A Melman Minute — July 11, 2011

It has been said that a picture is worth a thousand words, and I suppose the rule also applies to well-selected charts. In todays case, then, we are about to offer two thousand words worth of discussion, as there are two charts which we believe are beginning to tell quite a tale.

The first one is the chart of gold and, in our interpretation, reflects a technically important trading range. As can be seen, there are now three highs to the range, all just below the $1,560 mark while there are three lows to the range, all between $1,460 and $1,480. Therefore, we believe that the direction gold comes out of this range could be quite significant.

The second chart is the U.S. Dollar Index and it shows a similar trading range structure. In the case of the DX, an array of tops can be found in the 76.5 to 77.0 area while three clearly-identified bottoms come in between 73.5 and 74.5. As with the gold chart, we believe that the direction the U.S. Dollar moves out of this trading range could have great significance.

However, there is another vital factor for us to consider. Throughout both ranges, the U.S. Dollar and Gold have moved almost in tandem in the same direction. In our opinion, this is most unusual behaviour, particularly in historic terms. In past golden bull markets, as the Greenback has weakened, gold has soared and vice versa, and that pattern repeated itself over and over again.

Our interpretation of todays contra-historic action relates to the severity of the potential currency crisis building up in relation to the vitally important Euro. As one nation after another falls into crisis mode, a panicky reaction can be observed in financial markets. Key to our interpretation, as money attempts to move out of the Euro, we believe that some of it is finding its way into American private and government debt instruments, thereby strengthening the dollar. At the same time, it appears that other European funds are heading toward the historic safe haven of the precious metals.

We would offer the opinion that as long as America seems to offer comparatively better stability than Europe, money will continue to flow into the U.S. Dollar, but when the U.S. financial background weakens dramatically, which we continue to believe is a high likelihood, then the inflow will cease and eventually reverse itself. It is our believe that when that trend takes hold, a truly powerful bull move in gold relative to the Greenback will take place.

The question of stability in relation to the Eurocurrency is once again front and center as it is beginning to appear that both Spain and Italy are becoming increasingly vulnerable to potential default, in addition to those nations such as Ireland, Greece and Portugal which have already required bailouts. However, once Italy and Spain enter the rescue equation, it begins to take on a much more ominous appearance. This is due to the relative size of those two nations debts in comparison to those which have already been the recipients of such packages. The latest figures for the relative National debts are:

Portugal 146 billion Euros

Greece - 331

Spain - 607

Italy - 1881

In other words, the combined total of the national debts of Spain and Italy are more than five times the combined national debts of Greece and Portugal.

It is Italys government finances which are now coming under the closest inspection as their debt woes are closely following the paths already established by Ireland, Portugal and Greece. In each of those nations, the public was assured that there were no serious troubles which the government could not handle. Next came concern shown in debt markets, followed by more assurances, followed by statements that a rescue plan was only being considered, followed finally by actual details of substantial rescue operations.

Selling in Italian government bonds has recently accelerated and the spread between the yields on German and Italian 10-year government debt paper has now reached now reached close to 3% which is the highest level ever recorded since the introduction of the Eurocurrency. These high rates which Italy must now pay to raise capital accelerate expansion of total debt and are beginning to make it appear unlikely that Italy will ever be able to repay its debt in a timely manner into the future.

Actually, Italys problems appear to be as serious as Greeces or Portugals. Italys economy has stagnated over the past decade with an average annual growth rate of an anaemic 0.25%. In a recent Wall Street Journal evaluation, it was noted that, Italy needs to hack away at the traditional cradle-to-grave labor agreements...nearly one in three Italians between the ages of 15 and 24 is unemployed...productivity is very low..., and they also noted that the political system appears to be in disarray as open squabbles between Prime Minister Silvio Berlusconi and Economy Minister Giulio Termonti make almost daily headlines.

In our opinion, we believe that the Italian difficulties are real, they are insoluble without drastic political action which the government appears unwilling to even consider such as wholesale cutting of civil service staffing and, if anything, the overall situation could become much worse as specific debt repayment deadlines approach.

When the perilous situation of Spain is added to the total unstable European debt equation, it can be readily understood why the Euro itself is coming under increasing selling of late, clearly shown on the Euro chart, and this entire picture explains why the Greenback and the price of gold have been moving in tandem both being considered as islands of relative safety.

Part of our overall concept is that as governments around the world enter even greater economic difficulties, they will turn to higher taxation as a means of resolving their problems, at least on a temporary basis. With that in mind, we cannot help but note that there is no area of safety from rising taxation even the grave after death. It turns out that Moab, Utah is raising its fee for a city burial plot from $150 to $700 in one shot! Brunswick, Georgias fees for digging and filling a grave just rose from $200 to $900!

This is just one area of taxation that is on the rise and there are many others, including medical care taxes, income taxes, property taxes, gasoline taxes and a host of others too numerous to mention. We will provide examples of new tax increases as we learn of them. On the other hand, it is relatively simple to record examples of tax decreases, since they happen so seldom. In terms of economic activity, tax increases are always a concern since those revenues are taken from productive consumers and turned over to governments which are seldom efficient in their operations.

Markets this morning have made some truly substantial moves. Financial markets in both Canada and the USA are trading sharply lower, with the TSX Index off by about 180 points and the Dow Industrials off by about 140 at 9:45 AM PDT. Gold opened sharply higher, touching $1,558 before falling back to the upper $1,540s while silver is down almost $1.00 to near $35.85. Base metals are down across the board and mining share indexes are off moderately.

In other markets, crude oil has fallen back to about $95.00 per barrel, long term interest rates are headed lower and, as noted, the US$ is up sharply in currency trading.

All quotes US$ unless otherwise indicated.

Next Melman Minute scheduled for Wednesday, July 13, 2011.

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