on the stock market last week when the US Treasury had a record amount of bonds to sell? Is a sustained recovery in US housing in prospect? Larry Edelson of the Real Wealth Report, who has made some good calls in the past, believes so. He recently made a high conviction bullish call “US House Prices Have Bottomed” (here) stating that it is: “a forecast that I want to put on the record”. He went on: “I believe U.S. real estate prices have bottomed and are on the mend. Not many will agree with me. That’s for sure. And mind you, my forecast doesn’t mean property prices in every town in the United States have hit bottom. Nor does it mean you should run out to blindly buy property and expect to get rich on it overnight. But all the evidence I see tells me real estate prices in the U.S. are now a bargain … that we’re at the bottom … and that there will be a recovery in property prices, albeit slowly, over the next several years.” The main reasons for Edelson’s optimism are:

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BB Inventories of existing homes are down to a level which Edelson believes will see house prices find support;

BB The Pending Home Sales Index (i.e. sales that will complete within two months) has risen for five months in a row; BB Housing affordability has improved with the trend in house prices dropping all the way back to that of the reported CPI.

Other factors put forward by Edelson are that new home inventories are below their average level of the last forty years and house prices for overseas purchasers are at their lowest level for a decade helped by the decline in the dollar. Edelson is so bullish that he finishes with what he calls “a little unconventional wisdom”: “Don’t expect any rise in mortgage rates to kill off a recovery in U.S. property prices.

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Quite to the contrary, I would consider rising long-term interest rates bullish for U.S. property prices. Chief reason: Rising interest rates will likely set off a stampede of potential buyers and investors to get into real estate — before rates head higher.” I have my doubts about that, but let’s consider the bearish case put forward by Whitney Tilson and Glenn Tongue of T2 Partners in their latest presentation (here) from earlier this month. T2 believe that the current signs of stabilization are the “mother of all head fakes”. Firstly the fundamentals remain negative: BB While Edelson talks about the fall in inventories providing support for house prices, the T2 guys argue that at 10.2 months of supply, the industry is still close to a peak. Not only that, but even this figure fails to take account of the significant “shadow inventory” – homes that banks have foreclosed but not listed for sale and homeowners who can’t sell because they are so underwater; BB The trend in foreclosures remains upwards, While the May data showed a 6% decline to 321,480, it was still the third highest number of foreclosures behind those of March and April. Last Wednesday, RealtyTrac published the data for June and the first half of 2009. June foreclosures rebounded back to 336,173 while total foreclosures for the first half of 2009 were 9% above the previous six months and 15% higher than a year ago. According to James J. Saccacio, chief executive officer of RealtyTrac: “In spite of the industry-wide moratorium earlier this year, along with local, state and national legislative action and increased levels of loan modification activity, foreclosure activity continues to increase to record levels,” Looking through the presentation, there are other reasons why the foreclosure rate is likely to continue increasing BB There is a staggering statistic on Option ARMs which I hadn’t appreciated – about 80% of them are negatively amortising, i.e. unpaid interest is being added to the value of the loan. Most Option ARMs reset to fully amortising after 5 years unless negative amortisation reaches 110-125% of the original loan – in which case it is automatically triggered. Outstanding Option ARMs amount to about US$750bn. BB the resets of Alt-A mortgages have hardly even started – there are nearly US$200bn during 2010-12. They also have some worrying charts showing the rapidly rising delinquency rates for jumbo prime mortgages and HELOCs (Home Equity Lines of Credit) as well as Alt-A’s. Outstanding HELOCs amount to about US$1.1trn. On the subject of the problems spreading to higher quality borrowers, Lender Processing Services noted in a report from last Wednesday: “Reflecting the mortgage crisis’ evolution away from all things subprime, prime jumbo mortgages continue to fare the worst, comparatively: foreclosures among good-credit borrowers with high loan balances are up a whopping 580% since Jan. 2008 The conclusion of T2’s analysis is that US house prices will almost certainly fall by a further 5-10% down to the long-term trend line at 40% below the peak. The bigger question for Tilson and Tongue is whether they overshoot on the downside? Their view is that this scenario is “highly likely” due to overhanging inventory, negative psychology (buyers continuing to hold back) and further weakness in the economy. They do not see a bottom until mid-2010. On the subject of overshooting on the downside, Andrew Butter (managing partner of ABMC in Dubai) wrote a interesting piece on house price valuations (here) in the US and UK. Butter has a quantitative method for valuing house prices (based on income capitalisation and long-term interest rates) and then showing the divergence from the theoretical equilibrium. Unlike UK house prices, his analysis suggests that US houses prices don’t always correct to below their equilibrium level, although that is the normal course of events:

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US and UK house price - over/under-valuation (1945-present)



Source: Andrew Butter

After the biggest rise during the entire period, I would be surprised if the quid pro quo was not a period of below equilibrium pricing.

Gold – more insight on what’s really going on In the last two Thunder Roads, I argued how we are getting close to a dollar crisis and the disappointing US Treasury bond auctions last week were an early sign of its approach. On Wednesday, the bid-to-cover ratio of US$39bn was a worse-than-expected 1.92. Of course, this is very positive news for real money, like gold and silver, but with a total of US$115bn of Treasuries to sell this week and its Chinese creditors in Washington DC, the gold cartel went into action – gold went down while the dollar had a sudden (and probably brief) reversal just as it was set to test its June low. When the Treasuries had been sold and the Chinese left town, up went gold and down came the dollar.

Gold price (US$/oz): 29-31 July 2009



Source: Kitco

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Obama, Bernanke and Geithner continue to play lip service to bringing down the US federal deficit but their actions and future plans only make the situation even worse. In the wings, despite the denials, it looks like a new stimulus programme is being prepared by the US government. There was an interesting nugget of information from San Diego-based fund manager, Jim Puplava, the weekend before last: “We may get one to two, maybe possibly three, quarters of positive economic growth but you are going to see the unemployment rate climb close to 11%. The economic growth rate, even if we see it turn positive, will be so low it will be anaemic. And then we’re going to go right back down again which is why they are secretly working on a stimulus bill and I want to tell you folks, we’re going to get another one…I have it on good authority from the services we subscribe (sic), one of the economists is working with Pelosi on a second stimulus package that may be proposed in the President’s State of the Union speech in January.” Then there’s the proposed healthcare reform although now its got stuck in the legislative process. How Obama can claim that he can provide cover for 46 million more people without increasing costs is beyond me – and Doug Elmendorf, the Director of the Congressional Budget Office. In a letter written to Kent Conrad, the Chairman of the Committee of the Budget on 16 June 2009 he commented: “Many proposals to significantly expand insurance coverage would add to federal costs…Depending on the specific policies selected, the added cost could be on the order of $100 billion…We do not see the fundamental changes that would be needed to reduce federal spending by a significant amount and, on the contrary, the legislation significantly expands the federal responsibility for healthcare.” Elmendorf got summoned to the White House afterwards. Vice President Joe Biden has been canvassing support and at an AARP (American Association of Retired Persons) town hall meeting argued that if nothing is done about the unfunded healthcare liabilities (total US government unfunded liabilities are c.US$60trn) “We’re going to go bankrupt as a nation.” Biden is correct, but the problem is the nonsensical solution currently being proposed: “Now, people when I say that look at me and say, ‘What are you talking about, Joe? You’re telling me we have to go spend money to keep from going bankrupt?’ The answer is yes, that’s what I’m telling you.” As Mish (Mike Shedlock) commented on his Global Economic Trend Analysis website: “This is reminiscent of the My Lai massacre and the destruction of various Vietnamese villages in the Vietnam War. An American major said after the destruction of the Vietnamese village Ben Tre: ‘It became necessary to destroy the village in order to save it.” I was also amused to watch California “fix” its US$26bn budget deficit problem. Part of the fix comes from the possibly illegal withholding of US$2bn in taxes from local jurisdictions (e.g. cities) and what looks like about US$1.5bn from moving the last payday for state employees in the current financial year into the next. California, like the federal government and, therefore, the US dollar is living on borrowed time. Since the last Thunder Road, we have gained some important new insights into the gold and silver markets. First, how about this for an admission from a former insider? Ronald Reagan’s Assistant Treasury Secretary, and reputed to be the “Father of Reaganomics”, Paul Craig Roberts, said in the bi-weekly paper, Counterpunch: “The price of 1-ounce gold coins is $1,000 despite efforts of the U.S. government to hold down the gold price. How high will this price jump when the rest of the world decides that the bankruptcy of ‘the world’s only superpower’ is at hand?” How high indeed! His downbeat comments on the structure of the US economy apply equally to the UK: “There is no economy left to recover. The U.S. manufacturing economy was lost to offshoring and free trade ideology. There is no economy left to recover. It was replaced by a mythical ‘New Economy’. The ‘New Economy’ was based on services. Its artificial life was fed by the Federal Reserve’s artificially low interest

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rates, which produced a real estate bubble, and by “free market” financial deregulation, which unleashed financial gangsters to new heights of debt leverage and fraudulent financial products. The real economy was traded away for a make-believe economy. When the make-believe economy collapsed, Americans’ wealth in their real estate, pensions, and savings collapsed dramatically while their jobs disappeared.” Craig Roberts has been on blinding form recently. One of my key themes recently has been the countdown to a dollar crisis and here is part of an interview Craig Roberts did with the broadcaster, Max Keiser: Max Keiser: Quick question. What should the Treasury Secretary be doing? Craig Roberts: He should be trying to save the dollar as the world’s reserve currency which means stopping the wars, reducing the bailout money, and trying to reduce the trade and budget deficits in order to save the dollar. That’s what he should be doing. Max Keiser: Does the Treasury Secretary work for the people or does he work for the banking system on Wall Street? Craig Roberts: He works for Goldman Sachs (well the dark global brotherhood of transnational money interests, Paul). Gerlald Celente, of the Trends Research Institute, was brilliant on the Financial Sense news hour this week discussing increasing anger of ordinary people with the current state of affairs: “As we say in the trends business, there are three worlds out there. There’s the media world, there’s the political world and there’s the real world. And the media world and the political world are totally out of touch with what’s going on in the real world. This is just the beginning.” And: “The Americans can make fun of the French all they want, but the French workers stand up and the French people stand up (You’ve got to love the French in this regard – action not apathy, Paul). There’s going to come a time in this country where the people that aren’t weighed down with junk food and aren’t ‘Walmarted’ to death are going to stand up and fight. We are on the cusp of the second American revolution.” This is an interesting point as we watch the Anglo Saxon governments bankrupt themselves. It also fits with a theme highlighted by Martin Armstrong recently that protest/revolution goes in waves on a GLOBAL basis. A key theme in my bullish stance on gold and silver is that demand for physical bullion will eventually overwhelm all efforts by the authorities to suppress gold and silver prices. More indications of the tightness in gold and silver supply continue to pop up. GATA supporter Dave Kranzler finally received delivery on his COMEX silver contract: “it took over 6 weeks for HSBC to physically deliver the silver to our fund from our May Comex contract technically it should have left HSBC’s vault on May 29th.” And he did better than other buyers of silver bullion: “the people at our depository - First State in Delaware - told us they have customers still waiting for delivery of silver on their April contract.” We should also not forget the anecdotal evidence of how COMEX has put pressure on some investors to settle for cash rather than demanding physical bullion. Here’s another example. Although it was not announced in the press room (sneaky) of the US Mint’s website, the Prudent Investor found this elsewhere on the site “Production of United States Mint American Eagle Gold Proof and Uncirculated Coins has been temporarily suspended because of unprecedented demand for American Eagle Gold Bullion Coins. Currently, all available 22-karat gold blanks are being allocated to the American Eagle Gold Bullion Coin Program, as the United States Mint is required by Public Law 99-185 to produce these coins ‘in quantities sufficient to meet

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public demand’…The United States Mint will resume the American Eagle Gold Proof and Uncirculated Coin Programs once sufficient inventories of gold bullion blanks can be acquired to meet market demand for all three American Eagle Gold Coin products. Additionally, as a result of the recent numismatic product portfolio analysis, fractional sizes of American Eagle Gold Uncirculated Coins will no longer be produced.” As the Prudent Investor asked, why can’t the US Mint risk buying the gold it needs in the free market since it is legally required to sell these coins? Or will it contact the IMF, which is a seller of gold, about an offexchange deal although it might be at the back of a long queue of sovereign nations. That said, if history is anything to go by (like Gordon Brown selling 415 tonnes of our gold to bail out US banks who were the “wrong way” in the gold market versus a US$300/oz strike price), the IMF will try to unload it into the market at the most opportune time – like when gold next tests US$1,000/oz. The whole question of whether gold and silver ETFs are really the equivalent of buying gold bullion surfaced again with the 13 July 2009 announcement by Greenlight Capital that it had switched out of its 4.2m shares in the SPDR Gold Trust ETF (known by its ticker as GLD) and into the equivalent amount (nearly US$400m) of physical bullion. This was a significant move by a sophisticated investor - Greenlight is a US$5.0bn hedge fund founded by David Einhorn back in 1996. The question now is whether other large buyers of gold ETFs will follow suit and move into physical bullion. John Paulson, another huge buyer of GLD, comes to mind. Coincidently or not, Dave Kranzler (mentioned above) had sent a report outlining his concerns about investing in gold and silver ETFs to the Greenlight fund on two occasions since February. Several analysts, starting with James Turk of goldmoney.com and including Kranzler and J.S. Kim have looked at the prospectuses of major gold and silver and raised legitimate concerns as to whether an investment in the major gold and silver ETFs are really backed by gold and silver bullion and whether the massive gold and silver shorts on COMEX are legitimate custodians for the bullion in the biggest gold and silver ETFs since their identity appears to be the same. As I’ve highlighted in a previous Thunder Road, the delivery notices for gold and silver served on COMEX bear almost no relation to bullion moving into and out of the dealers’ inventory. Adrian Douglas, founder of marketforceanalysis.com and a director of GATA did some excellent sleuthing on the settlement procedures on COMEX and found this: “Exchange Rule 104.36, which governs exchange of futures for physicals (“EFP”) transactions on the COMEX Division, refers to a ‘physical commodity’ as one of the required components of an EFP transaction but also indicates that the physical commodity need only be substantially the economic equivalent of the futures contract being exchanged. The purpose of this Notice is to confirm that the Exchange would accept gold-backed exchange-traded Funds (‘ETF’) shares as the physical commodity component for an EFP transaction involving COMEX gold futures contracts, provided that all elements of a bona fide EFP pursuant to Exchange Rule 104.36 are satisfied.” As Adrian Douglas remarks: “The system is the ultimate alchemy. If ETF shares are NOT backed by gold but are accepted by the COMEX as equivalent to physical gold...presto! You have turned paper into gold - and paper is a lot cheaper than lead.”

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Author: I started work the month before the stock market crash in 1987. I’ve worked mainly as an analyst covering the Metals & Mining, Oil & Gas and Chemicals industries for a number of brokers and banks including S.G. Warburg (now UBS), Credit Lyonnais, JP Morgan Chase, Schroders (became Citibank) and, latterly, at the soon to be mighty Redburn Partners.

Disclaimer: The views expressed in this report are my own and are for information only. It is not intended as an offer, invitation, or solicitation to buy or sell any of the securities or assets described herein. I do not accept any liability whatsoever for any direct or consequential loss arising from the use of this document or its contents. Please consult a qualified financial advisor before making investments. The information in this report is believed to be reliable , but I do not make any representations as to its accuracy or completeness. I may have long or short positions in companies mentioned in this report.

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