Change. Discontinuous change.

If you were a wealthy Southerner in 1860, most of your money was invested in land and slaves. It had been a sometimes bumpy road, but from the time that Eli Whitney was granted a cotton gin on March 14, 1794, slaves and land had continually gained value as world demand for cotton cloth exploded.

That was 1860. No one could foresee the discontinuous change that would take the South from the richest section of the United States[1] to the poorest (for over 100 years). No one could foresee that lifetime investments in slaves and land would be worthless by 1865.

On page 59 in the July 8, 2002 Newsweek there appears a section called “The TipSheet – Smart Strategies for your Money, Health, Family, Technology, Design, Real Estate, Travel.” In the “Ask Tip Sheet” column this appeared:

“Q: I’m 34 years old. The mutual funds in my IRA have lost nearly 70% of their value in the last two years. I realise that this is a long-term investment, but when is enough enough? Should I look into other forms of investment? – Stephen Bacchi, Boyertown, PA.

“A: The first thing to look into is how you invest. I’d bet that most of your funds carry names like ‘opportunity’ or ‘growth.’ They owned high-tech and telecommunications stocks, with a few dot-coms tossed in for fun. These are the principal stock groups that dropped 70%. The broader market lost 32%. Most bond mutual funds are up. It’s fine to keep some of your money in one of your growth-stock funds. Shift the rest into funds that call themselves ‘balanced’ (stocks and bonds), ‘index’ or ‘value.’ -- Jane Bryant Quinn.

On July 19, 2002, Mr. Bacchi and Miss Quinn received notice of the Emancipation Proclamation. More money had been liberated from their already shrunken stock accounts. But note that Miss Quinn’s advised Mr. Bacchi to shift his IRA – or the 30% of his IRA left – into stocks that had only lost half as much. Surely this ranks as a classic, if small, example of inability to perceive a discontinuous change and adapt.

For most of our lives, tomorrow will be pretty much like today, only more so. We don’t think much about historical discontinuities – massive, far-reaching changes that occur only rarely. Rare, however, only means “infrequently.” It doesn’t mean “never,” and discontinuity destroys the fortunes of those who refuse to recognise and prepare for them.

From August 25, 1999 (when the Dow Jones Industrial Average topped against gold at G$925) through March, 2000 a discontinuity was taking place: the primary trend in stocks was turning down. The bubble was bursting. That event taking place would determine many, many other events for years to come.

Not many were watching, and no wonder. Human nature takes our minds and expectations down the well-worn path of habit and experience. It’s been a bull market so long that it will be a bull market forever. Think about it. In 2000, a 40 year old money manager or analyst or financial adviser had never known anything but a bull market. It had begun in 1982, when he was 22, just about the time he got his first job. He had only experienced the rising tide that lifts all boats. Pick a stock, any stock – a year from now the bull market will bail you out and carry it to new highs. Under those circumstances, you can hardly pick a loser. It becomes easy to draw the wrong conclusion, and confuse a bull market with financial genius.

It hurts to say it, but in a bear market (as my friend B.P. reminds me) money returns to its rightful owner. Millions of investors discover that the market is not benevolent.

By now the news about the bear market is beginning to reach more and more minds. What amazes me, however, is that most of those minds are not moved to act. They have not yet panicked. They will stay in stocks until they have lost all their money. I hope you, my readers, aren’t among them.

In the fall of 2000 I began writing a long manual, The Next Great Depression Survival Manual. In it I outlined what I thought was the most probable economic future, and what specific strategies would protect your family. The three areas threatened were stocks, real estate, and the US dollar.

· Stocks -- The bubble in the stock market had already burst, so stocks would decline at least 50% and the economy would remain in difficulty at least ten years.

· Real Estate -- Since history shows that real estate bubbles never outlive the stock market bubbles that spawn them, real estate values would also drop steeply.

· US Dollar -- Because it is a fiat currency created out of thin air the US dollar is inherently fragile. The ballooning US balance of payments deficit was rendering the dollar even more vulnerable. Financing that deficit was easy as long as the US stock market and the dollar rose, because foreigners were happy to recycle their excess dollars back to the US to buy financial assets. But once stocks and the dollar headed down, foreigners would begin selling assets and dollars.

· Most likely government response -- The government only has two weapons against a depression – liquidity and blarney, printing money and propaganda. Government measures to reflate the economy will only add to the dollar’s problem. I also outlined specific strategies to protect you and your family, beginning with getting out of debt and selling stocks. Now I want to look closer at what has happened in the last year and a half, and what we can expect further.

GASP! In the last two months the downtrend in stocks has gained alarming speed. Back in February I published the chart, “Stocks versus Gold,” (shamelessly purloining the idea from Ned Smith – well, I did ask him first.) Since that time, the NASDAQ 100 has dropped 36.8%, the NASDAQ Composite 31%, the S&P 500 24.5%, the broad Wilshire 5000 22.9%, and the Dow Jones Industrial Average 19.1%.

Wait, wait, notice what these figures mean. These are not the drops from the highs in these indexes, but the drops since February 1, 2002. Because the Dow in Gold Dollars (DiG$) topped against gold on 8/25/99, I chose that as the starting comparison date for all these indexes. August 25, 1999 fell before most indexes topped in March, 2000, but the results are still devastating: NASDAQ 100, down 60.8%; NASDAQ Comp, down 53%; S&P 500, down 38.6%; Wilshire 5000, down 35.5%, and DJIA, Down 29.2%.

Finally, if we compare the closes of these indexes at their highs versus Friday, July 19, 2002, the carnage bleeds yet more redly:

A single question roils our minds: how much farther can stocks fall? The answer comes back, a lot. A bear market can eat up 50% to 98% of the previous bull market. Silver lost 93% from 1980 through 1993; gold lost 70.4%.[2] Stock bear markets in this century have averaged losing 52% of their bull market high. In 1929, the Dow lost 89% from November 1929 through June 1932. However, that wasn’t the end of it. The Dow began to recover, but was whacked again in 1937-38, and never reached its 1929 high until twenty-five years later, in November 1954. Counting the loss for inflation, it didn’t recoup its equivalent purchasing power until sometime in the early 1960s.

Eventually the market itself will tell us how much more stocks can lose, but it’s obvious that the blue chip Dow has quite a ways to fall yet. Bear this in mind – don’t turn loose of it – remain on guard -- because after stocks complete this leg down, they will inevitably react upward. That reaction rally will breathe life back into dying bulls, and they will proclaim the worst is over. Like all bear market rallies, its strength and speed will steal your breath. So will the collapse that follows. In truth, the worst will be yet to come.

If you still have stocks, should you sell? Well, how much pain can you stand? Ponder the math. If you are holding NASDAQ 100 stocks, you’ve lost nearly 80% from the high. You bought, but should you still hold? Your stocks would have to quintuple, yes, multiply five-fold, for you to recoup your loss. And they could still drop more, from an 80% loss to a 90% loss – another 50% of their value. From a 90% loss your stocks would have to double just to reach the 80% loss level.

What about holding on and waiting to sell into a near term reaction against this long slide? I would not do that.

First, if you are still holding stocks, that proves you have already failed to sell into the numerous rallies in the last year. Why expect you will be able to steel yourself into selling on the next one, lower than the earlier ones?

Second, all the indexes I follow have broken to new lows below the September 21, 2001 lows, except the Dow Transports. The Transports did not beat their 9/21 low, but did make a new low from their 3/2002 high. This implies that stocks will now drop much further, probably to Dow 7,600, before this leg ends.

Third, no matter how low a market goes, it can always go lower, until it reaches zero.

Those of you with IRAs and 401-Ks (many now 201-Ks) that you cannot withdraw without penalties have to make some tough choices. Some plans offer the choice of an all-government money market fund. These funds hold nothing but government bonds, preferably US government and no municipal or foreign government bonds. They pay hardly anything, but they’re not going negative on you. Well, actually they are going negative, because the US dollar is dropping, but at least the dollar is not dropping as fast as stocks. Perhaps your particular plan offers some way for you to buy gold stocks or gold mutual funds or Central Fund of Canada. If so, try that. If all else fails, cash out and pay the penalty, before you have no cash to take out and no penalty to pay.

The classic refuge from stocks in deflationary times is buying bonds, supposedly to protect your capital. Deflation usually accompanies depression and interest rates usually drop, so your bonds might even gain price and purchasing power.

But wait, Moneychanger -- with mountains of debt all around and asset values collapsing, how can you think about inflation?

Simple – because that is the only weapon the government and Fed have against depression, and it won’t work. Need evidence? Inflation didn’t pull the US out of recession from 1934 to 1941. It took a war to overcome that deflationary depression. Inflation hasn’t helped the Japanese in the last 13 years. In 1989 the Nikkei peaked at 40,000. Today it stands a little over 10,000, and the Japanese have flooded their economy with government spending and inflation and even zero interest rates. None of those inflationary measures has helped. Great – you’re unemployed and your savings evaporate, too.

But aren’t deflation and inflation opposites? How can opposites happen at the same time? Don’t deflations cause depressions? How can you have an inflationary depression?

Trust your Fed, and your federal government, because they will deliver it. The deflationary forces are economic, the inflationary forces strictly monetary. The deflationary forces are the mountains of bad debt and bad investments made in the bubble days. That must be liquidated, and will be – stocks will drop, bonds will default, debtors will belly up.

Meanwhile, trying to kick start the economy, the federal government and the Fed will be inflating at top speed? Why? Because besides blarney (propaganda)[3] they have only one weapon: liquidity. And as H.T. always reminds me, “When all you have is a hammer, everything looks like a nail.” The manipulators possess only the hammer of liquidity – printing money, increasing the money supply, spending for public works, pumping up bank reserves, lowering interest rates, offering government loans. They will use all these tricks and others I know not of, but all will fail. In the end, they will succeed – only in devaluing the dollar.[4]

Considering all this, I have been telling you readers and others, “Look, if you don’t believe me about gold and silver, then at least get out of stocks and put your money into US Treasury bills. You may not make much, but at least you’ll save some of your capital.” I even gave them the telephone number for Treasury Direct, the government office that sells you government debt directly, cutting out the middleman – (800) 722-2678. However, I warned them that at some point the dollar would start dropping so rapidly that they would have to jump out of government debt instruments. That’s why I recommended the short term Treasury bills.

Has the day of the dollar panic arrived? Not exactly, but a very close cousin has shown up. Since putting in a new high above 120 in February, the US dollar index has fallen about 14% to a low of 103.5. That amounts roughly to a 33.6% loss on a yearly basis, but I don’t yet see signs of a panic out of the dollar. Yes, the Euro has risen from 88 cents to 100 cents, but the rise has been fairly orderly, if steep. So has the dollar’s fall. Looking at the amount of US government debt securities the Fed is holding for foreign official entities, there’s no sign that official foreigners (governments and central banks) are jumping ship yet. From US$729 billion opening 2002 that figure has climbed to US$792 billion as of 7/18/02.

No, this dollar decline doesn’t smell like a panic. It smells like mackerel – a government mackerel. The mystery of the high dollar has been puzzling everybody for several years. Using normal standards to judge a fiat currency’s value, the dollar should have been declining, but wasn’t. What was keeping it up? Certainly foreigners’ demand for US investments helped net out the dollar’s trade deficit, but remember that fiat currencies have no value to begin with. Politics determines their value. Evidently the Bush administration has decided that US manufacturers and exporters have suffered the high dollar long enough. So they are now easing air out of the dollar bubble, with a probable first target of 95 – 100 on the dollar index.

But what if they slip and set off a panic? Either way, the long term is clear. The manipulators possess only one economic and monetary weapon against depression: inflation. Therefore they will inflate. The less it works, the harder the deflation bites, the more they will inflate. The deflation threatens to overthrown the entire system, the Symbiosis.[5] It could cause enough hardship to foment a revolution. The Establishment will be fighting for its life, and it never fights like a gentlemen. They will continue to inflate because they must, even if it utterly destroys the US dollar.

The real estate bubble has kept on inflating, pumped in part by investors fleeing stocks. Signs of a top are yet ambiguous, although the stocks of Fannie Mae and Freddie Mac, the Government Sponsored Entities created to real estate with mortgage money, appear to have turned over and down, a warning for real estate optimists. Just wait. Real estate will undergo the same correction as stocks.

Of course I addressed gold and silver when I was writing The Next Great Depression, and strategies for profiting from both metals.

Never mind supply-demand analysis for precious metals. The key issue – the only issue really – is monetary demand, demand for gold and silver as money. Only monetary demand can drive gold and silver to never-before-seen highs. Fortunately, our friends in government are helping us out here. First Alan & Co. pump up the money supply and create the biggest stock market bubble in human history. Next they shoot the liquidity gun at interest rates, lowering them and simultaneously the cost of holding metals. Then they suppress the gold price for six or eight years, building up a huge short position. Then they run the dollar’s exchange rate up 20% or so above reality.

It’s almost as good as just sending us a large check, except we get to keep the proceeds with a clear conscience.

Until this bear market in stocks ends, the strategic principle to grasp is that gold and silver will become more valuable than stocks. Since a friend first pointed me toward the Dow/Gold ratio in 1996, I’ve been watching it. That has paid off handsomely. If you had sold all your Dow stocks for gold on August 25, 1999, when the Dow in gold Dollars topped (although the paper dollar Dow went higher), you would have avoided a 29.2% loss in stocks, and gained 28% in gold. On balance you would have been 57.2% better off than if you had followed “buy & hold” (better termed “hold and die”).[6]

My research also suggests – at about 40 decibels – that silver will outperform gold. From its present 63.5:1 level the ratio should fall to 16:1 or better. Watch the ratio and trade from gold to silver whenever silver becomes cheap in terms of gold, and reverse the trade when silver becomes expensive against gold. That way we increase our metals holdings while we are waiting for them to rise.

Gold and silver stocks not only benefit from a rise in gold and silver, they also offer leverage. They may rise faster than the metals themselves. However, events in South Africa last month prove once again that an investment in gold stocks is not the same as an investment in gold. The Marxist South African government proposed a new mining law that would effectively strip away mining companies’ ownership of their deposits. So although South African gold mining companies find themselves in the best of all possible worlds – declining operating costs (thanks to a depreciating and), marginally profitable reserves (increasing their leverage to gold), good management, and the beginnings of a gold bull market – suddenly the government may make them worthless.

This illustrates an important principle about gold and silver stocks: stocks are not physical metals. Stocks impose a host of risks unrelated to the metals themselves – bad management, bad luck, bad government. Metals can rise while your stock tanks. That’s why you must invest in physical gold and silver. And we ought to apply the same critique to metals futures and options as we apply to stocks: they move for similar, but not the same reasons as bullion, and they interpose another layer of risk between you and the bullion markets.

I do not recommend specific gold stocks because my expertise doesn’t lie there. The only stocks I do recommend are Pan American Silver and Central Fund of Canada (a vehicle for owning gold and silver by owning a stock and thus fit for IRAs). If you want go stocks, I can without reservation (or kickback) recommend Sam Parks in Seattle at (800) 552-7574. He is a man of integrity. For futures or options, call Sue Rutsen and her group at (800) 621-0265.

I’m not simply blowing a cold, gray, clammy cloud of gloom and doom here, I’m facing realities. No investment is forever (except a spouse and children). One fine day we will sell gold and silver and buy stocks and real estate, but if we don’t sell stocks and real estate now, we sure won’t be buying any then. We’ll be standing in a soup line.

To my readers it also ought to be obvious that I discourage riding out the next decade in a city. As all the promises are broken, stock values, savings, and pensions evaporate, the hard times get harder, cities will become mean places. I’d rather enjoy that in absentia. I’d move to the country. In fact, I already have.

Knowing all these things is worthless unless it helps us protect ourselves. What action should we take?

1. Get out of stocks, unless they are gold stocks or very special situations. “Out of stocks” means “out of mutual funds” because mutual funds invest in stocks. Don’t buy stocks again until a bottom is confirmed, whether tomorrow or five years from now.

4. If you don’t trust gold or silver, stay in cash or US T-bills and avoid corporate, state, or municipal bonds,

5. But watch the dollar for signs of panic selling. If that occurs, switch to gold and silver immediately.

6. Speculators meanwhile can short stocks with bearish mutual funds or stock market put options, and go long gold and silver with futures call options.

7. Minimum targets: Dow well below 6,000, stock P/Es from 10 – 14, stock yields above 8%, gold above US$1,250, and silver above US$20.

[1] In the 1860 census the three states with the highest per capita (including slaves) incomes were Mississippi, Louisiana, and South Carolina.

[2] I know because I rode it all the way down. How do you think I learned what not to do?

[3] You know, like “We have nothing to fear but fear itself” or “Be patriotic – have faith in America -- buy stocks!” I missed my chance for an alliteration. I should have called their weapons “Lying and Liquidity,” but I’m stuck with Blarney now. Never mind the terminology, you get the picture.

[4] Thus the grand old analyst Franz Pick used to refer to government bonds as “certificates of guaranteed confiscation.”

[5] My term for the intertwined US government-business partnership. I also call it “The Establishment” or “The Insiders.” “Fascism” is the technical term.

[6] This is not 20/20 hindsight. Not only did the DiG$ top in 8/99, Dow Theory gave a primary trend change signal in September 1999. The later (January 2000) high in the DJIA was not confirmed by the Transports. By the time the carnage hit the other indexes after they topped in March 2000, there was no question that the primary trend in stocks had changed. But that was already signalled in September 1999 by Dow Theory.

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