Cornerstone Planning October, 2008

The 4 Horseman Have Arrived

Key Points Debt, Derivatives, Deficits and the Dollar
Expect rallies, don’t By John Riley the bear will continue to attack. Only when hope is
trust them. Chief Strategist gone can a bear market bottom.

Are Fed’s policies Expect rallies in the market. Expect good economic That is why so few investors get in on the beginning
increasing or numbers. Expect the government and Wall Street of a bull market. They’ve been fooled and savaged
decreasing debt? through their marketing machine, the mainstream by the previous bear market rallies. They don’t be-
media, to tell you the worst is behind us. lieve the new one is legitimate.
Are Fed’s policies
doing anything to But don’t believe it. Don’t believe any of it. They Bear market rallies can last months, even a year or
reduce the use of will be false prophets. Don’t get hooked into what more. But then watch out. The bottom falls out from
derivatives? we in the business call “Sucker rallies.” They are under the market. Whatever caused the bear market
bear market rallies. Every bear market has rallies. in the first place shows that its fangs are still sharp
Is the Federal budget They make investors think the waters are safe again. and in place.
deficit getting better And then the next tidal wave hits.
or worse? So always ask questions whenever anybody tells you
The result of a Bear Market is to permanently chase the market is alright and the bear market is over.
How badly has the away investors. As long as there is hope, and that is They relate to Debt, Derivatives, Deficits and the Dol-
US Dollar’s value what a bear market rally is made of, investor hope, lar.
been eroded?
Bear Market Rallies
4 0 ,0 0 0

N ik k e i 2 2 5
3 5 ,0 0 0

3 0 ,0 0 0
+ 2 5 .8 %

2 5 ,0 0 0 + 5 5 .2 %
+ 4 9 .8 %
+ 1 3 1 .6 %
2 0 ,0 0 0

1 5 ,0 0 0

1 0 ,0 0 0

Down 80%
5 ,0 0 0
J- 8 8 J- 8 9 N- 9 0 M- 9 2 O - 9 3 M- 9 5 A - 9 6 F- 9 8 J- 9 9 J- 0 1 J- 0 2 D- 0 3 M- 0 5 O - 0 6 A - 0 8

400

350
D o w J o ne s
+48%
300

+12%
250

200
+21%
+27%
150
+35%
100 +72%
50

0
S-29 J- 3 0 A -31 J- 3 2 N- 3 2

Source: Yahoo!; Format: CIS

Both the 1929 - 1932 Dow Jones and 1989 - 2008 Nikkei bear markets had substantial bear
market rallies. None of these rallies reversed the downward trend. Buy and hold didn’t work
during these periods, but nimble money management should be able to take advantage of
both the rallies and the declines.
Key Points Debt Derivatives
What has happened to debt? Have debt levels de- Are banks reducing or increasing their addiction to
It will take a long time clined? Have the Fed’s policies increased or de- “financial heroin” – otherwise known as derivatives?
to reverse the creased debt levels?
diminishing returns Debt compared to GDP Derivative Growth
debt has had on the
economy

Debt needs to be
reduced in real terms

Everything the Fed is

doing is increasing
debt, not decreasing it

Derivatives need to be
reduced and/or
eliminated

Source: Federal Reserve; Format: CIS

The Debt to GDP Ratio is the highest since before the

Great Depression. In order to reverse this, the economy
either has to grow extraordinarily, or debt levels must
come down substantially. Negative debt growth would
negatively impact the economy and markets.

Source: OCC; Format: CIS

With everything that has been going on for the past year,
it is unbelievable that the major banks have been adding
to their derivative positions. When will the insanity end?
They are growing their derivative portfolios at multiples
of the GDP growth.

Source: Federal Reserve; Format CIS

Diminishing Returns
0.9
$0.80
0.8
GDP Growth Per Dollar of Debt Growth Derivative Growth Continues...
$0.70
0.7

0.6

0.5

0.4 $0.35
$0.30
0.3
$0.20
0.2 $0.16
$0.10
0.1 $0.07

0
1975 1980 1985 1990 1995 2000 2005 2007

Source: Federal Reserve; Format: CIS

With all of the debt growth, you would think the GDP
would grow more. But instead, we’ve gotten less and
less economic growth for each dollar of new debt.
When debt starts to be paid down, what will happen to
economic growth?
Source: OCC; Format: CIS
The use of derivatives just keeps on marching upwards.
It is so out of control that the growth of derivatives in just
the 2nd quarter of 2008 at the 3 big banks almost
equaled the entire US GDP.
 Key Points Deficits The Dollar
Has the Federal Budget Deficit declined or in- Has the Dollar bottomed? Has the value of the Dollar
creased? Has the Trade Deficit and Current Ac- improved or been eroded by the Fed’s actions? What
Fed’s actions are
count Deficit declined or increased? will have to happen for the Dollar’s value to actually
making the Federal
improve, not just go up on world currency markets
Budget deficit worse Federal Budget Deficit due to panic?
Federal Budget Surplus/Deficit
Strong Dollar doesn’t 300000 The Dollar Bear
help Trade Deficit 200000
2008 is only
through Q3

100000
Foreign buyers have
started to back away 0

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008
from buying -100000
US Treasuries
-200000

Fed’s actions have -300000

eroded the value and -400000

diluted the US Dollar Source: Federal Reserve; Format: CIS

Treasuries represent Since 2002, the Federal Budget Deficit was with us
once again, putting a drag on the economy. It had
only 26% of Fed’s been declining in the past several years though. The Dollar has been in a Bear market since 2002. Is the
assets recent rally a reversal, setting the stage for a new Bull
With all of the bailouts and takeovers, if the budget deficit market in the Dollar, or just a Bear Market rally? Has the
likely to shrink or grow? By the 3rd quarter of this year, Fed done anything to improve the value of the Dollar?
the budget deficit is already the highest it has been in 4 No.
years. Some estimate next year’s budget deficit could
reach $1 trillion.
Eroding the Value of the Dollar
Trade Deficit and
Current Account Deficit % Treasuries in Fed's Holdings
105%
Trade Deficit and Current Account Balance
$0
95%
1992M1

1992M11

1993M9
1994M7

1995M5

1996M3

1997M1
1997M11
1998M9

1999M7

2000M5

2001M3
2002M1
2002M11

2003M9
2004M7
2005M5

2006M3

2007M1

2007M11

85%
-$10,000
75%
-$20,000
65%
-$30,000 55%
Millions

-$40,000 45%

35%
-$50,000
25%
-$60,000
D-03 S-04 A-05 D-05 A-06 M-07 J-08 S-08

-$70,000
Source: Federal Reserve; Format: CIS
Trade Deficit Current Account Balance
-$80,000

Source: Federal Reserve; Format: CIS Over the past 12 months, the Federal Reserve has sys-
The weakening Dollar was supposed to alleviate the tematically eroded the value of the Dollar. Historically,
Trade Deficit. It didn’t work that way. As the Dollar fell Treasuries had been the staple of the Federal Reserve’s
for the past 5 years, the Trade Deficit kept going lower Balance Sheet, accounting for 90 - 95% of their assets.
too. The recent uptick has given some hope of a
reversal, but a strong Dollar is already showing it is Now only 26% of the Fed’s assets are in Treasuries.
dashing those hopes. This is what is backing the Federal Reserve Notes in
your pocket.
Foreigners may not want to hold Dollars for much longer
as our economic and financial woes deepen. Is it any wonder we believe the current Dollar rally is not
based on fundamentals?
Foreign Buyers of Treasuries
$200,000

Net F o reig n P u rch ases o f T reasu ries Fed Assets Explode

$150,000

$100,000
M illions

$50,000

$0
J-87 F-89 M-91 A -93 M-95 J-97 J-99 A -01 O-03 O-05 N-07

-$50,000

Source: US Treasury Dept; Format: CIS

Foreign buyers of Treasuries have helped to finance

our deficits. At the same time, they have taken it on
the chin as the US Dollar has declined.
Source: Federal Reserve; Format: CIS
The red line in the chart above shows the trailing 6
month average. It looks like foreigners are not so in- The Fed has been busy running the printing presses and
clined to buy Treasuries anymore. loading up its balance sheet.
 Strategy
The Fed Saves the Banks ...With More Debt
Independence gives
us an advantage Non-Borrowed Reserves of Depository Institutions Total Borrowings of Depository Institutions
$100 $500

$450

We have developed $50 $400

appropriate strategies $0
$350

$300
to handle the major J-80 J-82 J-85 J-87 J-90 J-92 J-95 J-97 J-00 J-02 J-05 J-07

Billions $
$250
issues facing the -$50
$200

markets -$100
$150

$100

-$150 $50

$0
J-86 J-87 N-88 M-90 O-91 M-93 A-94 J-96 J-97 D-98 M-00 O-01 A-03 S-04 F-06 A-07
-$200 -$50

Source: Federal Reserve; Format: CIS

In the past year, the reserves at banks have been wiped out and replaced with debt. The Fed has lent over $400 billion in
the past year. The printing presses are working overtime!

This is what we are watching. Debt, Derivatives, these issues in mind and set up hedge positions that
Deficits and the Dollar. They will tell us when the can benefit from the problems.
bear should be over. They also tell us that things
are likely to get much worse before they get better. If you would prefer to benefit from these problems
instead of being their victim, give us a call. We will
Being independent and knowing these problems listen to you and help you determine your needs and
gives us an advantage. We are able to invest with you will find out what we can do for you.

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