Money and Markets

Before Dad passed away, we often went for walks while we debated how history might repeat itself, and when.

Our primary concern was the wild 1970s, the time of the most rapid, the most threatening and the most profitable market events in modern history.

That's when double-digit inflation reared its ugly head ... the dollar's value collapsed ... gold surged from $103 to $850 ... and short-term interest rates catapulted from 4% to 20% -- all in less than four years.

That's also when major American banks lost so much money in the bond market it wiped out most of their capital ... and when investors made so much money in precious metals, Midas would have been green with envy.

Under what circumstances could something like that happen again? How could investors protect themselves from the fall-out? How could they profit?

The key to finding the answers, we agreed, would be to identify parallel patterns -- not only in the world of money but also in the arenas of political conflict.

Those parallel patterns are precisely what I see today.
My one regret: That Dad is no longer here to see them with me.
My great wish: That you see the perils and take the needed actions.

Parallel Pattern #1
Easy Money Creates Bubbles

Major market moves -- and even many social ills -- often begin with money.

When money is too easy to get, too easy to spend and too cheap to borrow, it creates economic bubbles that inevitably burst: Bubbles in stocks and bonds ... bubbles in real estate and housing ... plus bubbles that are not always visible to the naked eye.

That's what happened in the late 1970s. And that's also what's happening right now.

Late 1970s

The troubles began in 1974-75.

We saw the Dow plunge 40%. We saw the economy suffer its worst recession since the 1930s. And we saw giant companies like Chrysler and Penn Central Railroad sink into bankruptcy.

Even America's largest city, New York, was going under.

Federal Reserve officials reacted with one common emotion: fear. They feared a chain reaction that could sink the nation into another Great Depression. And it was that fear which drove them to abandon all restraint, opening the money floodgates like never before.

They made massive amounts of easy cash abundantly available. They slashed the cost of short-term money to 4%, its lowest level of the decade. And they encouraged Americans to borrow, spend and speculate with wild abandon.

Sure enough, the stock market recovered. But simultaneously, massive bubbles emerged throughout the American economy:

• There was an obvious bubble in real estate as thousands of savings and loans, flush with hot money, dished out cheap mortgages to nearly all takers.

• There was an obvious bubble in Detroit, as millions of American drivers piled into gas-guzzling automobiles.

• And there was a not-so-obvious bubble in the bond market, where investors loaded up with long-term Treasury bonds, tax-exempt municipal bonds and speculative junk bonds.

Today

Decision-makers at the Fed have followed an almost identical script.

In the early 2000s, former Fed Chairman Greenspan and his cohorts watched the Nasdaq -- representing America's largest and most advanced technology companies -- crumble by 70%.

They watched the plunge of Enron, WorldCom and hundreds more into a cesspool of scandal and red ink.

And they saw the ugly face of the monster that scared them the most of all -- deflation and the threat of falling values on every front.

So again, much like their counterparts of the 1970s, they began flooding the economy with easy money. But this time, they went even further.

Rather than just cutting interest rates down to 4%, they slashed them all the way down to 1%, the lowest in a half-century.

And rather than just allowing ordinary, traditional borrowing, they encouraged Americans to literally hang themselves with the most dangerous kinds of loans ever created.

Sure enough, as in the 1970s, the stock market recovered. But ...

• Again, there was a bubble in real estate, as millions of households borrowed at low fixed rates ... and millions more rushed to take out adjustable-rate mortgages, interest-only mortgages and even negative amortization mortgages in which the loan balance gets larger month after month.

• Again, there was a bubble in Detroit, as America's love affair with the gas-guzzling sedans and station wagons of earlier decades was replaced by a love affair with the gas-guzzling SUVs and trucks of today.

• And again, there was a not-so-well-known bubble in the bond market, this time attracting mostly investors from Western Europe and East Asia.

The precise names and places have changed. But the overall pattern is uncannily similar: a big scare ... a bigger outpouring of easy money ... and the biggest bubbles in history.

Parallel Pattern #2
Benign Neglect of the Dollar.
Major Explosion in Gold Prices!

The inevitable consequence of cheap and easy money is a cheap and falling dollar.

Late 1970s

Despite occasional lip service to the contrary, the dollar was, at best, neglected by domestic politicians ... and, at worst, viciously attacked by international investors.

Its value sank precipitously against all the major currencies of the time -- the German mark, the Swiss franc, the Japanese yen, even the relatively weaker British pound.

And as the dollar fell, gold rose.

On the afternoon of August 25, 1976, the price of gold was fixed in London at $103.50 per ounce.

Just three years and five months later, on January 21, 1980, the London afternoon fix was $850 per ounce.

In a very short period of time, the price of gold surged more than 8-fold.

Today

The pattern is almost identical: The dollar is falling -- this time not only against the currencies of Europe and Japan, but also against those of emerging nations.

And, as before, the dollar's fall is stimulating gold's rise:

On April 2, 2001, the London afternoon fix for gold was $255.95 per ounce. Just one week ago, on Monday, May 12, it was $725.

But in comparison to the 1976-1980 surge, gold's current rise is still in its infancy.

Just to match the 8-fold magnitude of the 1970s rise, gold needs to go much higher -- to $2,062 per ounce.

And, not coincidentally, that's also roughly the same level it needs to reach just to catch up with the inflation that's occurred since 1980.

Parallel Pattern #3
Steep Gold Market Corrections
Lead to Even Steeper Upsurges

Even as gold rocketed higher in the late 1970s, there were many more naysayers than enthusiasts.

Like their counterparts today, Wall Street brokers looked upon gold with great disdain. They saw it as the anti-investment, the domain of prophets of doom, the den of profiteers of gloom. So they jumped on every chance they could to discourage precious metals investors.

In 1978, for example, there were two steep corrections in the gold market:

• Gold surged to an all-time peak of $190 per ounce on March 8, and then suffered a 15% correction to $160.90 by April 27.

• Then, in November, after hitting an even higher all-time peak of $242.75, it suffered an even sharper, 20% setback, down to $193.40.

But no matter how steep the corrections, the ensuing price upsurges were even steeper. Anyone who abandoned gold in the wake of a correction was sorely disappointed; anyone who bought on the dips, richly rewarded.

Finally, in late 1979 and early 1980, gold went virtually straight up. Indeed ...

In the last hurrah of gold's bull market, the yellow metal rose more than it did in all the years and centuries that preceded it. It surged from $374 on October 29, 1979 to $850 by January 26, 1980 -- a rise of $476 in just 54 trading days.

Anyone who had lost faith and bailed out during an earlier correction missed an opportunity that was greater than virtually all previous opportunities combined.

Today, we see very much the same situation:

Gold suffers periodic corrections, such as last week's 10% drop. Each time, a regular entourage of analysts inevitably makes the media circuit, seeking to talk the yellow metal down further. And each time, gold turns right back up again, surging to even higher peaks.

Can there be more corrections? Yes.

Will they end the bull market? No.

Parallel Pattern #4
The Gold Bull Market Continues Until
The Fed Slams the Door on Easy Money

In the 1970s, the gold bull market didn't end when the Fed started raising interest rates. Quite to the contrary, the Fed had been raising interest rates since 1975, and the rate hikes did nothing to slow down gold's rise.

Nor did gold stop surging when Fed officials began talking the talk about getting tough on inflation. Investors took one look at the still-low interest rates and laughed in their face. They ran from the dollar. And they rushed to gold in even larger numbers.

In fact, gold didn't stop surging even after the Fed started walking the walk.

By that time, the Fed was so far behind the curve in fighting inflation, it had to take a running jump to leap ahead of inflation

In other words, the Fed had to jack up rates to astronomical levels. But no one at the Fed had the guts to do so.

The end result: Throughout the 1970s, rising interest rates did nothing to stop the gold bull market.

The Fed funds rate rose to 8%, 10%, 12% ... and gold still kept surging.

It wasn't until the Fed funds rate got up to 20% that it finally had an impact. That's when the Fed finally slammed the door on easy money and ended the bull market in commodities.

In contrast, take a look around you right now. Do you see the Fed slamming the door on easy money? Do you see astronomical interest rates?

Not even close! The Fed funds rate is still at only 5% and just starting its rise. Like in the late 1970s, the Fed is so far behind the inflation curve, it's the laughing stock of investors all over the world. And those investors are likely to use every opportunity -- especially sharp corrections -- to dump the dollar, dump their U.S. bonds and switch some of their money into gold.

Parallel Pattern #5
Wars and Winds of War

An inevitable consequence -- and cause -- of any easy-money boom is the intensifying global competition for scarce resources.

That competition always breeds economic conflict.

And it often leads to war.

In the 1970s, just as the Fed was losing control over spiraling inflation, President Jimmy Carter was losing control over world events.

In Afghanistan, Soviet tanks swarmed into Kabul, triggering worries of a hotter cold war, a ballooning military budget, and still another fire under inflation.

In neighboring Iran, the Shah, America's staunchest ally among oil-exporting nations, was deposed, and subsequently, students took over the U.S. embassy, capturing 54 hostages.

All over the world, the power of America and its dollar was being questioned.

Today, the parallel patterns are so numerous they boggle the imagination.

In Afghanistan, for example, the same die-hard Taliban fighters that defied the Soviets are again defying the U.S. and its allies.

And in Iran, the stand-off between Carter and Ayatollah Khomeini of 1980 is mirrored by today's showdown between Bush and Ayatollah Khamenei.

Even the places and some of the names have not changed substantially.

Parallel Pattern #6
Falling Confidence and
Rising Exasperation

In 1980, President Carter, snowed under by inflation and sandbagged by the Iranian hostage crisis, found himself losing support domestically at a very rapid pace. His approval rating dropped from the 80s in the first months of his presidency to the low 30s as his term approached an end.

Today, President Bush is following the same path. The president is sandwiched between an avoidable Iraq war which he can't end and a unavoidable Iran war which he can't start. Despite growth in the economy and improvements in the job market, his ratings have dropped from the 80s to the low 30s, just like Carter's.

The Carter and Bush administrations may be separated by 26 years and vast differences in ideology. But their political plight is one and the same: A cycle of economic malaise, wars they cannot control, falling confidence and rising exasperation.

Grave Perils and
Great Opportunities
For U.S. Investors

These parallel patterns point to a parallel future.

There will be many differences; history will twist and turn events to surprise us all. But throughout it all, I have little doubt that surging gold, and commodities and interest rates imply some of the greatest opportunities of a generation. That was true in the late 1970s. I believe it's true again today.

To profit from them, you don't need a big stake. Nor do you need to catch every up and down move. What you need most is patience.

Although protective measures, like stop-loss orders, are always prudent, don't run at the drop of the hat. Don't let your vision be clouded in the shadow of each correction. Stick with your core positions and strategies.

Always remember: It's not until the Federal Reserve slams the door on easy money that you need to worry about an end to the rise in gold, silver, oil or other natural resources.

At the same time, recognize that these kinds of sweeping upsurges don't come every year or even every decade. It is a once-in-a-generation cycle that you or I are unlikely to ever see again.

So if your aim is large profits, and you have speculative funds available for leveraged investments, it's now or not at all.

If not, stick with the exchange-traded funds and mutual funds that we have been highlighting here. And enjoy the ride, whether bumpy or smooth.

One Last Thought

Dramatic change is not the end of the world. We went through this a quarter-century ago, and we're still here. We have survived, even thrived. So although Dad saw the dangers clearly, he also had a vision of a better world. Like me, he was truly an optimist at heart.

Next week, I'll explain why.

Good luck and God bless!