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The daily televised circus of the Enron scandal is mere titty-tainment, a smokescreen obscuring a real crisis: The breakdown of global capitalism. In this issue we examine recent developments in Japan, and the ominous signs of things to come, not only for Japan, but for the rest of the world economy.

Ominous Signs from Japan
SEATTLE - 11 February 2002 - by M.A. Nystrom
Japan's economy, mired in stagnation and recession for the past 12 years, has seen its stock market lose 75% of its value, unemployment and homelessness climb to record levels, and public debt soar beyond belief. Now, things are about to get worse for Japan and the rest of the world.

A Sea of Debt
The rate on Japanese 10 year bonds, the primary financing mechanism for Japan's public debt, has risen from 1.25% to 1.5% since the beginning of the year. Because these figures are so low, it does not appear to be a significant development. However, Japan has a $5 trillion public debt, rivaling that of America's ($5.9 trillion) in sheer size, but much larger as a percentage of domestic GDP. A ¼% increase in financing $5 trillion will have a huge impact on Japan's economy and the rest of the world, and this rise in rates does not appear to be temporary.

Japan's government, like the government of the United States is, for all intents and purposes, bankrupt. As obligations come due each month, both governments must sell bonds to finance repayment of the obligations. It is akin to a household shifting most monthly expenses onto a credit card, and when the bill for that credit card comes due, paying it with a different card. While an individual household could do this for only so long before its credit was shut off, this system has functioned perfectly for decades for both the governments of Japan and the United States. The system is, in fact, the way most governments function. But more and more countries have seen their credit shut off in the past few years.

The recent experience of the emerging markets - Mexico, the Asian Tigers, and Russia - is that when foreign capital flees, currencies collapse, output declines and unemployment and inflation soar. Among the Asian Tigers, Thailand was the first casualty of capital flight in 1997, and it saw its currency fall by about 90 percent in 6 months. Inflation and unemployement soared. It took about 6 months for the contagion to spread fully to the rest of the region.

Argentina is the most recent example of a country that has had its credit cut off. The result has been a complete disaster, and there has been no international aid or bailout packages to soften the blow, as there was for Mexico and most of the Asian nations. There is hope that this contagion will remain contained to the country itself, but only time will tell if this will be the reality.

The quick rise in yields in Japan is a sign that investors are beginning to get nervous about the quality of Japanese debt. The increase represents a 20% rise in the cost of government borrowing in only 2 months. Annualized, this is a 200% increase. We may be witnessing the roots of hyper-inflation in a country which has seen only deflation over the past decade. And this, not in some backwater emerging market, but in the second largest economy in the world.

Stock Market Lessons from Japan
The Japanese stock market continues its brutal 12-year decline, now hitting lows not seen in 18 years. At the time of this writing, the once venerable Nikkei rests at 9420, having last week closed below the Dow for the first time since 1956, when the Nikkei was at 420 and the Dow at 460. Technical analysts warn that the market could easily fall another 20%.

Nikkei-Dow Crossover

This bear market is beginning to rival that of gold for length & brutality. Gold is the perennial punching bag as the bear market that will never end, but it is finally beginning to show signs of life. Recently no one seemed to care much about the yellow metal, not when stock market gains of 20% were the norm. But Japan's situation is another story. It is scary because it is occurring in an economy that is substantially similar to our own. And for reasons we will see below, the continuation of Japan's equity bear may finally help spell the end of declining prices in gold and ignite a rally for the history books.

Stock market strategists, analysts and pundits in this country seem oblivious to any history stretching beyond that of the recently ended U.S. bull market. They seem to have only one recommendation: Buy. They said buy at the top, they said buy as the market fell, and now they say buy because this is the bottom. They seem to think that the news in this country is sufficiently rotten that the bottom must be near. They try to play the old contrarian card, except all analysts seem to be in agreement on this point: Buy. This is not contrarian thinking, but consensus-group-anti-think.

The American situation pales in comparison to Japan's. Our recession is less than one year old (compared to Japan's 12), and the Dow is suffering a mere 2 year bear market, while still sporting a hefty P/E ratio of 27. Buy now! They say. You don't want to miss the next leg up, and the economy is fundamentally sound…

Chronicles begs to differ, and offers the following artifact, unearthed in this writer's basement, as a case in point.

Buy Japan!

The picture is from an article titled "Buy Japan" from the April/May 1992 issue of Worth Magazine. At the time of its writing, the Nikkei had seen 2-1/2 years of declines, and was down about 42% from its peak of 38,000, resting near 22,000.

The article begins, "The Japanese Market has been a disaster over the last couple of years - and that's exactly why it's attractive…"

Paraphrasing the highlights of the two page article: "Japanese stocks are quite attractive on a value basis, presenting a rare buying opportunity….Japan has seen a lot of scandals and other bad news recently. That's good, not bad…Japanese company earnings are weak, but that, particularly when other news seems dismal, is just when one should buy…Japanese banks' troubles won't be a hopeless drag on the earnings of Japanese growth companies…"

And the article ends, "Should the market go even lower at some point, don't panic. Buy a bit more."

It is disgusting what passes for financial journalism today. The article was published when the Nikkei was at about 22,000, and 10 years later, it rests at just over 9,000, a further 60% drop. If you had taken the advice of the article, you would have seen your investment decline by over 60%. Had you taken their further advice to buy more on dips, you would have really been screwed!

Keep this in mind the next time you hear an analyst on TV say something like, "The Nasdaq is down 60%, so we think it has found the bottom." Every "point" made in the above article can and will be rolled out by every glossy business magazine and news show as justification to buy the American market. Don't buy the hype. Beware of articles containing neither analysis nor evidence, but only platitudes, rules of thumb and intellectual acrobatics done to justify the point of buying.

Our SPX is currently trading at a 27 P/E, near the highest ever from historical standards. The trend for earnings over the next few years will be down. Not only will the economic slowdown will take its toll, but tighter accounting standards and the reining in of phony Enron-style accounting will also take their toll on inflated earnings. And if Senators John McCain and Carl Levin have their way, companies would be forced to count stock options as an expense against profits. Currently, companies have it both ways, getting a tax deduction for the options but not counting them as an expense, even though they dilute the stakes of their shareholders. Enron received $625 million in tax deductions from stock options from 1996 to 2000. Other companies such as Microsoft, Cisco, and Dell have been heavy users of this accounting technique, erasing tax liabilities and juicing earnings.

Bull markets start when prices are low. P/E's of 6-10 represent value and are common at bear market bottoms. Current P/Es, based on inflated earnings represent no such thing as value.

Falling Yen, Public Mismanagement
The Japanese currency is down 15% this year. A falling currency means imports are suddenly 15% more expensive for the Japanese, and Japan is nowhere near self-sufficient in energy or food. This means inflation for Japan, on top of an already stagnating economy.

The falling yen will be of no help in repaying the public debt. As stated above, yields are rising on Japan's $5 trillion in public debt. In order to pay it back, more debt will be issued, at higher prices, thus increasing the overall debt. If rates rise higher quickly, the situation could easily spiral out of control, leading ultimately to default. It is a hopeless situation, one utterly destructive to wealth. This is where Japan finds itself: depressed and in a debt trap, with no easy way out.

While investors are dumping Japan's long term bonds, they are pig-piling into short notes. When the government auctioned 2.1 trillion yen ($15.8 billion) worth of six month Treasury bills last Tuesday, it received bids to by an astonishing 142 times the number it planned to sell. Ordinarily, such auctions are oversubscribed by two or three times.

To me, this looks like a panic, or a bank run in reverse: Long-term bonds are risky, cash is risky due to the perilous situation of banks, so there is huge demand for the short term notes. This is the manifestation of a beginning crisis in confidence.

As the Japanese markets fell last week, the government pledged to spend taxpayer money to help prop up the market if it falls below 9,000. According to the NY Times, "Traders took the remarks as an invitation to hammer prices down to that level to test the government's resolve." It's all fun and games, as they say, until the world economy implodes.

Japan is in big trouble, friends. The government's solution is to allow the yen to weaken, hoping that will push up exports and profits. But this will certainly lead to inflation. Japan's economy is falling down a hole, with no clear solution. And this means trouble for the rest of the world, most notably America. Japan is still the largest foreign purchaser of American Treasury bonds.

For the time being, the U.S. Dollar is holding its own, though both 10yr and 30yr bond yields are up sharply from their November lows. The Fed is done easing, and rates are back on the upswing.

Ten Year Yields

Against this backdrop, gold is caught in a mere image trap as an investment. This is why Chronicles is so bullish on gold, and the rest of the market is apparently as well. Gold is perfect credit - an asset without a corresponding liability. For every dollar or yen an investor holds, the issuing government holds a corresponding liability. This is not true for gold. It is perfect credit.

Gold in Japan
In the mean time gold sales in Japan are starting to pick up. In the 4th Quarter of last year, investment gold sales rose 54% in Japan, according to Grant's Interest Rate Observer. There is news that this investment is coming from citizens, buying physical gold, keeping it in their homes as a store of value. Extreme nervousness must be setting in to see this type of activity.

Unfortunate as it is for Japan, this development is extremely bullish for the world gold market: Avid savers, the average Japanese has over $105,000 stashed away. Half of that is in the bank, earning next zero yield, precisely the same amount that gold would earn. Gold, however is not at risk of vaporizing into thin air, the way a fiat currency is. Gold is a rock solid store of value, and also sports a nice potential upside. Japan currently accounts for only 20% of world investment in gold. There is plenty of room to grow! And from a cultural standpoint, there are few barriers to an increase in the purchase of consumer investment gold. This is a country where the majority of people are still paid in cash on payday! Fear of theft, a big impediment to physical gold investment in this country (where am I going to keep it?), is nearly non-existant in Japan. One good marketing campaign on the part of the gold industry could spur unbelievable demand. Japanese marketers can be masterful, and consumers quite obedient to their overtures…

The Feb 10 Observer notes: "Japanese consumers have also been flocking to banks to convert the rapidly depreciating yen into gold bars. There are fears that the banking system could collapse when government deposit guarantees lapse in March."

While "flocking" may be an overstatement, it is a growing trend.

In the next issue, we will discuss Tamisuke Matsufuji, a former Salomon Brothers bond trader who wants to blow the lid off the gold price and how he plans to do it.

The Japanese economy, once the envy of the world, has stumbled for 12 years, and now appears to be falling down. In its glory days, the Nikkei was worth more than the rest of the world's equity markets combined. It has been a stunning reversal of fortune for the second largest economy in the world, and it foreshadows what could be in store for the United States. If Japan falls far enough, it could easily take the rest of the world financial system with it. America is walking in Japan's footsteps, and great caution is warranted. Now is not the time to buy stocks. It is the time to plan an exit strategy for real estate, dollar denominated investments, and ultimately the dollar itself. Stay tuned for further updates on the unfolding of the second great depression.


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Special thanks to Robert Prechter of Elliot Wave International, for the grand macro economic vision which inspires this website and this publication.

Special thanks to Robert Kiyosaki of Rich Dad, for the grand micro economic vision which equally inspires this website and publication.

And finally, thanks to Michael Nystrom, editor of Chronicles, for executing the vision.