Water Torture for the US Economy

Buying Silver offers an "elaborate play" on the likely money inflation ahead...

EDITOR of the Gold Stock Adviser and International Contrarian as well as his Addicted to Profits advisory, David Skarica is currently completing his latest book, The Great Super Cycle: Profit from the Coming Inflation Tidal Wave and Dollar Devaluation, to be published by John Wiley & Sons in November.

Speaking here to The Gold Report, he forecasts "Chinese water torture" for the US economy, spurring more quantitative easing that will only buoy Gold Prices still further...

The Gold Report: You said in a recent Addicted to Profits newsletter that your stock-market indicators are not really screaming "bear". What are your indicators, and what has led you to believe that?

David Skarica: Part of it is sentiment, and part of it is the monetary outlook. And part of it is the cycle of the stock market.

On the sentiment side, I watch a few indicators: Investors Intelligence and the American Association of Individual Investors (AAII). Essentially, these are sentiment polls. Right now, Investors Intelligence levels are showing very high bearish readings, much like the AAII reading in late July showed more bears than bulls. In late June, early July, one AAII reading had the most bears since the 2008-2009 bottom. Investors Intelligence showed something similar. A few weeks ago it showed the highest number of bears since April 2009, which, of course, was the start of the bull market and rally.

To get a bear market, you need panic and people selling. But if people are already bearish, it is very difficult to get that selling pressure.

In the monetary outlook, at any point now the Fed is going to start more quantitative easing. That's usually very positive for equities. Then what people have to remember is that everyone's likely to get really bearish on the economy. We had a really great unwinding of leverage in 2008, and I don't see that occurring again. I will talk about that with my third point. That is why I don't see a huge amount of downside in stocks. Even if the S&P were to drop to 900, that is when quantitative easing would really begin, big time.

Part of my analysis in my new book examines the last three secular bear markets: between 1900 and 1920, the start of 1929 to 1949, and 1966 to 1982. Those were all 15-20 year periods when equities went sideways. There are usually two big bear markets, and they happen in the first half of the secular bear market. The examples were 1907 and 1914, 1929 and 1937, and 1970 and 1974. In the second half of the bear market, more muted moves occur in the stock market, combined with much higher inflation. That's where I think we are.

The rally we're seeing in the stock market is very similar to the 1908 or 1975 rallies, and those were followed by long-term trading ranges rather than big dips. The low of 666 on the S&P that was reached last March will probably hold, but inflation adjusted, we actually could go lower. If we get a drop of another 10-15% in current levels in the stock market, they're going to come in with quantitative easing, which will actually probably lift stock prices, even if it doesn't help the economy.

TGR: You're saying that if the market starts to dramatically slide, the government is going to come in with some more money to prop up the economy again. But America doesn't really have any money.

David Skarica: They're going to print it.

TGR: Won't that just prolong the inevitable?

David Skarica: What will happen in this cycle is very similar to what happened in the late 1940s or in the early 1980s. In those cycles when the bear market ended, the Fed and the government raised interest rates and the money supply dropped. Everything dropped in price, and that cleansed the system. But I just don't think they're ready to do that yet. If you look at interest rates, we're coming off a secular low. That tightening cycle has to be the end. I don't see that occurring for quite a while. The Brits had to do this after the Second World War when the Pound ceased to be world's reserve currency. They essentially devalued way into the early 1980s, a 35-40 year period. There's no reason why the US can't slowly devalue over that long as well.

TGR: What's your near-term market outlook, David?

David Skarica: That is really difficult because if you had talked to me in late June or early July, I was really bullish because of the terrible sentiment we saw. I still have a muted bullish outlook here. One chart I have in my newsletter compares the 1907-1909 period with the current period. The 1907-1909 period saw almost a 50% drop over a two-year period followed by a very strong reaction rally, followed by consolidation like we saw recently, followed by a second move higher. If that correlation continues, it means we would be at the top of the market in the first or second quarter of next year, and the S&P would rally to about 1,300.

In the very short term, we could see one more drop in the fall before we rally, but I really think those lows of May-June are going to hold. We could see a pullback. But after that pullback, we will be headed higher because of the quantitative easing.

What people have to understand is that this is a global market. Don't be so focused on the US market. If you look at Turkey, the market there has actually broken above its 2007-2008 pre-crisis high. Brazil and India are within a few percentage points of their respective pre-crisis highs. When the US market broke down to new lows in late June, all of the Asian markets essentially held their lows and some went higher.

TGR: But if the US continues to print money, doesn't it risk losing its status as the world's reserve currency?

David Skarica: I think that's a question of when it's going to happen and not if. This is why it will lose its status: about 75% of its debt is short-term oriented, meaning two to seven years in duration. That means that if you run a deficit of $1.2 trillion a year over the next five to seven years, you're going to rack up $5-$7 trillion Dollars in debt. And you're going to have to roll over about $8-$9 trillion of the current $13 trillion in net debt. That means you're going to need between $10 and $15 trillion to cover the debt. They're going to do that by printing money.

TGR: Doesn't it get to a point where they're not going to repay their debt?

David Skarica: I think they'll repay it because they can just print money to repay it. It's not like in Argentina where you have to do a partial default because some of your debt is issued in another currency. They can just print the money and repay it. I don't think default is ever a problem.

The real risk is more in these unfunded liabilities. You're going to see what happened in Japan happen in the US They're going to raise the taxes and the outlays on Social Security and then reduce the amount you receive. That is more where I see the risk rather than in defaulting on foreign debt.

TGR: So you don't believe a massive crash is imminent in the US economy.

David Skarica: I think what you're seeing today is what's going to continue; it's going to be more depressing, like Chinese water torture.

TGR: You mentioned earlier that some of the foreign markets continue to do quite well despite the economic problems in the US What will the role of these emerging markets be in tomorrow's economy?

David Skarica: I think their role is consumption. We can talk about how their per-capita GDP is much, much lower, but most of these economies do not have the huge personal or federal debt load that the US has. This is where the emerging consumer is going to come from. You have 3.6 billion people in Asia as opposed to 300 million in the States. If you can generate one-twelfth of the per-person buying power of the U.S, the total Dollar amount is going to be equal.

I still think the US is going to play a really important role in the new global economy – global finance. That's where the US can really serve; it can still be a source of capital for these markets and help these companies raise money. There's definitely a role for US corporations going ahead, and obviously technology corporations are still top-tier companies.

TGR: What does the stagnating US economy mean for gold?

David Skarica: It means there are going to be higher Gold Prices because you're getting increased inflation, and gold is a hedge against that. Because the value of the Dollar is going to decrease, there's going to be more consumer demand for gold in the United States.

Also, in deflation, consumers get really worried and they hoard gold. That happened in the early 1930s before they made gold illegal to own, so deflation or inflation is really positive for the Gold Price because people are going to try to hedge with owning gold under those circumstances.

TGR: You're not really a gold bug, but you're certainly bullish on gold.

David Skarica: Well, one thing I really believe is that the gold bull market usually ends when the Dow-to-gold ratio – the number of ounces of gold it takes to buy one share of the Dow – goes about 1.5-to-1. That's what happened in 1932; that's what happened in 1980. Right now we're still 8-to-1, 9-to-1. There's a long way to go.

TGR: Do you have a price projection for gold?

David Skarica: I am really conservative in my price prediction, but last year I was thinking we would go to $1,100-$1,200, which we did. I would say by the end of 2011, I'd be pretty happy with $1,500 gold. But because quantitative easing might start again, I wouldn't be surprised if it was a lot higher than that.

TGR: How are you playing gold in this environment?

David Skarica: I really like the equities, and the reason is because if you look at the ratios like the XAU-to-gold or the HUI-to-gold stocks, the XAU-to-gold usually roughly trades historically at 20% of the price of gold. So if gold is $1,000, then the XAU should be at 200. Well, right now the XAU is just over 175, and gold is $1,220. If you took away the financial crisis, this is the lowest all-time ratio of stocks to gold, lower than when they bottomed in 2000.

This tells us that if gold goes over $2,000, then the XAU should be trading at 400. Well, $2,000 in gold is about a 67% gain from $1,200, but 170 to 400 on the XAU is about a 150% gain from the current gold stock prices. I think the equities have more leverage, if they go back to their historical valuations.

TGR: Let's talk about Buying Silver for a minute. Silver has traditionally traded at about a 15-to-1 ratio to gold. What do you see happening with silver throughout the rest of this year and through 2011?

David Skarica: I really like silver's chart. I would say in 6-12 months' time it will look better than gold because it hasn't broken out yet. Like we saw when gold finally broke $1,000, you get this kind of outperformance jackup. Right now, silver is seeing huge resistance in the $18-$21 range. It really looks like silver is building momentum to break out in the spring. When you're in the up cycle for precious metals, silver is essentially a more elaborate play. Silver Prices outperform on the upside and underperform on the downside. Silver goes up faster, but it also falls faster.

TGR: Thanks, David. We appreciate your interesting insights.

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