Update by Barbara....Scenarios

Frank Barbera/ 10/12 update

"In our last update dated October 1st, we told subscribers that the stock market was in an extremely unstable condition. We stated, “As shown in the chart below, prices are presently well outside the lower band. This type of condition is a sign of serious instability and often leads to downside acceleration. At this point, were stock prices to break to new lows from here, we would not be the least bit surprised to see the decline intensify with price declines carrying the S&P toward 900.” When we wrote those words, the S&P 500 was trading at 1127.27 and the DJIA trading at a value of 10,831.07. Since then, the S&P has nose-dived a heart stopping -228.05 index points or -20.23% in just seven days. For the DJIA, the decline has totaled a stunning decline of 2,380 index points or 21.97% with the DJIA closing Friday at 8,451.19. On Friday, the S&P closed at a reading of 899.22 --- reaching below 900 on the close for the first time since April 25th 2003 – over five years ago!



During the course of the week, we, of course, spent all of our time following the various markets and trying to get a better feel for what could be happening in the days just ahead. In our last newsletter, we advised subscribers that in our view, there was, and their remains, a very substantial risk that the US and the rest of the world financial system could be on the verge of a systemic banking failure. Such a ‘collapse’, inspired by the derivative side bets of the Shadow Banking System, could result in a ‘bank holiday’, and possibly even a Dollar devaluation during a period of bank closure. Acting as one of many catalysts to bring about this kind of Financial Armageddon type outcome is the Credit Default Swap market which has been incredibly destabilized since Fannie Mae, Freddie Mac, AIG and Lehman collapsed just a few weeks ago. This week, we saw additional spikes in CDS rates for General Motors and Ford, with both stocks collapsing even further along with waterfall type price action in the shares for any number of major insurance companies where CDS rates were also seen to explode upward. On Friday, Morgan Stanley stock collapsed in a situation, which was also attended by a CDS rate explosion. Morgan Stanley could be another potential monumental problem for the ‘system’ as a whole. Thus, to say that the current situation is residing on a rather large precipice is to put things mildly.

Yet, in pondering events very carefully over the last few days, we also have come to see some potential signs of hope and to that end, we are wanted to step back just a bit from the dark and gloomy tree’s, to get a perhaps more complete look at the forest. The view from 30,000 feet is always a good approach. To that end, we have put extra thought and time in preparing this report, which is why we felt it would be best delayed a few days. When things are moving quickly, it is often difficult to put out one’s best work, and in a time of severe crisis, we feel our subscribers deserve nothing less.

On top of that, since we exited the large cap Gold Stocks back on Monday, September 29th (Flash Update) with the GDX at $35.05 and the XAU at 133.92, we have been simply holding one fund, along with our moderate portfolio of Small Cap Juniors leaving us no direct exposure to the falling large cap stocks that make up the DJIA, and the S&P. Since our exit on the Gold Stocks on Monday the 29th of September, the XAU has fallen to a low of 96.38 on Friday, with a close on Friday of 100.56, down -32.44 index points or -24.36% in just 7 days. So far, while there have been some material digressions from the path of the stock market, ---overall, the Gold Stocks have been under a lot of selling pressure as the stock market has accelerated lower.

Above: SPX hourly, HUI hourly and R/S Ratio.

Nevertheless, over the last seven days, the magnitude of the current financial crisis has really made itself clear. For the system, the phrase “Inflate or Die” has never been more relevant. While we are concerned that the Derivative Debt Bomb could well be in process of going off and overwhelming even the US government, there is the alternative possibility which must be considered that the government efforts at “inflating”, - at de-escalating the crisis -- could be successful. What got us thinking about the government’s efforts at intervention was the announcement abit earlier this week when the Federal Reserve announced it would be venturing into the commercial paper market to provide back-stop liquidity. ---Talk about wading fully ---all the way into the pond, for the USG, this is truly a point of no return. The proverbial, “in for a Dime, in for a Dollar” philosophy is now fully clear, with the Feds movement into commercial paper there is now no way for the US Government to turn back. Since then, a wide array of additional proposals have now been put forth which include a G-7 initiative for governments to provide equity and balance sheet support for key

institutions with the aim of helping some of the most important institutions re-capitalize. This follows an approach used by Sweden some years ago when its banking system collapsed. Other measures, which have also been proposed, could come to fruition and could include the Fed moving into the inter-bank (Libor) lending market and guaranteeing short-term loans.

From AP October 11th:
“On Friday, Paulson announced the Treasury would begin buying part ownership in American banks, an effort similar to a program tried beginning in the Great Depression of the 1930s. The administration's decision is aimed at restoring the depleted capital reserves of banks, which have been forced to cut back on loans because they have suffered billions of dollars in losses in the current mortgage meltdown. The G-7 statement endorsed a program to prevent the failure of major banks in each of the countries, unfreeze credit and money markets, bolster capital and deposit insurance programs and get the battered mortgage financing system operating more normally.”
Gauges of Credit Market Distress, exploding Credit Spreads indicating that lending has seized up.

Charts not available:
Above: Commercial Paper to T-Bill Spread exploding higher as credit markets seize up.
Below: The TED Spread – Three Month Euro Dollars (Dollars held overseas) less 3 month T-Bills

Thus, like it or not, the level of global government involvement has exploded over the last few days in what is now an all out effort at trying to save the world financial system and avoid a global depression. As we see it, there are basically two scenario’s that could play out in the days ahead. One can think of the current situation and visualize an economic battle being waged between two opposing forces, much like the opposing forces of a teeter-totter. On the left side, are the forces of Credit Market Deflation, the demise of the Shadow Banking System (SIV’s, CDO’s, CDS) with a particular emphasis on the 55 Trillion Dollar Credit Default Swap market which is unregulated, and almost invisible to the ordinary investor. On the right side, are the forces of global Reflation led by Central Banks whose primary goal is to shore up the banking system by printing whatever quantity of money may be needed. As we see it, over the next few days, and few weeks, things are likely to shake out in one direction or the other. To that end, we are dedicating this report to help subscribers get an idea of what to be watching for in advance so we can let the markets tell us which outcome is winning out. In situations like this, it is NOT a good idea to pre-judge a situation. One can have certain ideas about what certain outcomes would imply, but in the end, you must let the markets tell you what lies ahead. In both outcomes, the action of the stock market among other things would be a critical gauge in coming days.

Scenario One – Deflation/Credit Collapse/Hyper-Stagflation:

This scenario is the kind of worst-case outcome which we described in a fair amount of detail in the last newsletter. Under this outcome, government intervention is simply not able to respond quickly enough, or in dramatic enough fashion to forestall a market disaster. While the good intentions are there, the response is simply “too little, too late”. In this outcome, the stock market experiences a crash – a real crash – below the 780 to 800 support zone which is critical long term support going back to the 2002-2003 market lows. That zone, hosted a market bottom that developed over a period of many months, so, for the stock market to break down below that zone, would be a major signal that the authorities have lost control (Presidents Working Group etc..).

Above: Long term view S&P, IF the 2002-2003 lows are broken in the next few days, next few weeks, the subsequent sell off will continue for months… months and months and months. The next area of support would end up likely in the 300 to 400 range representing approximately a 50% retracement of the entire preceding secular bull move. This would be a disaster for confidence, and a disaster for national wealth.

Above: A 1929-1987 style worst Case outcome, Deflationary Crash violating the 2002-2003 major lows at 780-800…this would be a major breakdown signal

Under this outcome, stocks could accelerate rapidly to the downside from current levels. The way of viewing the market under these circumstances is that of a snow-ball rolling down hill that just keeps on building up downside momentum. At the moment, downside momentum is huge. As a result, the market is either going to take a sharp bounce from near current levels (and most likely, a sharp bounce off the 2002-2003 support zone at 780-800) OR it will simply break down abruptly below those lows. As we try to illustrate by sketching in a potential snap shot of how things could look, (see preceding page), a break below 780-800 lounging into the low 600 area on the S&P, would end up likely running into major overhead resistance at the underside of 780 to 800, perhaps with the 850 level a more serious cap. The point here is this: A Stock Market break ( an additional 15 to 20% single day decline) in the days just ahead, carrying the S&P below 780-800 will strongly suggest this most negative set of outcomes is under way. It suggests a market which is ‘out of control’ (out of any ones control) and a contagion that is lose on the global financial stage which could end up morphing into the currency markets (in an even bigger way then it already has – ed. I know- hard to believe) at moments notice. Under this outcome, all market rallies would then be failing rallies for some time to come, with prices likely tracing out some kind of ‘triangle’ Wave 4 pattern below 780 –800 resistance over the next few months. That would then eventually lead to further sell off’s toward a final low in the 300 to 350 area for the S&P perhaps sometime in late 2009/ early 2010.

Above: the Hourly Chart thru Friday of S&P 500 implies there is still a super high degree of downside risk in stocks.
A bounce off 780 to 800 (should that level be tested, assumes a down opening, which may not occur) could runinto resistance in the 890-900 zone, if that fails and reverses lower, an even larger decline to below 700 could follow. MACD has not lifted anywhere close to zero, still at deep oversold values. Usually this implies a lot more downside still ahead. Can massive government intervention change this ?

In the breakdown scenario, the odds would be mounting, and the markets would be telegraphing that (a) a bank holiday could be in the cards and that at some point, a currency problem could also follow. Now, we note that the Dollar has been quite resilient of late. Normally, one would expect to see the Dollar (or any currency in potential trouble) trending down for weeks at a time before a currency devaluation could come to the fore. As a result, a Dollar currency devaluation is likely not in the cards right away, but with what makes that call very complicated right now are the unquantifiable currency derivatives that could explode if the rest of the system comes under siege. It is simply an ‘unknown-unknown’. One thing we can relate, that in economies which were debt laden in other countries in the past, currency devaluations produced a double whammy effect on the overall population. It was the ‘Double Whammy of

Deflation AND Inflation’ at the same time. When the value of a currency drops, imports get much more expensive and domestic goods prices follow import price inflation much higher. At the same time, a currency devaluation is unbelievably destabilizing to local asset values, wherein Home values (Real Estate values, in general) will fall even more radically. Stocks get cheaper still. Bonds are a disaster in a currency crisis if they are denominated in the currency that is being devalued. Thus, falling asset values are deflationary, while rising consumer goods prices are ultra inflationary, -- hence the ‘one-two’ punch. From the broad economy, higher prices for fuel and basic materials normally will hurt corporate earnings, and all of this fosters a surge in unemployment, hence a deepening economic contraction. Assets that will do well in this climate, are first and foremost, Precious Metals. Both Gold and Silver will explode. Not only that, but when the crisis ends, and currency stability is re-established, the hyper-inflated economy is always revealed to have experienced an enormous drop in real values (inflation adjusted values) and in real wages. Hyper-Inflation, or in our case in the US, the risk of Hyper-Stagflation, involves a hidden paradox that is difficult for many to comprehend. Our best attempt at explaining this would be to put it this way: Even as high inflation pushes up nominal prices in an inflationary recession, or a hyper-inflationary depression, real incomes are going down, and real asset values are going down. Thus, even as prices inflate to higher and higher levels in terms of the debasing local currency, underneath the outer surface, within the economy, things are actually deflating just the way they would be in a classic deflationary depression. In a hyper inflationary depression, all of the same outer symptoms appear, rising unemployment, people struggling to get by, with the big caveat that severe shortages will develop, and hoarding becomes a major event. Usually, government intervention will extend into daily lives with rationing of basic goods. In Mexico, during its inflationary depression of the early 1980’s, the government implemented ‘price controls’ on the basics, like tortilla’s and bus fare to prevent the public from rioting out of control. This type of outcome has been repeated in many countries, in many instances throughout even just the last 100 years, let alone before that. In this outcome, the purchasing power of Gold and Silver will explode through the roof, with a true ‘shock and awe’ outcome. A little bit of purchasing power protection by owning either physical metal or owning shares of something like Central Fund (CEF), could make the entire difference for a person in terms of determining how this downturn will affect them. This is one reason, we have been so adamant that subscribers load up on CEF (at the very least) and hold on to it no matter what. This is the time when you simply DO NOT SELL GOLD or SILVER --- period! To finish off this outcome, once things settle down months after a devaluation, stocks will recover, and natural resource stocks are very likely to go beserk. Gold Stocks could even begin moving up a lot sooner in response to a crisis then most other issues. In today’s reality, we would not be surprised to see the Gold Stocks explode off a market low with Junior Mining names leading the charge. For the Juniors, a super bull market could evolve into mania style proportions, as ‘metal in the ground’ will become perhaps the premiere inflation hedge.

Scenario Two: Containment/Re-Inflation/Currency Crisis:

This outcome is actually the better of the two outcomes, as the odds are it will buy a lot more time, maybe a really meaningful amount of time between the ‘wolf and the door’. In this outcome, we would again suggest that the stock market behavior in coming days will be a big tell. To this end, the current market is all about psychology and the collective power of government to act as a financial back stop of last resort. As we have watched the Fed take an escalating series of aggressive steps in recent days, it is clear that the Central Bank is trying to avoid a mega – collapse. To this end, the Fed is now ballooning its balance sheet on a scale never before seen. In the charts atop the next page, we show the Fed’s Balance Sheet, and the year-over-year rate of change for the Fed’s Balance sheet. A special Thanks to Chris Puplava at Financial Sense.com (PFS Group) for allowing me to include these charts. What we are seeing is nothing less then famed Bernanke Helicopter drops. Have a collapsing banking system, no problem, the Federal Reserve is here to print money. Collapsing credit markets, no problem, the Federal Reserve is here to print money. Collapsing stock market, no worries, we can take care of that too my printing money. Back in the early 1990’s, the Hong Kong monetary authority did precisely that, they intervened in the stock market and began buying up leading shares, causing the decline to come to a halt. There is some scant precedent for this kind of intervention. Just Friday, Paulson began speaking about intervening to support shares of key financial companies, and in recent weeks, as we all know, there have been bans on shorting financial stocks. Government intervention can change an equation and can potentially force a different outcome. In our view, the question is, how do we know if they are gaining traction and all of this money printing and intervention is starting to succeed ?

Above: The Double Bottom of all time? We’ll be watching.

In our view, if the government broad scale money printing is going to be successful, the chances are high that first off, the stock market collapse will need to be arrested above the 2002-2003 major lows. That means, we don’t break down below the 780-800 level in a material fashion. Now, mind you, we are in an ultra fast market, ---possibly one of the fastest moving markets of all time. A small overshoot of 780-800 is certainly possible, the question is, is it a momentary overshoot (if one happens) or is it a sustained overshoot. Overall, it is our view, that in order for some residual degree of confidence and crowd psychology to remain intact, it is crucial that stocks dig in very soon and take a sharp bounce off the 2002-2003 lows. We are quite convinced these lows will be tested, but will the market launch a big recovery rally in the near term off this support? In our view, that is the $64,000 question? If the market can succeed in bouncing off these former lows, and the rally can sustain itself for at least a few days, although a rally of 7 to 10 days would be ideal, especially back toward 1,000 on the S&P, then at that point, the odds will be shifting that government intervention is starting to carry the day. The real proof of a ‘bullish reversal’ would then come with prices moving down to “retest’ the panic low (some days later) and then turning up following a successful retest. Think about this as the “W” type bottom of all time!

Of course, during the course of this process, there would be all kinds of additional signs to watch for. A big narrowing in the Credit Spread charts shown earlier in this report, a strong rally in commodity prices with a decent bounce in Oil would be another. The Dollar Index should roll over on the downside, as in a reflation, the Dollar will be a longer range casualty. Increase the supply of anything, any commodity (in this case, Dollars, which is what the Federal Reserve is doing right now) and you will decrease its price.

More supply = lower price, Basic law of economics. Thus, the Fed in this outcome, will be seeking to create INFLATION to fight the current grip of DEFLATION. If they are successful, the stock market will come bounding back, and will move into a sustain advance, possibly a new bull market. Over time, as all the new money creation works its way through the financial system, prices for consumer goods will likely move higher, the Dollar will move lower, and stocks in the early and middle phases of a REFLATION will act as inflation hedge devises. Gold Stocks, and especially small cap Gold Stocks, will be the “GO TO” leadership within the stock market for this cycle. Gold and Silver will rise relentlessly, and will be rising in tandem with the stock market. Bonds will be the big loser. Bonds prices will move steadily lower, and interest rates will begin to rise steadily. In the early to middle phases of reflation, long term interest rates will move up the most, and then in the latter phases of reflation, ---when Acute Crisis will again return, Short-Term Interest Rates will move up the most aggressively (likely in response to a currency crisis) that will have been postponed for some months (maybe years) down the road. Every Reflationary effort has embedded within, the seeds of another even larger crisis down the road. In this case, the Von Mises “Crack Up Boom” where excess money printing has an initial affect of producing “outward, obstensible recovery” but then is followed by a ‘knock on’ currency crisis down the road. Essentially, this process (reflation) is an attempt to buy time, regain some measure of control, and post-pone a day of reckoning. The recovery process is usually fairly transitory, and in today’s world, we would not be surprised to seen another crisis surface within 18 to 24 months. That said, for the equity markets, if a reflationary effort is successful in the near term, it could generate one heck of a recovery rally lasting many months. For GST Subscribers, that is something we would most definitely want to get involved in, as it is already clear that within the stock market, some truly outstanding values now exist. Over the last few days, we have watched in near astonishment at declines in ultra high quality names such as Suncor (SU), Chesapeake Energy (CHK), Agrium (AGU), Potash Corp (POT), Conoco Phillips (COP), BHP Billington (BHP), Pepsico (PEP), Apache (APA), TransOcean Offshore (RIG), Schlumberger (SLB), Helmerich Payne (HP), Colgate Palmolive (CL), Procter and Gamble (PG), McDonalds (MCD) to name but a few. In the case of consumer goods producers, these are in many cases global power-houses, where a weak Dollar will be a huge boom for bottom line profits in coming years. By the same token, the world is going to need as much energy as it can obtain, and right now, a plethora of Energy names are on the potential bargain table. P/E Multiples, even cutting earnings in half and allowing for a brutal recession, are now fast approaching low single digits, which would have to make any market analyst stand up and take notice. Even within the financials, it is a given fact that if this market turns, the surviving entities will emerge in immensely improved competitive positions, think Goldman Sachs (GS), Bank America (BAC), HSBC (HBC) and US Bancorp (USB). For the economy, a recession will continue to unfold in the months ahead, and Real Estate assets will likely continue to remain weak for some time, even as stocks recover. For Real Estate, this will be a lost decade, as prices simply moved too high in the prior boom, and need to get back in line with longer term trends for income growth. If a major reflation were successful, the best outcome we could see for Real Estate would be a return to stability and then a return to nominal price growth on the order of 4% to 5% per year, but even then, Real Estate in real, inflation adjusted constant dollars is overwhelmingly likely to be moving lower over the next 10 years. As an asset class that hyper-extended, the rule of busted bubbles has historically been 10 years. Taking the place of a mania in Real Estate, will be Inflation hedge investments centering around commodities, with Precious Metals in the vanguard.

Capital Flight:

One of the untold events taking place in recent days has been a huge exodus among foreign investors, who have been repatriating assets from the United States. Is this a big surprise ? Not at all. Think about it. In the last few weeks, Wall Street finance has engulfed formerly blue chip companies like Morgan Stanley, AIG, Merrill Lynch as well as other names like Fannie Mae, Freddie Mac, and WAMU. With so many big name institutions on the ropes, confidence has been shattered in many quarters, with foreigners not the least among them. For a country that was not heavily dependent on the inflow of foreign capital, this may not be a big deal. But in the United States, where we are currently sporting a huge Trade Deficit and a huge Current

Account deficit, the exodus of foreign capital is a problem of such high order, it is hard to overstate. This is the breeding ground of serious currency problems, and that is now being compounded by the added risk of a Central Bank ballooning its balance sheet in unprecedented fashion to fight the financial crisis.

As a result, we take strong note of the fact that foreigners sold nearly $50 Billion in US Agency Bonds on September, and are now net sellers of US equities and US Bonds. In an attempt to insulate itself further from the US Credit Crisis, last week China’s regulatory Banking Commission instructed Chinese Banks to stop lending money to US Banks. In many ways, that could be a “Game Over” signal for the U.S. which is ultra dependent on Chinese re-cycled Capital, and on Petro-Dollar capital.

As a result, Subscribers should understand that last week’s Bond market response to a falling stock market was a six-standard deviation event. Talk about your “Black Swan”. Note the chart above. The stock market collapsed to much lower lows at Point B, Friday’s close (20% below) Point A, the low of Sept 17th. Note that

even when Bond prices rallied, and bond yields fell this week, they still held ABOVE the Sept 17th lows. IN “normal” times, during such a stock market ‘crash’, Bond Yields would have easily fell to lower lows in yield.
Not only that, but instead of going down in yield during the last few days of this week, yields actually spiked higher. There is no way in the world that this is a good sign. It is a sign that something is terribly wrong and that something is a withdrawal of foreign capital. In recent weeks, we have seen financial institutions like Wachovia and WAMU suddenly collapse over a weekend. What happened? Well, it was not average Americans that were pulling out capital, but foreign investors, --- large foreign investors. These were the folks that led the ‘runs’ on the bank, and are now instituting from what we can tell, a “run” on Wall Street finance. Treasuries are getting the ‘heave-hoe’ and that is a sign of major change. In theory, it is possible that the Fed has been trying to buy time by monetizing the quantities of exiting foreign capital in order to uphold the system. However, this does not augur well for the US Dollar which we suspect has benefited in the term by (a) some unwinding of leveraged carry trades where speculators were long commodities and short the Dollar, creating an artificial short covering move in the Dollar and (b) delevering in other currencies which were engaged in income oriented carry trades.

Above: Clockwise – Yen Kiwi Dollar, Yen-Aussie Dollar, Yen-Canadian, Mexican Peso (lower right)

In our view, the Dollar strength seen in recent days has been essentially a mechanically inspired reflection of hedge fund and carry trade unwinding. It is a reflection of the deleveraging process and a momentary flight for liquidity, but it has no bearing on the US Dollar as a safe haven asset. If the US Dollar was acting as a safe haven asset, money would be flowing into US Treasury Bonds and Bond yields would be falling to new lower lows. That simply was not the case, and in fact, all the evidence is pointing in exactly the opposite direction. As a side bar, Treasury Bonds are not the only bonds performing badly, Municipal Bonds are getting positively crushed with the Nuveen Muni Index (below) experiencing its largest decline ever this past week. For now, we are watching the action in Bonds, and may at some point in the next few days/weeks, consider positions in the Inverse Bond Funds, but not yet.

As a measure of the degree of economic dislocation yet to be faced, many states and municipalities are in a very bad posture to handle a recession of this magnitude. California is already requesting a 7 Billion dollar emergency loan from Uncle Sam. California, General Motors, New York, Ford Motor Credit, Prudential, Morgan Stanley, -- which one is not “to big to fail”, and which one does the US Government say “NO” to in its long list of lobbying constituents? As we have said before, this is one big pot of boiling hot water…."