What a year it has been! In this newsletter we will try to analyze the current situation and make some predictions of the trends for this coming year. We will attempt to show where our economy is, how it got there, and what might happen next. Let's start with the time of glory — the 1960's. The United States is the Factory of the World, the Creditor of the World, and the unquestionable Leader of the World. The US Dollar is the only real currency, "as good as gold." This was the time of the greatest prosperity; just a blue sky was ahead. So, what went wrong?

It is the same story that happened to all of the empires at the most glorious stages of their development. The US had decided that it is powerful enough to try to defy the laws of economics. "Maybe this time the force of gravity will not be so strong?" America just started enjoy the privilege of printing the reserve currency of the world — so that it can pay for both guns and butter simultaneously by just printing dollars. The US forgot that it guaranteed the world that the US dollar will be fully backed by gold ("as good as gold") and assumed that nobody would dare to actually demand gold. This was wrong. In three years (1968-1970), the US lost half of its gold reserves. The last straw was the actions of the French President, General Charles de Gaulle, who took almost 15% of American gold in 1970. In response, America reneged on the agreement with the world regarding US dollar gold backing and in 1971 Nixon completely decoupled the US dollar and gold. This is where present financial reality started to emerge.

So, 1971 was the beginning of the printing money uncontrollably so that government can 'take care of working people' initially, than to buy loyalty, to buy election, etc. We are now probably close to the end of this process. The price paid by this country for this experiment: the US became the biggest debtor nation instead of the world creditor; manufacturing infrastructure in the US dismantled and the country must import virtually all consumer goods — resulting in almost $1 trillion a year trade deficit; American standard of living was slowly reduced over those 35 years and now is about 35% lower than it was in 1971; the American educational system slipped from 4th place in the world to somewhere in low twenties; at the moment of this writing, the financial crisis is raging for the second year with no end in sight.

Of course, we have had recessions during those 35 years, but they would be followed by nice recoveries, and each recovery looked like prosperity will last forever again. Why can't the good life continue? Why can't further printing solve American problems like it did many times during the last 35 years? After all, the Financial Wizard, Dr. Alan Greenspan, has found a magic wand that allowed him and the Federal Reserve Board to manage the inflation and the economy. Everything was very, very simple: people perceived the economy like a car, and Alan Greenspan as a professional driver — if it slowed, he pushed a magic gas pedal (called the interest rates) and the economy would accelerate, if it it heated up too much — he would slow it down by pushing a brake pedal, — that's it. Simple.

But there is a mathematical limit to borrowing, and it is set by reality. In 2007, just before current crisis had started, the US already consumed 80% of the world savings; there is simply no more money to borrow in the world! And it looks like our government is just beginning to warm up with printing the dead presidents — look at the committed stimulus package, committed bailout money, projected trillion + budget deficits, social security and medicare entitlements, etc. We are frankly surprised that Mr. Larry Flint's request for $5 billion for the porno industry was not granted…

To finance all of this spending, the US has to solve a pretty formidable problem — to attract foreign purchases of US Treasuries with close to 0% rate of return. With higher interest rates, US will not be able to service its existing debt. That is quite a problem indeed.

At the moment the Fed is simply monetizing American debt by buying Treasuries and, as a result, keeping artificially low interest rates. At the same time, all asset values are dropping like a rock — not only the real estate which attracts the most attention, but equities and debt instruments as well.

This creates a very intriguing situation. Falling asset values look like a deflation. Unlimited dollar printing should create inflation. So, which one are we experiencing now? Did our government finally discover a holy grail and learn the secret searched for by many governments before ours — printing wealth (not just paper money), meaning the more paper they print the more valuable it becomes? It does not look very likely.

We think inflation/deflation debate is not very productive because our powers-to-be so many times changed the definitions of inflation and deflation that that nobody any longer understands what they are arguing about. We suggest a replacement term — currency debasement. Of course, currency debasement will INEVITABLY lead to inflation, but it will have to propagate through the financial system first. For now, we have concurrent uncontrolled currency debasement and falling asset prices. This cannot last long — mathematically.

Main stream media is trying to predict when recovery would begin. In post-1971 (fiat) period, each consecutive recovery required much more printing than the previous one.

For example, let's take a look at the last recovery, 2003-2007. It was unique in that it was accomplished without a single productive element in it — it was 100% artificially produced — by using the so-called equity in the real estate. According to the calculations done by Prof. Paul Krugman, this has generated approximately $750 billion annually without producing anything — anything at all!

Look at what happens when a house is being sold. The Mortgage bank gets its fees, the appraiser gets paid, two realtors get commissions, the state gets real estate tax, the city gets higher property tax and the seller keeps the rest. Then a bank sells the mortgage, mortgage bond is created and sold, derivatives of various kinds are created and sold. Then all these products are collaterized and sold to the hedge funds which resell them back to the investment banks, and they resell them to you, guys! It is all real money (they call it GDP) added to the economy. In the last recovery these activities accounts for 100% (!) of the growth. And absolutely nothing was created. The same underlying asset — a house — has generated substantial growth in overall economy!.

It is frightening even to imagine how many dollars will be printed in an attempt to engineer the next recovery. It is increasingly clear that monetary system will not survive this attempt and completely new system will emerge.

Therefore, the main approach now is how to position our portfolios to benefit from the huge investments in the infrastructure with understanding of the "debasement" of the dollar, and trying to preserve the purchasing power of your portfolios. That's the directions of our thoughts and the trades you see (and will see) in our portfolio reflect this new reality and this thinking.

We strongly encourage you to discuss your current portfolio and asset allocation with us in the nearest future. These are unusual times — and serious decisions need to be made.

We welcome your e-mails, inquiries and would love to meet with you or talk to you on the phone to discuss the positioning of your portfolio.