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November 09, 2008

Historic Victory! Now What?
by David Chapman

Congratulations to President-elect Barack Obama on his historic win on November 4. He does represent a watershed in American politics. But once the applause dies down, as inevitably it will, the real hard slog begins. He has inherited a mess.

So just what kind of mess?

• The worst financial crisis since the Great Depression, with bailout commitments that could add upwards of $2.2 trillion to the US debt.

• A fiscal budget debt that could hit $1 trillion in the coming year.

• Two unpopular wars that have cost the US taxpayer $860 billion and counting (source: CRS Report for Congress, October 15, 2008). Despite a desire to get out of Iraq it will probably prove to be difficult. Add to that cost the commitment to up the ante in Afghanistan and it will add billions to current costs.

• Deteriorating infrastructure, much of it old, leading to destruction by hurricanes or failures, as witnessed by the infamous collapse of the Minnesota Bridge and the New Orleans levees, all needing to be repaired or replaced at a cost of upwards of $2 trillion.

• Healthcare, although probably the best in the world, currently costs over 17 per cent of GDP, the highest in the industrial world. But control of healthcare lies with insurance companies, and over 50 million Americans have no coverage.

• While the US has a $14 trillion economy, with the additional debt due to the financial crisis its debt to GDP ratio is rapidly approaching 1:1. Add in corporate and consumer debt and the ratio soars to almost 4:1.

• Add in the unfunded debt due to Social Security, Medicare and Medicaid and the debt soars to $56 trillion.

• Major problems in the financial industry and in the automobile industry, where the Big 3 are struggling and may become two or even one or none. The collapse of the automobile industry in the US would add potentially millions to the unemployment line.

• A weakening economy that has lost 1.2 million jobs this year and an unemployment rate of 6.5 per cent, the highest since 1994. Unemployment is forecast to reach at least 8.5 per cent and could even reach the levels of the early 1980's recession over 10 per cent. Remember that this is merely the officially reported rate. Others have put the unemployment rate currently as high as 16 per cent (www.shadowstats.com - adds in discouraged workers who have dropped out of the labour force). Consumer confidence has fallen to an all-time low in October and horrible retail sales in October portend a dismal Christmas for retailers. Automobile sales have gone into freefall.

• Collapsing stock markets that have already shed more than 30 per cent this year and at one point were down closer to 50 per cent.

• A current account deficit adding $600 to $800 billion annually, or four per cent of GDP.

• A housing market in disarray. The latest Case-Schiller index shows an almost 17 per cent decline in prices over the past year on average. In many urban centres the declines have been over 30 per cent. Roughly 1 in 6 homes are either foreclosed, being foreclosed or the mortgage is worth more than the equity.

• An economy that has been in the state of deleveraging and is continuing to deleverage.

• The potential risk of deflation as the economy slackens and job losses grow. As well debt deleveraging is deflationary in itself as the value of assets plummet and the liabilities remain.

• The potential for a deflationary liquidity trap as the Fed approaches zero per cent interest rates.

• The potential for hyperinflation as the Fed tries to monetize the deflationary problems by pouring money everywhere in order to prevent a deflationary collapse. Central banks the world over have poured large amounts of capital and liquidity into their economies so from a strictly monetary perspective this is very inflationary.

• Because of the sharp increase in the monetary base it shows that financial institutions and consumers are hoarding cash as the credit crisis deepens. If no one lends money or only lends on very strict terms the credit crisis seizes up the economy choking any possibility of growth. This of course is deflationary as demand falls, inventories rise and the result is prices fall.

Obama was greeted by the worst post Election Day collapse ever, as the Dow Jones Industrials fell five per cent. This surpassed the 4.5 per cent decline that greeted Franklin Roosevelt in 1932 and the 3.9 per cent drop that greeted Harry Truman in 1948. The next day the DJI fell another 4.9 per cent. Welcome Obama.

Despite such a nasty drop, the odds of a market in endless liquidation over the next four years are extremely low unless one believes we are headed into a 1930s style Great Depression. Records show that only the hapless Herbert Hoover ever experienced a stock market that never had an up year during his presidency.

We thought we would show you the Presidential election stock market cycle from 1885. The record shows that often due to wars, recessions and bear markets, the markets are weakest in the first two years of the cycle. As prosperity returns the presidential cycle improves, with the third year recording the best gains. We divided our tables into Republican and Democrat Presidents.

* Assassinated
** Died in office
*** Resigned
**** Year to date

Republicans: average gain - 6.1%
# up - 42
# down - 26
% up - 61.8%

Perfect records: W. McKinley 1897-1900
C. Coolidge 1925-28
R. Reagan 1985-88

Nothing but losses: H. Hoover 1929-32

* Died in office
** Assassinated

Democrats: average gain - 7.9%
# up - 35
# down - 20
% up - 63.6%

Perfect Records: F. Roosevelt 1933-36
H. Truman 1949-52
B. Clinton 1993-96

Source: Stock Trader's Almanac 2008

When it comes right down to it, neither the Republicans nor the Democrats hold much in the way of bragging rights over the other. The Democrats have a slim lead with regard to the percentage of "Up" years, and Democrat years tend to be somewhat better for the markets than Republican years (average gain 7.9 per cent versus 6.1 per cent). In the third year of a presidency the Democrats have a big lead, with an average gain of 19.1 per cent versus 5.6 per cent for Republicans. Republicans have an edge of 9.5 per cent to 3.6 per cent for gains in the fourth year of a presidency. There is little to choose between them for the first two years.

Both parties have had three presidents with perfect records of four consecutive years of up markets, with Republicans William McKinley, Calvin Coolidge and Ronald Reagan joining Democrats Franklin Roosevelt, Harry Truman and Bill Clinton. Only the aforementioned Herbert Hoover (a Republican) has the ignominyof four consecutive years of losses. The biggest one-year gain is 81.7 per cent - in 1915, for Woodrow Wilson in the third year of his presidency, while once again Hoover saw a 52.7 per cent decline for the largest decline, also in the third year (1931) of his presidency.

We don't believe that this stock market will have the kind of collapse that buried Hoover. There were a lot of conditions present in 1930 that do not exist today to cause that collapse. We believe that this collapse is more in keeping with the financial panics of 1906-07 (101 years), 1937-38 (70 years) and even 1973-74 (34 years). There are some interesting similarities.

Financial panic declines (DJI):

1906-07 - 48.5 per cent
1937-38 - 49.1 per cent
1973-74 - 45.1 per cent
2007-08 - 43.3 per cent (to date).

We are not suggesting here that we have seen our final low. Typically, after the kind of collapse we have seen thus far, we get a rebound before we plunge to our final lows. In 1907 we had our absolute low in November; then followed a feeble rally that eventually had a higher low in January 1908. Similarly we had our low in March 1938 and after a feeble two-month rally we made another higher low in May 1938. 1974 actually saw a sharp low in October followed by a rally that lasted into November before we plunged to our final lows in December 1974.

Back in 2002 we had a huge plunge into July, a sharp rebound into August and the final plunge into October. Even that wasn't the end of the bear as we rallied once again through November to January 2003, than had one final plunge for a higher low in March 2003.

We are showing a chart of that 2002-03 market as it is an excellent example of lows followed by rebounds, then lower lows, then a rebound and a higher low. We are not suggesting that this one plays out exactly the same way, but we do believe that we could see some ups and downs over the next few months before we make either a lower low or a higher low, then rally later in 2009.

If this collapse is more like 1907, 1937/1938 and 1973/1974 the rally could fool a lot of people. The 1908/1909 bull added 89 per cent to the 1907 lows; a 60 per cent rally in 1938 followed the March 1938 lows before war caught up to the market in 1939; a 53 per cent rally from the December 1974 lows followed into 1975.

From the aforementioned 2002 lows the market rallied 40 per cent into highs in February 2004. Investors also might want to consider that the NASDAQ 2000-2002 fell 77 per cent which compares favourably with the DJI collapse of 1929-1932 of 89 per cent. The rebound rally of the DJI from 1933 to 1937 recouped just under 50 per cent of that collapse. The NASDAQ 2003-2007 recouped about 43 per cent of its collapse.

Despite all the problems greeting Obama as he assumes his presidency (he enters office on January 20, 2009) there are a number of positives developing. Setting aside the probability that unemployment has probably not yet peaked, we can list these as follows:

• US average gasoline price has fallen to an average of $2.40. This is down sharply from highs near $5 seen only a few months ago. This 50 per cent drop will put extra cash in consumers' pockets.

• Heating oil prices have also fallen, but the drop is not as dramatic as for gasoline.

• Retailers will be offering more enticements then you can imagine bringing consumers into the shopping malls this Christmas. While sales may be down, they may not be down as much as one expects. A favourite gift might be the gift certificate card, so that after Christmas consumers can go on a shopping spree at even bigger discounts. The alternative is hordes of zombie-like shoppers wandering the malls (a la George Romero's Dawn of the Dead (1976)) because that is what they are used to doing. Zombies of course buy nothing.

• Expect another fiscal stimulus package in the form of tax rebates similar to one last May. (We don't know the timing of such a package.) We could also see a big jump in support for safety nets, such as unemployment insurance.

• Interest rates have been falling. While there is always a lag between lowering of interest rates and the economy coming out of its contraction, they eventually do have their impact. The alternative is the Japanese effect, where zero interest rates had little or no impact as consumers hoarded and saved. The monetary authorities will probably keep rates low longer than most expect. Expectations are for another 50 bp cut in December, which would bring the Fed rate to 0.50 per cent.

• Pressure is easing in the LIBOR and commercial paper market. While spreads over US Treasury Bills are still high, they have fallen to near 200 bp for LIBOR and 250 bp for CP. LIBOR spreads peaked above 650 bp and CP near 450 bp. In more normal times spreads were often as low as 10-25 bp. CP outstanding is beginning to rise again after a number of weeks of falling. We are showing that chart below.

• The authorities are petrified of deflation. They would rather have inflation. The result: they are already priming the pump with increased monetary stimulus.

• If as we suspect the monetary stimulus creates inflation, the stock market will experience a series of rolling bull and bear markets. This phenomenon was seen in the bear market of 2000-02 followed by the bull of 2003-07 and now followed by another bear. The entire 1966-1982 bear market period was a rolling series of bull and bear markets. Even the vaunted 1929-1949 Great Depression and War bear market except for the huge collapse 1929-1932 saw a series of rolling bull and bear markets.

Our charts below show M1 and M2 monetary growth from a year ago. We show a similar chart for the Dow Jones Industrials. We note that huge increases in monetary growth are soon followed by a jump in the stock market. Note the period around 1983, when M1 and M2 jumped around 13 per cent. The DJI had a big jump in 1983 but faltered in 1984 as monetary growth also slowed. This sparked another big increase in monetary growth and the stock market rose sharply through 1985 to its peak in August 1987.

The late 1980s and early 1990s also witnessed declining monetary growth, particularly M2 (and M3 during that time). When monetary stimulus began in earnest once again in 1995-96 it led directly to the stock market bubble of the late 1990s.

The stock market peaked in early 2000 and already monetary growth had slowed considerably. The collapse of the stock market into 2001 led directly to another huge spike in the monetary aggregates, and that eventually led directly to the next bubble that manifested itself in the housing bubble. The stock market also began to rise starting in 2003, a good year or more after the spike in M1 and M2. The increase in monetary growth peaked around 2004 but it took another two years for the housing bubble to peak. The stock market peaked in 2007. From 2004 to 2007 the monetary aggregates grew at a much slower rate.

The recent stock market collapse has led to another spike in growth in monetary aggregates, plus an unprecedented jump in the monetary base. We suspect that aggregate growth in M1 and M2 will have to go well above 10 per cent in order to bring about the desired effect. As to the monetary base, we have never seen anything like this. But we expect once again after a lag that the stock market will rise and another bubble will form.

This leads us to the conclusion that while the first impact of the recent collapse will be deflationary ultimately the huge monetary stimulus will bring about another inflationary bubble.

Guessing what will benefit in the next bubble is difficult. The first huge burst of monetary growth created the high tech/dot-com bubble. The second gave us the housing bubble and the huge growth in leveraged buyouts and derivatives.

So what will be the next bubble? We suspect it will be gold and precious metals in conjunction with a collapse of the US dollar. We could be wrong, but given what has taken place thus far and seeing growth percolating in the monetary aggregates already, plus the unprecedented growth in the monetary base, we think that gold will be the beneficiary.

We have often noted what may be an 8.5-year cycle of lows for gold (Ray Merriman - The Merriman Market Analyst www.mmacycles.com). There were distinct lows in Gold in 1976, 1985, 1993 and 2001. This targets the next 8.5-year cycle to occur somewhere between March 2008 and August 2009. It appears that the 8.5-year cycle has unfolded and the price last March of $1,015 an ounce was the crest of the cycle.

The current 8.5-year cycle appears to have unfolded in three phases of roughly 34 months. Our first 34-month cycle bottomed in April 2004 36 months after the April 2001lows marked (a) and our second one bottomed in October 2006 30 months after the April 2004 lows marked (b). (Note: We erroneously thought our 34 month low was June 2007 a higher low thus throwing us off and also demonstrating the trickiness in predicting these things). The break of the 17-month moving average confirmed that we were falling into the 8.5-year cycle low. Our next 34-month cycle low is due ideally in August 2009 but could range from April 2009 to October 2009. So while there may be more work to do on this gold bear market, we suspect it should be absolutely finished by July to October 2009.

In the interim gold is oversold sufficiently that a rebound rally should soon get underway. If we are correct on this it will find resistance at $825 and again at around $900. We probably won't see new highs in this move. But once we complete our 34-month cycle low we should embark on a spectacular move up in the next 8.5-year cycle phase. The last 25-year cycle low was seen with the lows of the 1999 and 2001. The next 25-year cycle phase should peak in its second 8.5-year cycle. It will be during this period that gold takes off to $2,000 and possibly higher. The cause will be the huge stimulus provided by the authorities to get the economy out of this mess accompanied by a decline in the value of the US$.

We can't help but notice that Paul Volcker is an economic advisor to Barack Obama. Mr Volcker became Fed chairman in August 1979. Gold topped in January 1980, at $850 an ounce. As a result of Volcker's high interest rate policy the US$ reversed its downward trend and directly led to gold's collapse. Wouldn't it be ironic if Volcker were to be involved once again with US monetary and fiscal policy, only this time having the opposite effect on Gold. History sometimes has an odd way of repeating itself - in the opposite manner. Welcome Obama!

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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