Echoing out from the halls of Washington and the glitzy offices on Wall Street can be heard the rules of the road for the citizenry, “Heads I win, tails you lose.” Sadly, the cheerleaders on CNBC would probably even put a positive spin on this. Historians are going to have a chuckle over the choreographed “deer in the headlights” approach the government took to forgive $Trillions in mal-investments by the banking system and incorporate them on the balance sheet of the country, and rewarded the perpetrators with the means to do it all again. America has not solved its financial problems; it has created even bigger ones. The country has increased its debt in the past year by $2 trillion in addition to a $9 trillion stimulus package. This has done practically nothing except enrich the banks as lending has all but dried up. The administration is desperately trying to stimulate consumers again into the familiar mode of borrow and spend – a hangover from which they have yet to recover. Historians will conclude that the U.S. could have avoided many years of suffering and sub-par growth if it hadn’t propped up failed institutions, mirroring Japan’s debacle. Debts are always repaid, one way or another.

Mort Zuckerman wrote an interesting and pertinent piece in the July 14th The Wall Street Journal entitled “The Economy Is Even Worse Than You Think”. Mr. Zuckerman’s observations about the sad state-of-affairs in the employment sector and President Obama’s misguided policies on job creation is spot on. The Bond King at PIMCO, Bill Gross, has also focused several articles on the lack of job creation as the single most important factor for any sustainable economic recovery. Many analysts, including AIC, have shared this opinion for some time. Stable, well-paying jobs (and not simply service sector jobs) are essential for a strong and sustained economy.

Since this recession began in December 2007 – nineteen months and counting - according to the National Bureau of Economic Research, the country has lost roughly 7 million jobs plus. The accompanying chart illustrates the Bureau of Labor’s previous method of calculating unemployment, which includes discouraged workers and under-employed workers looking for a full-time job. Other calculations put the actual rate of unemployment somewhere between 16% and 20% at this time. The “official” stated rate of unemployment currently stands at 9.5%, although few believe in the figure’s accuracy. Among job losses, manufacturing jobs, which typically pay more than service sector jobs, or downstream jobs, led the way. Corporations have continued to cut costs with increased lay-offs in order to meet Wall Street’s already lowered earnings expectations. Although reported earnings for Q2 2009 are better than expectations, earnings continue to contract on a year-over-year basis. For the majority of companies, revenue or sales (top line growth) continued to decline in the second quarter. Earnings improvements (bottom line growth) were achieved mainly through cost cutting efforts during the quarter. Achieving earnings through cost cutting - layoffs, inventory reduction, share buybacks, etc. are not long-term strategies for success, but temporary fixes. Everyone is waiting for the return of the consumer and the consumer is waiting for the return of the job.

Today, the U.S. has both outstretched hands in front of our Chinese bankers; however, China is growing disgruntled with the value of its dollar investments. Not only does their investments in dollars earn so very little but the purchasing power of each dollar is declining at an alarming rate with no end in sight. Our Treasury Secretary offers only flimsy rhetoric to China’s concerns: “We have [believe in] a strong dollar policy.” China isn’t biting – who can blame them? China owns some $1.5 trillion in U.S. Treasury paper and has curtailed purchases of further debt. Apparently, the rest of the world is doing likewise. Foreign purchases of U.S. securities have dropped from a peak of $95 billion a month in 2006 to just $7.4 billion in May 2009. This has caused the Fed to monetize the debt and, just in recent weeks the Fed purchased $38.5 billion of Treasury Notes.

As we have pointed out in previous letters, the role of the U.S. dollar as the world reserve currency is paramount to our standard of living. If China and other countries around the globe diversify central bank holdings (as they are increasingly threatening to do) away from dollars to SDRs (special drawing rights, which are a basket of fiat currencies used by the IMF) or to other assets, the dollar will collapse and cause interest rates to skyrocket. Any hope of economic recovery in the U.S. will abate. A stable currency is the necessary hallmark of a strong and lasting economy.

Whether the U.S. can stave off a Japan-style deflation by its unprecedented fiscal and monetary stimulus is yet to be determined. In our opinion, stagflation appears to be the natural course given the path this administration and the Federal Reserve are treading. Inflation is likely to occur, but growth will be muted with continued strain on consumer spending and job growth for some time to come. Arguably, given the unprecedented spending and further exodus from the dollar by world central banks, hyperinflation in the U.S. is a real possibility during the years ahead.

Although the market has bounced back nicely from the March lows, many headwinds for the economy and the stock market remain, notably - an unstable dollar; dropping state and federal revenues; weak exports; falling residential and commercial real estate prices; rising foreclosures; unreliable corporate earnings; a retrenching consumer; rising unemployment; unemployment insurance running out for many; plans to increase overall tax rates on households and corporations in coming years; capital gains and dividend tax changes coming in 2010; end of the stimulus package in 2011; encroaching government controls in the private sector, and fundamental changes in the way America saves and invests.

If the current recession were a “normal” recession then one could justify the market bounce from the March lows to date as something more than a “bear-market bounce” but it is not; it is The Great Recession with no historical precedence. Although it is somewhat frustrating, in hindsight, to miss out on the somewhat speculative recovery in stock prices since March, to reinvest a large portion of ones’ accumulated cash back into the market at this time we would have to assume that everything that has occurred in the economy since 2007 has been relatively insignificant – a temporary blip on the road to riches. We would also have to believe that there would be no material effects from the largest increase in the money supply we have ever seen. The monetary base increase in the past twelve months eclipses the sum of all increases in the country’s history. Likewise, that there will be no consequences from the rising delinquencies and foreclosures in the housing market -- not to mention, rising unemployment and its prolonged duration, commercial loans, etc. One other troubling aspect of the bear-market rally is volume. On the New York Stock Exchange, trading volume has declined sequentially in each month since March. The market appears, at least to this writer, to be moving up on pure momentum and speculation on the thought that all is well and that we will be returning to our previous state of over-indulgence; mostly everyone wants the recession to be over. We need more convincing.

With that said, the best defense against economic and market uncertainty is diversification, void of emotion, within an investment portfolio. Concentration of securities within a portfolio should focus on sectors that have demonstrated better relative performance during inflationary periods and companies that possess pricing power (the ability to pass along rising costs); low debt to equity, and cash flows sufficient to offer stable and growing dividends to investors. Historically, these sectors include: agriculture, commodities and precious metals, foreign securities, healthcare, materials, oil and gas, and technology. Although the unprecedented monetary inflating may not show up immediately in consumer prices, it will. Asset price increases in the year ahead, including stock prices, may well be more the result of a debasing dollar than a vibrant economy. That does not, however, mean that one is necessarily better off. It all comes down to purchasing power. Since the Romans’ first coinage, gold has been unmatched throughout history for maintaining its purchasing power. To help protect your purchasing power and standard-of-living from possible runaway inflation during the year ahead, AIC is increasing its recommended allocation to gold-related assets to approximately 15% to 20% of one’s total assets, up from 10% to 15%.

The overall market has regained approximately one-third of the downturn that began in 2007, representing a typical bear market rally. The market could still go higher but is, in our opinion, overbought in the short-term and over-priced in the longer-term relative to potential earnings.