The history of the dollar is one marked by a dominance unrivaled in history. Following the Bretton Woods Agreement of 1944, which established the dollar as the global reserve currency, Americans have enjoyed an era of unprecedented wealth and prominence.

The impressive growth in America could not have occurred without a stable dollar. Stable currencies are the unheralded but undeniable foundation of any vibrant economy. Stable currencies allow for longer term transactions and help instill confidence in the public, which is critical, since the value of any fiat currency is ultimately a function of public confidence.

Assets are continually revalued against one another in an ongoing process to determine proper valuations. Investor preferences move in big waves, from paper assets to hard assets. The decades of the 80's and 90's were clearly periods when paper assets such as stocks, bonds, and derivatives performed exceptionally well. That era of paper wealth is gone for now, as evidenced by the mass failure of financial institutions last fall, and we have entered into a period when hard assets are in vogue.

The Dow to Gold ratio is a useful tool to track this process of asset reallocation, since gold is the ultimate hard asset. Usually, when hard assets enter into a bull market, the Dow to Gold ratio goes to under 5. For example, the ratio hit 1 in 1896, 2 in 1932, 3 in 1974, and 1 again in 1980. The current bull market in gold has brought the ratio from a high of 44 in 1999, to its current reading of 10.

In addition, there seems to be a tendency for the ratio to "overshoot" on the downside based on how overextended the ratio becomes. For example, an 18 Dow:Gold ratio eventually fell to 2 in 1932, and a 27 Dow:Gold ratio eventually fell to 1 in 1980. Considering that the Dow:Gold ratio was at 44 prior to this move, it looks like we still have a long way to go on the downside.

Moving forward, the most critical indicator of the viability of our economy will be consumer spending. Simply put, without a buoyant consumer, there will be no recovery. Due no doubt to the negative characteristics of consumer data, the death of the consumer is receiving scant coverage.

America is a nation whose growth in recent decades has been predicated on a model of consumption. From a nation that used to save to invest, we now borrow to consume. As buying power in Treasuries from foreign entities wanes, we will be forced to fund our consumption through currently non-existent savings. An increased savings rate will put pressure on consumption, which will in turn pressure GDP.

In the following chart, notice how consumption as a percent of GDP remains above historical norms. Consumption would have to contract another $800 billion for personal consumption expenditures as a percent of GDP to revert to historical levels.

If there's one thing you can bank on, it's that the public will be controlled by emotional whims rather than rational judgment. I do my best to lay out the facts, and whenever possible, support my claims with hard data. When the characteristics of the the data change, my outlook will as well.

Until then, I will report things as they are, not as I want them to be.

With the S&P closing above 1000, more and more people are convinced the economy has bottomed and a new bull market is at hand. Apparently, the reflationary efforts of the Fed have been effective in supporting stock prices and keeping consumer prices steady. The mainstream media says good times are here to stay, and that monetizing debt to fund $2 trillion dollars in deficits will not have long-term consequences.

The truth is, monetizing debt has historically been inflationary, which is why I would perceive the S&P at 1500, 2000, or even 10000 as a sign of trouble. While on the surface the current rally looks impressive, the S&P should be viewed in real rather than nominal terms. The S&P is denominated in dollars, so the dollar's relative value against other currencies is of critical importance. Since peaking in March, the dollar has fallen sharply against the Euro. A look at the S&P denominated in Euros reveals a much less buoyant rally:

There's a widely held belief that the stock market is a leading indicator of economic conditions. While this relationship typically holds true, it was proven dead wrong during the Great Depression. After the crash of 1929, the Dow rallied nearly 50% to much celebration. At the time, some of the most respected economic minds were calling for the end of the downturn. We now know in hindsight that the crisis was only beginning. A comparison of the 1930 bounce, and subsequent decline, with the current rally suggests the worst is perhaps not over for stocks and the economy. In other words, the current rally is well in-line with a structural bear market.

The way human psychology works, confidence can turn on a dime and feed on itself. When the inevitable shift in sentiment occurs, I would not want to be long this market unless I was in gold, silver, or resource-related stocks. I expect sell-offs to be brutal, and strongly believe economic events in the next 6-12 months will destroy any hopes of recovery.

Behind the excitement over stabilizing initial and continuing claims data lies the truth: people still aren't finding jobs. Continuing claims were down in the last week, which was apparently cause for celebration. However, continuing claims only include those who have yet to exhaust their 26 weeks of benefits. Unfortunately, there is a quickly increasing portion of the population that has exhausted their benefits.

From CNN Money:

If I were a forecaster of economic trends and had access to only one piece of data, it would probably be demographics. The forecasting power of demographic trends is underappreciated even though cycles of booms and busts have historically mirrored the age characteristics of the population.

It's no secret that different age groups have different spending patterns. Younger people are a drag on economic growth since they consume a great deal but don't produce. In other words, they exacerbate inflation since they increase demand and reduce supply for goods. On the other hand, middle aged people are high earners, producers, and spenders. They tend to moderate inflation and prop up asset prices. Peak spending occurs on average at age 48. Spending patterns resemble a bell curve, so beyond this age, spending tapers as people save for retirement.

Looking at the chart below, we can see that the Gold to Crude Oil ratio can be used as a good proxy for investor sentiment. Notice how the ratio started trending strongly upward when Lehman collapsed along with stocks. It is during times of fear that gold becomes less of a commodity and more of a monetary metal.

As a slightly bearish factor for gold, declining open interest implies we may be in for some whipshaw action before gold really takes off. Also, stocks are showing weakness, which recently has precipitated a "safe haven" trade to the dollar. My firm belief is that money will start flowing to gold instead of the dollar in the next downturn, but only time will tell. Nonetheless, by keeping an eye on key indicators and waiting for confirmation to enter trades, you can be assured of being on the right side of the trade more times than not.

Disclosure: Long AUY

As you dip your foot into gold stocks, here are some things to look for:

Management: Yes management counts. Pick a company with a proven leader at the helm. Rob McEwen, current CEO of U.S. Gold, is one CEO that comes to mind. Using innovative gold-locating strategies, McEwen helped turn the failing Goldcorp into a global giant.

<<< Return to Part 1

Periodically in history, the expansion of credit creates the illusion of prosperity that ends in the inevitable bust. When John Law seemingly struck gold by introducing fiat currency in France, he was hailed as a financial genius. Four years and an economic collapse later, he was humiliated, shunned, and exiled.

Stocks look poised to correct further in coming days and weeks. Since the high of 956 was printed 2 weeks ago, the S & P has steadily trended lower. Volume has declined, and insiders are selling at the fastest clip in 2 years. The rising trendline has been broken, and MACD is turning negative, confirming a trend change.

Stocks have come quite a way since the March 6th low with no meaningful correction. After a brief stint above the 200 day MA, the S & P is back to testing both the 200 day and 50 day MA. It's critical that the S & P recapture the 200 day MA in coming days, otherwise there's a lot of downside potential. I expect a test of 850, and then 810.

It's pretty intuitive that recovery isn't possible without sustained improvements in the rate of unemployment. The most recent unemployment reading for May was 9.4%--bad yes, but a far cry from the 25% levels and soup lines we saw during the Great Depression.

Now let's dig a bit deeper into the data. The "official" unemployment rate that gets all the headlines is the U-3 rate. The extent that the U-3 captures what the average person would define as unemployment is dubious. Three important categories are left out: (1) people not actively seeking work, or marginally attached workers, (2) discouraged workers, or people who have given up looking for a job because of the perceived weakness of the job market, and (3) part-time workers who want full-time work but can't find it. These 3 additional categories make up the broader calculation of unemployment, or U-6. U-6 is currently at 16.4%.

Recent moves in gold, oil, bonds and commodities as a whole are clearly warning of future inflationary pressures and economic dislocations. In an already weak economy, rising inflation will quickly dampen any hopes of recovery. Remember: rising commodity prices in 2008 precipitated the historic collapse in stocks and asset classes as a whole. There is a fine line between rising commodity prices evidencing recovery, and rising commodity prices laying the groundwork for the next round of economic collapse.

In an environment where confidence is quickly collapsing, gold should be bought on dips. What detractors of gold fail to realize is that gold has still not captured the attention of the mainstream retail investor. Once this happens, I believe gold will double in price rather quickly much like it did in the last bull market of the 70's.