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VulnerabilitiesDavid Chapman But we were referring to the hurricane season for the stock market. Contrary to popular opinion, October is not the worst month of the year. September is. Since 1950, September has seen 19 ups and 36 downs. No other month comes close. There were particularly nasty Septembers in 2002 and 2003, as the market lost more than 10 percent each time. (Note: statistics here are based on the Dow Jones Industrials.) The market also lost more than 10 percent in September 1974. Indeed, those three Septembers rank amongst the worst months ever since 1950. There are no Septembers amongst the best months. September also saw a few sharp market losses before 1950. One memorable one was in 1946, when the market fell nearly 10 percent. The master 60-year cycle from 1946 remains a real possibility this year as well. The alternative might be from the 30-year cycle; 1976 saw a pretty flat September, and it generally maintained that through the rest of the year. That was followed by a rather nasty 1977. The same thing happened 100 years ago, where the market held in for the last quarter of 1906, followed by a financial panic in 1907. The San Francisco earthquake was in 1906, but its full economic impact wasn't realized until the following year. Could the same thing be happening now? We had Hurricane Katrina and the destruction of New Orleans in 2005. We had warned last year that the full impact of Katrina might not be felt until 2006, largely because the banks protected homeowners until roughly mid-year. Now that homeowners are no longer protected, the housing market has begun to slide. While that doesn't explain how a collapse in the Gulf Coast can impact Florida (which was also hit by hurricanes) and the California (fires?), the parallel is there. The housing slump now under way is being described by homebuilder Toll Brothers as the worst in 40 years. That is curious, because the slump of the early 1990s was certainly nasty and it accompanied a steep recession. And, lest we forget, that housing slump was triggered by very high interest rates at double today's levels. We were also starting from a higher level of unemployment as well. So how did the recent housing boom become so vulnerable? Quite simply, it had gone on for too long and was allowed to get out of control through the Federal Reserves easy monetary policy with a prolonged period of abnormally low interest rates and bank lenders falling over themselves to lend under any conditions. Lenders were even providing mortgages up to 110 and even 125 percent of the value of the home. We are now witnessing the second bubble to burst this decade. First the stock market in 2000, and now housing. The baby boomers (of which I am a leading-edge member) are about to learn some hard lessons about markets coming down as well as going up. Grant you, many of us have been talking about the vulnerability of the housing market for some time. But expecting or anticipating an event where the fundamentals never made sense is one thing; trying to figure out when it might end is another. Not surprisingly, we have heard numerous analysts proclaim that any market drop should be short and shallow. But these are the same analysts who earlier said either that the housing market would not burst because it was not overvalued; or that if there was a risk, it was low; and that the worst case was that the market might soften. We expect them to be wrong on all counts, because what is being ignored is the second vulnerability. Well over 50 percent of mortgages are now floating rate, and over the past several months their costs have jumped by some 50 percent. There is $1.8 trillion of mortgages coming due next year on top of the $1 trillion this year. All these mortgage payers are facing higher costs. Couple this with sharply higher energy costs, and consumers and homeowners are being squeezed. Homeowners have been using their houses like credit cards, racking up debt to consume both durable and non-durable goods. With falling house prices it is becoming a negative wealth effect. Consumers will be forced to curb their spending if they can. Lastly, a lot of employment is dependent upon the housing market. According to a report from Nouriel Roubini (Professor of Economics at the Stern School of Business at New York University) ("The biggest slump in US Housing in the last 40 years" - August 23, 2006) upwards of 30 percent of all jobs created in the US in the past three years were due directly or indirectly to housing. As housing prices fall below both the purchase price and the value of the mortgage, consumers will begin to walk away just as they did in the early 1990s. Already we are seeing a sharp jump in defaults and foreclosures. As the crisis grows, pressure will come to bear on the financial institutions that provided the financing. Banks and mortgage lenders have been lending with enthusiasm, and as usual they are over-loaned at the top of the market. There is a very high proportion of second homes - usually vacation properties, and condos and houses purchased purely for investment purposes. It is the owners of these homes who will feel the greatest pain, along with the many marginal purchasers who mortgaged their property to the hilt and are burdened with high payments. The days of "condo flipping" are ending abruptly. Because housing had become such a huge force driving the economy, it will also become a huge force in taking the economy down. Ownership of housing is far more widespread than ownership of technology stocks that busted in 2000, so there will be a correspondingly greater impact not only on housing prices, but on employment and on financial institution earnings. Couple this with already high levels of debt, high debt service ratios, low savings (some say negative), and real wages that have not kept up with inflation (except at the top end, where they have clearly exceeded the rate of inflation) and it should be no surprise that the next slump will be far worse then what we saw in 2001-02. The latest drop in consumer confidence is just the beginning. Slashing interest rates (as was done in the early part of this decade) will not be a cure either. The technology collapse and the fall-out from the events of 9/11 were much more isolated than a collapse in the housing market is. Housing is across the nation, in every community, and it is global - other countries have already had their housing bubbles burst. Others who have not yet been impacted (such as Canada, to any great extent as it has been skewed in a few large cities particularly Calgary) will follow as well. And since it is just beginning, it will probably not be until next year that we begin to see the full impact. How this plays out in the stock market is yet to be determined. But if the mortgage market is squeezed it will adversely affect mortgage-backed securities and other mortgage-related instruments, especially at firms like Fannie Mae and Freddie Mac (FNM/NY and FRE/NY). That in turn could impact the junk bond market and hedge funds. A number of hedge funds were forced out of business when the market fell last spring, and as hedge funds are squeezed they will need to sell their stock portfolios to raise funds to meet redemption demands that are sure to grow. And none of this takes into consideration the possibility of further war in the Mid-East. The countdown on Iran is under way, and as usual the Iranians are sure to reject the demands of the UN. Iran is a signatory to the nuclear non-proliferation treaty and thus has a right to develop nuclear facilities and enrich uranium. They have made it clear that they are not about to give up that right. At the moment the argument surrounds the enrichment of uranium, and here Iran has insisted on further discussions - a premise that has been rejected outright by some (US and Britain). Even Iran's supporters in Russia and China have tried to bring them to the table. It will therefore be virtually impossible to obtain agreement at the UN on sanctions against Iran. That being the case, the US and Britain will have to decide whether they want to go it alone. Limited sanctions will be of little use. That leaves only one course, which is to destroy Iran's nuclear facilities. The question is what pretext will be used to bring about that course of events, and, if it happens, what the response of Russia and China and indeed the world will be. We can't help but note Iran has been conducting numerous military exercises and they have been involved in a low wage war with their Kurdish population in the North near the Iraq border. A similar war has been going on in Turkey against their larger population. Both countries have been experiencing attacks from Kurdish rebels from Iraq as well. Russia and some of their Central Asian allies have also been conducting military exercises in the Central Asian region. On the other side there have been numerous stories in Israeli newspapers about Israel taking out the nuclear facilities on their own. The US has not ruled out attacks against Iran either. Israel and the US are on record as desiring regime change in Iran. All this tension, coupled with what could be a nasty fall in the housing market, should make the next two months interesting as the US heads into the mid-term elections. History does not favour the President's party particularly if the economy is showing signs of weakening. Over the last 21 mid-terms there are only three recorded gains for the President's party - although one of them was in 2002, under Bush. The other two were in 1934 under Roosevelt and 1998 under Clinton. The record of the market is quite mixed: leading up to the mid-terms, the market experienced 10 ups and 11 downs. After the mid-terms to the end of the year, the market fell seven times and was up 14 times. (Source: Stock Trader's Almanac 2006). Given the threat of the US falling into recession in 2007 as the housing market unravels, the thought that war could break out at the same time would only add to the problems. The US is already running a major budget deficit in the $300-$400 billion range, largely as a result of its defence budget, which is the world's largest, indeed larger than virtually every other defence budget in the world. The cost of the war in Iraq has already surpassed $300 billion. Another war would add billions more to these costs. At the same time, the US faces huge infrastructure costs. In the public sector the US faces estimated infrastructure costs exceeding $1.6 trillion over five years. This was highlighted by the failures seen when Katrina broke the levees of New Orleans, creating the biggest natural disaster in US history. The levees of New Orleans were long cited as being a potential major problem and highly vulnerable in the event of a severe hurricane. Pleas to fix the problem were ignored as funds were diverted elsewhere, primarily to defence and Homeland Security. None of this would be positive for the US$. Just as the housing market was overvalued, the US$ remains overvalued. Our chart highlights the potential huge head and shoulders topping pattern. A collapse of the US$ would of course be positive for gold and would start it on its trek to $1,000 and higher. Irrespective of any strength seen in the US$ or weakness in gold in the short term the long term trend for both the US$ and gold remains down and up. This overvaluation of the US$ cannot be underestimated, irrespective of short-term considerations. A falling US$ would force the Federal Reserve to re-examine its interest rate policy and may force the Fed to hike rates to protect the US$, even as the economy starts sliding. If the Fed instead decided to flood the system with liquidity to counter the threat of recession, that could still be negative for the US$ and could touch off a bout of hyperinflation as the financial system is flooded with funds. Not having the old measurement of M3 around any more, it will be difficult to ascertain just how much the Fed is providing. We are moving into dangerous times. As we have often noted, we are at the crossroads of several long term cycles including the well known four-year cycle in stocks, an 18-year cycle in stocks, the Kondratieff cycle for the economy and as well for stocks, and what may be a 72-year cycle that is characterized by major depressions such as we saw in the 1930s which was the possible last occurrence of the cycle. The next two months will begin to give us some sense of just how vulnerable we are. We are looking for a drop of roughly 20% in the major indices from today's levels for a low sometime into late October or early November.     Aug 30, 2006 321gold Inc |
