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Jeff Saut Presents: Investment Strategy


We're not in Kansas anymore...


"'I worry incessantly that I might be too clear,' Alan Greenspan once said. He needn't fret too much, at least when it comes to headline writers. 'End to Rate Rise Cycle Signaled,' Wednesday's Financial Times splashed on a banner page one headline after last week's meeting of the Federal Open Market Committee. 'Fed Gives Mixed Sign of Rates; After 13th Raise, Hints of More,' The New York Times reported that same day. 'Fed Raises Rates, Modifies Its Tone; Neutral Point May Be Near As Statement Leaves Room For a Pause in the Increases,' according to The Wall Street Journal, which split the difference."

"Meet the Press," by Randall Forsyth (Barron's 12/19/05)

Alan Greenspan was anointed "Fed Head" on August 11, 1987, making him the second-longest-serving Chairman (18 years and 173 days), only superseded by William McChesney Martin's 18-year and 304-day reign. During Mr. Greenspan's tenure we have repeatedly noted that we often couldn't decipher what the esteemed Chairman was saying because he tends to speak in the quatrain-like fashion that was lionized by the prophet Nostradamus (1503-1566). Consequently, we hope the incoming Chairman, namely Ben Bernanke, will be clearer than Sir Greenspan because he will be confronted by many domestic and international challenges. Indeed, the new Chairman is by default the"head" of the world's financial system. As such, Mr. Bernanke will need to address the current disequilibrium that exists between the U.S. and the world's largest economies. He will also need to make some tough domestic decisions regarding the housing sector, the burgeoning debt situation, an undersaved/overspent consumer, the trillion dollars of mortgages that are going to reset at higher interest rates over the next two years, and the list goes on.

So far, however, EVERYONE is convinced that Ben Bernanke's transition will be seamless. As the brilliant Jim Bianco notes:

"The financial press has really fallen down with its Bernanke coverage. About all they agree on is he's a good choice. Why is he a good choice? Think of every possible combination of reasons known to man - all of them are featured everyday! He's bold, he's timid, he uses rules, he pragmatic, he will change the Fed, he will keep its continuity with the Greenspan era, he's a dove, he's a hawk, he's Red Sox fan, he's a Nationals fan. The man is everything to everyone at the same time!"

Like Mr. Bianco, we think "the Street" is pretty darn complacent regarding the transition of power at the Fed and complacency always worries us. We are focusing on the Federal Reserve this morning because it was 92 years ago last Friday (December 23, 1913) that the Federal Reserve Act was passed into law. The House had passed the bill the night before, while the Senate passed it the next day. Subsequently, at 2:30 p.m. on December 23, President Wilson signed it into law. Charles S. Hamlin was appointed the first Chairman of the Fed on August 10, 1914 and he was followed by 12 other "Fed Heads," making Mr. Bernanke the 14th Chairman of the Federal Reserve. Interestingly, the main mission of the Fed is to guard against inflation. As espoused by Fed Governor Donald Kohn recently, "Price stability is our responsibility as central banks - it is how, in the long run, we contribute to society's welfare. Achieving and maintaining price stability will be more efficient and effective the better we understand the causes of inflation and the dynamics of how it evolves." Amazingly, Mr. Kohn didn't even "wink" when he made this statement.

Price stability indeed, for as can be seen in the dollar chart (courtesy of Barron's) on the following page, since the Fed's creation in 1913 the greenback has lost more than 92% of its value. The decline has been so subtle, however, most Americans haven't noticed. As one savvy seer noted - it's kind of like putting a frog into a pot of warm water and then gradually turning the heat up until it boils. The frog doesn't seem to notice what's going on until it is too late. Of particular interest is how the "buck's" depreciation accelerates when the dollar is de-linked from gold. We thought a lot about gold over the holiday as we watched "The Wizard of Oz."

Now, most people know The Wizard of Oz as one of the most popular films ever made. What is little known, however, is that the book it was based on was an economic and political commentary surrounding the debate over "sound money" that occurred in the late 1800s. Verily, L. Frank Baum's book was penned in 1900 following unrest in the agriculture arena (read: farmers) due to the debate between gold, silver, and the dollar standard. The book, therefore, is supposedly an allegory of these historical events, making the information easier to understand. In said book, Dorothy represents traditional American values. The Scarecrow portrays the American farmer, while the Tin Man represents the workers and the Cowardly Lion depicts William Jennings Bryan. Recall that at the time, Mr. Bryan was the official standard bearer for the "silver movement," as well as the unsuccessful Democratic presidential candidate of 1896 (he was also a main character in the Federal Reserve Act of 1913). Interestingly, in the original story Dorothy's slippers were made of silver, not ruby, implying that silver was the Populists' solution to the nation's economic woes. Meanwhile, the Yellow Brick Road was the gold standard and Toto (Dorothy's faithful dog) represented the Prohibitionists, who were an important part of the silverite coalition. The Wicked Witch of the West symbolizes President William McKinley and the Wizard is Mark Hanna, who was the chairman of the Republican Party and made promises that he could not keep. Obviously "Oz" is an abbreviation for "ounce."

As we watched the movie we thought how appropriate an apologue for our current environment given the recent action of gold, silver, the dollar, the T'Bonds. This time, however, the "man behind the curtain" is Alan Greenspan, to which we are paying little attention. What we are paying attention to is the charts, since in this business price is reality. Consequently, when we look at the "gold standard" of our era, namely the dollar, the picture is still not a pretty one, even after its recent rally. As a sidebar, it should be noted that before 1873 the U.S. dollar was defined as consisting of either 22.5 grains of gold or 371 grains of silver. This set the legal price of silver in terms of gold at roughly 16:1 and put the country on a gold/silver bimetallic standard. Since both metals had other uses than just coinage, whenever the ratio got out of whack, rational people would buy the cheaper metal and take it to the mint to coin. That provided a natural stabilizing arbitrage. With the 1873 Coinage Act, however, the silver dollar was omitted, effectively shifting the country from a bimetallic to a gold standard. Other countries soon followed this shift and as tons of silver were unloaded, the market silver price of gold rose from 16:1 to 40:1. The result was that the dollar was now linked to a metal that was getting scarcer and scarcer.

Particularly hurt by these events were the net debtors, among them the farmers because they had to face a rising real value of their debts combined with declining agricultural prices (in dollar terms). Now, while there was a bunch of "noise" in between (the Sherman Silver Purchase Act of 1890, the panic and depression of 1893, etc.), the situation hit its zenith in 1896, culminating with William Jennings Bryan's "Cross of Gold" speech at the Democratic National Convention. While we have digressed, we truly find monetary history fascinating and would further note that the value of our current dollar, valued in 1900 dollars, is worth roughly $0.03, causing one Wall Street wag to lament, "So much for the Federal Reserve System."

The call for this week: As commodity trader Hunt Taylor opines, "You have to pay the most attention to market moves that seem to make no sense, because those are the moves that contain the most information. They will make sense to you later on, but only as prices are very different from today." We think the concurrent rally in gold AND the dollar over the past few months is such a "makes no sense" move. One of the two is lying! Our sense is that it is the dollar, which we expect to lose its tailwind in the New Year. Meanwhile, gold's strength infers upcoming inflation that will be greater than most think. Or as Bill Fleckenstein notes, "In a social democracy with a fiat currency, all roads lead to inflation." We continue to invest accordingly.

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