The following is an excerpt from the September 2009 Morgan Report. Many have asked what to expect after October 1, 2009. Well, that time has arrived and the following may give you the reader some insights into my thinking…

“With respect to future debt; would it not be wise and just for that nation to declare in the constitution they are forming that neither the legislature, nor the nation itself can validly contract more debt, than they may pay within their own age . . .” —Thomas Jefferson

As we come near the end of summer in North America, we are receiving mixed signals about the U.S. and global economy. The mainstream is speaking about the worst being behind us, both within the U.S. and globally. However, we see things a bit differently.

This month’s quote about debt is one that I found from the most respected Thomas Jefferson. Indeed the current financial (credit) crisis would not be taking place if every nation adhered to the principle of living within one’s means on a national level. Alas, that is not reality and we need to examine where we are presently, and with that, we want to project the most likely road ahead so you can observe carefully for verification and take the correct action.

As the system continues to add more debt to a debt-based system, we know that this “fix” might help bring confidence back into the markets for a short time, but longer term it cannot solve the problem, because excess debt is the problem. This month I want to focus on what the most likely scenario is going from the end of summer to the end of this year and into early 2010.

First, we do provide market timing, but in a very broad sense—meaning on an intermediate-term basis. This timing is where we see very strong upward moves resulting in overbought situations and also looking for “washout” bottoms where buying into this sector is at the lowest possible risk.

Having called the top very near the $21 level in silver turned out to be accurate. But it was a long wait to buy back into the market, with my forecast being to buy until the end of September last year. Well, I admit my top was correct, but I failed at calling the exact bottom, as we now know; looking back, we got a bounce in September and all looked good for a while, and then the bottom fell out into the November timeframe.

Personally, we did buy back in most of our large trading positions during September but held some cash and did get some purchases very close to the ultimate bottom. Looking at those purchases today, the November buys are of course doing well, but the September purchases are about even. Remember, these are large companies as outlined in the top of the Asset Allocation Model. Our Franco Nevada position is doing well; as the best royalty company for gold and oil, it is difficult to think of a better long-term buy-and-hold than that company.

At the beginning of the summer I expressed that we would see a “normal” summer, which meant a broad trading range for the precious metals sector. I am well aware that we have a few more weeks before summer ends officially, but it will end before the October issue. We are going to examine the longer-term trends and then make some forecasts.

Big Picture - Bumps Ahead!

As stated earlier, I was concerned with the macro picture of the global economy going into summer last year and it seemed very few others were concerned with the “rollover” of loans and derivatives coming due one year from the first major warning in August of 2007. In other words, I was deeply concerned that we could see a major move down in the entire financial sector in the August to September timeframe. Well, as we all know, that is what occurred, but it carried on into November. Now we come into the same season and quite frankly I fear that this time may be even worse than last year.

The Fiscal Year 2009 Financial Report of the United States Government is required to be submitted September 30, 2009. My thinking is that anyone who truly understands finance and compound interest will readily see just how difficult it will be for the U.S. to ever dream of meeting many of the obligations that it has promised its citizens, foreign governments, and others. To me, this may be the moment of truth.

Earlier in the year, the Financial Accounting Standards Board (FASB) allowed many institutions in the U.S. to bend the rules in order to preserve the economy. We know, however, that only by a clear assessment of the truth—or in this case, true financial picture—can we determine where we stand exactly and what can be done to address the problem. By allowing the accounting rules to be changed by bowing to congressional and financial industry pressure, many financial firms were given “flexibility” in valuing toxic assets. This was expected to boost bank earnings and improve their capital levels.

And the FASB voted unanimously to let banks exercise “more judgment” in using mark-to-market accounting that has forced billions of dollars in write downs and been blamed for worsening the recession.

Now beside the Federal Government, many financial firms are going to report at the same time, and perhaps this time, the mark to market will be more accurate. In other words, I expect to see the markets react to reality as the reports are issued this time. The largest money center banks are too big to fail—JP Morgan, Bank of America, Wells Fargo, and Citigroup. These banks hold about half of all mortgages and two-thirds of all credit card debt.

To fully understand the real situation, we can divide the economy into three main areas. First, the real or physical economy—this is your farming, mining, real estate, manufacturing and wealth creation. In other words, where real goods and services take place. For the United States, this part of the economy has been on a decline for quite some time as the manufacturing base has been moved outside of the country. Certainly new innovation and products are being invented and brought to market in the U.S. and elsewhere all the time, but on a broad scale the trend has been down and many Americans have been displaced by foreign workers.

I cannot emphasize this part of the economy enough, as this is the real world and it is what every human on the planet is truly dependent upon. As the physical economy goes so goes the wealth and well-being of the vast majority of the people on the planet.

Now there are two other markets that are supposed to reflect the physical economy. The first being the financial markets, which is the stock market generally. This is where investors can become partial owners of business through stock purchases. The financial markets reflect the real economy but like all financial assets at times, this market (stocks) can be undervalued, fairly valued, or overvalued.

And we also have the money markets—this is the money supply measured in a broad sense by money in circulation and credit extended by loans. Think M3 or the broadest measure of money and credit.

What is actually taking place is that the money supply is climbing rapidly, while the financial market has already put in its peak and is falling. Yes, we have had a good bounce but the major trend is down, because sooner or later the equity market does reflect the true economy.

So, the physical economy is going down in the U.S., the financial markets have acknowledged this fact, and the authorities are trying to paper over the whole problem as if this can help.

Thus in a concise way, as much as some (mostly Wall Street) have “enjoyed” this recovery, we have based it upon fudging the truth. Once the real numbers come out, most likely in early October we may see the financial markets react in a very big way.

What will add credence to this outline is the breakdown in social services that even the most unaware Americans will be forced to recognize. As social services are cut back, schools become overcrowded, prisons release inmates early, and states go broke, the reality of the physical economy will reach nearly everyone. In our view, this is a watershed moment just ahead and we need to prepare our thinking.

This is what I expect, yet markets can surprise any of us. If the stock market were to start selling off in October (as I am suggesting), the bigger question for us is how will the precious metals react?

David Morgan