Meltdown dead ahead?
David Chapman
October 25, 2004
We are always surprised at the complacency of the bulls in the
face of mounting evidence that may have got it wrong. Indeed
we have listened endlessly recently to forecasts of how we have
now survived through the worst month (September) and that traditionally
markets often bottom in October (although sometimes as late as
November) and then take off in the traditional late fall and
Santa Claus rally. They might still be right but that doesn't
mean they may not get a good Hallowe'en scare first.
But complacency is what we have seen of late with the VIX at
record lows while the indices were not even at the highs seen
earlier in the year. Even recent sentiment numbers in the mid
to high 50's and even low 60's suggests that the market was once
again becoming overly confident. Of late the economic numbers
while certainly not in the depressing range have been below expectations
(see leading indicators). And job cut announcements just keep
on coming the most recent from General Motors.
Grant you not all the job cuts with GM are in the US but still
when you realize that thousands of job cuts have been announced
recently beyond GM then there is a growing problem. The high
tech sector in particular has seen very high job cuts of late
with no particular up tick in new hiring. And it is being born
out by the recent employment numbers where the non-farm payrolls
came in sharply below expectations plus revisions to the downside
in previous months. Couple this with the generally rising trend
in the weekly claims report and someone somewhere is going to
realize that the economic recovery is not all its cracked up
to be. Is there a saving grace on the jobs front? It has been
suggested that the underground economy is where the jobs are
and is also behind why the retail sales numbers still look good.
But the underground economy aside job losses are just a part
of the growing problem. The recent trade numbers came in at a
deficit of $54 billion the second highest on record. We are on
track for a $600 billion dollar deficit for the year or roughly
5.5% of GDP. In 1987 we had a stock market crash when the trade
deficit hit 4% of GDP. So is this a problem? Well it is easy
to rationalize away the deficit and say it doesn't matter because
it is just a recycling of goods and dollars. Asia (China) supplies
the goods to satisfy the demand for goods in the US and then
recycles its dollars right back to the US to finance the deficits.
Trouble with that picture is that not necessarily do all of the
dollars come right back into America. Nor does it always come
back in the form of just financing the debt through the purchase
of Treasury Bills and Treasury bonds and notes and/or the bonds
and paper of US corporations and agencies. Some of it is used
to purchase other US assets including buying other companies
and real estate. And some it is going to buy assets in other
countries. An example of that is the takeover attempt being made
by the Chinese state owned MinMetals to buy Noranda Inc. (NRD-TSX)
the giant Canadian zinc, nickel and copper, producer. China with
its insatiable demand for metals needs to secure its own supply.
And they have indicated it won't stop at Noranda.
To add to the deficits the recent budget deficit numbers came
at over $400 billion or approaching 4% of GDP. Still low by some
standards (Japan's is around 8%) but we are reminded that the
only G7 member to run a surplus is Canada. The US budget deficit
in percentage terms to GDP is not yet as bad as it was in the
late 80's, early 90's under Reagan and Bush Sr. But in listening
to the recent Presidential debates there seems little hope that
no matter who gets in that it is not about to come down any time
soon and indeed could get a lot worse especially given the growth
rate under Bush Jr.
We are reminded that all US debt including future social security
requirements is now well in excess of 3 to 1 to GDP an unprecedented
number not even seen during the Great Depression. Even taking
the more conservative numbers seen in the Federal Reserves Flow
of Funds the number is roughly 2 to 1 to GDP but that number
excludes future social security requirements. We wonder how the
over leveraged economy will end especially for the overleveraged
consumer. The consumer stands at the highest levels ever for
debt to income of 125:100. In Australia a recent Economist
article said that there consumer debt/income ratio was over
160:100. Seems that there are others that are even more profligate.
Oil (and natural gas) prices just keep ticking higher. Higher
oil prices act like a tax on the economy not dissimilar to a
hike in interest rates. The impact of higher oil prices can be
delayed similar to interest rates. But oil is an essential in
many consumer products besides automobiles. The world faces both
a demand and a supply problem with growing demand, no new major
sources coming on stream and threats to supplies due to attacks
in the Middle East where 65% of all of the world's oil resources
lie. Plentiful and more expensive sources of oil are available
but many of them are in extremely environmentally sensitive areas,
deep in the ocean or expensive to produce (Canadian oil sands,
Venezuelan shale fields).
What is disconcerting concerning oil prices is listening to a
large number of analysts that view the current rise as merely
temporary and when this passes oil prices will fall back to the
$30 to $35 range especially with the lifting of such temporary
disruptions as the Gulf of Mexico stoppages due to the hurricanes.
Offsetting this is bullish sentiment numbers for oil as high
as 77% suggesting that there are very few bears out there.
But with a falling US$ another reason oil prices are moving higher
(along with numerous other commodity prices) is to compensate
producers for their declining purchasing power. The US$ has started
what looks like another leg down with minimum targets projected
down to major support at 80 on the US$ Index. Longer-term targets
project down to the 60/65 levels with some analysts projecting
down to 50.
For a number of months now we have consistently maintained targets
for oil to rise to the $55 to $58 range. We are now at the bottom
of that range. It is very possible that we could hit another
temporary high here. But as quickly as we hit the zone and staged
a reversal oil prices oil has reversed right back to the upside
again and is threatening new highs. What could be the unexpected
in this oil bull market with many expecting lower prices, is
that it will surprise instead to the upside.
Amongst those soft-pedalling the rising oil prices is Alan Greenspan
who insists that prices are nowhere near high enough to inflict
the kind of damage caused by the 1970's oil crisis. Of course
Mr. Greenspan is correct in that oil prices are nowhere near
the inflation-adjusted prices of the 1970's, which would have
to rise to $80 or higher to attain those levels. But these kinds
of statements are whistling in the dark unless Mr. Greenspan
knows that prices will never reach those lofty levels. In Iraq
there have been numerous attacks and shutdowns on the oil pipelines
during the ongoing war. What if an attack occurred on the Saudi
pipelines?
But if a lower dollar, higher oil prices and job cuts are not
enough to roil the markets the insurance scandal may what tips
it over the edge. Since the bubble tech market of the late nineties
burst the markets have dealt with numerous scandals including
Enron, WorldCom and plus others in the investment banking and
mutual fund industry. The latest target of Eliot Spitzer the
New York attorney-general is been civil charges against Marsh
& McLennan the world's biggest insurance broker. The scandal
also appears to go beyond Marsh and could soon envelope numerous
companies.
If there is one thing this scandal has accomplished is that it
has pushed the Fannie Mae scandal into the background. It may
be that it is in the background only because it takes so long
to try and figure these things out. It may yet rear its ugly
head and slam the markets not to say the potential for trouble
in the US real estate market given Fannie Mae's pre-eminent position
as American's biggest mortgage lender. But it could get worse.
We are hearing rumours that the next major investigation is going
to be in the Derivatives game. Could J.P. Morgan Chase the world's
biggest holder of derivatives an area we have long suspected
as being rife with problems be far behind being dragged into
an accounting scandal?
And lest we forget to mention the Fed is slowly raising interest
rates with at least two more hikes already priced into the futures
markets. Rising interest rates raise the possibility of cutting
off the cheap supply of money that has fuelled the markets for
the past few years especially for home mortgages. And long rates
could rise as well as we were intrigued when Goldman Sachs one
of the world's most pre-eminent investment banking companies
announced that investors should reduce their bond holdings for
the US from 25% to 10%. That's nothing they said to get out of
Canadian bonds altogether.
Finally there is the uncertainty of the election. This campaign
has made previous bitter, polarized negative campaigns look like
a walk in the park. The level of rhetoric has risen to atrocious
levels on both sides. The campaign is rife with personal attacks,
lawsuits especially concerning touch screen voting machines with
no paper trail and a history of computer glitches (and as an
aside the largest manufacturer Diebold is a major contributor
to the Republican party), and charges of fraud and deceit as
vicious attempts are being made to keep or prevent key voting
constituencies from voting or off of the voting lists. The polls
are too close to call and we may wind up like we did in 2000
with a hung jury for weeks on end and lawsuits and legal action
flying in every direction.
Given everything it is amazing the markets have held together.
But then it is an election year and in watching the market action
of late every plunge is met with buying to push it right back
up again and every piece of bad news is offset but even the slightest
good news as an excuse to rally. And all of this has taken place
on pitiful volume. A bull would observe that despite all these
recent problems of high oil prices, insurance company scandals,
slowing economic numbers, job losses, hurricanes, hung polls
and yes did we fail mention somewhere numerous profit results
somewhat below expectations that the market has been extremely
resilient. And did we forget to mention that terrorist alerts
remain at a high level and may intensify as we near the election.
So what are we to think? Will the markets melt down or will the
positive election cycles kick in and ride us into December and
then get the traditional Santa Claus rallies that will take us
onto new highs in 2005 where there has never been a down year
in a year ending 5? Or will the markets break down recognizing
the deteriorating economic situation, the growing scandals and
be pushed over the edge with a hung election ala 2000 and a possible
terrorist attack.
We favour the downside just because the markets have been so
complacent and the negative divergences are becoming unmistakable.
But then we can't rule out the upside either. The key levels
to watch for on the S&P 500 as we go forward are the 1080/1090
zone on the downside and 1020/1030 on the upside. Any breakdown
or breakout of these levels will lead us either to 960 or 1250.
As cycles analyst Michael Jenkins points out we have been dominated
in the first years of the new century by the 1930's cycle, which
for the most part we have followed reasonably faithfully. Of
course while 1933 was a huge up year so was 1935 following the
consolidation of 1934. We are showing that chart below. Note
that the cycles turn up into November until January and then
we correct into March before taking off for good.
The best hope for the bears is the Japanese 1990's cycle another
pattern we have been able to remarkably follow thus far. That
market topped in June 1994 (and we saw a high in mid June 2004
for our markets as well) but October saw only a minor high and
after a rally in December (Santa Claus rally?) we went off the
cliff straight down into July 1995.
We believe the growing negative news and high market complacency
will lead us into a meltdown dead ahead into 2005. Not what the
bulls would want at all. But until we break key levels on the
downside the bulls cannot be ruled out. We may be on the verge
of determining that direction.
October 21, 2004
David Chapman
Email: david@davidchapman.com
Note: Charts created using Omega TradeStation or SuperCharts.
Chart data supplied by Dial Data.
 David
Chapman is a director of the Millennium Bullion Fund.
The opinions,
estimates and projections stated are those of David Chapman as
of the date hereof and are subject to change without notice.
David Chapman, as a registered representative of Union Securities
Ltd. makes every effort to ensure that the contents have been
compiled or derived from sources believed reliable and contain
information and opinions, which are accurate and complete. Neither
David Chapman nor Union Securities Ltd. take responsibility for
errors or omissions which may be contained therein, nor accept
responsibility for losses arising from any use or reliance on
this report or its contents. Neither the information nor any
opinion expressed constitutes a solicitation for the sale or
purchase of securities. Union Securities Ltd. may act as a financial
advisor and/or underwriter for certain of the corporations mentioned
and may receive remuneration from them. David Chapman and Union
Securities Ltd. and its respective officers or directors may
acquire from time to time the securities mentioned herein as
principal or agent. Union Securities Ltd. is an independent investment
dealer and is a member of the Toronto Stock Exchange, the Canadian
Venture Exchange, the Investment Dealers Association and the
Canadian Investor Protection Fund.
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321gold Inc Miami USA
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