Shepherd Investment Strategist Review

Investment Recommendations – see below January, 2009

“The Rich Ruleth Over The Poor” “And The Borrower Is Servant To The Lender”Proverbs 22:7 King Solomon, who was, we are told, the wisest human who ever lived, wrote these words nearly three thousand years ago. The truth of them is just as apparent today as it was then. The ancient Roman Empire also experienced the sharp end of this principle, as it was their fiscal irresponsibility, moral and political decay that brought down the longest-standing empire in human history. So was the case with the decline of the British Empire; debt was the chief reason for their fall from world dominating economic power. I have on previous occasions pointed out the many parallels that exist between the recent history of the United States and that of late-stage Rome, particularly with respect to debt. When debt becomes unmanageable and unmarketable to others, inevitable consequences result. Sadly, we seem to be on the precipice of that very outcome right now. Some of you may have heard about the campaign of the former Comptroller General of the United States, David Walker, to alert the citizenry to the perils of excessive debt. I recently viewed a movie that documents his efforts and to say that it is scary would be the grossest of understatements. As I pointed out in the last two newsletters, our debt has bulged dramatically, and has in the last few months, as it will continue to do in coming months, expanded even more frighteningly. Yet, my numbers did not include the entire story. I only referred to the sum of the confessed national debt, and the recently added liabilities, which totals approximately 18 Trillion USD. That is a lot of money, but if you include the unfunded liabilities for Medicare and Social Security, the numbers become mind-boggling. The movie I am referring to should be seen by every person in this country; more information about it can be found at: www.iousathemovie.com. Although the

movie was produced just before the pledges and spending that were done recently, it demonstrates that the national debt, including the aforementioned unfunded liabilities, totaled some 53 Trillion Dollars! That is around $175,000 for every man, woman and child in the country. Again, this figure does not include the recent 8 Trillion or so of spending and commitments. Why, you may ask, do I keep harping about debt? Well, I assure you it is not to aggravate or frighten you; rather, I discuss this issue presently and frequently because I intend to demonstrate that the level of indebtedness we now have, almost guarantees some very unpleasant outcomes in the investment world in the nottoo-distant future. That is what I am interested in. History is clear: A nation that defies the laws of debt accumulation for too long loses its power. For example, as is mentioned in the previously referenced movie, the United States was able to exert political pressure on Great Britain in the Suez Canal crisis of 1956 by using the threat of dumping its substantial holdings of British sovereign debt and currency. The leverage worked, and the ultimate consequence was that the U.S. Dollar emerged as the de facto world currency, overshadowing the Pound, and has held that status ever since (although that may soon end, as we will discuss). Now, as we rely on foreign nations to buy our ever-increasing debt, we are putting ourselves in a position of being the servant, or slave, to our creditors. As the world‟s largest debtor nation, we absolutely are, to a major extent, answerable in our actions to our creditors. This includes totalitarian states that certainly do not have the same world views as our democratic ones. For example, we owe a combined more than One Trillion Dollars to China and Japan. This is a result, of course, of continuing trade deficits and the direct investment by these countries in our Treasury instruments. Now, so long as they continue to hold this paper without any substantial change, it could be argued that this is causing little harm. But, suppose they decide to start dumping their

investments in our Treasury paper because, for example, they fear that the fiscal mess we are in will torpedo the value of the U.S. Dollar? Or, suppose we have a political

disagreement with China, such as has occurred before? Could they use the leverage of threatening to sell their holdings to sink the value of the dollar? YES.

Of course, as we go forward in this financial crisis, not only will we have to continue servicing the existing debt, including the foreign portion depicted above, but we will also be adding huge layers to our national debt in the next few years. The fiscal 2009 deficit is already confirmed as being at least $1 Trillion! Is the U.S. immune to the laws of debt? Well, as we warned would be the case over the last couple of years, the U.S. consumer proved they were definitely not immune to these principles and the mortgage debt collapse we predicted has sent the world into financial chaos. Now, a grossly indebted Federal Government (not to mention state and local governments that are teetering on insolvency) intends to borrow and spend its way out of trouble. Had we not doubled our national debt in the last eight years, perhaps there would have been some latitude to provide enough fiscal stimuli, safely, to arrest the economic decline. However, since we did add massively to our debt, particularly from 2000 to 2008, we have little chance of not exceeding the debt threshold in our attempts to revive the economy. Ask yourself the question: Is it reasonable to think that the

cause of the disease (debt) can also be the cure for the disease? I don‟t think so. Just why, you may ask, do I think we have reached some magical level of debt that is unsustainable? Well for one thing, we have now eclipsed the highest Debt/GDP ratios since the Second World War. At that time, with the U.S. just an emerging industrial power, and with the massive spending needs related to the war effort, it was not surprising to see debt as such a large percentage of output. But now, with the national debt at the end of 2008 totaling over 10 Trillion Dollars, and with GDP somewhere around 14 Trillion Dollars currently (we know this will be shrinking over the next number of quarters) it is easy to see that the Debt/GDP ratio is approximately at 71%! Add to this calculation the expenditures planned and not included in the reported national debt of 10 Trillion Dollars, and it is quite likely we will soon see a national debt that significantly exceeds annual GDP. Is it logical to assume that a country can, for long, sustain a debt burden such as above? No, I do not believe so. It would be very much like an individual accumulating credit card debt in the aggregate that

exceeds their yearly income. Soon, as many have already experienced, such an individual finds it impossible to keep making the required payments. Then, bankruptcy looms. With a nation, there are other measures available.

Magic? No, Operations!

Open

Market

As I mentioned, unlike an individual, a sovereign nation has alternatives when it finds itself spending more than it takes in. Of course, in the case of the United States, this has been going on for decades and that is why we find ourselves with the massive amounts of debt that we do. Some of you have asked: What exactly does the Federal Reserve do to create money? The answer is not quite as difficult to understand as is the question, “How can you create something from nothing?” The Federal Reserve, as the Central Bank of the United States, controls the money supply and sets official interest rate targets. Without going into too much detail, which some of you may not wish to bother with (if you would like more information about the Fed, their website at www.federalreserve.gov has considerable information available) I will endeavor to simply explain how the Fed is able to create money „out of thin air.‟ When the Federal Reserve desires to increase the money supply in the banking system, the Federal Open Market Committee conducts what are called open market operations. The FOMC, intending to inject liquidity into

the system, will purchase securities from banks via the Federal Reserve Bank of New York. Previously, the Fed would only purchase Treasury securities but now, with the financial crisis intensifying, we know that they will purchase almost anything: student loan portfolios, mortgage backed securities, commercial paper, and iou‟s (just joking) to name a few. When the bank receives the credit for the purchase of the instruments, the intent is that more money will be available to be loaned. The securities themselves are now on the Fed‟s balance sheet and so, for all practical purposes, the money supply has been increased by the amount of the securities purchased. Notwithstanding the above, the creation of the Troubled Assets Relief Program (TARP) operated by the Treasury Department has not yielded the results hoped for. This is because banks, unwilling to commit the same blunders that got them into the trouble they are in, are reluctant to loan monies as before. Furthermore, those that are qualified to borrow are leery about doing so because they wonder about the prudence of borrowing to expand in a declining economy. This all relates to the issue of the velocity of money, which we have discussed in the past. In certain environments, such as the deflationary vacuum we presently find ourselves in (precipitated by the credit bubble burst and exacerbated by the worldwide economic contraction), the amount of money attempted to be pumped into the system is not necessarily consistent with the outcome desired. The emergence of this environment is, I believe, now very clear.

Source: Federal Reserve Bank of St. Louis

The above depiction of the rate of change of the Producer Price Index for Finished Goods speaks volumes to the issue of whether or not we are now in a very strong deflationary environment. I intend to deal with this subject much more thoroughly later in this

piece, and specifically how we can profit from it, but for now, please notice just how quickly prices are declining. This is due to demand destruction with respect to producers, as consumer demand for finished products has deteriorated in the face of recession, and, of course

the natural effect of the contraction caused by the bursting debt bubble. This is exactly what we have been expecting, and the clear emergence of this environment assures us of great opportunities ahead.

Whew, I‟m Feeling Much Older These Days! No, I am not talking about physical effects of the market on my individual health. I am very familiar with hectic markets and dramatic changes. What does make me feel quite a bit older is that, according to the computer models developed by Goldman Sachs, the credit crisis we are living through is only supposed to occur every 100,000 years! Now, I do have a lot of historical data in my records, but it doesn‟t go quite that far back! Amazing, isn‟t it, that a company such as Goldman could make such an inaccurate and frankly laughable (and arrogant) forecast? Yet, again, there are always ulterior motives at work in the investment world. The reality is the banking, investment banking and mortgage community had to make the likelihood of disaster with respect to the nonsensical lending instruments seem so infinitesimal that rating agencies would affirm and then investors would snap up their Structured Investment Vehicles (SIV‟s). They claimed that with the risk of these mortgages and other paper spread to investors around the world, there should never be a significant problem. However, they made one crucial mistake. The pyramid they built was upside down, with the entire weight resting on the very shaky and weak foundation of those with a demonstrated inability/lack of reliability to pay back what they borrowed. So now the financial community is suffering and will be heavily regulated by those who have no business being in business (some of these Congressional leaders encouraged this borrowing to give the „right‟ of home ownership to everyone---it should never be a right but rather an opportunity that people can work towards realistically), and we, the taxpayers, will be left holding the bill. Now, the very same financial geniuses that are responsible for this catastrophe are claiming to have the answers for what lies ahead. Can you trust their forecasts? Well, when you consider their inevitable conflicts it seems unlikely. They (the majority of financial advisors, brokers and analysts) are all tied to the same fundamental approach: you should be primarily invested in stocks at all times. This way, whether the market goes up or down, they make money. For their investors, however, it is another story entirely.

So, to remind you of what I said would be the outcome, I am including here a couple of direct excerpts from the January 2007 and 2008 newsletters. Again, anyone willing to look objectively at the facts at the time should have been able to come to the same conclusions; yet, as I said, very few did because they mostly had ulterior motives to drive their outlooks. I do not, and so I can freely say whatever I believe will be the case. January 2007 So, to sum up, unlike other expansions that were long-lasting and sustainable for valid economic reasons, this so-called expansion was merely a borrowing binge based on valuations that were driven up by artificial means. Since the economy depends upon consumer spending for fully three-quarters of its activity, it is not difficult to see that when the consumer slows their spending---not because they want to but because they will have to---economic activity will grind to a halt. This is precisely what causes recessions in the modern economic environment and with the level of debt in place, and the shock an economic downturn will deliver to the consumer, it is not unrealistic to expect a deflationary depression to emerge. January 2008 So, to sum up this section, I wanted to try to point out, not just by referring to my model’s readings, just how dangerous the stock market really is right now. It is telling us, technically, that it is on the verge of collapse and certainly the underlying economic fundamentals are saying exactly the same thing. This is what I have been pointing out for considerable time. Yet, as is often the case, the inevitable outcome has been delayed by some unprecedented and rather desperate measures by the Fed and others. Certainly, the blatant attempts by many financial firms to delay reporting the severity of the impact of their holdings in the toxic mortgage area will be scrutinized more and more as their financial health continues to deteriorate. So too will the fallout be great when the rating agencies, quick to grant AAA investment grade status to a basket of junk because of the fees they earned, are forced to significantly downgrade not only the holdings of many of these financial institutions but, even more ominously, the major insurers of a lot of Bonds and other investment vehicles. End of Excerpt Inclusions

What Lies Ahead? Early last year, I noted that I expected four great themes to emerge: collapsing stocks, tumbling commodities (especially oil), surging Treasury Bond Prices, and a rising U.S. Dollar. Obviously, all of these

came to pass, but the Dollar did not perform quite as well as expected so far. This, I believe, will soon change. Please observe the following chart of the U.S. Dollar Index, which represents its value versus a basket of world currencies.

Dollar begins to decline as massive spending promises erode credibility in its long-term value. U.S. Dollar begins to rally strongly as the financial crisis intensifies, leading to a flightto-quality mentality.

Dollar stabilizes as other world economies decline sharply, diminishing interest in their currencies, and deflationary forces build.

US Dollar Index Daily thru 1/12/2009

I realize some of you may be wondering why I am forecasting a rise, at least for a while, in the value of the U.S. Dollar, particularly considering the gloomy debt picture I painted earlier. It is a fair question and I am sure that ultimately the outcome for the Dollar will be exactly as the debt argument would dictate---much lower. Yet, we must operate in real time and for now, the Dollar is regaining upside momentum because, as the rest of the world sinks quickly into recession, it is still considered the world‟s reserve currency. In fact, many of our trading partners who rely on their exports to the U.S. are suffering even more than we are in the U.S. So, for now, I believe money will continue to flow into U.S. Dollars, especially since we have identified the clear emergence of deflationary forces. In a deflationary environment, since most prices are falling, the relative value of the world reserve currency rises. So long as the U.S. Dollar remains the de facto world currency, we should see it rise as the deflationary forces strengthen worldwide. However, as I have said, we must remain aware that once the inflation emerges that will undoubtedly develop due to the massive spending plans in the works, the Dollar will collapse and will likely lose its status as the world reserve currency. As to which currency will take over that status, I cannot as yet say. But, it would not surprise me to see the Yen

emerge in that role as the Japanese economy is very similar to that of the United States when the Dollar became the world reserve currency. Japan, as the U.S. used to be, is the world‟s largest creditor nation; they eschew debt as individuals (as Americans once did), and they have large personal savings (so did Americans in the not-too-distant past). Furthermore, the same relationship exists between the U.S. and Japan now as did in the past between Great Britain and the U.S. when the British Pound was about to decline from world dominance: The Japanese have massive holdings of U.S. assets, and they have no debt. They export huge amounts of goods worldwide (as did the U.S. at the peak of its manufacturing dominance) and have huge reserves. They are, as the title of this piece said, the lender to the world in many ways. So, to sum up this section about the Dollar, here is my straightforward forecast: The U.S. Dollar will strengthen significantly as deflationary forces intensify. Then, at some point in the future (once the model identifies the real beginnings of a spending induced inflationary cycle) it will sharply decline and eventually be replaced by some other currency as the de facto world currency.

Gold

Gold Daily thru 1/12/2009

Obviously, the price of gold is greatly influenced by the value of the U.S. Dollar, since like many commodities, gold is mainly denominated in USD. If the Dollar strengthens substantially, generally speaking, gold will decline. Similarly, when the Dollar weakens, gold benefits. As we look out into the future, it is very important to understand the implications for gold, and our approach to it as both an insurance policy and as an investment. As you may know, I have recently given my tacit approval to the accumulation of physical gold utilizing 5 to 10% of your portfolio. I made it clear that I could not make an all out recommendation to view gold as a pure investment just yet---not until we get an inflation reading in the model sometime in the future---and that over the short term gold could decline. We know that the long run prospects for gold are excellent, however, as it seems inevitable that the spending binge to bail out the U.S. economy will ultimately translate into strong inflation. Yet, we must look at the overall picture very carefully. While it is true that the U.S. is spending to stimulate, so are many other countries in the world. The Euro zone is spending just as aggressively as we are and interest rates there have been reduced dramatically. The same thing applies to many other areas of the world. So, if our spending is simply relative to others, we may not see a reaction for some time. I know many have said, “Why wait to buy gold if you think it is going higher in the future?” My answer is that I have noticed a distinct lack of long-term perception amongst investors whose

portfolios are in a nasty short term negative position! I believe we should wait until we get further clarification in the model to begin to aggressively accumulate gold as an actual investment theme. If you observe the above chart of gold, you can see that I have drawn in a couple of parallel lines. These lines define a fairly clear downtrend channel which has been in existence since the summer when many commodities began to peak, including and especially oil. As you can see, there have been a couple of occasions where gold has moved up to the upper trend line and was repulsed. This also happened recently and it looks very much like gold will move now toward the bottom of the downtrend channel. If that is the case, we could see gold quite a bit lower over the next few months, as the deflationary forces mount, and so I do not think it behooves us to get too aggressive in accumulating gold just yet. We are already, if I am correct, preserving our purchasing power by virtue of our holdings in U.S. Dollars for the time being and when things change, we will have already shifted our stance. Therefore, here is my second forecast, for at least part of this year: Gold will not shoot higher as one would expect in a spending environment because the deflationary forces that have been unleashed will, at least temporarily, overpower the stimulative forces that are being brought to bear. Later on, gold will advance mightily but only after we receive an inflation signal in the model.

Stocks and Deflation DJIA peaks September 1929 @386 50% retracement takes DJIA back to 297 as of April 1930

Deflationary spiral signal emerges in model Crash of 1929 takes DJIA to 195 by November

DJIA finally bottoms July 1932 @ 40!

DJIA Weekly --- Late 1929 – 1932

As I have pointed out on numerous occasions, a deflationary environment is not very friendly to many investment classes. This is true as well for stocks. In a strong deflationary situation, which would be defined as a deflationary spiral and which would result in such a reading in my model, stocks generally collapse. This was certainly true during the very deflationary environment which followed the initial crash of stocks in 1929 and to which we refer as The Great Depression. As you can see in the above chart of that era, I have notated the chart with some important points. First of all, you can see that after the crash of 1929 the DJIA was able to rebound from its initial lows in October 1929 by a factor of about 50% of the decline. It reached its rebound peak in early 1930 and if you review the history of that period, you will find there was a lot of optimism that the worst was over and that stocks were headed solidly higher for the foreseeable future. That certainly was not the case. As is apparent, after the DJIA had its 50% retracement rally it began an almost straight down collapse, eventually taking it from the rebound level of nearly 300 to its ultimate low of 40! This represents an additional decline of more than 86% of the value of the DJIA. Furthermore, it brought the cumulative decline of the DJIA from its peak in September 1929 to its low in July 1932 to a stunning almost 90%. That is the power of

a deflationary spiral, which began in early 1930 as indicated by my model (in historical fashion). Now, I have been carefully monitoring the situation with respect to deflation and my model over the past few months. As I have been expecting, and as we have previously discussed, deflation is taking hold in a very ferocious manner. Since Producer Prices are a component in my model, it is entirely possible that we could see the confluence of a deflationary spiral reading with a critical mass reading. This would insure the most dramatic of declines, I am certain. Unlike past times when news circulated slowly and investors had limited ability to move in and out of investments quickly, we now have lightening fast trading and news dissemination. This could mean a drop in stocks, (if these readings emerge as they very likely will) such as has never been seen before. Investors around the world, in a very compressed timeframe, could sink stocks worldwide in abject panic. We will have to monitor the situation very carefully, as such an environment would be devastating to most investments and fabulously profitable for those of us properly positioned. Do not think that such a scenario could not unfold and that it would be impossible. I am sure you would agree that a lot of what we have seen this year would have been deemed impossible as well, just a few short months before.

Deflation!

Producer Price Index (Finished Goods) Monthly Year/Year Change

As I was expecting, we have, as of the December PPI data released yesterday, seen the first emergence of actual falling prices in this data for a long time. This means that the likelihood of spiraling deflation is much higher, particularly since energy is such an important component of this data series and the direction for energy prices is probably much lower. So, what does all this mean to us? I have explained in the past that I use the PPI Index for Finished Goods as a measure of wholesale inflation, based on the monthly change from the previous year‟s level. This way, there can be very little manipulation in the data and I can be confident that the readings are accurate. If you notice the very last bar in the chart, representing December 2008, you can see that it has moved to a negative on a year-over-year basis. Since prices, as is evident in the chart, were climbing at a rate of 10% year-over-year just a few months ago, chiefly because of the influence of oil, this negative reading represents a very dramatic change in trend. This is why it is so important. Now I must hasten to say that we have not yet seen the outbreak of a deflationary spiral which would be recognized by the model. Yet, I would not be surprised to see this develop soon. So, we can safely say that this is a very dangerous environment for stocks and for most asset classes. Although the Government and the Fed are frantically attempting to re-inflate to stop this progression, so far their efforts have been ineffectual. I do not believe they will be able to halt this progression before we see a

deflationary spiral emerge, because the pressures generated by the bursting of the worldwide debt bubble are simply too enormous to overcome immediately. Therefore, we will be evaluating the proper deployment of our capital based on the environment at hand, not on what will emerge sometime in the future. This means that we will soon be re-entering the short side of the stock market, expecting to see prices decline consistently as the deflationary forces strengthen. As you can see in the above chart, when Producer Prices were negative in a good part of the 2001 – 2002 period, it corresponded to sharply falling stock prices. Remember, however, there never was a deflationary spiral signal at that time and yet stocks still fell sharply. I am sure you can imagine the pressures on stock prices if (which I expect) a true deflationary spiral does develop. If this occurs shortly after, or concurrent with, a critical mass reading in the model, we could see prices fall in very similar fashion to what happened in the early 1930‟s as previously depicted herein. So, we must be realistic enough to realize that sometimes all the King‟s horses and all the King‟s men simply cannot put a broken system back together again, at least not very quickly. I alluded to the fact that oil, a chief component of the PPI series above, was likely to continue to fall and add pressure to price declines. I believe it is entirely possible to see oil fall all the way back down to its pre-credit bubble level. This would be back to the price levels of late 2001 at least. As you can see in the following chart, that would be quite dramatic.

Light Sweet Crude Weekly

Rarely have we seen such a dramatic collapse in the price of anything as is depicted in the above chart of crude oil. From the summer, as you can see, it has moved virtually straight down, losing some 75% of its value from its high! This is a clear indication of powerful demand destruction brought on by the recession in the United States, and then having spread throughout the world. This is exactly what we were expecting, but the rate at which this decline has occurred has even surprised me. It means, I believe, that the aforementioned deflationary forces are more powerful than any we have ever seen, possibly even including the Great Depression era. This is very ominous indeed.

Bonds Although we made a great deal of money in U.S. Treasury Bonds, beginning all the way back to late 1999, I know some of you have wondered why we are currently not in Bonds. As you know, Bonds have spiked higher in price recently, as the flight to safety mentality has gotten intense. Yet, we still have to weigh risk and reward in our investment stance. Although Bonds rallied strongly in the latter part of 2008, I was concerned that the massive spending plans by the U.S. might influence investors around the world to dump their Dollar-denominated holdings as a reaction to the potential for emerging inflation. I feared there could be a bloodbath in Bonds if this developed. So, we chose to focus on shorting the stock market and then in preservation of capital by being invested in Treasury Bills, while we await our next campaign into stocks and other areas.

That said, I believe Bonds will still be a very profitable investment in the near future, once the deflationary forces really take hold. I would not be the least surprised to see Long Term Bond yields fall to the 12% level as this all plays out. With strategic investments in Bonds, perhaps at slightly lower prices than they are currently, this would translate into fantastic profits. So, I assure you, Bonds are still going to be one of our favorite strategies as the events we are expecting play out. There are a lot of things happening at breakneck speed. Yet, with the assistance of the model, which has accurately forecast most of what has transpired, I am confident we will be able to navigate these currents effectively and profitably. As we go forward into the New Year, let me say how much we appreciate all of you, and that I am dedicated to protecting and growing your capital as we go forward. I will keep you posted. Take care. EDITOR'S NOTE: Current investment recommendations are always deleted from complimentary newsletters. To subscribe at greatly reduced rates with SAVINGS of up to $300.00 and to take the next step in your preparation for the next TRADING OPPORTUNITY CLICK HERE If you have a friend, co-worker or family member who you feel could benefit from The Shepherd Investment Strategist , please forward this issue to them CLICK HERE

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