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October 19, 2008

Trying To Find A Bottom
by David Chapman

This past week was one of the wildest in our memory. The VIX indicator, a measure of fear and greed and volatility in the market, went above 80 before reversing and closing over 10 points lower. The VIX trades inversely to the stock market (S&P 500). This was a record level for the current version of the VIX indicator, although it only goes back to 1990. As we have noted before, the VIX this time around took out the highs seen at the 1997 Asian financial panic, the 1998 Asian/Russian and Long Term Capital Management (LTCM) panic, the 2001 September 11 attacks and the 2002 tech wreck/dot-com bust.

Some have noted that based on the old formula for the VIX, the past weeks high was around 100. That is the highest since the 1987 stock market crash where the VIX hit a record one-day high of 122. This crash occurred over a two-week period but nonetheless the impact was the same. As well this crash got underway after the market was already down roughly 20 per cent. In the period following the highs seen on September 19, 2008 the S&P 500 fell another 30 per cent to the lows on October 10, 2008.

Still the VIX took out the October 10 highs on Thursday, October 16, when the markets plunged initially and the VIX spiked. Interestingly the markets also reversed that day, closing up on the day while the VIX closed down. Since no new lows were seen in the S&P 500 and we did see new highs in the VIX, we have a potentially important market divergence that could be signalling a bottom in the market.

There are other signs that we may be seeing a bottom. The NY high-low indicator saw what may be a record 2,477 new lows on October 10. This was the third reading over 1,000 in the past few months, and readings above 750 often indicate a low being made. Investor sentiment had swung heavily in favour of the bears recently, reaching levels over 60 per cent bears - an area that normally records bottoms. While none of these indicators guarantee a bottom, it is a strong indication that we are probably at or near a bottom.

The 30 per cent collapse from September 19 was in keeping with other famous collapses. In 1974 the DJI fell from July to October by 27 per cent, and in 2002 it fell by 27 per cent again from May to October. While those collapses took longer, the drop was just as precipitous as the one we have just witnessed. The crashes of 1987 and 1929 were large but they were generally over in a day or two. So this recent 30 per cent collapse in barely three weeks may well qualify as the end of the move rather than a suggestion that there is more to come.

We indicated in Technical Scoop of October 13, 2008 that there was some interesting symmetry in the crashes of 1929, 1987 and 2008 from important pivot points. So we add this in with all of the other technical indicators and odds are favouring that we have hit an important low. Certainly we found this past week interesting, with Warren Buffett prodding everyone to buy stocks and the fact that despite numerous hedge funds and others going out of business, plunges this week were met with some heavy buying. Of course Warren Buffet may be wrong on the exact low but then he is taking a longer term time horizon.

The rescue plan, as ill-conceived as it is, with its nationalization of much of the banking system in the US and Europe, was the catalyst that finally got the market to trade up. Initially last Monday the market rallied almost 1,000 points before plunging back again.

The collapse of the hedge funds along with investment dealers such as Lehman Brothers plus the strains on Merrill Lynch, Morgan Stanley and other dealers, plus too many banks to even contemplate has put huge pressure on the market as the hedge funds and the funds of the dealers and banks are just liquidated. Particularly hard hit has been the commodity funds because when hedge funds go out of business everything must be sold. The hedge funds were particular large players in the commodity sector. In turn this has put huge pressure on the commodities themselves. But we note we don't see it as a sign of actual physical selling of commodities merely of the paper traded on the futures exchanges.

Not everyone has been able to liquidate .Think of the numerous hedge funds whose sole broker was Lehman Brothers. They are caught in a land of limbo, unable to access their funds to sell. Their portfolios have of course been decimated.

Morgan Stanley has stated that at least 30 per cent of all hedge funds will go out of business. In fact this figure may be low. The devastation in the financial industry is really just getting underway and thousands of stockbrokers, analysts, traders, back office staff and institutional sales people will be out of work in the ensuing year. Add to that thousands more real estate agents who will lose their jobs particularly in the United States and also here in Canada as house prices plunge.

We were surprised to learn that housing prices in Toronto fell 15 per cent year-over-year according to recent numbers. They also fell 11 per cent in the Toronto GTA. In cottage country north of Toronto the collapse should be even more dramatic.

Naturally the layoffs do not stop in the financial and real estate markets. Manufacturing, construction and other sectors are now facing large layoffs and plant closings. The giant North American auto companies have been growing smaller for years, with occasional talk of their demise or of a merger between two of them or maybe even all three. This would result in thousands of job cuts and plant closings.

Tent cities have sprung up in many North American cities as a result of the housing collapse. Not surprisingly the authorities view these tent cities as a blight on the landscape and have not been hesitant to go in and destroy them. Homelessness is apparently now a crime.

We expect the November non-farm payroll and unemployment numbers to jump dramatically. The upcoming Christmas season promises to be the bleakest in years. A number of retail firms are on the brink of going under or have already while countless others are closing stores to cut back. Not only is and has the consumer cut back as witnessed by the recent retail sales report the consumer is also being squeezed by continuing high prices for food and gasoline. In this environment necessities take priority over luxuries. The party is over.

Consumer confidence has plunged to levels not seen in years. On Friday the Michigan Sentiment indicator fell to 57.5, well below the expected 68. The Conference Board of Canada saw consumer confidence fall to the lowest level since 1982. While we continue to believe that we will not fall into a depression, all indications are that any recession will be deep and prolonged.

September saw huge withdrawals from fund companies. In the US over $100 billion was withdrawn and in Canada it was almost $5 billion. This all adds to the panic selling as the fund companies in turn are forced to liquidate in order to meet redemptions. In a panic the worst thing one can do is panic. Forced liquidations are of course another matter. Since those were September numbers we await the October numbers that were in the midst of the largest part of the collapse.

It is, however, and we repeat that it is these types of events that often help us see a low in the market. That, along with headlines of gloom and doom of which we have seen many of late. You would think that they were taking a page from the gloom and doom writers of the past several years. While many predicted a collapse (they were called perma bears and that was just the polite reference), the extent and speed of it has undoubtedly shaken many of them as well. It is one thing to talk about and another completely different thing to be experiencing it.

One of the so-called safe places to invest has been the money and bond markets. Here yields on government instruments have fallen to levels well below the headline rate of inflation. At the other end, the spreads for corporations and other borrowers (assuming they can even borrow) have widened to the highest levels in years. The TED Spread (Eurodollars vs. Treasury Bills) still sits at 440 bp, down from the highs of over 650 bp but still well above levels seen only six weeks ago of 130 bp. Even the spread between 10-year Treasury Notes and AA bonds has leaped to 250 bp from less than 100 bp a year ago. With Baa bonds the spread is over 400 bp, up from 150 bp a year ago. Credit default swap (CDS's) spreads have also narrowed somewhat given the government bailouts.

But rather than be complacent about being in government Treasury Bills, Notes and bonds, investors in these instruments should be worried as well. Treasury Bills are virtually at zero for one month or under, and a mere 0.83 per cent for three-month Treasury Bills. Ten-year notes are at 3.98 per cent but that is up from lows of 3.48 per cent seen only a week or so ago. With inflation running at 5.4 per cent annually, bonds and bills are a losing proposition. But we suppose just getting your money back is worth the loss in purchasing power.

The bond market has been experiencing a huge topping pattern for years. The recent breakdown in the bond market is a sign that all is not well there either .Indeed the losses may soon get bigger. We are astounded with the recent growth in the monetary base. M1 in the most recent report is now up 6.4 per cent year-over-year and an astounding 19.5 per cent in the most recent three months. M2, after falling recently, also reported a 6.9 per cent leap in the most recent three months. We don't have the reports on the old M3 of late but will be watching www.shadowstats.com for updates. The monetary base has exploded. US debt has leaped an astounding $1.2 trillion in recent weeks. The Federal Reserve is printing money to bail us out of the mess and ultimately that is hyperinflationary.

Our chart of the iShares Lehman 20 Year Bond (TLT-NYSE) shows what appears to be a multi month top forming. Despite the higher highs the recent upswing failed the previous high a sign that the rally is now over. A break under Friday's lows will quickly target the bottom of the channel near 91. Under 91 the market will go into breakdown mode. We would ensure that we are exiting all bond positions especially long bonds.

We are showing the recent charts of the monetary base adjusted for changes in reserve requirements. The change as one can see is the most astounding ever recorded, surpassing the change recorded during the Y2K crisis and the September 11 attacks. Both led to huge bubbles: first the high tech/dot-com bubble, then the housing/leverage buy out and derivatives madness. Given the rate of change we can only contemplate as to what the next bubble will be, but we can be assured that it will be truly amazing.

This is ultimately very inflationary. The result will be a bonds collapse. We suspect that that process is already under way as what they will be trying to do is monetize the debt. This has serious repercussions for the holders of US debt instruments particularly the foreign buyers (China, Japan, Saudi Arabia). Bonds have been telling us that they are in the process of making a long term top (price) or bottom (yield), as yields move inversely to price. For those who owe money it will be very good as they will pay back in depreciating dollar value, but for those who hold debt it may well be as devastating as the recent stock market collapse.

Naturally we believe that the beneficiary of this next bubble will be gold (and by extension silver and even platinum). Despite the recent 20 per cent plus drop in gold prices they remain above their recent lows and have generally outperformed the stock market. Silver and platinum prices, however, have been devastated, falling over well over 50 per cent from the highs. But we are reminded that silver has virtually no above ground supplies in storage despite production of over 600 million ounces annually. Platinum is even more scarce then gold as all the platinum in the world would fill an average living room. All the gold ever produced would fill an average house.

We also have a huge detachment between the official reported market and what we call the "black market" for gold and silver. First, on the official side we did have the report of a European gold sale recently, but even so that was within the realm of planned announced sales. Secondly, the European central banks have ceased leasing and lease rates have soared. Many central banks including Russia and other Asian and Mid Eastern banks have stated their intentions to add to gold reserves. The Bundesbank has stated they view gold as an essential base of their reserves.

The collapse we believe is largely paper-related as hedge funds and other commodity funds have been facing forced liquidation. The "black market" for bullion coins has seen a huge surge in price premiums, with shortages developing. Mints are reporting shortages and an inability to keep up with demand. Even the commitment of traders (COT) rose to 29 per cent in the recent report, up from 28 per cent the previous week. This was down from the 38 per cent seen in early September.

All this is telling us that we should soon see a rise in gold prices (and that will also take silver and platinum prices higher). Silver has been particularly hard hit; it broke a trend line up from the 2005 lows and is currently testing a trend line up from the 2003 lows. We have for silver corrected just over 61.8 per cent of the entire move from the lows of 2001. If there is a danger to the downside it is the highs of 2004 (just over $8) that could be tested in a wash out panic. Gold prices have been testing an uptrend line from the 2005 lows. They are well above the trend line from the 2001 lows. In inflation terms both gold and silver remain bargains. They are also holding their uptrend lines in inflation adjusted terms.

The gold stocks have rarely been more beat up then they are today. The Gold/HUI ratio sits at 3.8, the highest level since 2001. The Gold/XAU ratio is at a record high - at levels not even seen at previous lows for gold and stocks in 1986 and 2000. The stocks are trading at levels not seen since gold was near $400. While it is easy to say that these stocks are grossly undervalued (they are) and are screaming buys (they are), we do need signs that these ratios are turning around and beginning to decline, breaking their current uptrends in the ratio.

We could point out the same thing in energy, where the oil and gas stocks are trading at P/E levels not seen in years, and as if oil were $20/barrel and not the current $70. Nonetheless oil prices have halved over the past few months because of declining demand, particularly in the US (daily consumption has fallen from almost 21 million barrels to around 19 million). With prices falling, OPEC is considering production cuts and many oil producers are facing a credit crunch and may be forced to curtail production as well. The high-flying Alberta oil patch has been rudely brought back to earth with one of the more devastating collapses in the stock market.

In inflation-adjusted terms oil prices have fallen back to levels seen late last year and are now back below the peak levels of 1980. The Oil/XOI ratio has jumped in recent weeks and is either poised to break out through a key level of resistance or will turn back down once again. As we note, oil stocks are like gold stocks, at their lowest and cheapest levels since the 2002 lows.

The past few weeks have been very scary. We believe we are trying to find a bottom. But until we get a confirmation with a break above this week's highs with no new lows we will continue to sit on pins and needles.

Monday is the 21st anniversary of the 1987 stock market crash (following the options expiration). We like to think it will be the opposite, with a jump rather than a collapse, but again until we see the evidence it is difficult to say. All signs are pointing to a bottom. But we emphasize it may well just be a temporary bottom but still one that lasts a few weeks and could easily add 15 to 30 per cent off the lows.

Our chart of the S&P 500 over the past several years also shows some interesting symmetry. We note the seven-wave advance from the 1997 lows was somewhat comparable to the seven-wave advance from the 2002 lows. The 2000-02 collapse fell in 7 waves (labelled ABC, etc) and thus far this one has fallen by our count in five waves (again labelled ABC). The coming wave would be the sixth but that would still suggest that we will see a seventh wave down that could easily challenge the 1997 lows near 733 or even the 1996 highs near 680. We have thus far corrected roughly 50 per cent of the entire advance from 1982. A Fibonacci 61.8 per cent correction would take us to 665, so the 1996 high roughly coincides with that level.

This may be an intriguing ultimate target as surely we are correcting that entire move from the 1982 lows. We note that 1982 ended what we believe was the Kondratieff spring. The Kondratieff autumn began in early 2000 with the stock market highs. The bottom of the Kondratieff winter which we are in is not as yet determined.

Of the events of the past week we can't help but note that the world leaders have agreed to an international summit to discuss reforms to the world's financial system. Some are hailing this as a potential start to a new Bretton Woods something we have mentioned the need for on numerous occasions over the past year. Still no dates are set and they have warned that it must not threaten global capitalism. Of course it is the collapse of the capitalist system that is at the root of the problem or at least the collapse of the huge corporate version of the capitalist system. Naturally they will resist and we expect any summit to be an abject failure. More crises will have to occur before they are forced to re-examine the global financial system. We suspect as part of the future crisis we will face will be a US Dollar collapse.

Currently it is the Europeans who are leading the way towards reform of the global financial system. The US is resisting many of these reforms as it does not suit their agenda. Many of the reforms would target the bank regulation plus regulation of hedge funds and tax havens (elimination?). As well we have noted the US Dollars place as the world's reserve currency also has to be on the table as well as currency regulation and the role of gold as a monetary asset. These were at the heart of the original Bretton Woods in 1944.

In the midst of the financial crisis we can't help but note as well that food prices have barely budged. The global financial crisis can and will threaten food supplies on a global scale. The UN's FAO has pointed this out. Food prices are draining the reserves of poorer emerging countries. As well while the agriculture sector in North America has been robust it could be facing serious credit issues themselves in the coming year. The global drop in commodity prices can and will hurt the commodity producing countries including the prices of many food staples. If the growers cannot get their price necessary to live on, production will quite simply come to an end.

The market has been exceptionally dangerous and devastating to many over the past few weeks. Nonetheless the current fear in the market is what bottoms are made of. It may only be a temporary rebound lasting a week or two or even several weeks to a couple of months or so but it could be dramatic in the order of 15 to 25 per cent. Investors will get an opportunity to restructure when confidence and hope comes back. But ultimately it will end as well.

Note: Chart created using Omega TradeStation. Chart data supplied by Dial Data.

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: 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.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2009 David Chapman

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