Storm Watch Update
COLLATERAL DAMAGE
Subtitle
by Jim Puplava
www.financialsense.com
September 21, 2001

Last week it was the image of terror that occupied this nation's attention. Aircraft hitting buildings, the fire and smoke from explosions, and the collapse of an important American landmark filled our television screens. The strike against the World Trade Center and the Pentagon, symbols of America’s military and financial strength reminded us of our vulnerability.

The images of lives lost, the anguish of those looking for loved ones, and the tears and sorrow of all Americans cast a somber pall over the country. It was a horrific event that shocked and numbed our senses. It was all so surreal. The tragedy was watched in real time as it unfolded. Terrorists had done the unthinkable. Anything was possible now. The attack on America’s homeland has changed our country forever. Nothing will ever be the same. The life we had taken for granted changed on Tuesday, September 11, 2001. How we now view ourselves and the rest of the world will have to be reevaluated. What happens to other nations has just happened to us. Tragedy was something that struck others -- not us. An unseen enemy had struck us, and like Pearl Harbor, we were taken by its surprise.

Yet, like other catastrophes, it was an event that has united America. We have come together as one nation, indivisible, with God and country as rallying cries. Among the scenes of devastation and rubble at ground zero rose the image of America’s Finest doing their duty and giving their lives that others might live. Flags were hung at half-mast to commemorate those who had fallen. Candles were lit. The sound of praying is heard again. Long lines form to donate blood. A renewed spirit has risen across this great land.

And Then, There Was Monday...

With the markets closed and the economy on hold, our attention was directed towards the tragedy. That focus changed on Monday as the financial markets reopened. We braced ourselves as we had been forewarned by the reaction of markets from overseas. Monday, September 17, 2001, the markets reopened and the collateral damage of the terrorist attack was visible everywhere. Billions in insurance claims, airline losses, and layoffs captured the headlines of newspapers and the evening news. Alongside the economic damage, we began to see the meltdown of our financial markets. Stocks plunged at the opening bell. Not even a preemptive Fed rate cut enjoined by other central banks around the globe could arrest the decline. The Dow lost over 7% in its first day of trading since the tragedy. Up until this time, the Dow Jones Industrial Average seemed to be immune from the loss inflicted on the other major indexes. Prior to September 17th, tech stocks and the NASDAQ had borne the brunt of most of the selling. Now it had spread to the Dow. Investors seemed to be dumping everything. Nothing was immune from the panic that gripped investors. Like past wars and terrorist attacks, and crisis investors reacted predictably.

Past Crises Are No Predictors of The Present
It was no different this time. They simply sold. The mantras of “Buy and hold”, “Buy on dips”, and "I’m in it for the long run” were abandoned in the selling melee. When the markets opened on Monday, the powerful emotion of panic was unleashed on the floor of the exchange. The new mantra had become "Sell, sell, and keep on selling."

As each day unfolded, the markets dropped further as volume hit record levels. Was this the final capitulation that experts talked about? At this time we still don’t know. The prevailing wisdom was that there would be a sharp drop in the market as soon as fighting began and then the markets would rally with victory. But things are different this time. This will not be a Nintendo War fought with high tech weapons and push button armaments. The first war of the 21st century has just begun. There are no armies gathered on battlefields on which we can unleash our fury of revenge. There are no large targets in the open desert on which to fire our high tech missiles. This is a war with two enemies: one unseen and one from within.

Market Reactions to Rogue Wave Events

Record Losses As America Held Its Breath... Hoping
Each day brought new selling pressure as panic gripped investors and the markets. Comforting words and encouragement for a patriotic rally from analysts, politicians and Fed governors seemed to fall on deaf ears. Investors wanted out and they were selling. Day after day brought new rounds of selling and major averages plunged through key support levels only to plunge through another. "Where will it end and when will it stop?" seemed to be the question that occupied the captains of Wall Street and the politicians in Washington. Since the markets reopened on Monday, over $1.38 trillion in wealth was erased from the stock market. Many had hoped that the selling fury in overseas markets last week would cushion some of the blow. Instead the contagion spread with full force to our financial markets. By the end of the week, the Dow had lost 1,370 points for a loss of 14.3% for the week. It is down 23.7% for the year. For the S&P 500, the losses were similar with a drop of 126.8 points, a loss of 11.6% for the week and 26.9% for the year. Like last year, the NASDAQ has borne the brunt of the losses. The index lost 272.2 points for a loss of 16.1 percent for the week bringing its year-to-date losses to 42.4%. For the Dow Transports the damage was far worse. The transports lost 622 points this week for a loss of 23.2%. Year-to-date losses are over 34%.

Uncertainty Rules Decisions
Today, the panic continues non-stop. The wealth that has evaporated is sobering to investors. What politicians, analysts, and economists must gauge is the collateral damage to the economy. One key effect of the attacks and resulting declaration of war has been the impact on consumer confidence. Spending plans have been halted. Vacations and conventions were cancelled. Home buying has been put on the back burner. The problem for the markets and the economy is that there will be no quick closure to this tragedy. Markets abhor uncertainty. It is this uncertainty which is driving the panic selling and the reversal of spending plans.

Confident Spending Halts

The economy was already in the process of slowing down before the unfolding of last week’s tragedy. Housing starts tumbled in the United States last month by 6.9%. It was the steepest drop in housing since March of 2000. The housing market, supported by low mortgage rates, has been the one bright star during the year-long downturn. This month's tragic events will most likely accelerate the housing market's decline. It will knock the legs out from underneath one of the last pillars of strength of the American economy. The other pillar, consumer confidence, was also dealt a mortal blow. Major department store chains from Sears to Nordstrom’s to Barnes & Noble reported sales that fell 50% or more. The Bank of Tokyo-Mitsubishi reported same store sales dropped 1.4% from the previous week. A separate report showed that mall traffic around the country plunged by more than 65% on the day of the tragedy. Shoppers returned the next day, but traffic declined by 14% for the week. Frightened consumers were at home locked on to their television screens. If the trends in housing and retail spending continue, they will accelerate the move toward recession.

Travel and Tourism Industry in a Nosedive
Tourism has been another casualty of last week’s destructive events. Hundreds of meetings and conventions across the nation have been cancelled. For cities dependent on tourism, it has been a devastating blow. Fall is one of the busiest seasons of the year for business travel. Conventions and meetings for September and October have been cancelled or postponed. This is impacting the travel business in many ways. Hotels, airlines, and sales tax revenues have all been hit. State governments will have to share in the pain along with business. Even in the nation's capital, the World Bank and International Monetary Fund meetings set for later this month have been called off. Billions of dollars in revenues and resulting taxes have been lost. States dependent on tourism like Nevada, Florida and Hawaii will be hurt because of the drop in air travel.

Big-Ticket Items - The First to Go
In the Midwest, the purchase of big-ticket items, known as durable goods like cars and aircraft engines fell to Gulf War levels. The fallout was hurting businesses in Ohio, Indiana, and Michigan. Even the urge to gamble has been impacted. Las Vegas hotel occupancy has fallen from 85% to 50%. In half of our nation's cities, visitors arrive by plane. The shut down of air travel has had a direct impact on business. In times like this, travel, tourism and discretionary spending are the first casualties from the front lines. When you are glued to your television set, you aren’t spending money. The National Retail Federation has lowered its outlook for consumer spending for the remainder of the year. Most importantly for retailers, the forecast for the critical holiday shopping season was readjusted downward. Everything was on the table for review. As for discretionary spending, shopping will be centered on necessities. Given all of the uncertainty, it is difficult to make any numbers stick. Forecasts are being changed daily. People are wondering, "Is this it. Will there be other terrorist’s attacks? When will the U.S. military attack? Will we invade Afghanistan?"

Consumer Confidence - Innocence Lost
Even before last week's terrorist attacks, confidence had been eroding. The attacks only served to accelerate the decline. Retailers haven’t issued warnings and only a few analysts have lowered their earnings estimates. With so much tragedy, people needed a diversion. Sporting events were cancelled, so Americans spent their weekend at the movies or shopping malls. Cable companies are working full time. Americans want to be entertained and informed. So the cable business is brisk with workers asked to work overtime. The few bright spots within the economy, consumer spending and housing, are hanging in abeyance. It all hinges on closure. A quick and decisive victory would prop up consumer confidence. That illusion was shattered Thursday, September 20th as the President addressed Congress and the nation. There would be no quick fix. The struggle would be long-term. For economists, avoiding a recession now seems unavoidable.

The Economy Faces Challenges on Multiple Fronts

#1 Fiscal and Monetary Policy
The future of this downturn and its duration will depend on how effectively the battle against terrorism is fought. We are at war with an elusive enemy. This will make Washington’s job more difficult. The sooner the government gains control over the situation and restores a sense of calm with investors, businesses, and the public-at-large, the better off we will be. The Bush Administration is already moving on two fronts. The first is fiscal and monetary policy. The Fed is lowering interest rates, while Congress will authorize new spending for rebuilding New York, a bail out for the airlines, and defense spending. Forty billion has been authorized and more will come. Additional stimulus is coming in the form of a possible new round of tax cuts. They could include lowering the capital gains rate, investment incentives in the form of accelerated depreciation or investment tax credits, and some form of tax relief for the poor by expanding the earned income credit.

#2 War on Terrorism
The second front, and by far the most important, will be the fight against terrorism. This could become more important than monetary and fiscal policy combined. Washington needs to prevent further attacks of terrorism from occurring if it wants to restore public confidence. Thwarting and preventing terrorists from acting again will determine whether the attacks on the Trade Towers and the Pentagon were a singular event or just the beginning of a new wave of violence that could alter the behavior of consumers and businesses. If there are new attacks, as lethal as September 11th, then irreparable damage will be inflicted on consumer confidence and the behavior and action of businesses across the nation. Consumer spending would retrench permanently, mall traffic, and attendance at sporting events and other forms of entertainment would fall. Tourism would not recover. Business travel plans will be curtailed and spending plans shelved.

#3 Government Intelligence & Military Effectiveness
Confidence building will also depend on the government’s ability to demonstrate that it is in control of the situation. Uncovering a terrorist network, exposing and destroying terrorist cells, and a decisive military strike would elevate public confidence. They need assurance that what happened to the Trade Towers would not become a recurring feature of the 21^st century. Some form of short-term results is necessary to shore up confidence. A quick and effective retaliatory strike would go a long way in restoring a shocked and numbed public psyche. The longer the period before decisive action is taken, the greater chance there is for consumers to start taking more risk-adverse actions.

#4 A Decimated Airline Industry
Besides the damage to public confidence, the greatest damage outside ground zero has been the airline industry. Since the destruction of the twin Trade Towers, airline traffic has declined by 20%. Major airlines have announced layoffs totaling 96,800. This does not include layoffs being announced with those who build their planes. Boeing will shed 30,000 workers. Many airlines are hanging by a tread. Others have shut down. Southwest Airlines, which prides itself on avoiding layoffs, is now considering the option. The airlines were in trouble before the attacks. This week airline executives told Congress they will lose $4.7 billion from the day of the attack until the end of the month. Even with staff downsizing and aid, the airlines cannot survive dramatically reduced passenger traffic.

#5 Monetary Instability
For government officials, the paramount task has become the defense of our homeland. However, in order to do that, ordinary business commerce must be resumed. The longer it is delayed, the greater will be the collateral damage to our economy. Without the restoration of commerce, the President and the Fed, along with this nation's business leaders, may be facing the equivalent of The Perfect Financial Storm. Following Monday’s surprise rate cut of half a point to 3.0%, the Federal Funds Rate dropped to as low as 0.5% at mid-week. This points to the failure of the Fed to control the targeting of interest rates. The markets have moved beyond the Fed’s ability to deal with them. Not even global intervention by central banks has been able to prevent financial markets worldwide from tumbling. With the rise in long-term Treasury yields and falling stock prices, the sinking short-term Federal Funds Rate indicates that control of the financial markets has temporary slipped out of the hands of central bankers. It is now in the hands of the crowd and subject to their fear.

Crisis Accelerators
What is happening has become the central banker's worst nightmare. The longer it continues unchecked, the greater chance it will become uncontrollable. The desire for safety and liquidity is already driving interest rates close to zero. The official Fed Funds Rate is set at 3.0%. But, in actuality, Fed Fund Rates are trading far below that. Greenspan isn’t setting interest rates anymore. The world is doing it for him. The Fed has been reduced to reacting rather than directing the outcome. On numerous occasions over the last week, the Fed has been forced to execute repurchase agreements by essentially purchasing government securities and opening the throttle to the printing presses. In addition to repurchase agreements, the Fed has initiated swap agreements mounting to $100 billion with other central banks in Europe and Canada.  With Fed funds trading as low as 0.5% on Tuesday, 1.5% in overnight trading Thursday evening, and ending on Friday at 3.25% in the spot market and 2.50 on the October contract, interest rates are moving far beyond the Fed’s ability to control them. Conditions in the financial markets have moved to the extreme. The crisis accelerators, which the Fed dreads, are staring it in the face. The scramble for liquidity, accelerated selling, the implosion of leverage and the loss of confidence are picking up their tempo.

Recession is Unavoidable
Margin calls are going out as fast as stock prices are dropping. Even the big boys have been hit with Sid Bass being forced to sell 135 million shares of Disney to answer a margin call. Not since the Great Depression has the stock market ever been hit this hard. The question is, "Has it stopped?." Experts believe this is all emotion-driven panic selling. Foreign investors are pulling out of the U.S. markets as they no longer view it as a safe haven. Institutional investors have been forced to raise cash as fund redemptions accelerate. Uninformed investors are throwing in the towel as gains evaporate and losses mount. The quarterly expiration of options on stocks, stock-index futures, known as “triple witching” have contributed to push volume levels up and selling pressure down. This week, while mourning has subsided, worries about equity values have competed for coverage alongside the coverage of the Trade Center attack. The combination of falling economic statistics, rising unemployment, and faltering financial markets are just a few side effects of last week's attack. It is inconceivable at this point that the American consumer can emerge unscathed. Hit by layoffs, and falling stock prices, consumer confidence can only recede. From here, the threat of recession looms large.

For Wall Street, which is only now coming to grips with reality, earnings estimates and year-end forecasts are tumbling. It may be wishful thinking at this point to be talking about gains. As this graph indicates, even before the tragedy, the stock market was extremely overvalued. If there is a recovery, it will take strong earnings to drive it. Outside a few pockets in energy, it does not even appear remotely possible. Today it is a question of valuation. What would you pay to own these companies? Before, this kind of value investment question was ignored. Now, everyone is asking it.

Even before the attacks occurred, Wall Street was revising its estimates for the third and fourth quarters based on company guidance. Original estimates for the third quarter estimated a decline of 15%. Those numbers have now been lowered to 20% or more. Fourth quarter estimates forecast an additional 5% decline. Realistically, I expect them to go lower. This week's Barron's includes the following charts.

Source: Barron's

Most firms predict a rebound in earnings by the first quarter. That rebound, if it occurs, may not take place until later on in the year and it will depend on many variables. Most of those variables are in the manner of "ifs"... if there are no more rogue waves like a terrorist attack or derivative crisis. Those are big ifs in my estimation.

Wall Street is doing its best to sell the public on recovery. "Buy stocks now because they are cheap," has become the new mantra. The latest argument comes from the Fed's own stock market model. The model compares the yield on 10-Year Treasuries, now at 4.69% to the future earnings yield on the S&P 500 Index.

Let's Do A Little Math
The earnings yield is the reciprocal of the P/E ratio. At the moment, forward earnings estimates for the S&P 500 are expected to be $55 a share. If you divide that number by Friday's closing price for the Index at 965.8, you get a P/E multiple of 17.56 which translates into an earnings yield of 5.69% [1/17.56 = 5.69%]. This is higher than the yield on 10-Year Treasuries, which makes the S&P 500 undervalued.

See Forbes     

This reasoning depends on two assumptions: earnings and interest rates. Assuming that earnings for the S&P500 next year will be $55 a share is a bold prediction. Earnings of $39 to $40 a share is more realistic. The $55 a share number is a lot like this year's predictions for a 12,000 Dow or 1,500 for the S&P 500. The second assumption deals with interest rates on longer-term Treasuries. The Fed may control short-term yields by its influence over Fed Funds, but investors control long-term yields. The following graph taken from Peter Brimelow's article, "No Hiding Place?," in the October 1st issue of Forbe's Magazine, shows that the return from bonds is 50.2% above its long-term trend line. As the graph illustrates, whenever bond returns have gone far above that average, they go into a corrective phase similar to what happens to stocks. With all of the money injections taking place right now, it is more probable that long-term interest rates will rise rather than decline. Higher interest rates and lower earnings for the S&P 500 call into question the Fed's model that stocks are now undervalued.

Banking System Hit Hard As Well
In addition to the destruction of the Trade Center, another part of the financial system was hit by collateral damage. The Clearinghouse Interbank Payment System (CHIPS), the system operated by the New York Clearinghouse Association for the benefit of clearing payments for New York Banks and international banks, saw part of its infrastructure of telecommunications damaged by the collapse of the Trade Center. The biggest banks in the world from J.P. Morgan, Citibank, to Deutsche Bank and Mitsubishi own and operate the system. Over $1 trillion dollars a day passes through this system. It handles hundreds of thousands of currency transactions on a daily basis. The system handles 95% of all dollar payments worldwide. Disruption within the system could trigger a global financial contagion. For these reasons central banks around the globe began to inject hundreds of billions of dollars of liquidity into the system. What was at stake was the avoidance of a spreading brushfire, hopping from one part of the financial system to another. The real danger posed here is the settlement of derivatives between counterparties. If settlement problems appear, they could ripple throughout the financial markets and bring the whole system down.

The Next Rogue Wave?

See 2Q OCC report

Outside this week's trillion-dollar loss in the stock market, one wonders where the next rogue wave will emerge. I believe it will come from either another terrorist attack or from a derivative portfolio being held by a commercial bank, brokerage firm or leveraged hedge fund. The derivative portfolio of commercial banks increased by $7.3 trillion or 39% during the first half of the year. The top 7 banks now own close to $47.8 trillion in their derivative portfolios. One bank, J.P. Morgan Chase accounts for over half of that. The derivative holdings of these banks are almost five times our nation's GDP. Backing those leveraged bets is only $43 billion in shareholder equity. That is probably keeping our nation's commercial bankers and central bankers up at night.

Most of those derivative holdings are based on models of certainty. The models incorporate 1:2 standard deviations of risk. What happened at the World Trade Center is a once-in-a-lifetime occurrence. It lies at the tail end of the curve. September 11th would have driven models off the charts. Someone, somewhere is unprepared for this. Surely the attacks were a statistical anomaly that would be incalculable, a risk the models didn’t foresee. Somewhere out there in the shadows of this opaque world, there is an anxious trader.

In derivative transactions, there are two or more parties to a trade. One of them is right, while the other is wrong. This is what is known as counterparty risk, the ability of those who are wrong to honor their obligations. What we don’t know now is whose cards will fold?

In the complex world of derivatives, individuals considered to be savvy and well informed set the price of contracts. Nobody seemed to be informed of the Trade Center attack. Our government didn’t know. Law enforcement and intelligence officials were unaware. The financial traders inside those buildings were tragically the last to know. The experts never saw this attack coming. It was an unexpected event. It was a crisis that emerged out of nowhere, at a time they did not expect. It was the one event that was not anticipated. It became the rogue wave that took the financial experts and politicians by surprise.

Stability Models Are Vanquished in The Wake of the Wave
Contract prices are considered to be in constant balance. Trades are done on the basis of never paying more or never paying less than what a contract is worth whether a stock, bond, commodity or the direction of interest rates. But markets aren’t always rational, nor do they remain in balance. Sudden events can turn them upside down. This is not a problem if you aren’t leveraged. Leverage always gives way to a brutal dynamic that magnifies gains when you are right and accelerates losses when you are wrong. It is this danger that is too often ignored in the financial world. The hubris on Wall Street is that the foundation of most trading is based on price. It is as if each day’s print of closing prices is a reliable gauge of the future. Those models are based on the certainty that can only be found in actuarial tables. Those actuarial tables can predict the certainty of a lifespan, but not the sudden tragedy of taking a life. What happened at the World Trade Center unleashed a financial tsunami that has rippled through the world’s financial market. It was a statistical freak, a random event that unleashed tragic consequences for the financial markets. What has emerged from it is chaotic disorder.

At the moment, it is impossible to know who has been right or who has been wrong. Time will flush out the loser. In the world of derivatives, contracts are hedged. Hedges can cancel out risk provided the counterpart to each transaction can be relied on to honor their commitment. It is a giant game of faith. The parties to each transaction are closely knit. If one falls, the other falls. Within the smoke and ruins of the World Trade Center, another fire is smoldering somewhere in those derivative contracts. Every time financial fires have erupted in the financial markets, the trail has led to derivative trades. Remember Barings Bank, Orange County, Metallgesellschaft, Sumitomo Bank and LTCM. The question now is, "Who will be this crisis' next victim?" Stay tuned. The fireworks have only just begun.

The Dollar is Damaged, But Not Decimated
What has emerged from this crisis is that the dollar is no longer considered a safe haven in times of international unrest. The crisis' epicenter was in the heart of America’s financial district. From the first moment of the attack, the dollar has been one of the victims suffering from collateral damage by financial shrapnel. Financial markets in the U.S. have fallen sharply, losing their image of invincibility. While investors around the globe were dumping dollars and shedding equities, they were moving into safe havens like cash, gold and silver. Excluding the shares of select defense stocks, the biggest winner from this crisis has been precious metals. In past crises, the money crowd moved into the dollar. Most of those past crises were centered elsewhere. This one was spawned right on the U.S. mainland.

Recent Trends Intensified

U. S. Treasury Market as of 9/19/01

Last week's senseless World Trade Center disaster has only served to accelerate trends already in place and help ignite others that were in their formative stage. The economy, the stock market, and the dollar were already in downward trends. The mountains of liquidity being injected into the system are bound to surface somewhere. An eventual stock market rally is still possible however short-lived it may turn out to be. The yield curve has steepened as a result of Fed intervention. As this table indicates, the yield on short-term Treasuries is next to nothing. It shows the paltry returns from short-term maturities. Investors may be tempted to come back with any sign the crisis is over. However, the allegiance to financial assets has been dealt a severe confidence blow. Investors have suffered heavy losses. Allocation models are being rethought. This may be one reason behind all of the trading volume of this week. It has been a week of record losses accompanied by record volume.

New Bubbles Will Emerge

Like pieces on a chessboard, strategies are being reworked. Make no mistake. A new trend is in the process of emerging. The ocean of money being created by central banks will create a new bubble in asset classes. That new bubble is starting to ferment in the metals and energy markets. Soothing words from OPEC helped to bring oil prices down this week. That is before any shooting begins. Most certainly, any U.S. led effort to seek and destroy the terrorists will lead in one way or another to the Middle East. When trouble erupts in the region, oil prices will rise due to the possible disruption of the supply of oil. One of the world’s most vital sources of energy is located in the states that border the Persian Gulf. Some of those states are friendly with the U.S. Others are not. In fact, any spike in the price of oil benefits them all. It is their one precious resource and a major source of revenue for the governments that control the region. America’s dependence on this unstable source of energy points to our vulnerability. Oil is essential to our country’s national security. The President knows this and will make oil supply a priority in securing our homeland's defense.

Trends to Watch

Oil. It's Always Oil
As a result of this week's panic selling, many high-quality oil and natural gas companies are selling at P/E multiples as low as 4 times this year's earnings. Some pay healthy dividends that are two to three times the yield offered by most companies that make up the S&P 500. Insider buying has never been this strong as evidenced by the flow of money into the sector. Finding large oil deposits is getting harder. Great elephants (discoveries of one billion barrels or more) are a rarity. This is why major oil companies are sitting on $40 billion in cash. Majors are more likely to pursue a strategy of takeovers rather than expend money for exploration.

We are moving closer to a world of scarcity. Despite this year’s slowdown in world economic growth, the IEA still forecasts demand growth this year of 460,000 barrels a day. The growth is coming from the developing world in China and India. The Wall Street consensus is still predicting prices will fall below $20 a barrel. Some are predicting a steep fall below $20 a barrel to as low as $15. They have been predicting this for the last two years. Frankly, consensus is almost always wrong. Many of the firms predicting lower oil prices have been the same firms forecasting higher stock prices this year and last.

Precious Metals
Another emerging trend is the explosive rally in gold and silver prices as evidenced by the graphs below. As reported in previous Storm Series installments, the demand for metals has created supply deficits for more than a decade. Central bank selling has made up the deficit. Now much of that gold lies buried underneath the rubble of the World Trade Center. Just imagine what would happen if investors moved even a fraction of their money out of cash and into metals and demanded the physical. A disaster, greater than has been witnessed in the stock market this week, would quickly be upon us.

For silver, the situation is even more serious. Unlike gold, there are no large central bank vaults brimming with silver that could be dumped on the market to drive its price down. The above-ground stockpiles have all been drawn down as evidenced by these charts. Silver prices have been driven down by huge short positions in the paper markets. ED&F Mann is estimated to be short 10-15,000 contracts of silver. While supplies have been consumed, demand continues to grow. The Census Bureau reports that July silver imports are up 34 percent over last year. The silver shorts have boxed themselves into a corner. Maybe they will get lucky in the short-term. Large paper short positions could keep the spot and futures price from percolating short-term. Long-term is another story. In the long-term supply deficits dictate that the natural order of economics prevail. What is scarce and in short supply will always go up over longer periods of time. It is a basic law of economics that remains irrefutable.

Some may argue that basic economic laws have been repealed. They have not read history. There have been short periods of time some lasting decades when paper money has dominated commerce. It happened for a brief period in the 18^th century in France and England. It happened again in the 20^th century in 1933 and again in 1971. Since the Bretton Woods System collapsed in 1971, the world has revolved around the dollar and a system of fiat currencies. Governments want their citizens to accept its fiat paper. They have in fact enforced its acceptance by making it legal tender. The real battle taking place now is the battle between the government forces of paper and the forces of real money represented by gold and silver.

From Russia, Asia, and India to the Middle East and Mexico, the hard money forces are making a come back. Russia has introduced gold coins to compete with American dollars. In Russia the people spend rubles, but save in dollars. To compete with those dollars, they now have a choice of Russian-minted gold coins. Which do you think will become their savings preference? Mexico is also considering a silver-backed currency. The dollar-based fiat system is about to implode. It will take time, but it will eventually happen. The U.S., as a result of its continuous trade and current account deficit, has been exporting dollars around the world. Billions of those dollars are being held as reserves by the central banks around the globe. When the realization that the dollar's store of wealth is illusionary, they’ll begin to export them back. Once those dollars arrive on American shores, they will be exchanged for physical assets. The consequences of those returned dollars will end the era of deflation. Hyperinflation will be the result.

The Questionable Path of This Present Storm

I’ve already outlined the course of action for whatever course these storms will travel. Tangible assets such as gold, silver, energy and defense stocks are the preferences for stagflation and The Perfect Financial Storm. Cash and short-to-intermediate Treasuries are the preference for deflation. It appears now that we have both forces at work. As the graph of M-3 indicates, the money supply has gone parabolic.  Printing this much money will bring inflationary consequences. The Federal Reserve just reported credit data for the second quarter. Credit expansion during the second quarter continued at an annual pace of $1.8 trillion. That's a bucket of money, even for an economy the size of the U.S. On top of that, non-federal borrowing grew by an annual rate of 8.3%. Consumer borrowing grew at an annualized rate of 9.3%. Mortgages grew at a 12% annual pace.

Financial experts and our public leaders have reassured us that our economy is sound. Yet, the market gyrations over the past two weeks point to a different conclusion. Storm fronts are cropping up everywhere around the globe. Bear-o-metric Pressure hasn’t dropped this fast in over 70 years. A rogue wave just hit the U.S. Others will follow. One can only speculate as to the extent of the damage of last week's attack. Realistically, it has impaired our financial system. Irrespective of the $1.38 trillion in stock market losses, the system was headed for trouble. A decade of debt accumulation, mounting trade deficits, a mushrooming money supply, and a surfeit of speculation in our stock market has led us to this precipice. The losses in our markets and those in stock markets around the globe make it clear that the global financial system has now become imperiled.

The key question going forward in determining the path of this current storm will be the dollar. If it holds, the storm is heading for a deflationary path. If the dollar collapses, and is repatriated home, then inflation will be the result.

Some Final Thoughts...
As a first generation-born American, I am saddened by the tragedy of last week’s events. This week's losses have only brought greater sorrow to Americans across this great land. Having studied our nation's history, I know that we have stood in this place before. We have endured hardship and overcome its travails. That determination is what makes America what it is. It is the spirit of this country that I have come to love. Adversity serves only to strengthen us. I saw it in face of our President as he addressed our nation. It was a look of determination and resolve. It was the face of a man who was transformed from what he once was to what he will become. It was the look of leadership. It said to me, "I am ready and I am with you." It was a look of confidence, while at the same time, there was humility and compassion. It was the look of a man at peace with God, knowing that God isn’t impartial between good and evil.

What brings me great comfort is to see the rise of patriotism from coast to coast -- in reality, across our fruited plain. It is this bond that unites us. It goes beyond religion, race, or creed. This tragedy has brought our great nation together where only months ago, it was divided. Democrats or Republicans, liberals or conservatives, Christians, Jews or Muslim, will not win this battle. We are all Americans now. As Americans we will endure the storm of adversity that is now before us. Like our forefathers before us, we will rise to the challenge and be strengthened by it. Once again, “God Bless America” has become our nation's song. A song, long forgotten and seldom sung, is now being heard everywhere. May God bless America and strengthen its resolve.  ~ JP

© 2001 James J. Puplava
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