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Gal^Stad
Investments Inc.

spacer July 2005
Commentary

Aah, summertime is here once again, that brief stretch in the Canadian calendar when corporations slow their activity and CEOs and CFOs are even harder to reach on the telephone than usual. "You want to talk to Mr. Lippincott because our financials are the worst they've been in ten years? He should be out of his life jacket -- err, getting back to you on the corporate life-saving thing -- in a couple of weeks. Yes, of course you can leave a voice mail."

Being great believers in quality of life ourselves, we fully appreciate the need to shut down during these hazy, lazy crazy days. Those 60-hour weeks can wait as long as the fish are biting a couple of hours away or the birds are chirping on the golf course -- no doubt telling the one about the golfer, the leprechaun and the religious leader of their choice.

However, escaping from the office does not mean turning off the brain. In fact, now is the time to let the mind run afield and see what it stumbles over. In our case, thoughts turn to the Darkness of 2006.

Now, we're long-term players, and everyone should know that the shorter the time frame given for the prediction, the less likely it will occur on schedule. But as surely as George Carlin's Hippy-Dippy Weatherman can call for dark tonight followed by light tomorrow, forecasts of economic woes do always come to pass, eventually.

While some pundits choose to point to a particular event for a crack, declines are normally stimulated by the collision of a group of misfortunes. And the time is ripe for just such a confluence.

Over the past number of years, fears have percolated about deflation -- and more recently, inflation -- as we quietly went about our business. Neither case appears very dangerous now, unless the USD has a major meltdown from current levels. (We consider a downturn realistic, but not a meltdown.)

But the American economy, that driver of the global enterprise, is severely ailing. The Disruptive Duo, debt and deficit, are both at record levels and growing, with no hint that a peak is in sight. The tally of debt is now three times larger than the total number of dollars in existence. Not only that, but our American cousins' obligations to those beyond their borders grows at a rate of about $700 billion annually, or six percent of GDP. In fact, foreign investors hold two-thirds of American debt.

What might that mean? Consider that the Central Bank of China and the Bank of Japan have more than a trillion dollars' worth of U.S.-denominated assets. What if they decide not to cover the growth in the American deficit, or even to go a step farther and actually start selling notes?

Nations, particularly those for whom oil or commodities are big business, might switch from a dollar-based global yardstick to one based on a basket of currencies. The reduced demand for American paper would provoke a crisis. How can such a precarious scenario be avoided? Given that Bush's spots are unlikely to change of their own accord, America must be jolted into reality by other forces. A group of organizations with the ability to do this are the debt-rating bureaus.

In an ideal world, rating agencies would be proactive rather than reactive. Rarely, however, do these traffic cops start tweeting their whistles until after the multiple-car pile-up has occurred. For the moment, the U.S. continues to enjoy a sterling Triple-A rating, one that is unwarranted. It should be lowered at least one notch, and perhaps two or three, as was done with Japanese sovereign debt in 2002.

Such a kick in the groin might just rouse the snoozing giant; of course, it could well enrage the leviathan. It would take some serious cojones to tell the USA they're not number one anymore -- and assuming you get them to discard the foam fingers, it's a safe bet they'd quickly display a more significant digit.

Can this ship alter its course in time to avoid ramming the iceberg? To some degree, yes. But the ever-widening gap between rich and poor must be addressed, giving those lower on the scale more purchasing power. Remembering Benjamin Franklin's words about the importance of saving would also help.

And as Sun Tzu stated, "When the army engages in protracted campaigns, the resources of the state will not suffice." He didn't say anything about tax cuts, but we're pretty sure those tend to diminish resources. Americans have to stop fighting hither, thither and yon, spending hundreds of billions of dollars as if they are filling up the tank on the way to the office. Maybe the next president will get it.

The U.S.'s fate is only one factor putting the brakes on the world economy. Another is black gold. We're talking about Texas tea. Saudi soda. An interesting note: previously, oil price hikes went hand in hand with a decline in the greenback; but more recently, there's no such linkage. Whatever the circumstances, the more it costs to gas up the SUV, the longer consumers will put off other purchases.

The upward revaluation of the yuan, soon to be noticed at a Wal-Mart near you, will be inflationary. Those "Made in China" stickers are even more common than "Made in Japan" was in the '60s. Rising prices always loom large in the consciousness of the powers that be. The default response is to reach for the interest-rate lever, and that would rein in inflation, but it would also slow down spending, while economies churning out debt faster than products (hello, Uncle Sam) would break their backs trying to pay the piper.

The Chinese can't help but be aware that a stronger yuan is in their best interests. It's tough to name a nation that has a high standard of living and an extremely low currency. Money may not buy happiness, but anytime you can get a higher price for the same product, you're bound to crack a smile. Foreign companies are something money can buy, and a higher yuan will certainly help in that regard.

When we contemplate the clouds that are forming in our crystal ball, we must not overlook real estate, which is looking bubblicious. Does this compare with the situation in technology, which we wrote about in November 1999? Not quite; at least terra firma has a hard asset as its underpinning. Tech dreams, on the other hand, were built on a foundation of candy floss.

We don't foresee the market turning in a single day, with stocks plunging 22.4 percent overnight. It won't be possible to one day recall, with pinpoint accuracy, that on Sunday, September 19, 2005, the bottom fell out of real estate. It will be recognized over time, perhaps as a gradual decline as inflation ramps forward.

But the time is at hand; people can only move so often, and they have been mobile lately. It can't get any easier to buy: financing is virtually free and you can move in with five percent down -- even if you wanted to goose the sales, where is there left to go? Also, contractors have been swamped, and renovations can only be made so often.

If the market for houses is chugging along, demand for that other domestic staple, the automobile, is another story. Auto makers, particularly the Big Three, are hurting in a big way. It may be that what's good for General Motors is what's good for America; the flip side of that coin is that when the monolith sneezes, a whole network of suppliers and dealers catches the flu.

Oil prices may drive buyers away from energy-hogging, yet highly profitable, SUVs, in favour of more efficient vehicles. And the future seems to belong to gas-electric hybrids and other alternative power sources. But plants can't be retooled overnight, and changeovers require large sums of money.

Unemployment hasn't made a blip on most people's radar screens, or in the business pages, in a while, but it seems poised for a comeback. Since the populace has been piling up the debt like scrambled eggs at a Vegas buffet, such a development will force many to unload assets.

Assuming we're right, what have we been doing to prepare? Quite frankly, there is little that we need to do. Both of us detest debt, so we've paid it down religiously. Our portfolios are well diversified, with ample liquidity outside of the stock market to cover reasonable necessities and emergencies. While higher rates have inspired us to give investments such as income trusts a sniff, their faddish nature and often-poor balance sheets have so far enticed us only to assume positions gingerly.

What are the chances of our vision coming to pass? Timing is so very difficult. Our tea leaves show 2006 as the point where these dangers converge. But bear in mind that Alan Greenspan made his famous remark about "irrational exuberance" in December 1996; those who heeded his warning immediately would have missed out on healthy stock market gains over the next three years.

So, yes, there was exuberance, but those in the market took some time to appreciate its irrationality. The omens are usually accurate; it's the interpreters who sometimes err.


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