“Rommel … I Read Your Book” – Feb 17, 2012

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. “Rommel … I Read Your Book”: The Fed’s January FOMC meeting concluded that this year would disappoint, prompting a lower projection of U.S. economic growth. With that conclusion came the expressed intention to keep rates low well into 2014, the longest period of unnaturally low rates in U.S. history. In addition, Bernanke has recently suggested that the Fed’s inflation target of 2% will need to run a little hot, as economic recovery is still a real concern. With unemployment remaining high (8.3%, down from 8.5% on seasonal adjustments, and up to 8.8% sans the adjustments), the course ahead is intentionally biased toward inflation. The political compromise the Fed is making should be plain to see – justified, of course, by its dual mandate.

Pinpointing our concern, the very folks that didn’t see an economic crisis coming in 2008 continue to suggest that they have solutions in hand (using the same economic school of thought), thereby exhibiting the proverbial definition of insanity. Inflation, in their view, is something you control scientifically in order to add stimulus to the economy. Again, our concern is that marginal increases in inflation are really a tax on the economy, not a form of stimulus. They produce a negative result quite different than the result assumed by the FOMC. The Fed would argue that inflation is used strategically – but only when necessary (which seems, given the Fed’s record since its founding in 1913, to be all the time). We recall with some pain the comment by Malcolm Bryan, former Atlanta Fed president, regarding the impact of inflation targeting: We should have the decency to say to the saver, “Hold still little fish. All we intend to do is gut you.”

You see, it’s not just high rates of inflation (which are coming) that hurt you. A low rate of inflation, even over a short period of time, picks your pocket. A recent Forbes magazine article illustrates this by showing that 2% inflation compounded over 4 years results in 10% of hard-earned savings stolen. The Fed is orchestrating legal theft, with no protests from the public, because, as Keynes liked to remind the central planners of his day, “not one person in a million understands inflation.” The gift of economic recovery promised by the Federal Reserve, in truth, is nothing more than a reassignment of wealth – from the many to a few.

Today’s topic, though, is silver – not inflation. In the silver market, we observe several interesting undercurrents. What does that market tell us about economic growth or contraction? Are there different demand variables that are driving that market in 2012 and beyond? First let’s look at COMEX warehouse stocks.

For some time now, 80,000,000 ounces has been a consistent combined number. This week, however, the CME reports show closer to 130,000,000 ounces – a 62% increase. For several weeks, the demand for large bars (.9999 purity, 1,000 ounce bars) had put an extra premium of 15-20 cents on those bars. None exists today. There is ample supply, which we believe reflects slowing industrial demand. Note the Fed’s view of an economy not yet on its feet, with industrial users slowing orders considerably. Investment demand continues at a steady pace, with a critical question presenting itself: Will investment demand be sufficient to replace the absent industrial buyers in the coming months? This will have to occur to drive the price higher. Without it you can expect lower prices. Our view: You’ll see both. First the fade in price, then a growing inflation concern as we move into the second half of the year, drawing in investment demand on a grand scale, grand enough to more than replace industrial demand destroyed by an ailing economy.

What are we suggesting? Consistent with Audio Commentary observation a month ago that a gold-silver ratio of 58:1was compelling, you should own silver with patience. Hold it in anticipation of inflation awareness becoming prevalent by 2014-2015. $29.00 to $32.00/ounce are very attractive entry points. Should prices be pressed lower than that, we’ll add to positions strategically (our orientation is more to ratio than price, with 55 and higher being compelling).

I began with a discussion of the Fed because, under the current circumstances, the Fed looms large in the silver investor’s thesis. This variable (inflation targeting run amok) is likely to add significant investment demand. Buying low on deflationary concerns and selling high in the midst of the inflationary battle that ensues between the market’s deleveraging tendencies and the Fed’s relentless commitment to growth at any cost seems a reasonable course. The President will not be satisfied until the employment statistic has improved (pressuring the Fed to help where ever it can via monetary policy), and the Fed leadership will do all it can to keep the financial world of yesteryear buoyed on a sea of currency and credit.

Our advice: Take any bad news (short-term declines in price) as good news. The ensuing events promise reward. Please read this speech by Ben Bernanke for your weekend homework and see for yourself the playbook being used. Like the field generals of old, it’s important to know what your adversary thinks and how he operates. Remember Patton: “Rommel … you magnificent bastard, I read your book!”

2. Stocks – Counting Down … For those paying attention, signs that world financial conditions are worsening resurfaced during the week. S&P downgraded 34 Italian banks (most by two notches). China, in order to avoid default at the local government level, extended maturities, delaying repayment on $1.7 trillion worth of debt. Moody’s downgraded six European nations (Spain down two notches), issuing a negative outlook for our money printing friends in the UK, while Greek and German lawmakers are still at odds over default remedy (as if there ever was one). This, however, did not stop US markets from advancing on the heels of whatever story came up, whether flimsy or not (see the box scores at right).

US jobless claims fell to 348,000 for the first week of February, and housing starts increased 1.5% from December. That was the good news. However, the more forward-looking data revealed trouble ahead. Building permits dropped off slightly, while the auto sales component was a heavy drag on US advance retail sales – shaving 0.3% off of a 0.7% advance for the month of January. Industrial production was flat (a 0.7% gain was expected for January), and inflation data remained firm, with CPI and PPI data rising 2.3% and 4.1%, respectively, compared to last year at this time.

Foreign support for our dollar continues to erode. Treasury data released for the month of December indicates foreign purchases have been cut in half over the last six months running. Said another way, the dollar had twice the amount of support the last time the index traded near 80. The dollar index closed the week at 79.331. We have stated this before, but the dollar rally seen since August of last year will stop short of traders’ and gold bears’ hopes.

Also of note, the record amounts of gold acquired by central banks worldwide once again defied the multitude of bearish claims made in December. Banks acquired 12% more in dollar terms and 9% less in metric tons on a year over year basis. Total investment demand (including retail) rose from 443.4 metric tons in the 3rd quarter to 489.3 metric tons in the 4th quarter of 2011 – suggesting small investors outpaced central banks at the end of the year. This would also suggest – once again – that paper contract markets (leveraged speculators) were largely responsible for the downturn in December of last year.

Considering all of the above, it will be hard to see the metals undergo any significant decline either in duration and or percentage terms. While we believe a modest descent to the low 1600s could be in the making, we have nonetheless increased some stock market shorts (in which the dollar would rally temporarily) as insurance against the possibility of something greater in magnitude.

Best regards,

David McAlvany
President and CEO

David Burgess
VP Investment Management