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Where Are We?

Investors have been a pretty battered lot. Since the stock market topped in 2000 it has been extremely difficult for even the best money managers to make money. Despite the difficulties the soothing ads that generally come from the industry are usually along the lines of "don't worry, in the long term the market just goes higher". What they never seem to tell you is that there are periods like 1929-1954 before the market recouped the highs seen in September 1929. Or the Japanese stock market that topped in 1989/1990 at over 39,000 and 13 years later it is at 8000 and still hasn't found its bottom.

What investors do not understand, nor many others for that matter, is that markets and the economy move in cycles. Of course if they do think of cycles they think of short-term cycles as in moving from a period of recession to a rising economy and market and when the cycle is over we have an economic downturn and the market pulls back.

Less understood is the concept of long cycles. We have often mentioned the Kondratieff Wave cycle that has been seen to occur over periods of 55-60 years as measured from trough to trough. The Russian economist Kondratieff observed the phenomena in western capitalist economies dating from the mid 1700's. Subsequent studies have confirmed the existence of Kondratieff waves going back even to the times of ancient Rome.

The Kondratieff wave cycle goes through four distinct phases of beneficial inflation (spring), inflation (summer), beneficial deflation (autumn) and deflation (winter). Since the last Kondratieff wave winter cycle was determined to have ended in 1949 we have seen a period of beneficial inflation 1949-1966, inflation 1966-1982, and beneficial deflation 1982-2000. According to Kondratieff wave analysts we have now entered the period of deflation or the winter of the cycle.

Of course there are many that argue that the cycle does not exist or today's modern monetary and fiscal policies will override such a cycle. But the record for the current Kondratieff cycle is compelling. The Kondratieff winter is all about debt collapse, a deflationary depression, and major bear markets in stocks, real estate and currencies and bonds and a major bull market in gold. We also believe that the Kondratieff winter not only is about an economic darkness but as well a political darkness. Indeed one would flow from the other as major economic problems give rise to false political prophets who have all the easy answers. During the last Kondratieff winter 1929-1933, the world suffered through not only an economic depression but also the rise of fascism and a world war.

Will this one be any different? We don't think so even if all of the pieces are not as yet evident. Our most compelling argument has been the currency devaluations and the potential for debt collapse. First the currency devaluations. As we have noted many times the 1990's was a period of currency devaluations. But a devaluation of the world's reserve currency the US$ has more far reaching ramifications.

In 1994 the US$ was falling sharply and the US bond market had its worst year in history. The stock market was weak the entire year. Only massive intervention and an attempt to reflate the moribund Japanese and the US economy at the time prevented what many agreed was the potential for a major world financial crisis. In 1998 the Asian and Russian currency crisis brought on the collapse of a little known hedge fund, Long Term Capital Management (LTCM), which almost caused a major banking crisis and collapse. Again only a massive reflation by the Federal Reserve saved the day. Since then we have had further crisis in Y2K and September 11, 2001 that brought further massive injections of liquidity into the banking system.

But while the massive liquidity injections in the 1990's brought us the stock market bubble we have now had a market that has been falling for three years recent rebounds aside. And the US$ is now falling again. It is one thing for the say the Turkish Lira to collapse as the Turkish people pay and the IMF comes knocking on the door. But it is another thing for the world's reserve currency to fall. The last time the world's reserve currency collapsed was the British Pound in the 1930's leading to the adoption of the US$ as the world's reserve currency at Breton Woods in 1945 and the establishment of the IMF and the World Bank.

At the time all currencies were pegged to the US$ and the US$ was convertible into gold. But that ended in 1971 when Richard Nixon first abolished the gold standard and then in the mid 1970's the world's currencies were set to float against each other. Since then the world has been battered by numerous currency crisis with each one generally more than severe than the previous. As well only the supposed faith and strength of the government and the economy of the country back currencies. This is the world of fiat currencies where in the truest sense the currency is mere paper. Since the US$ was set free of the gold standard in 1971 the purchasing power of the dollar has fallen over 90%.

There have been numerous calls for a new Breton Woods to solve what many see as a pending world financial crisis. While the world certainly needs a new system having one in place in time prevent a major financial and currency crisis will undoubtedly not happen. Going forward the US$ is key to the world's financial system. Given that we have had already over the past thirty plus years at least three significant dollar crisis we appear fated to have a fourth.

Since making a wide topping pattern from 2000-2002 the US$ has broken down and is now trading at its lowest levels since the Asian currency crisis in 1998. This is despite the fact that the Federal Reserve has continued to allow the monetary system growth in the 6-8% range and maintained low interest rates. Markets tend to see the problems before they unfold and the world's markets are looking nervously at the growing mountain of debt in the US.

Total US debt including governments, corporate and households and domestic financial sectors stands at $20.7 trillion as of the 4th quarter 2002 as stated in the Federal Reserve Flow of Funds accounts. Add Federal debt to trust funds and the debt soars to $34 trillion. Of this $34 trillion, $26 trillion is attributed to business/household and financial sectors. The current account deficit is a cumulative $3.4 trillion and rising now by about $500 billion per year. This does not include obligations for social security, unfunded government and private pensions nor Medicare. Roughly 40% of the debt is held outside the US primarily with central banks as reserves. The debt has grown by over 60% alone since 1990. All of this is against a backdrop of record bankruptcies both business and personal and a flat savings rate.

With the budget deficit now growing at over $300 billion and projected to possibly reach $500 billion this year a recent study commissioned by the Bush administration showed that the debt was going to grow to $44 trillion. The study was quickly shelved, as it was clearly the wrong answer. The Financial Times of London revealed the study to the world. All of this is against a backdrop of anemic economic growth in an economy that generates about $10 trillion before inflation adjustments. Clearly even a ballyhooed tax cut is only going to make the situation worse not better. We can only guess that a collapsing dollar is easy way to make the debt disappear.

But it won't, as eventually a dollar crisis will erupt that will shake the world's financial system. With one of the key characteristics of the Kondratieff winter being debt collapse and deflation is debt collapse that causes deflation. We admit we are not sure at this time what will trigger a broader debt collapse. Even the consumer seems to have an inexhaustible ability to keep the economy going fuelled by more debt. Overall household debt has grown almost 4 times faster than the economy over the past decade.

It is against this backdrop that we continue to recommend gold as the only asset that will grow over the next decade. We are still in the early stages of the Kondratieff winter so those that are concerned that gold has not risen fast enough or that the recent up swing in the market is counter to this argument need only ponder the enormity of the debt numbers to realize that the world's financial system sits on the precipice even if it is still teetering and has not yet fallen off.

Our best recommendations for holding gold in its purest form other than purchasing gold coins is to own it through either the Millennium BullionFund (www.bullionfund.com, 416-777-6691) a mutual fund trust and Central Fund of Canada (CEF-TSX, CEF.A-AMEX) (www.centralfund.com, 905-648-7878) a closed end fund. Millennium BullionFund is now available across Canada haven recently received approval from the remainder of the provincial securities commissions. It is recommended that up to 5% of any portfolio should hold gold. Both are RRSP eligible. Central Fund can trade at substantial premiums or discounts to net asset value (NAV) depending upon demand.

And it is for similar reasons that we view the financial sector as the most vulnerable to a collapse because ultimately it is the banks and financial institutions that hold the debt obligations particularly of the vulnerable household. While many argue that the securitization of the industry and derivatives can offset these possible risks what was discovered in the near financial collapse of in 1998 that events triggered by outside events that were not predicted can have a potentially devastating impact on the world's financial markets. Except for September 11, 2001 we have avoided the unpredictable event. In a world of unpredictability it is assured that the unpredictable will happen.

We leave you with a weekly chart of the Royal Bank of Canada (RY-TSX, NYSE) (www.royalbank.com, 416-974-8393) and Fannie Mae (FNM-NYSE) (www.fanniemae.com, 202-752-7115). Royal Bank has been forming a bearish rising wedge over the past two years. The stock recently fell sharply after reporting sharply lower profits. Fannie Mae has been in a downtrend since 2001 but has recently recouped back above the 40 week moving average on reduced volume. But Fannie Mae along with Freddie Mac are extremely vulnerable as they are major holders of the US's household mortgages. Their capital ratios have been cited as being under stress. Over the past few years the number of mortgages on houses has grown sharply. Many of them have been made with only 5% down. Indeed the cry of "Buy now, nothing down, 0% interest" seems to have been a rallying cry for the consumer economy and it will be the Achilles heal for the Kondratieff winter. That is where we are.

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