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July 09, 2004

Summer Musings
by David Chapman

Going completely away for a number of days over a long holiday weekend is a time to clear your head and hopefully refocus. When I say completely away I do mean completely away, no electricity and no news. Instead of having to try and figure out what the Fed might do or whether some unknown event will hit the markets your biggest concern becomes how to deal with the mosquitoes and black flies and whether your muscles will hold out to allow you to make it through the next portage.

Well believe me dealing with mosquitoes, black flies and portages does seem easier then trying to figure out the next move in the markets or that some event might blind side you causing unexpected monetary losses. The bug bites will heal and your muscles will rejuvenate but a blind side causing monetary loss could last a life time.

So coming out of the bush on Monday it was almost disappointing to discover that nothing much happened over the long weekend. Not that you want something to happen but given in particular the US holiday it was almost surprising to learn that we didn't even get an orange alert (The US remains it seems on almost permanent yellow alert (elevated)). Maybe the terrorists have lost interest. Of course some think that the real terrorist attack came on June 25 when Michael Moore released Fahrenheit 9/11. While the film has been received very well in numerous quarters the impact on the Bush Administration thus far seems muted as polls show Bush/Cheney slightly ahead of Kerry/Edwards.

But lest we forget about the potential for a terrorist attack before the week was out Tom Ridge declared that Al Qaeda was getting ready for an attack somewhere in the US before the elections. Naturally we remain baffled as to 1. How do they know and if they know why or how come they can't do something about it before hand, and 2. How does someone running around the mountains of Tora Bora living in a cave direct anything?

Despite all the rhetoric there remains the risk of an attack of some sort. In an environment of a stock market that remains overvalued and where profit gains from here appear to be coming only grudgingly and both financial risk and terrorist risk is rising we wonder where the impetus will come from to push the market through the significant resistance zones above.

As expected the Federal Reserve raised the discount rate by a quarter point. Getting what everyone expected the market yawned and promptly sold off. Then on Friday the much-anticipated employment numbers came out. It was sharply below expectations. The market became worried and sold off further; the US$ looking less attractive sold off as well; and gold seeing the US$ fall rose.

Grant you a quarter point hike really does not say a lot or do a lot to the still very low cost of money. The one major thing that has differentiated the actions of the current Federal Reserve from say the actions of the monetary authorities in the US in the 1930's and Japan in the 1990's is that they did lower interest rates sharply and quickly. In both the earlier instances the monetary authorities were criticized for not cutting rates fast enough. In the 1930's they actually hiked rates at first. It is the low interest rate environment and the easy monetary stance that has numerous pundits declaring that the bears have it completely wrong that this time it is different. The Federal Reserve under "Easy" Al can save the day and he has done a miraculous job of preventing a deeper and wider slump.

Indeed by most measurements the slump experienced in 2001/2002 was pretty shallow. Again the bull pundits site the shallowness of the slump and the continued low interest rate and easy money environment as the prime reason that they are right and we will never have a huge economic collapse. Are they right? Or are the economic catastrophe pundits right?

Time of course will tell and the real answer may be somewhere in between but it may not stop a decade long slump in equity prices to work our way out of the excesses of the 1990's. Trouble is the tactic of easy money and low interest rates have created different problems. With the sense that low interest rates and easy money are here to stay the consumer in particular has gone on a spending binge, wracking up the debt on their credit cards, lines of credit and through mortgage refinancing. Household debt to disposable income, which was only about 90% even just a few years ago, is now around 115%.

What cheap money does is encourage people and companies to take risk. For the banks, hedge funds and financial companies because rates are so low from normal business they seek higher risk instruments using derivatives, or junk bonds or high-risk foreign emerging market debt hoping to increase returns. For the consumer it comes in buying a second (and third) SUV or speculating in property prices. Indeed the surge in housing prices over the past few years has been a direct result of the low interest rate, easy money environment. Yet the Fed comes out and says there is no bubble. A recent report by HSBC, the giant British and Hong Kong bank begs otherwise. The report entitled "The US Housing Bubble – The case for a home brewed hangover" puts a more official stamp on the potential problem rather than coming from the usual array of doomsayers.

And overall debt is a major problem. At the beginning of the 1980's when the economy was experiencing another major shakeout the US debt to GDP ratio was a mere 130%. Today that number is well over 300% and rising. Yet we have no problem? Every year for the past number of years bankruptcies have risen to record levels and today it continues that way along with record delinquencies and foreclosures. And we are not even in a slump yet.

Rising interest rates are not something that is friendly to debtors. At least 50% of US mortgage debt is of the floating rate variety so a hike in rates could have a very negative impact. Already we are seeing a slowdown in car sales (and especially SUV sales with higher gasoline prices). The surprising weakness in the recent job numbers is a possible sign that the great ballyhooed job growth is not what it is supposed to be. Net, the US is still down at least a million jobs since 2000. Indeed under more normal growth conditions and given population growth job growth should be up 8 million not down 1 million. While the unemployment rate is reported as 5.6% numerous studies show that the real unemployment rate could be as high as 9.6%.

We still believe that the summer could prove quite interesting and potentially pivotal for the markets. The US election will be heating up with on one hand the incumbents Bush/Cheney who clearly have a core group of supporters. They hang in there despite calls in some quarters for in particular Cheney's resignation who is considered the master mind behind the invasion of Iraq and the so called neo-conservative agenda. The invasion of Iraq of course was premeditated on now what is being accepted as falsified information and has resulted in an unbalanced and insecure country. Evidence also exists that the Abu Ghraib prison scandal goes right up into the White House. Add appropriation of funds for war purposes without congressional approval (an impeachable offence in itself) and the creation of the biggest debts ever and it is amazing they are even running again.

On the other hand the opposition Kerry/Edwards are painted as protectionists, allegedly beholden to Unions, pander populist "soak the rich" policies (odd given that Kerry is pure blueblood and is married to the Heinz fortune) and that Edwards a self made millionaire lawyer who made his name effectively as an ambulance chaser or what some call a "Learjet lawyer". Whatever it promises to be as what all US election campaigns are now pure smear and nastiness. And no matter who wins the current war on terror will continue and oddly enough could even escalate under the Democrats (It was Democrats after all who escalated the Vietnam War under Lyndon Johnson).

While the focus in North America will be on the US election we may wish to focus ourselves outside North America. A few things have popped up over the past week that bears watching. First is the Yukos bankruptcy which given the fear of reduced oil supply from one of the world's largest producers helped push oil prices back over the $40 level once again. This despite the OPEC promise of increased oil supply in August. We continue to have targets on oil of $55 to $58 this year. Higher energy prices no matter what will not emboldened consumer confidence and will continue to hurt car sales, which are already slumping. As well higher oil prices pushes up the costs of numerous products and has been a significant contributor to the 3%+ inflation rate over the past year (while US interest rates remain around 2%, a level that is below the rate of inflation telling us that the Federal Reserve is behind the curve).

The second event that broke in the past week was the closing of Russia's 22^nd largest bank and the announcement that several Russian banks are in trouble. In order to stem the growing banking crisis Russia cut reserve requirements and are trying to bail out the problem. Trouble is this is the type of problem that could spread. Remember that the Chinese and Japanese banking systems are equally fragile (read deeply indebted and technically bankrupt despite some signs that the Japanese banks in particular are coming around with cleaner balance sheets).

As well numerous banks across Asia are equally fragile. We all remember the Asian contagion of '97 and '98 that started in currency and banking troubles in Asia and Russia. It resulted in a near financial meltdown, which only massive injections of funds from the Federal Reserve could save. Trouble is that this time the Fed has already been making massive injections of liquidity into the system (M3 growth up nearly 12% in the past three months) and this is before a crisis has even occurred. And this growth is occurring at a time of decent economic growth. Could the Fed be anticipating something?

The monetary authorities are of course saying all the soothing words but the reality is that these things have a habit of suddenly spinning out of control as defaults beget defaults. No one is paying a lot of attention to this dismissing it as a Russian problem. Where have we heard that one before?

Finally the hot spots remain. Iraq is still in turmoil and the newly installed government is being seen for what it is, puppets of the US. The Israeli/Palestinian conflict continues with no foreseeable solution. The only good news (or bad depending on which side of the equation you are on) is that there has not been a suicide bombing on the Israeli side for some time now. Unfortunately the killing continues on the Palestinian side particularly in Gaza. Finally and almost completely unnoticed, the US alongside Taiwan has been conducting a huge show of military power with at least 7 US carriers in the region. The show is one of allied co-operation. At the same time the Chinese will be conducting their own powerful military exercises across from Taiwan. As one wag states we hope there is not a misunderstanding.

We want to leave you with two charts. The first one is a weekly chart of Wal-Mart. We showed this chart at a recent ROBTV Market Call but it is worth repeating. Wal-Mart is the store of the masses. But recently it has been experiencing problems. WMT is making a huge symmetrical triangle. Symmetrical triangles can be consolidation patterns or topping patterns. This pattern has now been forming for 5 years. One side of us says it is consolidation pattern. The other of course says it is a huge topping pattern. Either way the break out is clear. Above $60 WMT could go to $88/$90. Below $50 it falls to $20/$22. We might just well trade around the range for awhile. But the response is clear which ever way it breaks you will know what scenario is about to play out. 

Our second chart is the US Dollar Index. This is one bearish chart. Not only do we have a bearish rising wedge that ensures at minimum that we will fall back to the recent lows near 84/85 we also have a possible head and shoulders pattern that is now breaking down. As well we failed at major trend line resistance and at key moving average resistance of the 200 day MA. The H&S pattern projects down to the 83 zone. We believe that ultimately the US Dollar Index target is down in the 60/65 zone but that is for later. A fall now to the 83-target zone would of course send gold sharply higher to at least the $450 zone if not to $480. These patterns tend to play out fairly quickly.

Of course a falling US$ has negative ramifications for inflation and interest rates as well. Trying to keep interest rates down as your currency is falling is almost a sure thing to guarantee that your currency will fall further. And a falling currency is inflationary as well. The US with its mega debts of budget, trade and current account are paying the price for its prolificacy. Of course many will say that is fine because effectively you are transferring the burden of the all that debt to the holders. The primary holders include Japan and China. They may not be amused. As for me I think going back to the black flies and mosquitoes might turn out to be more appealing.

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 © 2002-2008 David Chapman

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