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-- Posted Wednesday, 13 September 2006 | Digg This Article

To view Grandich's newsletter in its entirety with graphcs and charts, go to
http://www.grandich.com/docs/alertGL_09-12-06.pdf

9:00 a.m. EDT

September 12, 2006

Editor’s Note – Starting with this issue, the themes of the “Blue Chip & Income Report” and the “North of The Border” newsletters will be incorporated into The Grandich Letter.

While I remain an avid follower of the Canadian markets, the original reason for publishing NOTB was the belief that it would fill a niche for American investors who want to know more about their neighbors to the North. Unfortunately, most Americans seemingly care only about Canadian hockey and cold fronts. The vast majority of NOTB readers have been Canadians who appear to want to see what an American is saying about their markets. I will honor that desire by continuing to comment on the Canadian economy and markets from time to time in the Grandich Letter.

 “Reality is the leading cause of stress amongst those in touch with it.”  

                                                - Jane Wagner

While I’m now in my 23rd year in the financial arena, I have never seen such a discrepancy between what I perceive the future holds versus how the majority of Americans are living their lives and are seemingly unprepared for it. I don’t consider myself a pessimist but a realist. I believe America as we knew it just a couple of decades ago, has ceased to exist—only it’s politically incorrect to even suggest that. Cultural relativism and secularism is becoming the norm while the very fabric that held this country together for the first 200 years is being ripped apart. At the same time, our country’s financial health is rapidly deteriorating and little if anything is being done to prevent a catastrophe that will make the Great Depression look like a walk in the park.

Don’t for one minute assume this is merely a stance due to my work within the mining and metals industry. I am in no means a “gold bug.” I’ve been bearish and avoided gold during my career. However, it has been a most appropriate investment vehicle in recent times and nothing appears on the horizon to change that. My “dark” outlook comes more from work with Americans as a financial counselor who specializes in an alternative to traditional financial planning (which is a process destined to fail and why so many Americans’ financial futures are in jeopardy). My work specializes in a family’s “cash flow” and the recent “flow” has been to “rob Peter to pay Paul” but Peter is tapped out. Much of my work is within the county in which I reside-Monmouth County. Money Magazine has ranked it among the top 20 wealthiest in the nation. From what I’ve seen in the last year or so, that so-called wealth has been built on a house of cards whose foundation is debt, debt and more debt. Throw in living way beyond their means, and you have a recipe for economic hardship unlike anything this generation has seen or could imagine.

The fact is that just about everyone I find who has used their house as an ATM, has many possessions but owns outright very few of them.  These people, who see the cup as half full despite drowning in a sea of red, find my analogy of the future to be either foolhardy or scar-mongering. This makes me even more confident of my outlook.

Debts, Deficits and You

The social, economic and political upheaval facing America will be unprecedented in American history. We’ve become the world’s biggest debt junkie and foreigners are our Pushers. Terrorism and energy crises will pale in comparison to the biggest crisis America has ever faced – the aging of America. Moreover, come this November, new all-time lows in political mud slinging will be everyday occurrences as the Democrats and Republicans make the Hatfields and McCoys look like a love fest.

“A man in debt is so far a slave.”  -  Ralph Waldo Emerson

Whether you believe the Holy Bible is the word of God or just another book, it’s full of advice on money and possessions (theologians say it’s the second most spoken about topic in the entire Bible). Throughout the new and old testaments, debt is spoken about often, yet nowhere can you find even a sentence that encourages one to become a debtor. The inspiring voice for the Bible must have seen America at the beginning of the 21st century. By believing Madison Avenue’s marketing extraordinaire that more money and possessions equals more happiness, Americans have been like hamsters on a wheel in a futile attempt to keep up with the Joneses. The seductiveness of borrowing is at an all-time high:

n   Credit-card debt alone spiked from about $250 billion in 1992 to $804 billion in 2005.

n   To appreciate how much homes became “ATM machines” for Americans, one has to only recognize that Americans borrowed just $11 billion in home equity in 1995, but by 2005 borrowing had soared to $243 billion.

n   U.S. spending has reached 107 percent of GDP, requiring an $800 billion annual infusion of foreign money and even higher levels of debt to prevent a slowdown. We can’t stabilize both growth and debt levels at the same time. One of them has to give- I believe it will be growth.

Not since the Great Depression 70 years ago have Americans saved so little. In fact, we now have a negative savings rate.  In Debt We Trust will soon replace In God We Trust.

Uncle Sam: Hey Buddy, Can You Spare A Dime?

This past July, an extraordinary paper was published that said a ballooning U.S. budget deficit and a pensions and welfare time bomb could send the U.S. into insolvency. The author of that paper said by some measures, the U.S. is already bankrupt. What makes this paper so extraordinary is the fact it was published by one of the key members of the country’s central bank- the Federal Reserve Bank of St. Louis. The author was Professor Laurence Kotlikoff.

http://research.stlouisfed.org/publications/review/06/07/JulAug2006Review.pdf

In the paper, Professor Kotlikoff said, “To Paraphrase the Oxford English Dictionary, is the United States at the end of its resources, exhausted, stripped bare, destitute, bereft, wanting in property, or wrecked in consequence of failure to pay its creditors?” According to his central analysis, “the US government is, indeed, bankrupt, insofar as it will be unable to pay its creditors, who, in this context, are current and future generations to whom it has explicitly or implicitly promised future net payments of various kinds.”

The professor noted, “The proper way to consider a country’s solvency is to examine the lifetime fiscal burdens facing current and future generations. If these burdens exceed the resources of those generations, get close to doing so, or simply get so high as to preclude their full collection, the country’s policy will be unsustainable and can constitute or lead to national bankruptcy.”

So is the United States broke? No, but it’s already well down the road to insolvency.

Thankfully, the federal government keeps two sets of books. The one you hear about promotes a better bottom line – a $318 billion deficit in 2005. The set the government doesn’t talk about is the audited financial statement produced by the government’s accountants following standard accounting rules. It showed a $760 billion deficit for 2005.  And, if Social Security and Medicare were included, as the board that sets accounting rules is considering, the federal deficit would have been $3.5 trillion (giving new meaning to cooking the books).

Does the U.S. Congress play by its own rules? When it comes to accounting, they have written their own rules (which would be illegal for a corporation to use because they ignore important costs such as growing expenses of retirement benefits for civil servants and military personnel). According to a USA TODAY analysis, the audited financial statement, prepared by the Treasury Department, revealed a federal government in far worse financial shape than official budget reports indicated. The “official deficit was just $729 billion but the analysis found the government ran a deficit of $2.9 trillion since 1997. Congress and the President get away with this because they don’t count the growing burden of future pensions and medical care for federal retirees and military personnel. To appreciate how massive these obligations alone are, if they were accounted for back in the late 1990s, the then budget surpluses would have actually been deficits.

If standard accounting rules had been applied, the government would have reported nearly $40 trillion in losses since 1997 due to the deterioration of Social Security and Medicare. You see in the “real” world, generally accepted accounting principles require reporting financial burdens when they are incurred, not when they come due. Let me give you an example. XYZ Corporation decides to give a new drug benefit to its retirees. The company would be required to count the future cost of the program, in today’s dollars, as a business expense. If the benefit costs $ 1 billion in today’s dollars and retirees were expected to pay $200 million of the cost, XYZ would be required to report a reduction in net income of $800 million.

Social Security, Pensions, Retirement and You

I’ve written often about the coming aging crisis so I won’t spend any real time on it in this issue. However, in a related matter, I can never speak enough about the impact the baby boomer generation reaching retirement age is going to have on us … to the downside. Again, I draw your attention back to my other business where I work with families in an alternative to traditional financial planning. It’s truly amazing to meet these folks in their 5,000 square foot homes (after I passed two leased Lexus and/or Mercedes in the garage), discover they have incomes anywhere from $100,000 to $500,000 and have little or no retirement funds. But it should come as no shock as this Social Security study shows the extent to how little Americans have saved.

The cottage industry built around financial institutions is very evident on television networks like CNBC-TV. You won’t have to wait long before you see a commercial showing some older person/couple living the good life thanks to ABC Company helping them.

One of my favorite slides in a presentation I make called "Investing For Excellence" in my financial counseling business features the cover of FORTUNE MAGAZINE, and a couple floating in a tropical ocean.  The headline reads, "Retire Rich."  To start, who wants to retire “poor”? In just one picture frame, the magazine clearly suggests an older couple enjoying their “retirement.” Much of the financial services industry markets in the same fashion (if not more aggressively). Why then, are study after study showing most Americans have not saved enough to retire “comfortably?”  The Employee Benefit Research Institute’s (based in Washington D.C.) annual retirement confidence survey this year found that about 68 percent of workers are confident about having adequate funds for a comfortable retirement, yet half of all workers said they’ve saved less than $25,000 toward retirement. Even among workers 55 and older. Almost half have saved less than $25,000.

What I find most disturbing about America’s poor savings performance is it comes at a time when the nation’s employers are eliminating “defined benefit plans” – better known as pensions and are eliminating retiree health care coverage or asking retirees to contribute more for it.

A study by the Center for Retirement Research at Boston College found that many Americans are doing far too little to prepare financially for retirement and are unaware of how their lives might change as a result.  Ms. Alicia Munnell, the center’s director and one of the author’s of the research said, “Retirement is going to get tougher for people over time, and people don’t know it. Look at these numbers: they tell you that there’s trouble ahead.”

FED Chairman Greenspan spent much of his last few months in office speaking out about the entitlement nightmare he envisioned if steps weren’t taken ASAP. Knowing his need to double-talk was behind him, he made numerous dire comments about the coming aging crisis, social security and the financial health of Americans. I believe it was no coincidence that he was doing so while Social Security and Medicare trustees were reporting further deterioration in the financial condition of the government’s two biggest benefit programs. These trustees now say the Social Security trust fund will be depleted by 2040 and that the Medicare hospital insurance trust fund will be depleted by 2018. The trustees, who include the head of the Social Security Administration and three members of the cabinet, said long-term growth rates for both programs were not “sustainable under current financial arrangements.” Former Treasury Secretary John Snow, chairman of the trustees group, said without action “the coming demographic bulge will drive federal spending to unprecedented levels” (thanks to 78 million baby boomers approaching retirement).

I unfortunately half laugh, half cry, when I hear politicians talk about “lowering” taxes. How anyone can speak of an era of “lower taxes” knowing what America faces on the entitlement issue alone, is either stupid, ignorant or a liar (okay, I know I just gave the job description for a congressman). The math is simple: There’s an estimated $80 trillion in unfunded future entitlement liabilities, which is six times larger than the U.S. economy and 16 times the federal debt held by the public. It’s been estimated that future workers are going to have to pay tax rates from 55% to 80% over their lifetimes to fund these promises. Say hello to European socialism. Those who say the problem is not severe are banking on a much stronger U.S. economy over the next couple of decades and therefore future payments will come from a bigger pie. Warning – Goldilocks Economy believers are urged to stop reading now!

Okay, I assume if you’re still with me, you are like me and watch much of CNBC-TV with the sound off. My friend, you don’t have to be an economist to know that the “promised” benefits are scheduled to rise at the rate of real wages increases. This means in the end, the only real answer to the entitlement nightmare is raising taxes, extending the age before one can receive benefits, or lowering and/or eliminating the benefits. Impossible you say? What do you think Congress will choose: to renege (default) on a T-Bond and effectively file “bankruptcy” or not pay an entitlement benefit, which is not a contractual government obligation (look up Flemming v. Nestor, a 1960 Supreme Court ruling that said there is no legal right to Social Security)?

I believe (and advise in my counseling) that one of the key reasons the government has been allowing so many new ways for people to save for retirement is the knowledge that Social Security will one day cease to exist (or be so maligned that future retirees will surely never see a dime). Look for more bad news on our pension system as the Pension Benefit Guaranty Corporation – PBGC, is the Savings and Loans crisis of the 21st century.

Parents tell little children fairytales like Goldilocks and the three bears. The “Don’t Worry, Be Happy” crowd on Wall Street tells investors fairytales like “Goldilocks’ economies” and the ever elusive “soft landing” (I would sooner believe the Vancouver Canucks winning the Stanley Cup-LOL). I wish the next time one of the many “soft-landing” preachers appear on CNBC-TV, one of those “softie” anchor personnel would actually ask when in the last 30 years did we ever have a soft-landing? The answer is that since the mid-1970s, almost every time the Fed had pushed rates higher, it has created a recession, a bear market or both. The notable exception came in 1994 and 1995, when the Fed raised rates without causing either, but bonds blew up and the Mexico Peso tanked. I have a recommendation if you’re betting the soft landing theory actually works this time: make sure your life insurance is fully paid and remove all sharp objects from your reach.

“But all bubbles have a way of bursting or being deflated in the end.”  - Barry Gibb

The Bee Gees’ Barry Gibb wasn’t talking about market bubbles, but his commentary was indeed most appropriate for the 21st century real estate market. And the Bee Gees song, “Jive Talkin'”, certainly could describe those who claimed there was no bubble.

It’s been my contention that Americans have been living way beyond their means by robbing Peter to pay Paul. They have managed to prolong the party (but the hangover will now be even greater and longer) by tapping the last ATM available to them- the equity in their homes. And just like the stories I heard in the late 1990s from then “market players” on how great the market was, I, like others, was hearing how real estate was the “can’t miss” investment for the new millennium (and of course Wall Street was there to lead them to the “promised land”). And just like the scores of people who “banked” on the Internet-led stock market bubble for their road to riches, sheep-like, overnight real estate mavens are now well on their way to being sheared. Home sales are plunging, inventories are bulging and the last missing ingredient to the total bust, falling prices, is knocking at the door (that’s not Avon calling).

Remembering that if they tossed a real estate agent off the top of the empire State Building, the only thing you would hear them say on the way down is, “so far so good”, the next few years may prove its “not always a good time to buy real estate.” Housing starts are already down 20% from their January 2006 peak. The National Association of Home Builders recently reported that traffic of prospective buyers had tumbled to its lowest level since 1991 (a recession year).

The cup is always half-full at the home of the “Don’t Worry, Be Happy” crowd. And at the height of the real estate bubble, they were out in full force (CNBC-TV is one of the favorite “stumping” grounds). The “come on in, the water’s fine” boys made many claims that are now being ripped apart in a dramatic housing slide:

The Hype – Real estate was a safer and better bet than stocks. The huge price gains were not only going to hold, but additional appreciation rates better than money markets would continue.

Reality – Prices actually have begun to fall where housing is most vulnerable, in the West and Northeast. Not earth-shattering yet, but realize that prices fell 2.1 percent in the Northeast from July of 2005 while at the same time rose around 3 percent nationwide.

The Hype – CNBC-TV’s eternal optimistic economist has misfired on many fronts but one I’ve heard him harp on many times is going to bite him where the sun don’t shine. He states that so long as the jobs market is strong (and that’s highly questionable at this time), housing prices can’t fall (the theory is people doing well will want to buy and buy homes).

Reality – This General in the always-positive army, fails to take into account how overextended the average American is. Most I see are barely able to make it each month, let alone now step up to bigger homes, cars, etc. And, the large increase in inventories will bring a halt to the consistently rising prices, effectively pulling the food chain down with it.

The Hype – House values can only continue to rise in a low interest rate environment, or at worse, keep prices constant.

Reality – The bubble grew because real interest rates fell sharply starting in 2001. After reaching historic lows, interest rates are all but certain to at least not go significantly lower than they were in 2005. This won’t allow most to borrow more at what they see as the same (or even lower) monthly payment, which allowed them to step up the food chain.

The Hype – Home builders are much smarter than they were in past housing slumps. They won’t build lots of unsold “spec” homes.

Reality – Just look at the actual operating results of some of the best known builders lately. Robert Toll, CEO of luxury home builder Toll Brothers, said recently that in his 40 years as a home builder, he has never seen a slump unfold like the current one. Can you spell U-G-L-Y?

In the August 28, 2006 edition of U.S. News & World Report, an article ran entitled, “Housing Slump Threatens Jobs.” It began by noting how many Floridians had been “…hoping to cash in on the real estate gold rush but are now facing the cold reality of working in one of the cyclical businesses…” Home sales fell by one-third in Florida last quarter.

I, along with other “bubble-busters,” have repeatedly warned how the housing industry had been the biggest single engine for job growth in the U.S., accounting for one-third of all new jobs added to the economy since the boom began several years ago. Add to that the fact that Americans withdrew over $600 billion in equity from their homes in 2005 alone (according to a Fed study) and the inability to see price growth and/or significant interest rate declines any time soon, and you can be assured that this stimulus to the economy will be missed.  It will likely only add to more blood spilling in housing going forward (and let’s not forget the Bush tax cuts, which added to the consumption mania.)

Just as we heard countless tens of thousands complain how they were caught up in the stock market bubble of the late 1990s, so shall we hear the anger from many Americans who took the bait of exotic mortgages (that gave new meaning to “creative financing”) in order to get into a new home and/or speculate in housing. One of the most riskiest and complicated home loan product ever created is the option adjustable rate mortgage (ARM). The “devilish” attraction of low minimum payments became among the single biggest lures the mortgage industry used to bring in the very people who could least afford the “downside” and allowed the bubble to get even bigger. Countless media reports hit the wires almost daily on how these “last to the food chain line” folks are now seeing their payment schedules ratcheted up substantially. With home prices leveling off, borrowers can’t count on rising equity to bail them out. They’re also “surprised” to find out they can’t refinance again without steep penalties.

What’s really going to piss these folks off is when they learn their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan’s interest rates might not have been set by a bank but rather a hedgefund; and that they will soon (if not already) face either making higher payments or leaving their home.

Another fact that will come out in time and be part of the “blame game” is according to the National Associated of Mortgage Brokers, 80% of all mortgage originations are now being dome by unregulated mortgage brokers (the pennystock brokers of the 21st century?).

Other “hindsight” stories sure to come will be:

n   Fixed-rated Interest Only Loans – Here, too, a relatively low monthly payment in the early years is the attraction. While the borrower gets to enjoy their “castle” (and you would be surprised to find how little furniture is in the castle), they don’t build up any equity other than potential price appreciation. They can also be hit with sharply higher monthly payments once the interest-only period ends and the borrower is then obliged to repay the balance of the mortgage over the rest of the loan’s term. They will also discover the savings wasn’t that great since their loan typically had a higher interest rate than a 30-year fixed rate mortgage.

n   Piggyback loans - In recent years, many cash-strapped buyers opted for piggyback loans — a package of mortgages that includes a first lien at 80% of the property's selling price and a second lien for some portion of the remaining 20%, depending on how much money they could put in the deal. In the old days, 20% down was virtually mandatory and kept people who couldn’t afford the risk of lower home prices and/or higher interest rates out of the housing market, and that was a good thing. We all know where pigs eventually end up?

n   Inflated Appraisals – Critics inside and outside the appraisal business have been warning that appraisals have been unrealistically high. You see, the loan officer and mortgage broker often choose the appraiser. If a home is appraised at less than the buyer offered, the deal is likely to fall through. Inflated prices meant little during a rising housing market but now some sellers are getting hit with a reality blast. This leads to having to lower the asking price. Some, who were about to lock in new loan terms, are finding they have less equity then they assumed, thanks in part to the original inflated appraisal. You can even see lenders and mortgage investors taking a hit if the collateral backing the loan is worth less than expected.

Things are going to have to get a lot worse, for a long time, before any light can be seen at the end of the real estate tunnel (any light now being touted is a freight train heading right at you).

Real estate special note – Real estate as an asset class is now larger than the US equity market and approaching the scale of outstanding corporate bonds. Recognizing institutional clients such as builders and mortgage investors need to manage their exposure to real estate, the Chicago Mercantile Exchange (CME) has begun trading futures and options on an index tied to changes in residential real estate prices. It’s called the S&P CME Housing Futures and Options. Should you hedge your house against it? Probably not. But if you’re heavily invested in real estate, you may want to explore this further.

IRAN / IRAQ:

The Last Letters Are Different, But Both Spell Major TROUBLE

One could write hundreds of pages describing the conflicts in the Middle East and still not come close to fully describing it. I won’t fool you or myself into thinking I’m an expert on the matter (there are enough highly paid think tanks in Washington for this). But I don’t think one needs to be a rocket scientist to figure out how America stands with regard to these conflicts. A Harris/Financial Times poll recently taken showed that Europeans see the US as a greater threat to global stability than either Iran or China. Five thousand people in the UK, France, Germany, Italy and Spain took part in the poll. European nations, once considered America’s strongest allies, are no longer a big fan of Uncle Sam. In fact, when it once only took two hands to count all the countries in the world who disliked Americans, you can now basically count Uncle Sam’s real friends on those same two hands.

American Middle East policy, touted by the Bush Administration as on the threshold of democracy less than two years ago, is unraveling as we speak:

n   Dubbed in Washington the “Cedar Revolution,” the protests following the assassination of former Lebanese Prime Minister Rafiq Hariri, were hailed by the Bush administration as a blow to radicalism and a vindication of America’s push for freedom. Unfortunately, I have no doubt that America is more unpopular to the people of Lebanon today, than it has been in a long time, thanks to the recent conflict.

n   Iraq has gone from a major break-through for democracy to teetering on secular civil war.

n   The death of the PLO’s Yassir Arafat and the election of more moderate Mahmoud Abbas was hailed as a big first step by the Bush crowd towards lasting peace. Instead, Abbas is an emperor with no clothes while the radical Palestinian group Hamas is now the real power.

n   The “Kefaya” movement in Eqypt, which was yet another “sign” of democracy unfolding in the Middle East during Bush’s “watch,” has fizzled. The Egyptian regime has reverted to its repressive ways.

n   The first nationwide municipal elections in Saudi Arabia failed to lead to wider elections so far.

No matter how much “spin” the Bush Administration puts on it, America’s clout and influence in the Middle East is likely at its lowest point in history. This fact is going to have a profound affect not only on the world stage, but here at home as well.

I believe the Middle East is now set to be an “explosive” factor in our investment planning. For starters:

n   Hezbollah has redrawn the Middle East. For the first time ever, Israeli Defense Forces were not the victors. In fact, Israel’s inability to eradicate Hezbollah has empowered the radical Islamic front at the expense of the far more moderate Arab community who appeared ready to accept coexistence with Israel. In addition, radical Islamists now have a significant say in mainstream electoral politics through Hezbollah and Hamas. Hezbollah’s leader is now seen as the “Nasser of the 21st century” among many Arabs. The fact that Egypt, Jordan and Saudi Arabia went deafeningly silent after the Lebanese conflict is just another indicator that Hezbollah was the clear winner.

n   Syria’s sliding influence within Lebanon has been halted and may rise on the back of Hezbollah. They were quietly appreciating Israel’s destruction of an already weak state and will benefit so long as Israel doesn’t attack them. Behind the scenes, no one really wants to see the current regime in Syria ousted, because sooner or later the Muslim Brotherhood radical Islamist movement would be in charge.

n   I don’t think many people realize why Iran has been a major supporter of Hezbollah. Yes, it has created a mess in the Middle East again at a time when the world’s eyes are upon them. But, the Iranians feel they have revenged their defeat at Iraq’s hands back in 1988, when Arab Sunni nationalist and Islamic movements supported Iraq against Iran. Now, Tehran is playing the “Arab Street” and undermining the legitimacy of the ruling Arab regimes by leading this new alliance of Islamic and Arab nationalism in the near east.

n   Israel, once viewed as an immoveable force, is now viewed beatable (the legitimacy of that view is not very important). There will be internal strife in Israel as the hardliners feel betrayed by the current regime while, the peacemakers feel (now more than ever) the need to appease the Arab world. In the end, the conflict with Hezbollah will lead Israel to rethink its strategy. I believe part of it will be that they spent too much time on the Palestinian militants in Gaza and the West Bank instead of the two biggest state sponsors of terrorism in the region- Iran and Syria.  Israeli Military sources claim Israel is already preparing for a war with Iran and Syria. It cannot, and will not, live with Iran having a nuclear bomb. Meanwhile, look for Hezbollah to be behind supporting Palestinian militants in the Gaza strip with weapons and tactical expertise.

n   Iran can be considered America’s “third front.” The other two are Afghanistan and Iraq. One’s a draw at best while the other is just inches from falling into the abyss. There’s no doubt in my mind that President Bush believes Iran poses an existential threat to close ally Israel. The U.S. Congress recently passed a resolution that said an attack on Israel is an attack on the US. While one assumes the world can’t be naïve enough to think Iran is seeking nuclear capability merely to enhance its agriculture and ability to treat and diagnose AIDS and cancer patients (that’s what their UN ambassador said in a recent speech), it’s also not even close to having the “you no what” to stand up to Iran in a manner that would satisfy the Bush administration. The question will become, “Can the US afford another front?” What effect, if any, will a return of a Democrat-controlled Congress mean to Bush’s ability to do what he thinks needs to be done against Iran. There’s little doubt that Iran has won the publicity battle up until now but some real serious challenges are now on the horizon.

Iran and Iraq are going to remain major factors in our investment decisions for the foreseeable future.

China – Is It Really A Sure Thing?

Finding a needle in a haystack would be easier than finding a bear on China’s economic outlook. I’m always nervous when I find just about everyone in the same boat. Knowing some are already penning an email to me on the belief that I’m about to pan China (pun intended), rest assured this is by no means a bearish forecast. It is, however, a strong suggestion that it may be wise to pull the reigns in somewhat and to recognize the only three things in life that are certain are death, taxes and no team named the Canucks can win the Stanley Cup.

Since 1978, China’s annual GDP has averaged 9% (giving new meaning to urbanization, marketization, privatization and globalization). In less than 30 years, China has gone from being a peasant-rich Maoist autocracy to an economic behemoth. It has been without a doubt, the single most important reason we’ve experienced the greatest commodities bull markets in the modern era. And, with a population of 1.3 billion, it’s a multinational business dream scenario. It’s hard to find anyone who is anything but bullish when China’s future prospects are considered. To me, that’s enough reason to consider it is possible.  Could the “live happily there after” mentality of the Chinese bulls be premature at best and a potential negative surprise at worse?

Here are some factors to consider before you board the Chinese “gravy train:”

n   While China isn’t about to face the aging crisis ready to engulf America, it does face some significant hurdles thanks to its “one-child” policy of recent years. Chinese bureaucrats have often stated their fears that their land will grow old before it grows rich. The Rand Corporation is forecasting a graying of the Chinese workforce within 10 years. By 2050, the ratio of Chinese active workers to retirees will become among the world’s worst, with the aged (meaning people at least 60 years old) rising to more than 400 million (from 120 million in 2003) and comprising more than 30% of the population (now less than 10%). While neighbors Korea and Japan face similar demographic problems, China is far poorer, doesn’t have social safety nets, no pension protection mechanism and will still be in its economic infancy when compared to Korea and Japan. Decent healthcare is either unavailable or beyond the means of most Chinese.

n   Economic growth has come at a great expense to China’s environment. About 300 million Chinese drink contaminated water, with some 190 million being sickened by it each year. According to the World Health Organization, 5 of the 10 most polluted cities in the world are in China. With growth also comes acid rain, deforestation, serious soil erosion, silted reservoirs and growing carbon-dioxide and sulfur-dioxide emissions.

n   One of the biggest potential problems is water. Its quality and availability is most likely going to become a constraining factor on China’s economic growth. Severe water shortages plague the North of China, which boasts two-thirds of the country’s arable land, produces half of its grain and is home to much of its manufacturing and population. Deserts are cropping up around Beijing, and the city’s water table is dropping rapidly. A recent government inspection of 500 new water-treatment facilities showed that fewer than half had even been turned on. Locals took the money to build the plants in order to create jobs and kickbacks, but don’t want to spend local tax revenues on running them.

n   Corruption can be found at all levels of government. While it’s not hard to find it anywhere in the world, major world organizations believe it has become acute in China. Local party officials are increasingly seen at high-roller gambling tables of Macau and even in Las Vegas. Again, while corruption is nothing new around the world, all those dollars one assumes are going directly back into China’s economy are not anywhere near it.

n   Boom to Bust? There’s no question it’s a boom right now, but in every great economic birth in history, a period of serious digestion or bust followed. Why should China be any different?  If a period of slower growth is on the horizon, it’s the incredible investment boom that’s the most likely cause. The bulk of the financial risks reside in China’s banking system. It remains shaky, despite efforts by Beijing to reform the system.

My comments on China are not warnings of impending doom. China should remain the tiger it has been only it’s not the one-way street so many would have you believe. In the last few months, Chinese authorities have implemented several measures that are likely to cause its growth rate to lose at least a few percentage points, if not more. It’s foolhardy to assume China is going to continue growing at 10%+ and not have internal problems that could lead to an imploding of that growth.

Who Really Won the Cold War?

Historians will tell you that when it comes to the Cold War, the final score was: Free World 1, Soviet Union 0. But from that reported victory, a key part of the “losing” team has emerged not only to play another day, but is fast becoming a serious player on the world stage- RUSSIA!

With a 70 percent+ approval rating and an economy growing at more than 6 percent a year, Vladimir Putin has led Russia back to the world stage. Russia’s brief cutoff of natural-gas supplies to the Ukraine last January not only shocked European customers further down the pipeline, but made many in Europe realize the dramatic rise in energy prices turned Russia from a supplicant for foreign aid to a cash-rich power courted for its energy resources. Europe has grown quite dependent on natural gas to generate electricity. It already gets a quarter of its gas from Russia, a level that is expected to rise by a third in less than 10 years. Why is this important? While the U.S. is concerned about the Middle East for its oil, Europe is now viewing Russia as its “Middle East” for its energy.  Therefore, Russia can use this in its political positioning on the world stage and knows Europe can ill afford to jump down its throat. This is a net negative to relations between the U.S. and Russia, at a time when the U.S. has far fewer pieces in the world chess game. I believe Russia is going to be more than just a thorn in the side of America.

Final Worldly Thought – It seems there’s a crisis in whatever direction the White House looks. Mr. Richard N. Haass, a former senior Bush administration official who heads the council on Foreign Relations, said recently, “I am hard-pressed to think of any other moment in modern times where there have been so many challenges facing this country simultaneously. The danger is that Mr. Bush will hand over a White House to a successor that will face a far messier world, with fewer resources left to cope with it.” I don’t think anyone could have summed it up better.

Blue Chip & Income Report –

I was in my local bank recently when the teller was finishing a conversation with the in-house “investment expert.” When the “expert” returned to his desk, the teller beckoned me up to her window while mumbling the following “I will never be able to retire if my portfolio doesn’t get going.” I asked her what she meant. She proceeded to tell me that her account has been basically flat for over five years and is still significantly lower than it was in the late 90s. She said what little it made was eaten up in fees and she could have done better if she simply put the money “in the bank”.

Now, don’t get me started on my opinion on the “quality” and qualifications of these financial advisors at local banks, but what the teller expressed is what I find from the public-at-large these days. Yes, the market has had some nice rallies and if you’re the 1 in 100 who can beat it trading it, congratulations. But for the vast majority, the stock market has not provided the rate of return I suspect that teller was shown when she first sat down with the “expert.” And this is becoming an acute situation for the baby boomers who will begin to hit the retirement age target next year.

U.S. Stock Market Outlook –

While you would think it should be at 15,000 based on what you hear daily on CNBC-TV, it has only treaded water in 2006. The “Don’t Worry, Be Happy” crowd on Wall Street will tell you that the Fed’s tightening mode is what prevented a big rally and that should now occur given it looks like the Fed is done tightening. Having been around sheep (the animal kind) numerous times on my family farms in Ireland, I’ve seen first hand how they follow others almost blindly. Therefore, it comes as no surprise that stock market players remain very optimistic and believe it’s virtually certain that share prices will head higher now that the bulk of interest rates hikes are done. 

The problem with that assumption, IMHO, is while it can allow a rally to new all-time highs on the DJIA, there are numerous bearish factors that should not only curtail any rally, but eventually lead to a new bear market:

n   The upcoming general elections are going to deeply-polarize the nation. A Democratic win in Congress should not be received well on Wall Street. It’s hard to make a case that Democrats are favorable to big business.

n   I believe earnings growth peaked in the 2nd quarter. There were strong hints of that in the GDP numbers. Productivity has been the backbone of the economic expansion and it has clearly seen its best days.

n   The housing market is caving in. Much of the wealth effect from it has kept consumer spending up. Literally overnight, the Americans who have been robbing Peter to pay Paul by using their house as an ATM machine, will wake up to find themselves in an uncomfortable position. A dramatic economic slowdown has begun.

n   The United States is no longer the star on the world stage. It’s no longer a certainty that foreigners will continue to pay for our sinful deficit spending ways without demanding either a cheaper currency and/or higher interest rates.

n   Our fiscal house, both as a nation and as individuals, is in sorry shape and the longer we avoid the inevitable painful measures (is any diet fun? If so, please tell me one I can go on), the more painful the future will be. Debt, deficits and the aging crisis should all combine to make the foreseeable future the most challenging yet for the American public.

Until further notice, it’s better to be a live chicken versus a dead duck when it comes to the U.S. stock market.

North of The Border –

Up until a few months ago, I greatly favored the Canadian stock market over the U.S. However, I felt oil would peak this summer and the next $15 move from the highs would be lower, not higher. Knowing the TSX was heavily weighted towards energy, I felt it could see a correction of at least 20% and put it on the same level as the U.S. market.

What Canada does have going for it over the U.S. is a far, far, far better fiscal house. It took its medicine in the 1990s and put its house back in order. While a peak in energy and base metals prices is likely to lead to less economic strength than in recent years, Canada should remain the preferred choice. The only dark cloud not even on the horizon yet is the old adage, “when America sneezes, Canada catches a cold.”  Because the U.S. is still Canada’s largest trading partner by far, any serious U.S. economic contraction can spill over into the U.S.

Precious Metals and Uranium -

The Party Is Far From Over

People keep asking me why I remain so bullish on gold. Their questioning becomes acute during corrections and periods of consolidation (like right now) as concerns grow regarding is the bull run is over? I would like to tell you that I’ve created a scientific formula or have a secret black box, but the fact is that my ever-increasing gut remains my most accurate forecasting tool. That, and the sentiment I see both in the market and communications sent to me from the general public (some emails make you wonder what happened to people at an early age). Because of this, I’ve decided to detail my observations on gold and also finally say something more on uranium than “It’s the no-brainer metal” or “I Love It” (although both clearly described my fondness and being on the right side so far).

Gold –

While I clearly have been on the bullish side far more than the bearish, there have been periods of time during my 22+ years in the financial arena that I avoided gold or bet against it. However, in the Spring of 2003, after being out of the resource market for over three years, I returned to the bullish camp with gold on the verge of breaking above $325, (which was considered key resistance back then). Other than stepping aside for some serious corrections, I’ve been blessed to be on the right side of gold. Now the “law of averages” players may want to play the “Grandich puts his pants on one leg at a time like the rest of them” fact and bet against me. I can appreciate that (the wife has been suggesting I lighten up… Okay, urging!). However, my “tea leaves” gut and charts suggest the “perfect storm” remains for gold.

Here are some of the key bullish factors:

n   Supply versus Demand – At the end of the day, supply versus demand will decide the fate of any commodity. I continue to find most “goldbugs” downplaying or even ignoring the single most important factor for gold: jewelry demand.  (Don’t scream, manipulation and conspiracy followers. I’ll get to that shortly). Jewelry demand is still about 70% of the market. Investment demand is about 20% and the remainder is industrial and dental demand. 2005 was a barn-burner for demand so the drop off in the first half of 2006 comes as no surprise. Jewelry demand is always price sensitive so it takes time for the market to adjust to higher prices. We’re entering the most seasonally–favored period, so I don’t envision a lack of demand to impact prices for the balance of the year.

Demand should also remain strong on the investment side. I’m totally convinced that America is well on its way down a slippery slope to economic, social and political upheaval, thanks in part to the country as a whole living way beyond its means. This reckless spending and borrowing has set the stage for the most dramatic economic downturn that can make the “Great Depression” look like a walk in the park. The U.S. Dollar is terminally ill so gold is the best alternative and safe-haven investment vehicle, bar none. While old-line goldbugs dislike Gold Exchange Traded Funds (ETFs), they have grown from near zero demand in 2003 when they were introduced, to nearly 500 tons at the end of the first quarter of 2006. I’m convinced much of that buying came from investors who otherwise wouldn’t have bought physical gold (but it did take away some of the buying that used to go into mining shares as a way to play gold). I believe they will continue to be a big positive for gold.

On the supply side, there are three key sources: mine supply (61%), gold scrap (22%) and Central Bank Sales (17%). I will discuss mine supply and Central Bank sales below.

n   Mine Supply – Back in early 2005, I stated we were going to see a dramatic increase in mergers and acquisitions within the metals and mining industry. Sure enough, the “good ole’ boy’s network” within the mining industry has been welcomed to the 21st century! Like when oil first went to $30 and the oil industry found it cheaper and faster to look for oil on Wall Street versus in the ground, mining companies have discovered that Wall and Bay Streets have excellent targets. The lack of enough mega discoveries, combined with higher costs and operation difficulties, should cap any real increase in mine supply for the next few years.

n   Manipulation and Cartels – I want to devote space to an extended view on this factor, as it’s as critical to the gold picture as jewelry demand.

Let me begin by noting that I was not a real believer but for years knew there were very unusual trading patterns. When I returned to the speaking circuit, I began to hear Bill Murphy and Chris Powell of www.gata.org speak. At first, I thought Bill had a screw loose (but don’t we all have one?). However, as I began to digest GATA’s research and analogy, it began to make a lot of sense. As the circumstantial evidence piled up, I concluded GATA’s view was realistic and deserving of recognition.

Now, allow me to make a critical observation to the claim of manipulation. The non-believers, many of whom have badly missed the great bull run in gold, simply dismiss manipulation as impossible and/or nothing more than the ravings of a madman. Before you, too, make this fatal error, I want to take you back to October 20, 1987.

Young Peter Grandich was Head of Investment Strategy for a then New York Stock Exchange Member Firm called “Philips, Appel & Walden”. On August 11, 1987, in my capacity as “Investment Strategist”, I sent out a commentary that forecasted a market crash of 500 to 1,000 points. We all know what happened by October 19, 1987. Most people forget (or simply weren’t in the business or investing back then) that October 20th was looking even bleaker than the 19th. By early afternoon, many of the DJIA stocks were still not opened. The DJIA was off almost 200 points and blood was truly running through the streets. The regulators shut the S&P 500 futures pit in Chicago in part because it was the selling of futures related to program trading that was causing even more selling. However, the Kansas City Bo