A Melman Minute — February 5, 2008

As reports go, it seemed relatively unimportant, but it turned out that the Institute for Supply Management (ISM) report on the service sector of the American economy had a major impact on a host of world markets overnight and into early trading this morning.

They reported that the service sector encountered serious weakness during January with their index plunging to 41.9 from December’s reading 54.4. Any reading below 50 normally reflects a contraction of that segment, and a reading near 40 suggests that the decline could become serious.

With this further indication that the U.S. economy may be weakening, several markets moved decisively Gold, already lower on European selling, reacted to this suggestion that inflation might be less than expected by falling to the upper $880 range, a drop of almost two percent on the day and the other precious metals including silver, platinum and palladium also fell sharply. Base metals reacted to this weak report by falling sharply with copper, zinc, lead and nickel all about two percent lower. Petroleum also fell with crude down to near $88 while the possibility of lower inflation provided strength to the U.S. Dollar with the Greenback showing strong gains against every other major currency. (all quotes in US$)

With gold falling, the Greenback strengthening and oil lower, one would normally expect financial markets to be rallying, but that is most assuredly NOT the case, at least up until 8:00 AM PST as the Dow Industrials are down by over 250 points, following the lead of European markets which also sold off by an average of more than two percent overnight. In Canada, the TSX was down by about 130 points or one percent.

Mining indexes continue to under-perform other markets of late and the widely-watched XAU mining share index has been particularly hard hit. It is down a further five points this morning and, as can be seen from the chart, is now about twelve percent off from its recent peak of 199.25.

Of even greater importance is the performance of the XAU index compared to gold itself. When gold made a relative peak at $840 in early November, XAU soared to near 195. Today, with gold fifty dollars higher, the XAU Index is twenty points lower. Historically, that type of performance has had negative implications for the metals themselves and for the industry in general.

Perhaps the most important economic debate of recent weeks, months and even years is the ongoing stimulative efforts by the Federal Reserve Bank to forestall any impending recession - or worse - for the American economy. They have been adding liquidity to their financial system and driving interest rates sharply lower of late. Clearly, high among their goals are the avoidance of as much pain as possible in the real estate markets by enabling more loans to be re-written at lower rates and also to provide the American consumer with more borrowing power in order to ‘hypo’ additional consumer activity.

Such actions have indeed worked in the past when then-Chairman Greenspan, concerned about the negative fallout from the impending collapse of a multitude of ‘dot.com’

Companies, drove short term interest rates all the way down to 0.75%, inflating the money supply and setting the stage for the stupendous real estate boom of 2000-2006 during which values on homes across America typically rose by 100%, 150% and even 200+%. These increases, in turn, provided incredible amounts of readily -accessible borrowing power for American consumers to engage in a buying binge of historic proportions.

Now, once again, the same fiscal medicine is being attempted, with the same hoped-for result clearly in mind.

Some caution might be in order and Japan is a case in point. Japan also enjoyed a real estate boom of stupendous proportions, lasting from the 1960s until the late 1980s, a boom which spread prosperity throughout the Japanese economic society. The Nikkei Index soared from under 1,000 to near 40,000 by 1989. Then reality hit home as the real estate market peaked.

As property values plunged, so did the Japanese stock market, with the Nikkei eventually reaching a low near 8,000 in early 2003 and, even today, sits near 13,500 - a loss of about two-thirds from its peak of nineteen years ago.

The situations bear remarkable similarities. Once real estate values began to plunge in Japan, the level of economic activity contracted and bad loans started to accumulate in their banking system. The Japanese government drove interest rates lower and they still remain near one percent. However, their markets remain mired in the depths after so many years.

So, the great debate becomes this: will the American economy, and, by implication, the world economy, recover quickly now that the stimulative taps are opened wide - or is this a much more serious matter, perhaps similar to the Japanese story?

This is one of the important questions to be addressed at the upcoming Cambridge House Conference in Phoenix, AZ February 9 and 10 at which your editor will be a participant, appearing on two panels and conducting a workshop entitled “Four Dynamic Trends - updated.”.

Because of travel commitments and other business matters, it will be necessary to take a ‘vacation’ from our daily MELMAN MINUTES until their planned resumption on Tuesday, February 12.

We look forward to meeting any of our readers who might be able to attend this invaluable conference. We highly encourage you to do so.

DISCLAIMER

The information presented above is based on data which we believe to be from reliable sources, but the accuracy of which cannot be guaranteed. Any opinions or predictions contained herein are those of the editor and are likewise offered also for information purposes only.

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