Gold and foreign currencies are finally getting a rally. The rally has been driven by technical factors and pronouncements by more and more foreign nations stating that they will diversify more of their bond portfolios away from U.S. dollar instruments. We know that the dollar must decline more in the long run. Last week, Britain cut interest rates, but the dollar still fell versus the pound. This is a change of pattern and amounts to the market ignoring the fundamentals. We believe that the fact that this has happened is significant and it is enough to cause us to reestablish partial positions in foreign currencies. We are buying partial positions in the British Pound, the Euro and the Canadian Dollar.


Remember when I said, “…be careful what you wish for”? Well, the U.S. wanted the Yuan to rise, and now the U.S. dollar will be only one component of the Chinese basket of currencies. This implies very strongly, that the Chinese will purchase a smaller percentage of U.S. dollar bonds, and a larger percentage of bonds in the currencies of their other major trading partners. Has anyone noticed that the Euro, Japanese Yen and Korean Won have been rising against the dollar? They are the other major trading partners. This is another reason for a current and expected decline in the U.S. dollar.


Gold continues to act well. As we projected, the small gold shares, such as Tan Range Exploration, have done very well. We are not selling, and are holding our shares for higher prices.


The Fed is concerned about a resurgence of inflation, but they are more concerned about a resurgence of inflationary psychology. It has been 25 years since the last bout of inflationary psychology in the U.S., which was during the later 1970’s and early 1980’s. Inflationary psychology is more dangerous than inflation itself. Inflationary psychology creates economic incentives to speculate, hoard goods, and to purchase certain assets as a hedge against inflation. The effect of this psychology is to create inflation and to create numerous bubble effects within the economy. The economic professors and central bankers who sit on the Federal Reserve board know this well. Accordingly, they will raise interest rates to stop the real estate bubble in the U.S. before it expands enough to create a speculative/inflationary psychology in the public mind.

It is a small mistake to stimulate consumption by allowing residential real estate prices to rise at unreasonably rapid rates, but is a much bigger mistake to allow inflationary psychology to take hold in the nation. Therefore, we expect the Fed to raise short-term rates for several more months. This will cause mortgage rates to rise, which will cause real estate prices to level off or fall.


The following was my email response:

Dear David,

I enjoyed Barsky’s article, and thought he made some good points. I agree that there is not excess housing capacity. I also agree with his point that speculation is not driving home prices up (except in a few small areas). I disagree with his statement regarding interest rates and the effect of risky lending products (i.e. interest only, no down payment mortgages). Way back in 1968, I wrote an academic paper about forecasting residential construction in Orange County, CA. At the time I wrote the paper, Orange County was one of the fastest growing areas in the U.S. I looked at numerous variables, and I found that most of them were coincidental or lagging indicators of new housing starts. The only predictive variables were short-term interest rate related. They were T-Bill rates and the prime rate. In those days, the prime rate was a much more important rate than it is today. Back then, the banks lent to corporations for their working capital and accounts receivable financing, as well as their capital spending. Today, Wall Street financial instruments are sold to the public to finance corporations in all of these areas.

T-Bill rates and the prime rate had an extremely high correlation to housing starts, and they led by about three months. Once they passed the inflection point, housing starts collapsed. This was because developers and builders could not borrow money at rates that would economically allow them to make a profit on the land development, and/or on the home itself. Today, homebuyers are buying (especially in high priced neighborhoods) not houses, or lots and infrastructure. Homebuyers are actually buying land at prices that cannot be justified on any economic basis. The only justification is that prices are rising for land in attractive areas.

I have seen this syndrome time and again in many parts of the world economy, such as commodities in the 70’s, emerging market stocks in the early 90’s, Internet stocks in 1999 and many others.

There is no logic behind these bubbles except how much liquidity is in the system and what kind of favorable terms (no money down etc.) can be obtained. This is unsustainable because like the Internet bubble, it requires a leap of faith, and the hope that will things will continue to move in the direction that psychology has recently led them. For example, the hope was that Internet stocks would earn so much money some day because of a new paradigm. This thinking made the wild valuations reasonable. People said to me during the Internet bubble days when I mentioned that valuations were ridiculous, “You just can’t see it Monty because you are too set in your ways and are not aware of how the world will soon be working.”

In my opinion, interest rates will once again work their magic. If they rise high enough, real estate prices in some over priced parts of the U.S. and other countries will decline substantially.


A number of people have asked me to explain why speculative bubbles form.

In my opinion, the short answer to why real estate, stocks, commodities and other assets periodically inflate toward bubble proportions is global liquidity. If any country prints money at a rate in excess of the rise in productivity in their economy, they are helping to create excess liquidity. If this money moves out of the country, whether to buy assets or hide in a foreign bank, it adds to global liquidity. Liquidity sloshes from one place to another according to fashion, which is a function of perceived opportunity. In my opinion, real opportunity can be determined by doing cash flow analysis or other asset based analysis. If investments don’t meet certain criteria they are gambles on fashion.


We have included below an article that appeared on the front page of the August 1st edition of the Financial Times. If circumstances allow the predictions made in this article to come true, the U.S. and their allies can depend more on relationships with moderate groups in the Muslim world and less on military activity to pursue the anti-terror campaign. Although it will probably take several years for such a policy to be effectively implemented, we believe the effects will be very salutary.

U.S. shifts anti-terror policy
By Guy Dinmore in Washington
Published: July 31 2005 21:56 | Last updated: August 1 2005 06:13

The US is working with Britain and France to undermine the appeal of Muslim extremism by reaching out to moderate groups, in a sign that its counter-terrorism strategy is moving beyond the “war on terror”.

US and European officials say the Bush administration’s review–expected to lead to a formal declaration of a new national strategy–represents not just a shift to a more multilateralist approach towards foreign policy but also an important development in thinking away from the emphasis on the military.

Already a shift in language has emerged that reflects the new approach. GWOT “the global war on terror” is being replaced in pronouncements by senior US officials by SAVE: the “struggle [or some say “strategy”] against violent extremism”.
Philip Zelikow, special adviser to Condoleezza Rice, secretary of state, is leading the effort at the head of a 10-member US committee. Talks began in London and Paris in June with the blessing of the White House. Mr. Zelikow’s goal, according to a US official who asked not to be named, was to “develop and implement a comprehensive strategy to discredit and demystify extremists’ ideology and promote moderate Islamic voices”.

A French official welcomed what he called the beginning of a “strategic dialogue on terrorism”, although he said nothing had been formalized. Speaking as questioning of four suspects in the failed July 21 London bombings continued for a second day in the UK and Italy, and in the wake of the deadly July 7 attacks, he added: “The process began before the London bombings but that gave us a sense of emergency.”
US, British and French intelligence agencies have enjoyed close co-operation since al-Qaeda attacked in September 2001, but the new initiative reflects a more fundamental approach to countering a long-term danger that appears to be surviving the arrests of senior al-Qaeda figures. “The buzz is moderate Muslim outreach,” one participant commented.

Buzzwords abound and there are some concerns that the US team does not include leading experts on Islam. Mr. Zelikow wants to come up with a “single narrative” that crafts a message to moderate Muslims of a “common humanity” to counter the Osama Bin Laden message. The principles of the strategy appear to draw on the findings of the 9-11 Commission in the US, whose report, issued a year ago, was authored by Mr. Zelikow.

A former senior intelligence official who served in the Bush administration commented: “Conviction has been growing steadily and strongly here that we needed to come out of the tactical phase of this war and into a strategic phase which would include this outreach to the Muslim world and it would make sense to structure this some way with a couple of allies, particularly the French, who understand that world so well.”
Additional reporting by Demetri Sevastopulo


Whether one is for or against the war in Iraq, most agree that the war and the fear of terror diminish the level of optimism felt by the public in the countries who are fighting the war.

If the approach to moderate Muslim groups is only equally as effective as the current approach, it will be beneficial because it will cut costs. If moderate Muslim groups can become the eyes and ears of the anti-terror campaign, it could have a positive effect on law enforcement’s ability to identify and root out terrorists before they can strike. This would clearly be in the interest of all investors globally. Fear diminishes optimism. Lack of fear creates an optimistic framework for investment.


A large part of the U.S. budget deficit is the spending for the war in Iraq. It appears that the new initiative will be focused on public relations and on financial support of moderate Muslim groups. The decrease of coalition military activity in Iraq could cut the U.S. budget deficit, and thus improve investor confidence in the future of the U.S. market environment. It could also have the effect of diminishing U.S. interest rates, as the Treasury is required to float fewer bonds to finance the cumulative national debt. Although this is a longer-term project, in the short-term, the U.S. is talking about decreasing the military presence in Iraq by 30,000 soldiers by early 2006. This will have a similar effect.


Stocks compete with bonds for money. If fewer bonds need to be floated, a downward pressure on interest rates will be exerted, and thus lead to more money flowing into stocks and away from bonds. Let us hope that hot war can be replaced by working with moderate groups. It will be good for all areas of the markets.

This is not yet a reality. Today’s reality is substantially less optimistic. The positive trends mentioned above may develop. We will wait and hope. In the meantime, we are still investing in tune with the current reality.