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December 17, 2004

Forecast 2005
by David Chapman

Every year brings its share of surprises and ups and downs in the stock market. But if there has been one thing investor's have been able to take to the bank over the past 100 years or so is that in any year ending in 5 it has never known a down year. That number should tickle the fancy of investors, fund managers, hedge fund managers and anyone else who has a stake in the stock market. This record is quite remarkable as even the record shows that the odds of an up year are only around 60%. So going into 2005 while the odds favour an up year one has to realize that whether we have an up or down year is somewhat random.

Over the past 123 years 76 years have been up years or the Fibonacci 61.8%. We are repeating the ten-year stock market cycle below because this is a handy little guide or at least an interesting piece of trivia for any investor. We first saw the table in an issue of the P.Q. Wall forecast.

Ten-Year Stock Market Cycle
Annual % Change in the Dow Jones Industrials Average
Year of Decade

Setting aside the fact that there has never been a down year in a year ending in 5 over the past 100 years or so for the US stock markets there is also the Presidential cycles. 2005 will be the first year of Bush's second term. Covering the same period as outlined above we note that there has been 9 Presidents who were re-elected for a second term. We created a small table of these Presidents to note what happened in the first year of their second Presidency.

Here the record was primarily for a down year in the first year of Presidency's second term in office. Two of the exceptions were years ending in 5. Of course this is a year ending in five so despite the weak record of the first year of a Presidency starting a second term the leaning is for an up year. As well we couldn't help but notice that in both years ending in five for the first year of second term the gains were very similar at 38.2% and 38.3% respectively. That reminds us that a pundit we have debated with in the past has said unequivocally that this coming year will see a 50% rise in the markets. Even he would probably settle for 38.3%.

So is that it? The record is clear and 2005 is a "can't lose" year, as all of the cycles appear to be very favourable. If there is a note of caution it is the first half of the year. Cycles have shown that for the years ending in 5 the first quarter often stretching into the second quarter tend to be weak. There were exceptions to that of course the most notable being 1975 and 1995 where weakness in the market did not develop until the fall. In both those instances, however, they were coming out of troughs that were seen in both 1974 and 1994.

With a stock market that is showing high bullish sentiment of around 60% or higher and a VIX volatility indicator at record lows certainly the odds highly favour that a correction is coming. This would be in line with weakness generally being seen in the first quarter of years ending in 5. What is important here though is that the correction is shallow certainly not much more than 10% then if things fall into place we rally to new highs or even record highs as some have been calling for into the fall of 2005.

If there is one that is fairly remarkable about the action in the stock market in the first decade of the new century is the comparison with the market of the 1930's. While the 1930's market topped in 1929 versus the high for this market in 2000 it otherwise has been very similar. Down years were seen in 1930 (2000), 1931 (2001) and a major low was seen in 1932 (2002). The low was followed by a significant rally in 1933 (2003) followed by a sideways/down market for most of 1934 (2004) that finished with a small gain for the year. What followed after that was a weak first quarter in 1935 followed by another strong rally that continued right through into 1936 and peaked in early 1937 followed by the crash of 1937 (See chart below of the DJI 1930-1939). Absolutes levels do not necessarily have to be the same as before but the general trend must be similar for comparison purposes.

Could something get in the way of this very bullish scenario? After all if the odds of an up year are only in the 60% range and the fact that statistically the fact that all of the years ending in five have been up is somewhat random then are there cycles that could blemish this perfect record. The biggest cycle that we are aware of from Ray Merriman (MMA Cycles) is one of 72 years. Major lows where the stock markets lost 80% or more of their value 3-22 years from a stock market occurred in 1784, 1857 and 1932. So we are currently in a period of another 72-year cycle low that could occur anywhere from 1992 to 2016. The stock market of course peaked in 2000 and we did have a low in 2002 where the NASDAQ lost 80% but it was the only one to do so. In the other instances it was major market or Dow Jones Industrials that lost 80% or more.

Of course that didn't happen this time for the DJI (fell about 36%) so it is very possible that this 72 year cycle has not bottomed as of yet. Merriman also describes the half cycles (36 years - last bottomed in 1974 and due to bottom 2004-2016) and quarter cycles (18 years - last bottomed in October 1987 according to Merriman although one could argue 1990 as the low but the next one is due to bottom 2002 to 2008). We also note that we are in the Kondratieff winter phase that could last anywhere from 12 to 20 years or given the peak in 2000 anywhere from 2012 to 2020. With so many major cycles pointing to negative endings the question is when this current up cycle will peak.

There is also the well-known 4-year cycle in stocks, which actually form a part of the 18-year cycle. Certainly since 1974 this cycle is well defined with lows in 1974, 1978, 1982, 1987, 1990, 1994, 1998 and 2002. The next one is due in anywhere from October 2005-June 2007 (Merriman). If we are truly in a bear market as we suspect then we should have either left or centre translation for the peak. In a bull market the cycle peak will right translate. If we are to have weakness in the first quarter as we suspect given the very high bullish sentiment then we once this current Santa Claus rally completes we could start a decline. Returning to our 1930's cycle the rally out of the lows of 1932 saw extreme right translation, as the 4-year cycle did not bottom until very late in the cycle in 1937. It is possible that we could do that again.

The earliest period we have for a top in this cycle is the first week of January. But if the pullback from this high is shallow we could start another comeback that should peak no later then mid March. A decline after that would carry us into May/June. Again if the correction is shallow of no more than 10% or so then another up leg for this cycle could carry us up for another top into the fall of 2005. Odds do not favour that as we believe that the bigger cycles will start to dominate after June 2005 and after a possible bullish summer that does not make new highs we start a decline that should get underway later in the year that takes us into 2006. All of this could play out to be another up year for the markets in a year ending in 5 but there are a lot storms out there that could break that cycle.

The storms are both financial and political. On the financial side there has been continued weak economic and profit numbers; rising interest rates; negative interest rates that have persisted for some time and often presage a recession once the rising interest rate cycle gets underway; the unsustainable deficits of budget, trade and current account; retail sales held up on a wave of easy consumer credit; a housing bubble that is vulnerable to rising interest rates and incidentally in November showed the sharpest one month decline in housing starts since 1994; and the falling US$ which could yet trigger a wave of competitive devaluations. Of course all of these things have been with us through the past two years and it hasn't stopped the market yet.

The question then becomes what if there is a financial accident such as another Asian currency crisis triggered by another wave of competitive devaluations or a derivatives crisis caused by the collapse of a high profile hedge fund similar to Long Term Capital Management (LTCM) in 1998. The current bull market has brought us bull market as well in junk bonds where yield spreads are at record lows and risk very high if a crisis got underway.

The bulls like us to think of all of this as climbing that wall of worry. They might be right if we were coming out of a longer slump but the correction of 2000-2002 in the economy and the stock market did not wash out the excesses of the great bubble economy and stock market of the 1990's. Indeed it barely made a dent despite September 11, 2001 and the ensuing war on terror and the invasion of Iraq. And the characteristics of the last two years suggest that the stock market bubble of the late 1990's is back along with a bubble in the housing market.

On the political side it is more complex. Certainly Bush is riding a wave of bullishness with his re-election. But already there are dents beginning to show. There were a number of high profile resignations including Secretary of State Colin Powel, Attorney General John Ashcroft, and Homeland Security Chief Tom Ridge. There were of course several others but few with the profile of these three. While leavings in a second term are not unusual there was this time around a very high number of leavings. And new appointments have not come without controversy. The most obvious one was the scandal that surrounded the appointment of Bernard Kerik as the new Homeland Security chief. He was quickly forced to back out despite records that were widely available on Mr. Kerik beforehand it seemed that the White House did not do its homework. With the numerous resignations and the problems of Kerik it is a rocky start to the second term.

It might have all blown over except that one cabinet minister that did not resign, Donald Rumsfield, was once again in trouble over cavalier comments to the very defense forces he heads up. Many had felt that Mr. Rumsfield should have resigned over the Abu Ghraib prison scandal, which showed authority, and responsibility went right up into his office but he did not and cries that he be removed were ignored. The prison scandal still lurks in the background unresolved and could yet become a major headache in Bush's second term along with a fight to force Donald Rumsfield to resign.

We also continue to follow stories of voting irregularities and possible fraud and vote tampering particularly in Florida and Ohio where lawsuits, protests and congressional forums are taking place still largely under the radar of or ignored by the major media. Can it go anywhere? We don't know but if it does it could yet become a major scandal in the second term of the Bush Presidency. We are reminded that the last three Presidents that had second terms faced major scandals (Nixon - Watergate, Reagan - Iran Gate, Clinton - Monica Gate).

Internationally Iraq remains a powder keg and the elections of January 2005 remain in flux as insurgency attacks continue; the election of a new Palestinian Prime Minister could start to steady the long simmering Israeli/Palestinian/Arab conflict or it could end up making it worse; rhetoric continues negatively towards Iran who are claimed to be building nuclear weapons and the potential for a crisis in the Ukraine remains high despite the agreement to hold the elections once again. It is becoming clear that Russia still sees the Ukrainian elections as having only one acceptable outcome. Finally the risk of destabilization in Saudi Arabia remains very high as the recent attack on the US consular demonstrates.

Other markets of interest are of course gold/silver, oil/gas and the US$. First the US$. While we expect the US$ to at some time reach as low as 60-65 we may be approaching an intermediate low that could be good for a few months. This low should occur sometime in the first half of this year. During the formation of that low gold should run to our projected cycle tops of $480-$550 where there is long-term resistance. Silver may run to $9/$10 in the same period but it may also have topped now with the second attempt at breaking over $8. Longer term we remain very bullish on gold/silver but a top in these areas could be significant for at least a year as important cycle lows are due into late 2005 and 2006 corresponding with 4/5 year cycle in precious metals.

Irrespective we believe we have seen the last of $400 Gold and silver will not go back below $5.50 again. Both Gold and silver have broken their respective long term down trend lines and the 18-20 year bear market cycle is over. We remain in the early stages of a longer term bull market in the precious metals that began with the major breakouts in 2001.

Similarly Oil prices may have peaked with the top at $55 for now and enter a period seeking its own four year cycle low that is due late 2005 into 2006. It is possible that after a low in the first quarter of 2005 we do rally to new highs with targets of $70/$75. Certainly we believe we will not see oil below $30 again but corrective targets down into the low $30's could be seen. Natural gas prices will also remain high for the foreseeable future but will generally follow the path of oil prices.

As we go into 2005 the rally that began with the lows of October 2002 is still in play. The longer-term cycles suggest that the upcoming year should be positive again following a first quarter correction. Key to this forecast is that the first quarter correction remains shallow at no more than around 10%. As well never at any point must the lows of 2004 be broken. Second it is important that any possible scandals percolating in the background stay there. Third it will be important that for the most part the geopolitical arena remain low keyed. And finally the credit and monetary stimulus that has fueled this rally to date must remain in place and the market can gain more time to push the inevitable day of reckoning further into the future. Of course the authorities are hoping that the day of reckoning never comes or when it does that it is muted. It after all is why Alan Greenspan wanted to be the Fed Chairman during the Kondratieff winter, as he believed he could beat it.

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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