SEDGWICK´S GHOST / CASEY´S DAILY DISPATCH ( VERY HIGHLY RECOMMENDED READING )

Sedgwick’s Ghost

Dear Reader,

During a casual inspection of the enemy’s position at the battle of Spotsylvania, American Civil War General John Sedgwick noticed men ducking about and said loudly for all to hear, "What! what! men, dodging this way for single bullets! What will you do when they open fire along the whole line? I am ashamed of you. They couldn't hit an elephant at this distance."

As you might guess, seconds later, a Southern sharpshooter proved the opinionated general wrong.

Dead wrong.

That story popped to mind this morning as I looked at the screens to see what impact the government’s latest downward GDP adjustments would have on the markets and saw with some surprise that the stock market was actually rising and gold and silver taking a pummeling.

Keeping Gen. Sedgwick’s ghost in service for a moment longer, could we here at Casey Research be misgauging just how well the armies of the Fed fight? Could Bernanke & Co. actually be so precise in their monetary deliberations that, like the son of the South who extinguished Sedgwick’s candle, they might succeed in hitting the economy with exactly the right amount of ginned-up money, then surgically remove it once the danger has passed?

Given all the new spending programs being announced almost daily, that seems unlikely in the extreme – especially the whole “surgically remove” thing. Yet I am sure that General Sedgwick felt every bit as confident in his assessment of the long-distance marksmanship of his adversary.

And look where that got him.

So, what are we to make of the fact that – rather than growing at 3.5%, as was originally projected, and then being revised downward to 2.8% -- third-quarter U.S. GDP actually rang in at 2.2%? Or that the U.S. stock market is trading up on the news, and so is the dollar? Shouldn’t bad news beget bad news?

Well, for one thing, the downward adjustment doesn’t surprise us. As our own Kevin Brekke pointed out in the October 30 edition of these musings, issued shortly after the preliminary GDP number for Q3 2009 was released,
"... the BEA shows in another chart that the average revision from the advance GDP (what was just reported) to the final (what will be reported in two months) is ±1.3%."

And indeed, the 3.5% guesstimate was first reduced to 2.8% and now to 2.2% -- hitting exactly the upper boundary for error.

Kevin also points out that the Cash for Clunkers scheme added 1.47%, and inventory replenishing was way above the historical third-quarter trend, juicing the number another 0.66%. Adding these two one-off events gives us 2.13%, meaning the growth in the real economy, the one that will provide jobs and bring the country a sustained recovery, was 0.07%. A rounding error.

That said, there’s no question that the government’s energetic easing is buying some GDP stabilization. That easing is everywhere, from its purchases of $1 trillion of mortgage-backed securities designed to keep rates low… to the $8,000 tax credits for first-time home buyers… to the Cash for Clunkers… even to the massive military spending… and, soon, health care for all. And that’s just for starters.

Ducking behind a tree to regroup our thoughts, we admit that it is conceivable that all the deficit spending will result in an economy that doesn’t take a nose dive. Which further suggests that selected stocks will do well, per my discussion yesterday.

But it is the dollar that concerns us most. If for no other reason than that the fate of gold and the dollar are inexorably linked.

While I will return to a few of the key themes related to the dollar, before I do, it’s worth gaining some perspective of the battlefield by looking at the five-year chart of the greenback – using the Dollar Index as our proxy. The Dollar Index (DXY:Ind) shows the U.S. dollar against a basket of competitive paper currencies.


A back-of-the-envelope calculation shows that, in 2005-2006, the Dollar Index ran up by about 14%, a move that took about a year to unfold before the dollar turned down again.

When the dollar did turn down, it continued to fall for just under two and a half years, losing 21% over the period. It then had another sharp one-year rally during which the dollar shot up by about 24%.

In the latest bear leg, the dollar moved down by 16% over the period of about nine months.

Does that tell us anything? Not much, other than trend moves in the dollar tend to be fairly long in duration. If the latest uptick is more than that – if it’s an honest-to-goodness rally – then it could last a year. That is what many traders are looking for.

But, of course, it’s too early to tell if the latest move is just a head fake. If it is, the dollar could easily have another year or two of pain ahead of it. More on that in a moment, but first, adding a bit more in the way of perspective, I have overlaid gold (using GLD as the proxy) and gold stocks (using GDX) on top of the Dollar Index for the last five years.

In the chart, the Dollar Index is shown in yellow, gold is shown in green, and the gold stocks in orange.

While the scale of the chart makes the moves far less pronounced, a couple of observations can be made.

First, the general trend for the Dollar Index over the last five years has been moderately down. Meanwhile, gold has been strongly moving higher. For those of you who consider gold as sound money, and the only currency worth using for comparison purposes, the dollar has been a serious loser in the currency contest.

But not all has been clear sailing for gold. As you can see, during the big spike in the dollar that started in mid-2008 and lasted about a year, gold got hammered off by about 55%. And gold stocks did much, much worse than that.
So, this question of whether the dollar rally is for real is not academic – for those of you own gold and gold stocks, it is of serious import. Maybe not as serious as getting shot by a Southern sniper, but close.

Now, I wish I could give you a reassuring thumbs up and tell you that there’s no way this rally can last. But I can’t.

I can, however, make a few further observations, followed by a friendly suggestion. First, the observations.

In 2007, at the peak of the recent bubble, the U.S. trade deficit – which provided most of the fuel for the massive purchases of the Treasuries that fund the U.S. government’s operations – was running at an annualized rate of close to $900 billion. Today, the trade deficit is about 60% less than that.
That means that the Chinese, Japanese, oil sheiks, etc., no longer have anywhere near as much money available to fund U.S. government spending.

Yet, as you don’t need me to remind you, our current administration is hell-bent on running deficits in excess of $1 trillion for as far as the eye can see, perhaps even for another decade. Without the foreign buyers who have taken most of the seats at the auctions in recent years, how will the government cover the necessary borrowing, without outright monetizing it?

The short answer is, it can’t. And once that monetization begins in earnest, don’t you think the U.S. dollar will come under a lot more pressure? I do.

Especially because that alarming level of spending may be understating things. That’s because the government will feel compelled to keep spending “whatever it takes” to prevent mortgage rates from running up… or to avoid widespread bank failures due to hundreds of billions of dollars of failing commercial real estate loans… and to support a new trillion-dollar healthcare plan.

I have long thought that the bursting of the Japanese bubbles in real estate and equities provided a solid analogy for what the U.S. is now going through.

There is, however, a significant difference. Namely that throughout Japan’s bust, its manufacturing sector continued to do land office business.

That provided a tremendous amount of support for the yen (purchasers of Walkmen having to effectively trade dollars for yen in order to make the purchase).

The U.S., as a net debtor nation, doesn’t have that support. What we do have that no other nation has is that, by virtue of its preeminent use in global trade, the dollar is a de facto commodity. As long as demand for the dollar to play that role continues unabated, the currency will be supported. Thus, while it will swing in value based on other inputs, the greenback should be able to avoid the worst.

Dragging his groaning corpse back into service, that is what Gen. Sedgwick would tell you, were he a member of the Fed’s governing board or a Wall Street cheerleader. Specifically, that there is no way the dollar can succumb. And he might have it right. I mean, we are talking about a change-over in the world’s reserve currency. That sort of thing doesn’t happen very often, maybe once a century?

You might expect me to utter the time-honored precursor for a flawed forecast, “Yes, but this time it’s different.”
The fact is, though, that the dollar’s descent, should that happen, would not be different. I say that because a fiat currency sinking under steady abuse is a continuum that goes back to the clipping of Roman coins, and before.

In the beginning, back when the dollar grabbed the throne for its own, it was backed by gold and fully convertible.

Over time, as you know, it became non-convertible and the gold backing went away. Predictably, because it has unfailingly been the precedent for all unbacked currencies, the politicians begin to mistreat the currency. Gently at first, but then, as new and more social programs are launched to curry favor with the public, the mistreatment turns to downright abuse.

In time, the currency begins to struggle and stumble under the weight of its debasement. Until, ultimately, it falls and is rolled back, relaunched, or replaced.

In actual fact, given the truly unprecedented debasement it is now being subjected to, were the dollar to turn in a strong and lasting rally, that would qualify as being “different this time.”
All of which is to say, I don’t see the rally lasting.

Consider these as observations colored by what must now be an ingrained bias against the dollar. Although I believe this bias is correct and warranted, it could make me blind to the risk just over the hill.

When you get right down to it, in the months just ahead, either we here at Casey Research are going to be shown to be the Sedgwick, or the administration and its cozy allies on Wall Street will be.

Which brings me to my suggestion.

Namely, pay attention to your allocations to gold and gold stocks.

While I personally don’t think this uptick in the dollar will last long into the New Year, if it catches the wind and runs higher for a year, despite the weekly auctions of hundreds of billions of dollars in fresh Treasury borrowings, the hit to the precious metals could be significant, and the one to precious metals stocks far worse.

While I rate the odds of gold breaking down as far as $850 as almost zero, that is no guarantee it won’t. Thus, just make sure you aren’t overcommitted to the sector, that you avoid uncovered leverage, and that you have enough cash on hand that you won’t be forced to sell out your precious metals positions at a loss. That way, come what may, you’ll be able to sleep at night.

This is not a change in our forecast, and we remain confident that precious metals will be trading higher at the end of 2010 than at the beginning. We also remain confident that before the book on this crisis is closed for good, the country will have to go through a massive inflation that will send precious metals and other tangibles to the proverbial moon.

But until we can determine whether or not this current dollar rally is for real, be extra cautious.

And with that, and with our deep gratitude for his service, we will bid General Sedgwick a fond farewell and return him to his long dirt nap.

Because I started late today, I must also bid you, dear reader, a fond farewell.

As I do, I see that gold and silver are weak but not plummeting, and more than a few gold stocks – as well as the broader U.S. markets – are rallying, but modestly.

Oil is up as well and continues solidly over $70 a barrel, at $73.00. With the lack of sunspot activity, the winter should end up being long and cold, which should continue to provide support. But that’s a story for another day.

David Galland
Managing Director