Special Report

Intensely Curious. Focused on Facts

The Good, Bad, and Ugly:

Outlook for the Economy
by David Galland

Following our Energy & Special Situations Summit in Denver last fall, I sat down with Casey
Research Chairman Doug Casey, Chief Economist Bud Conrad, Senior Researcher Jake Weber,
and Alex Daley, editor of Caseys Extraordinary Technology, to recap and review our assumptions
and conclusions about the outlook for the economy and investments.

On returning to the office, we followed up on our long and productive meeting by flushing out a
number of missing data points and digging further into areas where our conclusions seemed to
need challenging.

Finally, I gathered the elements of our discussion and subsequent research into a working docu-
ment that identifies the good, the bad, and the ugly economic outlook.

Please note that this is by no means a particularly deep analysis into the multi-faceted economic
issues facing the world. That would take a book. Instead, the overarching purpose of our discus-
sion in Denver, and this follow-on report, was to look for flaws in our analysis and logic that
would cause us to alter our deeply pessimistic view on whats next for the U.S. and, by extension,
the global economy.

We hope you find it of value.

David Galland

Managing Editor
The Casey Report

www.caseyresearch.com
 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

The Good
Agriculture the U.S. is self-sufficient in food and a major exporter. One way of thinking about the U.S. agricul-
tural trade is that the U.S. imports luxury food e.g., out-of-season fruit and fine wines and exports survival food, e.g., wheat,
rice, chicken.

Food imports into the U.S. rose 90% between 1997 and 2007. Much of that growth is easily explainable as a combination of
trade liberalization and a population feeling increasingly wealthy and spending more on a diverse diet. In the peak years of the
recent bubble, 2005 and 2006, the balance between agricultural exports and imports approached equilibrium, with an annual
surplus in favor of the U.S. of only about $4.5 billion the lowest U.S. agricultural surplus since the early 1970s. In 2007, how-
ever, the surplus more than doubled again and in 2008 ballooned to $36 billion the highest on record. And the record goes
back to 1935.

Agriculture is important, as it gives the U.S. one less potential national security issue to worry about, and it offers the coun-
try useful leverage with trading partners such as China that are not self-sufficient. But the fact that it represents only about 1%
of U.S. GDP means it cant be counted on to provide any real juice to the future economy, if youll excuse the pun. That said,
should the dollar weaken, as we expect it to, then the U.S. agricultural sector will be a big beneficiary.

The U.S. is an established technology leader. Technology is an important component in virtually every business in
the U.S. and increasingly around the world. In addition to the obvious areas of computers and telecommunications, the heavy
reliance on technology in sectors like health care and manufacturing (among many others) makes technology by a wide mar-
gin the single most important segment of the U.S. economy.

The good news is that the U.S. is the reigning champion of high tech. For instance, of the top ten software firms in the world,
eight are U.S. based. Software is the value driver of tech and its most profitable component.

It is also encouraging that U.S. institutions of higher learning dominate global rankings, holding the top ten slots, drawing stu-
dents from around the world. More on that in a moment.

While the U.S. still leads in spending on Research and Development, in-
vesting well over $330 billion in R&D in 2006 compared to the second-
place Chinese, who spent $136 billion, the U.S. share of global technology
exports has fallen over the last decade.

In recent years, the Chinese and Indians have been making noise about
moving up the value chain in technology and manufacturing, and history
supports that this path is natural (think about the difference now vs. as late
as even the 60s, when seeing a Made in Japan tag prompted laughter).
They have supported the noise by increasing year-over-year R&D spend-
ing since 2000 by 19% and 11%, respectively, compared to a 4% annualized
spending growth in the U.S.

While it is unlikely that any other country will catch the U.S. on the tech-
nology front at any time in the foreseeable future, as the chart above from
the OECD shows, the U.S. is beginning to fall well behind the Chinese, Ko-
reans, Japanese, Europeans, and others in the number of science and engi-

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

neering degrees being awarded. Though, to be fair, in many cases the engineering degrees awarded in third-world countries are
more akin to high school diplomas.

That is not the case with 38% of all science and engineering doctorates awarded in the U.S. that go to foreigners, with more
than two-thirds earned by students from Asia. In one recent poll, only 6% of Indian and 10% of Chinese students attending
U.S. universities said they planned on staying in the U.S. for any more than a few years after graduation. Instead, these students
are increasingly likely to take their degrees home, where theyll leverage them into jobs assisting in more and more liberalized
domestic enterprises. (And, perhaps, reverse engineering U.S. technology as soon as it is released?)

Should this trend continue, the U.S.s current advantage in technology must erode over time, though not anytime soon.

(Interested in participating in tech, now the single most important sector of the U.S. economy? Check out Caseys
Extraordinary Technology. Click here.)

The U.S. dollar is the worlds reserve currency. Since Bretton Woods in 1944, the U.S. has enjoyed a remarkable
competitive advantage (and political leverage) from the U.S. dollar being used as the de facto reserve currency by central banks
around the world. It is simply the worlds trade currency, with most commodities being priced in dollars.

Foreigners are attracted to our new ideas and creativity. No matter where you go in the world, you will find iconic
reminders of the United States creative leadership, at least in those ideas that can be readily mass marketed. Whether it is Don-
ald Duck sippy cups in a road-side kiosk in southern Patagonia or bootlegged Hollywood blockbusters on the streets of Shang-
hai, people around the world even those vocally opposed to American foreign policy, such as invading backward countries
have a peculiar fondness for all things American. This is good, no question about it, because it helps U.S. companies generate
revenues through exports. Unfortunately, as you can see from the table here, U.S. exports are off across the board, and by no
small amount. Interestingly, of all the subsectors of our export industries, the handful not suffering serious losses include sheep
meat and weapons.

U.S. Exports of Domestic Merchandise (in $ millions)

Absolute Percent Change

Item 2007 2008 2008 YTD 2009 YTD Change YTD YTD
2008-2009 2008-2009
Agricultural Products 94,541 119,762 111,343 92,102 (19,241) -17.3%
Forest Products 32,823 35,073 32,657 27,633 (5,024) -15.4%
Chemicals and Related Products 169,623 189,569 177,951 151,727 (26,224) -14.7%
Energy-related Products 36,401 66,778 63,015 43,307 (19,708) -31.3%
Textiles and Apparel 16,347 16,146 15,166 12,233 (2,933) -19.3%
Minerals and Metals 94,305 112,414 105,194 76,560 (28,634) -27.2%
Machinery 122,392 133,699 123,723 93,925 (29,798) -24.1%
Transporation Equipment 202,165 201,986 187,067 138,513 (48,554) -26.0%
Electronic Products 169,757 171,092 158,535 121,701 (36,834) -23.2%
Miscellaneous Manufacturers 70,753 82,104 77,288 61,168 (16,120) -20.9%
Special Provisions 37,253 41,201 37,994 30,496 (7,498) -19.7%
Total 1,046,360 1,169,824 1,089,933 849,365 (240,568) -22.1%
Note: YTD figures reflect January through November

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

U.S. capacity utilization is low. Between 1972 and 2008, average factory utilization in the United States was 80.9%. Just
over a year ago, in December 2008, factory utilization was 72.7%. By June of 2009, the number had dropped to 68.3%, the
lowest level in decades (the last time we got even close to these levels was in 2001, following the dot-com crash when the low
reached 73.5 in December of that year). At the end of 2009 capacity utilization picked up somewhat and stood at 72.0% in De-
cember. What this means, of course, is that U.S. factories are significantly underutilized and therefore, if the economy turned
around, should hypothetically be able to quickly pick up the slack without adding to the inflationary pressures caused by con-
strained supply. That there is also a large pool of potential employees for these factories is another positive, as that should help
keep wages down as prosperity returns.

The flip side, of course, is that the cost of manufacturing in America and mining and resource extraction fits into this cate-
gory is far higher than in other parts of the world. And its likely to get considerably higher still with the wave of new taxes,
pro-union legislation, punitive levies for carbon emissions, forced health care, etc., etc., ad infinitum as the government pur-
sues a perfect-world agenda with little regard for the costs. Money has a well-established habit of going to where it is treated
best. Thus, as we have already seen writ large, entrepreneurs may very well decide not to reopen or restaff their U.S. factories
but continue to shift overseas to more business-friendly jurisdictions, with markets that are less tapped out than the U.S. con-
sumer. Both GM and Ford have announced intentions to open new factories in China, and Fisker Automotive, which just re-
ceived a half a billion subsidy from U.S. taxpayers, will be manufacturing its electric automobiles not in Detroit but in Finland.
So much for handouts and bailouts creating U.S. jobs.

This firmly entrenched trend is likely to continue, unless of course the government, encouraged by the unions, decides that it
shouldnt at which point steps may be taken to interfere with international trade, for example levying tax penalties on foreign
direct income, implementing exchange controls, or adding tariffs on foreign-made goods. The recent decision to hit Chinese
tire manufacturers with a punitive 35% tariff provides a useful straw in the wind. The most likely form of trade war, however,
will be fought with competitive currency devaluations, a big positive for gold.

The American spirit. This is one of those intangibles that are hard to quantify, but we include it as a positive nonetheless.
Like someone raised in an affluent home, Americans have a widely acknowledged expectation of better things to come, and
a can do attitude that helps them in periods of adversity. Well, at least some Americans. As you can see from the table here,
while 45% of Americans now believe that the government is overregulating business, when you break that number down by
political affiliation, you find that the controlling party, the Dem-
ocrats, see things a lot differently. In general, do you think there is too much, too little, or about the right
amount of government regulation of business and industry?
Even so, the odds favor that, over time, the U.S. governments By party ID
overreaching will trigger a political backlash that should swing % Too Much % Too Much Change
September 2008 September 2009
the pendulum back toward a more pro-business and pro-capital-
istic stance. Ultimately, humans act in their own best interest Total Sample 38 45 7
and this is a cultural norm in the U.S. Since it is in no ones inter- Republicans 56 70 14
est to tax and regulate the productive elements of society to the Independents 38 50 12
point that they become unproductive, sooner or later there will Democrats 23 21 -2
be a change. Gallup Poll, Aug 31, 2008 - Sep 2, 2009

Supporting that notion, in the German elections in September

2009, against much the same background of economic crisis, a political coalition successfully formed around the issue of cut-
ting taxes and deregulating labor markets.

As stated at the beginning of this article, this is not meant to be a comprehensive tally, but rather a relatively fast-moving review
of the U.S. economys status quo. There is much more that is good about America, which gives hope for a relatively speedy re-
covery.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Flexible employment laws in the U.S. Compared to many countries in the world, U.S. employers have much more
flexibility when it comes to laying off workers. As soaring unemployment rates prove, theyve been exercising that flexibility a
great deal of late. According to the Bureau of Labor Statistics, in the twelve-month period through November 2009, U.S. busi-
nesses were responsible for just shy of 30,000 mass layoff actions, reducing payrolls by more than three million workers, a sig-
nificant erosion from the prior years 20,700 mass layoffs involving about two million workers. Year-over-year total unemploy-
ment in the U.S. rose by better than 33% in 2009. And total unemployment is up about 100% since December 2007.

Going into the crisis, unemployment rates in the

more restrained EU were significantly higher than
in the U.S. No surprise there, because of the gen-
erous social safety net and because European
businesses diligently try to avoid hiring people.

As you can see from the chart here, in March

2009, unemployment rates in the U.S. and Euro-
zone intersected. Since that time, both have con-
tinued upwards, but the steep U.S. trajectory has
taken our rates higher, to 10%, while the EU is at
9.5%.

The good news, if you can call it that, is that U.S. businesses have been able to improve their bottom lines and therefore their
odds of survival through aggressive and sharp cost cutting, much of it at the expense of their employees. And at the expense
of taxpayers, who are now footing the bill for unemployment benefits for 10 million people, an increasing number of which are
living off extended state and federal benefits.

Even so, the key point here is that, in addition to the quick cost cutting we have seen, we should also see a quicker return to ag-
gressive hiring than in the EU and elsewhere, once the recovery materializes. Until then, the horde of unemployed will contin-
ue to pressure the economy.

The Transitory Good

U.S. interest rates are low. The U.S. government has gone Japanese, slashing its benchmark rate to the lowest in
generations. We list this as a transitory good, because it is low strictly as a result of government intervention, meaning, on
balance, it hurts the economy by giving false price signals.

In the short run, however, low interest rates can be helpful to certain segments of the economy, for instance, housing. Likewise,
they can lower pressure on those facing mortgage resets but not entirely, because most such loans include terms that call for
an adjustment up to market terms after an initial period when lower bonus rates apply. Even so, lower rates can reduce the size
of the adjustment, mitigating some of the pain.

Likewise, all things being equal, lower rates allow borrowers to access money at a lower price. The government believes this
will encourage a return to the good old days of shop till you drop, an attempt to kick-start a consumption-led recovery. Un-
fortunately, all things arent equal; banks have been steadily tightening lending requirements, proactively canceling lines of
credit, and closing credit card accounts.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Stepping into the breach, the government directly and indirectly through Fannie Mae, Freddie Mac, the FHA, and the Fed,
which has been the purchaser of last resort for many of those mortgages has been providing the funding for virtually all
home loans. This has largely negated the positive aspects of low mortgage rates by transferring the obligations to the U.S. tax-
payers at artificially low rates. Kicking the can down the road is an apt description of these efforts.

In addition, low rates discourage the saving required for the capital formation that is necessary for a sustainable economic re-
covery. And they rob those dependent on their investment yields of the cash they need to consume and, in many cases, to live
at a self-sufficient level, leading to increased reliance on the state for assistance.

Low rates can also benefit banks, reducing their borrowing cost and allowing them to earn a more attractive spread on loans.
Of course, you first need to have lending in order to boost your earnings. And as much as the government would like you to
fire up the credit card, its not happening. On September 8, 2009, the Fed released numbers showing that in July, U.S. consum-
ers cut their debt by the largest month-over-month amount since 1943, when records began to be kept. Annualized, consum-
er credit decreased at a rate of 10.5%. Since then, household debt has continued to decline. Data from the Fed shows that con-
sumer credit fell an annualized 3.2% during the third quarter compared to the second quarter. While the reductions have a
long way to go to chew through the $13+ trillion in outstanding consumer debt, the point is that consumers are very much not
clamoring for new loans but rather paying down debt and saving more, a distinct reversal from the go-go days of the bubble
economy.

As well discuss further on, the governments unprecedented stimulus and deepening involvement in the economy must in-
variably lead to higher rates, so we dont expect the positive of low rates to persist to the end of 2010. And once they start mov-
ing up, interest rates will quickly shift onto the ugly side of the balance sheet, pressuring consumers, homeowners, and busi-
nesses at the same time they contribute to a rising cycle of higher government deficits.

Cash on the sidelines. There has been a lot of talk about the amount of cash on the sidelines, mostly in reference to
the $3.1 trillion sitting in money market funds that now pay effectively zero. However, a further examination of the data
by The Wall Street Examiner concluded that the increase in institutional money market funds over the past couple of years
is tightly correlated to the decrease in institutional holdings of corporate paper, strongly indicating that the money is not
likely to be allocated to stocks. Especially not after the overblown stock rally since March 2009 that has pushed valuations to
unsupportable levels.

Meanwhile, individual money market holdings are now back at the levels of September 2007, which is to say that the cash lev-
els are at what should be considered equilibrium levels. There is, however, a big longer-term downside that more than offsets
the transitory benefits of cash being available to support investment and consumption: this same cash will, in time, contribute
to the virulent inflation we see coming down the road.

Dollar devaluation helps U.S.-based exporting

companies. Absent a trade war, a falling dollar, which
we expect, will enhance competitiveness for U.S. manu-
facturers, at least for awhile. The bad news is that exports
currently are responsible for only about 11% of U.S. GDP
and that we currently import almost 35% more than we
export. The cost of those imports will go up. Thus, a weak
dollar will cost Americans more than it gains them.

Personal savings on the rise. The fact that personal

savings in the U.S. are on the rise is good news because
until the citizenry stops consuming more than it produces
to wit, begins saving a sustained economic recovery is
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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

nigh impossible. Yet, for the purpose of looking over the horizon at whats coming over the next couple of years, the squirreling
away of savings is an unwelcome signpost, pointing to continued slow growth.

Historically, the personal savings rate in the U.S. has averaged around 10% of disposable income, a rate that plummeted to be-
low zero during the recent spend-a-thon. As you can see from the chart here, through November of 2009 the savings rate has
bounced back to 4.7%, and estimates are that despite low yields, it will continue to rise toward historic averages. At a 5% sav-
ings rate, consumers will spend about $600 billion less annually than they did at zero, and at 10%, this would keep more than
$1 trillion under the mattresses and out of the stores.

We dont see this trend toward greater savings as short-lived but as secular. For a couple of reasons, starting with an aging soci-
ety, 60% of which, according to a recent study by Harvard, has insufficient savings to cover even a modest retirement. Also, as
the crisis grinds on, the virtues of frugality are likely to regain a strong foothold in the psyche of the average American, much
the same way those virtues took hold in the minds of those who lived
through the first Great Depression.

The Bad
Debt is at a critical juncture and vulnerable to collapse.
The chart here presents the big picture for the U.S., showing the ex-
treme level of debt that brought about the bubble and is rapidly col-
lapsing in the private sector.

Where the blue line goes from here will determine our economic fu-
ture.
Government Debt Growth Overtakes Private

Behind the scenes, we find that an egregious growth in government $2,500

Annual Debt Private (Business + Household)
Growth $
debt is now masking a breakdown in the private sector. $2,000
Billions Government (Federal + State)

Government takeover of the economy. As you can see from $1,500

this chart, as private debt demand has fallen a rational expectation $1,000
.COM
in a bad economy the government has more than stepped up to the $500

plate to assume the borrowing and spending that the private sector
would have otherwise engaged in. $0

Copyright Bud Conrad Casey Research 2009 Q2

2009 rst half year doubled
-$500
1975 1979 1983 1987 1991 1995 1999 2003 2007
But that borrowing is really just a symptom of the much larger and
more important phenomenon of a bloated government driven by the
philosophy that more government, not less, is the solution to all that % GDP
U.S. Government Debt Will Explode
250
ails. Including, in the case of global warming, non-existing or exaggerat- Debt Held by the Public % GDP Debt/GDP
ed problems. 200
Alternative Fiscal Scenario

Source: Congressional Budget Office

While some will think this is all fine and good, the simple reality is that 150
The Long Term Budget Outlook June 2009 Will Grow to 800% by 2083

governments dont produce much of anything. That means, paying WW II

.COM
down the ballooning debt will require either further fleecing the citi- 100
Depression
zenry (and there is now rising chatter about a value-added tax (VAT)) Civil War WW I
or simply debasing the value of the dollars with which the debt will ulti- 50

mately be paid back. Copyright Bud Conrad Casey Research 2009

0
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 2030

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Given the public is approaching a breaking point on the whole tax thing or at least the 53% that still pay income taxes are -- it
is a shoo-in that the government will take the well-worn path of debasement to eventually handle its many obligations.

But therein lies the rub

Dependence on the kindness of foreigners. Over the past decade, foreigners have been the single most important
buyers of U.S. government debt. This came about due to unprecedented trade deficits, which provided foreign suppliers of
flat-screen televisions, cars, oil, etc., with a mountain of cash that they then recycled into U.S. Treasuries. They stepped up to
the Treasury plate for a number of reasons, not the least of which was to keep U.S. interest rates low, adding debt-driven rocket
fuel to an orgy of U.S. spending.

The net result is that foreigners now hold an unprecedented $7 trillion or more in U.S. dollar-denominated instruments.

Despite much evidence to the contrary, humankind is becom-

ing more informed with each passing web page. Buyers of long-
term U.S. debt now know the name of the game, and they are
increasingly refusing to play it. As a result, were seeing a clear
trend toward foreigners reducing their purchases of Treasury
debt and skewing their purchases toward the short end of the
duration scale.

A clear straw in the wind is seen in a chart from the excellent

folks at Zero Hedge, showing that foreign purchasers are con-
gregating exclusively around the front end of the Treasury curve. Which is to say, they are shifting their purchases of Treasur-
ies to shorter-term obligations.

To our way of thinking, this is the equivalent of grabbing your hat and coat and beginning the process of thanking your host for
the nice party but the babysitter is waiting and its time to go.

That leaves the government faced with the untenable position of having to constantly roll over its debt. To stick with the color-
ful analogies, picture a panel of celebrity judges at a televised talent contest. Uncle Sam is taking the stage, announcing with a
flourish of hands and in a deep voice that he plans on spending another $1 trillion for his latest harebrained scheme. With little
hesitation, the judges in this case, perhaps, from China, Russia, the Middle East begin hitting the red button, signaling that
the performance has failed to please and that higher interest rates will thereafter be called for.

Another implication of the shortening maturities is that it

becomes much harder for the government to inflate away
its obligations. Thats because the rates adjust much more
quickly as the short-term instruments roll over, meaning
the government will have to use even more inflation to get
the job done.

Of course, another possible outcome is that foreigners will

simply stand up and walk out. That appears to be what is
already occurring, based on the TIC flows, shown in the
chart here. TIC data follow the flow of foreign investments
into the U.S. As you can see, net foreign capital flows have
actually turned negative in recent months.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

And what, really, are the implications of foreign investors turning their backs on U.S. Treasuries? Julian Robertson, the retired
founder of Tiger Management, recently shared his views, which parallel many of our own, in an interview on CNBC. Heres an
excerpt from the article recapping his interview.

The US is too dependent on Japan and China buying up the countrys debt and could face severe economic
problems if that stops, Tiger Management founder and chairman Julian Robertson told CNBC. Its almost Ar-
mageddon if the Japanese and Chinese dont buy our debt, Robertson said in an interview. I dont know where
we could get the money. I think weve let ourselves get in a terrible situation and I think we ought to try and get
out of it.

Robertson said inflation is a big risk if foreign countries were to stop buying bonds. If the Chinese and Japanese
stop buying our bonds, we could easily see [inflation] go to 15 to 20 percent, he said. Its not a question of the
economy. Its a question of who will lend us the money if they dont. Imagine us getting ourselves in a situation
where were totally dependent on those two countries. Its crazy.

(You can watch his interview by following this link.)

The U.S. consumer is tapped out. Going into the crash, U.S. consumption much of it based on the wealth effect of the
housing bubble was responsible for over 70% of U.S. GDP and for no small percentage of the GDP of our key trading part-
ners. Thus, the return of the U.S. consumer to the shopping aisles is highly anticipated as a clear signal the economy is on the
mend. Unfortunately, no matter what data point you look at, the American consumer is tapped out. In addition to reduced
consumption of non-essentials, the poor financial state of the public means it will be a long time before we see a shift from
what consumption there is back into investments. That, in turn, affects one of the key building blocks of the economy: new en-
terprises and the jobs they create. Reviewing the current landscape, we find the following evidence that the American consum-
er is on the proverbial ropes

Credit card defaults are soaring. Delinquent balances on U.S. credit cards reached record levels and defaults surged
higher in December 2009, according to the latest Credit Card Index results from Fitch Ratings. The 60+ day delinquen-
cy rate reached an all-time high of 4.54% for the December 2009 index. This surpassed the previous high of 4.45% set
in June 2009. Chargeoffs crept up to 10.68% from 10.09% in the prior month but remained inside of the record high of
11.52% set in September 2009.

Bankruptcies are soaring. According to the American Bankruptcy Institute, there were 1,054,000 personal bankrupt-
cies in the first nine months of 2009, an increase of 33% over the same period in 2008. And thats despite the fact that
bankruptcy laws were significantly tightened in 2005. The impact on business was even more pronounced, with 45,510
businesses filing in the first three quarters of
the year, already eclipsing the full-year total of
43,546 in 2008. And 2008 was no picnic.

Household debt continues to be stubborn-

ly high. As you can see in the chart here, though
there has been some moderation in recent years,
household debt as a percentage of GDP remains
near record levels. This is an important chart to
watch, and we will be doing so in future editions
of The Casey Report, as an improvement in the
trend line will signify either one of two positives:
a reduction in household debt or an increase in
economic activity.
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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Retail sales still weak. This chart shows retail sales leading up into the bubble, the crash, and through November 2009.

As you can see, sales have definitely

bounced off the bottom, though they re-
main well below the 2008 peak -- on par
with the level experienced just prior to
the blow-off phase of the bubble. We view
the summer 2009 turn-up in sales with a
lot of skepticism due to the application of
liberal doses of stimulus, such as the Cash
for Clunkers program. After the Clunk-
ers program expired there was a notice-
able drop-off in car sales in the following
months, supporting the argument that
the program merely compressed into Au-
gust those sales that would have material-
ized in other months anyway.

Further, high levels of government deficit spending on stimulus efforts which we surely have not seen the last of -- send
confusing signals to market participants.

Using the August auto sales as an example, are we as investors, or even automakers, expected to believe that the sales surge
was for real and invest in car stocks or staff up? Not many will take that leap of faith. And so, instead, suspecting that the
surge was in direct response to government interference in the market, we ask, What industries will be favored next?
and How long will the government continue the stimulus, and to what degree? And, ultimately, What happens when
the government is forced to dial back the stimulus?

The uncertainty surrounding this sort of interference is hugely damaging to the structure of the market and risks prolong-
ing the crisis. As to the question of how long the government can keep the stimulus coming, well get the answer soon a
year or two at the most, as the administration is forced to fiscal restraint by either foreign dollar holders or resentful Amer-
ican voters.

Consumer confidence in the tank.

The December reading for the Confer-
ence Boards Consumer Confidence in-
dex came in at 53.6, a slight improve-
ment from the previous month. As you
can see in the chart, the index has been
fairly flat since May. Even so, it remains
about half of the historic average, and
well below the level of 90 that indicates
a sound economy.

Can the U.S. really have both a jobless and a

consumer-less recovery? We dont think so.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Destruction of the dollars purchasing power. If there is one thing a saver dislikes, it is inflation, as that erodes the val-
ue of their savings over time. In Zimbabwe, one can imagine, track shoes are likely in increasing demand, allowing recipients of
the local currency to hot-foot it even faster down the road to pass the stuff on for something, anything, more tangible.

Here in the U.S., elevated levels of government spending with promises of much more to come are laying a trap for the pur-
chasing power of tomorrows dollars. So far, the government has done a good job of funding its vigorous levels of deficit spend-
ing without having the average Joe, as well the average Mr. Chang, ducking for cover. How it has accomplished its funding is a
combination of sleight of hand, hard dealing, and outright inflation.

Beginning in March 2009, the Fed instituted a program to purchase $300 billion worth of Treasuries, a program that has just
concluded. In fact, the total of its purchases is likely much higher than that.

And thats just for starters; through its announced program to purchase up to $1.2 trillion in mortgage-backed securities, the
Fed bought virtually all of the $690 billion in new mortgage debt generated last year, as well as older vintages.

Perhaps because it was so extraordinarily large, the federal governments record fiscal 2009 $1.4 trillion deficit has been a pri-
mary focus of most investment analysts. But, what happens when much the same level of deficits or larger are racked up again
in 2010? And in 2011?

The writing on the wall for the future of the dollar is there for all to see, and it is highly legible. It is not a fluke, in our view, that
an increasing number of savers are adding gold to their portfolio mix today, keeping its price high despite all the talk of defla-
tion in the mainstream media. You might say that it is better to buy gold today than track shoes tomorrow.

Unemployment remains high. Earlier we discussed unemployment, and we hate to be redundant, so well skim over
this data point. We will stress, though, that the ratio of unemployed people to job openings was just over 6:1 in November, ver-
sus the normal ratio of 2:1.

In addition, state unemployment benefits typi-

cally run out after 26 weeks, and almost half of
the unemployed in the U.S. have been in that un-
happy condition for over six months.

So far, the American public has been remarkably

civil about its changed employment status, espe-
cially since it has forced many people to give up
their homes and chew through their retirement
savings. Should high unemployment rates con-
tinue to persist, however, the stopgap measures
to extend unemployment benefits have become
a critical lifeline for many. That sets the stage for
even more government handouts, stimulus, and
FDR-style work projects. All of this comes at
a price and that price will be soaring govern-
ment debt and, in time, a dollar crisis.

Banks in Trouble, Part I real estate problems are far from over. If you attended our recent Denver Summit, you
can skip this section because you already know whats coming and whats coming is not pretty.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Residential

As of September 2009, 1.6 million loans had recently entered the foreclosure process, on top of 1 million homes already in var-
ious phases of being foreclosed. One participant at the Denver show told us that friends of his living in a $1 million home had
not made a payment in over a year, yet had still not received any communications from the mortgage holder. This is confirmed
by a Wall Street Journal report that another 217,000 homeowners who have not made a payment in more than 12 months
havent even been contacted by the lenders.

Simply, whats going on is that the banks dont want

to foreclose, because every foreclosure means ac-
knowledging a loss, requiring the banks to find yet
more capital. In the current setup, thanks to the dis-
carding of mark-to-market accounting standards,
banks are able to obfuscate just how absurd their
balance sheets really are but they are only able
to maintain this fiction if the light of day does not
shine on the extent of their losses.

Regrettably for the banks and other holders of

mortgage paper (the Fed, for instance), the outlook for home mortgage defaults is rapidly deteriorating. As we prepared to go
to press, Bud Conrad sent over the following from the Office of the Comptroller of the Currency. And we quote:

Seriously delinquent mortgagesloans 60 or more days past due and loans to delinquent bankrupt borrowersrose to
6.2 percent of the servicing portfolio. Foreclosures in process increased to 3.2 percent, while new foreclosure actions remained
steady for the third consecutive quarter at 369,209.

Of particular note, delinquencies among prime mortgages, the largest category of mortgages, continued to climb. The percent-
age of prime mortgages that were seriously delinquent in the third quarter was 3.6 percent, up 19.6 percent from the second
quarter and more than double the percentage of a year ago.

Reviewing the OCC report, you find 12.8% of all mortgages are delinquent or in foreclosure. There are, according to the Fed,
about $11 trillion in household mortgages, translating into approximately $1.3 trillion in mortgages now on the skids toward
potential default. Which is to say, toward potential losses ranging upwards of 50% as banks turn around and dump the houses
back onto the weakened market, further suppressing home prices, putting yet more mortgage holders underwater.

While some percentage of the delinquent mortgages will be pulled back from the brink either by something changing in the
familys income picture or through restructuring by the lenders, supported by the government the big-picture outlook is not
good. As the economic crisis wears on and worsens more and more homeowners, especially those with resetting Option
ARM and Alt-A mortgages, will be forced to throw in the towel.

This will, at the current sales pace, rebuild inventories of existing homes, which were already at a 7.2-month supply in
December. The decline in housing inventories, while encouraging (the peak was 10.6 months in August 2008), can be
attributed to a combination of lower home prices, the government creating artificially low mortgage rates, and an $8,000
handout for new buyers that is currently set to expire at the end of April 2010.

Contrary to public perception, homeownership is not an investment but a persistent financial burden. As the rising number of
mortgage delinquencies show, in a financial crisis, that is a burden many will soon be shedding.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

And then theres commercial

Meanwhile, in the $6.5 trillion commercial real estate market, things are going from bad to worse. Manufacturing facilities,
condominium projects (especially those built in the 1970s to 1990s), hotels, housing developments, office buildings are all
overbuilt and, with only rare exceptions, underwater.

At our Denver Summit last fall, commercial real estate insider Andy Miller provided hard facts on the slow-moving train wreck
in commercial real estate. You can see this occurring in the following chart from a recent Deutsche Bank presentation that
shows the soaring levels of delinquencies in U.S. commercial real estate.

At this point, for the reasons men-

tioned above, lenders dont want Where we are at the end of Q2 2009...
to foreclose, and mortgagees dont 30-Day 60-Day 90+Day Delinquent Matured Loans Total (Rt. Axis)
want to spend any more money on 2.00 4.5

failed projects. Thus, you have an 1.75 4.0

Total Delinquency Rate

accelerating deterioration in the 1.50
3.5
Delinquency Rate

buildings. In Denver, Andy Miller 1.25

3.0

shared the story of a condominium 2.5

1.00
company that didnt want to spend 2.0
0.75
the $600,000 needed to replace its 1.5
leaking roofs, so the buildings are 0.50
1.0
suffering structural and mold dam- 0.25 0.5
age. In the end, when the banks are 0.00 0.0
forced to take possession, they will Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

be left with either expensive repair Source: Intex, Trepp

jobs or the cost of demolition and a

total write-off.

Commercial loans tend to be relatively short-term in nature, because there are no government programs to subsidize 30-year
commercial mortgages. Over $2 trillion in commercial mortgages will mature between now and 2013. According to that same
presentation, the authors expect that between 64.4% and 72.5% of the commercial loans now delinquent will not qualify for
refinancing.

There are many types of commercial real estate loans that live as balance sheet loans on the books of banks and as collateral-
ized mortgage-backed securities (CMBS) that stuff the portfolios of banks, insurance companies, hedge funds, and investors
of all stripes, both in the U.S. and abroad. According to Deutsche Bank, banks alone are sitting on roughly $530 billion in es-
pecially risky construction and land development loans, and another $1 trillion in core commercial real estate loans. Many of
them were written near the top of the market and are short-term in nature (3-5 years), meaning they will come up for refinanc-
ing in the next couple of years.

Meanwhile, the rate of office vacancies nationwide has risen to over 17% nationwide, up from 12.6% in January 2008. It is now
over 20% in cities from San Diego to Atlanta and many in between.

Banks in Trouble, Part II big loans in bad shape. On September 24, 2009, the four regulators issued a report on
the creditworthiness of Shared National Credit (SNC) loans. Those are loans of $20 million or more held by multiple, feder-
ally supervised institutions. The picture shows growing deterioration through the end of March 31, 2009, which is the time of
the data in the report.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

The loans outstanding of this category are $1.563 trillion,

so the quality of loans reflects a likelihood of greater losses in
the future. The losses are only $53 billion in the last year.

Banks in Trouble, Part III problem banks on the

rise.

Heres a snapshot of the safety and soundness ratings of the

nations banks, divided in tranches labeled A+ through F. Of
course, A rated banks are the soundest, with F being the
ones now sitting in the principals office nervously awaiting
whats next. The overall trend is clear.

$ Billions

$16,000
Banks Asset Quality Deteriorates
Banks in Trouble, Part IV the FDIC is in trouble,
too. At this stage of the game, the FDIC has tried to avoid
$14,000
F foreclosing on banks wherever possible in the 1987 down-
$12,000
D
turn, almost 1,000 banks failed compared to just over 100 this
$10,000 time around (so far). In addition to being poor for morale,
$8,000 .COM C widespread failures are sure to lead some to the conclusion
that we havent seen the worst of things, and that further gov-
$6,000 B
Bank safety and soundness ernment stimulus (read, deficit spending) will be required.
$4,000 ratings calculated by the IRA
Bank Monitor using the data A
from the FDIC
$2,000 Yet even before the ugly default chickens come home to roost,
$0
A+
the FDIC already has blown through its reserves and now
finds itself looking over its shoulder while shaking the piggy
Source: HTTP://WWW.INSTITUTIONALRISKANALYTICS.COM Copyright CaseyResearch.com 2009 bank upside down. The Deposit Insurance Fund decreasead by
$18.6 billion in the third quarter and the balance now stands at
negative $8.6 billion.

Lo and behold, for the first time ever,

member banks were required to prepay
their premiums all the way through 2012
in order to replenish the FDICs coffers
with another $45 billion, which of course
will be promptly distributed to depositors
of the next wave of banks sure to fail.

Can you say desperate measures? And

while youre at it, you might also want to
say desperate small banks, because many
of those are already holding on by a string,
a string that the assessment from the
FDIC may sever.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

In the final analysis, this road leads in one direction, and one direction only: another bailout. But this time for the FDIC.

Interest rates will rise. Interest rates are at the lowest levels theyve been at in generations. This is an important input, be-
cause it gives the government very little in the way
of policy tools to work with in its attempt to fix
the flagging economy. That is, other than spending
money it doesnt have and which it has no chance of
repaying (at least not in constant dollars).

Annual government deficits and total accumulat-

ed debt will pile up, then balloon out of control due
to accelerating outlays associated with baby boomer
demands on Social Security and Medicare. Lenders
are going to require higher and higher rates for their
purchases of government-issued paper in order to
offset the growing risk from inflation and even out-
right default.

The increase in rates can be somewhat orderly, or it

can be decidedly disorderly, should the foreign holders of an unprecedented $7 trillion in U.S. dollars decide to stay away from
the Treasurys auctions or even actively begin unloading their dollars. The one thing that is a near certainty is that interest rates
are going to begin heading north, though determining the exact timing at this point is still impossible due to another certainty:
the Fed will pull out every rabbit in its hat to try and keep rates low.

And rising interest rates are a big problem on many, many fronts. For example, they could trigger a self-propelling feedback
loop, raising the interest cost on the federal deficits, begetting more borrowing, begetting higher interest rates, and so on and so
forth until the word Zimbabwe begins to appear as an adjective describing the U.S. monetary situation.

Higher interest rates, of course, also result in a dampened enthusiasm for housing, more savings (an individual positive, but a
decided negative for commerce), and a push over the edge for variable loan holders.

How high might rates go? Impossible to say, until the spending stops, but double digits seem a fairly safe bet given the mone-
tary debasement already witnessed in the first round of the crisis.

Pensions in trouble. The Pension Benefit Guarantee Corp. (PBGC), a federal corporation think Fannie Mae insures the
pensions of about 44 million workers in a combination of single-employer and multi-employer programs. Before it stopped
publishing the data (Because of concerns about limitations with respect to the estimation process), the PBGC had estimat-
ed that pension underfunding in its single-employer plans alone was, as of December 2006, at $225 billion. Of course, that was
before the 2007-2008 market meltdowns that certainly will have worsened the situation. While pensioners will suffer modest-
ly, the ultimate loser will be taxpayers, who will fund the government bailout.

As an aside, according to the PBGCs 2007 Data Book, out of the 914 pension plans terminated in 2007, close to 70% were ter-
minated as a cost-saving measure, leaving that many more prospective retirees with little or no safety net. Other than Social Se-
curity, that is.

Meanwhile, the PBGC itself is broke, running a $33.5 billion deficit, the largest in its 35-year history.

Does anyone doubt that the government is going to have to step in to bail out the PBGC as well?

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Stocks are not cheap. We have done a number of stories on U.S. stock valuations, but will avoid repeating ourselves by let-
ting David Rosenberg pick up the story. Rosenberg is the highly respected chief economist of Gluskin Sheff respected be-
cause he was one of the few mainstream economists who saw the crisis coming.

On a reported earnings basis, we have a trailing P/E multiple north of 180x. On an operating earnings basis and looking at
bullish consensus earnings estimates, the forward multiple is 15.7x, which is actually higher than the 15x multiple at the mar-
ket peak in October 2007. So, while analysts say that the market must be priced on normalized mid-cycle earnings, well, we
have news for you, the S&P 500 is actually trading at peak multiples.

What about on a price-to-book basis? Stocks are valued at 2.4x, which is exactly in line with the average of the past four de-
cades. As the FT suggests, a fair-value price for the S&P 500, based on ROEs, P/Es and price-to-book ratios, would place the
equilibrium level for the S&P 500 right now to be 867, which means we do have potential for a 20% correction here.
(David Rosenberg, Breakfast with Dave, September 2009)

Our own Bud Conrad, who also foresaw the crisis, has done his own analysis that confirms Rosenbergs contention that while
stocks are not cheap, neither are they egregiously overpriced. In time, after the current realities of the economy reemerge and
make themselves known to Mr. Market by slapping him upside the head, well-run stocks in the right sectors should do quite
well at keeping up with inflation.

The Ugly
The following is a summary of some of the trends that could worsen and turn the bad news into very, very bad news.

Militarization of the U.S. Andy of Mayberry has been replaced by Duke Nukem as the U.S. police forces are increasingly
transformed into Homeland Security functionaries, decked out with the latest in combat garb and weaponry. Already, we the
people have been trained to quietly shuffle, shoeless, through airport security checkpoints, lifting arms for a quick pat-down as
required. Another event on the scale of 9/11 could push things over the top.

Too dramatic? Consider the following from Army Times

3rd Infantrys 1st BCT trains for a new dwell-time mission. Helping people at home may become a permanent
part of the active Army.
The 3rd Infantry Divisions 1st Brigade Combat Team has spent 35 of the last 60 months in Iraq patrolling in full battle rat-
tle, helping restore essential services and escorting supply convoys.
Now theyre training for the same mission with a twist at home.
Beginning Oct. 1 for 12 months, the 1st BCT will be under the day-to-day control of U.S. Army North, the Army service com-
ponent of Northern Command, as an on-call federal response force for natural or manmade emergencies and disasters, in-
cluding terrorist attacks.
this new mission marks the first time an active unit has been given a dedicated assignment to NorthCom, a joint com-
mand established in 2002 to provide command and control for federal homeland defense efforts and coordinate defense sup-
port of civil authorities.
(Gina Cavallaro, Army Times, September 2008)

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Move toward socialism. In a CNBC interview in May of this year, former Democratic National Committee Chairman
Howard Dean summed up the view of many in government when he said, and we quote Weve had quite enough capital-
ism the last eight years. I think we need some regulation now.

As noted in last months edition, total gov-

ernment spending as a share of GDP in 1900
was running at around 6%. Today, its just shy
of 40% and headed higher in a hurry.

Added to that drag on the economy is a bal-

looning body of laws and regulations, each
one administered by someone collecting
his or her check from the taxpayer, and each
costing the population precious time and
money in compliance. When the Federal
Register was first introduced in 1936 to keep
track of federal regulations, it consisted of
2,620 pages. In 2009, 69,676 pages were add-
ed to it. While a healthy percentage of the
population have come to recognize the scale
of government as a problem in and of itself,
power is in the hands of those who think
more, not less, government is the way forward.

In a serious economic collapse, which we rate a distinct possibility, the shift toward demands of government-engineered salva-
tion could increase.

Litigation nation. In 2008, according to Law360, class action suits rose by 8% over the prior year, to a new record high. An-
ti-trust suits rose by 27%. Suits on environmental issues, including those related to greenhouse gas emissions, were up. As are
suits against employers over terminations a trend very much in motion given the increase in economically motivated staff re-
ductions. Even the IRS is now shifting policies to favor litigation over settlement.

Our high lawyer-to-general-population ratio, the worlds highest by a wide margin, is an ugly reality associated with living and
doing business in the U.S. With poor economic conditions, it will only worsen.

Rising energy prices. You cannot expect to consume a finite commodity, light sweet oil, at better than 80 million barrels a
day and not ultimately begin to run short. Peak oil has moved from a theory to a fact, forcing countries to move down the qual-
ity scale and up the cost scale to tap heavy oil. Concurrently, the race is on for clean, alternative base load energy sources which,
despite their many virtues, also possess not so attractive aspects they are far more expensive and of limited impact for the
foreseeable future. Adding to the cost equation is a large body of new levies and regulations aimed at the dirty energy sources
of oil (especially heavy oil), coal, and nuclear. Ironically, those dirty energies provide the vast majority of the worlds base load
electricity generation. Bottom line: energy prices will keep moving higher. And, depending on how carried away the Obama
administration gets on the environmental issues, maybe a lot higher. Given the importance of energy to, well, everything that
means that the cost of pretty much everything will go up based on this one key input alone.

Trade wars. It has already begun, with the first shots fired by the U.S. with its Buy American provision in last years stim-

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

ulus package, and taken to a new level with the 35% tariff on Chinese tires. While the Chinese explore their alternatives, the
EU is piling on its own 40% tariff on Chinese steel. The Australians, meanwhile, are looking to legislate 15% maximum lev-
els of large public company ownership. Again, no doubt about it, aimed squarely at the Chinese. For their part, the Chinese
have been reasonably polite while increasing their efforts to use their latent purchasing power and a very large pile of foreign re-
serves to cut deals for much-needed resources with trading partners from South America to Africa. The thing about trade wars
is that once they kick off, they tend to spread and, as domestic beneficiaries get their snouts deep in the trough, become hard to
unwind. In the end, the losers are consumers, though as investors we can profit as artificial constraints on commodity supplies
are layered on top of physical limitations.

Black Swans
Black swans are unexpected but entirely possible surprises with the potential to cause serious disruptions to the economy,
and even society.

War. Of all the enemies to public liberty war is, perhaps, the most to be dreaded because it compromises and develops the germ of ev-
ery other. War is the parent of armies, from these proceed
debts and taxes... known instruments for bringing the many Top 15 Countries Military Spending in 2008
under the domination of the few... No nation could preserve its U.S. military spending accounts for 48% of the total world military expenditures,
or more than the next 46 highest-spending countries in the world combined.
freedom in the midst of continual warfare. James Madison, $800
$711

Political Observations, 1795. $700

$600

$500
($ Billions)

Despite Madisons thoughtful warnings about continual

war, the U.S. has been the only country in the world to en-
$400 .COM
$300
gage in war pretty much 24/7 since the turn of last centu- $200
ry, taking a brief breather between WWI and WWII, then $100
$122
$70 $55 $54 $41 $38 $31 $30 $25 $22
hopping almost directly into Korea, then on to Vietnam, $0
$17 $16 $15 $14

then directly, or through proxies, into a rash of smaller ac-

tions in Grenada, Nicaragua, Panama, the Balkans, Soma-
lia, etc. With a budget that literally laps that of the rest of Copyright CaseyResearch.com 2009
Source: The Center For Arms Control and Non-Proliferation

the world and troops in over 130 countries, were good to

go like no one else.

Of course, throughout history, poor economic conditions have led to war. While one might think that with Iraq and Afghani-
stan still ongoing, well resist any new actions, that may be a false hope.

Iran continues to present what may be the most likely, and U.S. Military Expenditures

the ugliest, swan in this area. An attack by Israel on that $800

country could quickly result in virtually unstoppable re- $700

taliatory strikes involving dozens of shore-to-ship missiles $600

against the U.S. Navy flotilla in the Persian Gulf. Faced $500
War Supplemental

with a loss of American lives equal to, or even exceeding,

($ Billions)

those in Pearl Harbor, a fresh long-term military engage-

$400
.COM
ment in the Middle East would kick off with nary a pro- $300

National Defense Budget

test. It almost goes without saying that, should such a war $200

break out, oil would quickly be trading for multiples of $100

where it is today. $0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: The Center For Arms Control and Non-Proliferation, February 2009 Copyright Casey Research 2009

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

Meanwhile there is the simple reality of a very expensive military to contend with.

Derivatives. What can one say about derivatives, except that taken at their face value, they amount to over $600 trillion.
Oh, yes, and few people actually understand them. That is less so with credit default swaps, relatively straightforward contracts
used to insure against loan defaults until you consider that this form of derivative alone comes to $60 trillion which is pret-
ty close to the total wealth of the global economy. Could the world wake one morning to another derivative blow-up la AIG
and Lehman Brothers that risks taking down the financial system? Absolutely.

End of the dollars hegemony. This is a topic weve discussed at some length in The Casey Report, so we wont dwell
on it again here, even though its an important one. While a seismic shift in the reserve status of the U.S. dollar still has to be
viewed as a black swan, the talk of replacing the dollar as the worlds reserve currency appears to be gaining steam. Bloomberg
had to say the following about it:

Sept. 30 (Bloomberg) -- The U.S. dollars share of global currency reserves fell in the second quarter to the lowest level since
the euro was introduced in 1999, an International Monetary Fund report showed.

The dollars share dropped to 62.8 percent in the period ended June 30, from 65 percent the prior quarter, the IMF said today.
The euros share rose to a record 27.5 percent from 25.9 percent. Holdings of British pounds gained to 4.3 percent from 4 per-
cent, and the yens share increased to 3.1 percent from 2.9 percent, the IMF said.

For the American currency, it was the lowest amount held by central banks worldwide since 1999, when Europes common cur-
rency was first issued and the IMF started releasing quarterly figures. World Bank President Robert Zoellick has cautioned U.S.
officials not to take the dollars leading role as the main reserve currency for granted.

The dollar today, of course, remains the predominant reserve currency, but nothings guaranteed, Zoellick said yesterday in a
Bloomberg Television interview in Washington.

There are many implications to the end of the dollars reserve status, but none of them particularly good for the United States
and, during the transition, probably the world.

9/11 redux. In addition to the loss of freedoms mentioned earlier, the impact of another 9/11 event could strike deep into
the heart of the worlds economy. Even a small nuclear bomb going off in some city on the other side of the globe would be a
game-changer and would most certainly be followed by a literal shutdown of global trade.

The 50,000-Foot View

Despite the generally dire topics discussed, the meeting in Denver was punctuated with periodic outbursts of laughter. Many
of those were associated with what became something of a running joke. You see, as we talked through each of the important
influences on todays economy, looking for any prospective developments that could offer a ray of hope but finding none, in-
variably someone would pipe up, No hope on this one, were screwed.

Theres something to be said about the contention that people tend, by nature, to be either optimists or pessimists. And there
is no question that people like to hang out and work with people of like mind. That, of course, opens the door to the possibility
that we here at Casey Research are a negative lot, and that our shared natures skew our analysis.

Yet, by stepping back to take a 50,000-foot view the purpose of our review a clear and, at least to us, compelling picture be-
comes apparent.

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

And that picture is of a highly dysfunctional government, working in close concert with rent seekers from Wall Street and
Government is the answer constituent groups, attempting to manipulate the economy in ways they find acceptable. Starting
by trying to spend the nation out of the way of the runaway train that began heading down the tracks decades ago when pol-
iticians first discovered that the secret to getting reelected was to promise a chicken in every pot and to use the power of the
printing press to kick the nations problems forward to the next generation.

Of course, none of this would have been possible if the nation hadnt first abandoned the gold standard (or any standard, for
that matter), as that freed the politicians to liberally spend on all manner of schemes they believed at any given time to be polit-
ically expedient.

Unfortunately, the rolling pile of problems has now grown so large, and so intractable, that the only real hope for a sustained
recovery is for the current crop of politicians to commit political suicide by dramatically scaling back government spending
while stepping aside to let unfettered markets administer painful therapy for the massive dislocations that have built up over
time.

We all know that this is not going to happen. In fact, the exact opposite is occurring with more government and more regula-
tion now entrenched in policy. And the situation is made even worse by a lack of transparency; in the portfolios of the banks, at
the Treasury, behind closed doors at the Fed, and at all levels of government leading to even more uncertainty and confusion
throughout the economy.

Call us pessimists if you wish. But no matter how we look at the situation, theres only one logical conclusion an investor can
draw.

Were screwed.

What Can You Do to Protect Yourself

Some of the key themes uncovered provide what may be useful insights as to likely investment actions.

Taxes are going up. Tax-advantaged investments, such as they are, will be in high demand.

Dollar depreciation is a certainty. Tangibles of all varieties will be sought-after, from precious metals, to oil, to (in
time) real estate and common stocks of well-managed companies. Physical gold and silver will grow in popularity
and their prices will rise, roughly in proportion to the depth of the monetary crisis.

Bonds are a triple threat to your capital. From dollar depreciation, default, and rising interest rates. If you own
them, sell them. And if you have a taste for risk, consider shorting them.

Interest rates are going up. Inverse interest rate instruments and even futures markets, carefully managed to limit
risk, are obvious candidates for investment.

Technology and agriculture are good plays. These play to Americas strong suit.

U.S. companies with strong global revenue will do well. With American consumers tapped out, growth is likely

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 The Casey Report The Good, Bad, and Ugly: Outlook for the Economy

to come overseas. With a weakening dollar, internationally diversified companies will also benefit from currency ex-
change.

Banks are in for a difficult time. Make sure you keep deposits within the limits of FDIC insurance. Consider short-
ing bank ETFs.

Commercial real estate is toast. If you are risk-tolerant, consider shorting, but be careful about real estate REITs
versus individual companies, as the portfolios of REITs are less transparent and hold paper of varying quality and du-
ration, some of which may ultimately be supported by government guarantees.

The hotel industry is in trouble. The overbuilding in the hotel sector, a subset of commercial real estate, has been
extreme, yet individual stocks have rebounded strongly from their post-crash bottoms. These are very susceptible.

Exchange controls likely. The wealth trap of exchange controls will become more likely when the crisis deepens,
as the government attempts to prevent an exodus of money to friendlier climes. If you are considering moving funds
out of the country, it is best to do it sooner rather than later.

No Matter How Ugly It Gets

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