Confessions of an Unrepentant Bear

By: David Chapman | Fri, Nov 14, 2003
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I confess to being bear. An unrepentant bear. But being a bear is only on the broader market. On gold I am a bull. And I am bullish on oil and gas. So there really is some balance in my life.

Being a bear on the broader market has not been easy over the past several months. We are of course up since the March 2003 lows some 25% on the Dow Jones Industrials, 32% on the S&P 500, 25% on the TSX Composite and a whopping 54% on the NASDAQ. But as a gold bug I can point and say yes thats pretty good but we are up 91% on the Gold Bugs Index (HUI), 63% on the Philadelphia Gold &Silver Index (XAU) and 48% on the TSX Gold Index. And as well we are up 13% on the TSX Energy Index since the lows in April 2003.

Recent economic numbers are trying their best to tell everyone that bears like me are merely doomsayers and that now we must concede that the US economy is on its way to a blockbuster year. Well actually we don't and yes we still see it as a flash in the pan at best and papered over exaggerations at worse. Of course we all admit that the 7.2% growth pace of the second quarter will not be repeated and yes the recent jobs numbers were better than expected. But a closer look at what drove the better than expected GDP numbers reveals that government spending (and the tax cuts) played a big role in the numbers.

Kurt Richebacher, a former central banker and Austrian economist, writing for the Daily Reckoning noted that Government spending accounted for 38.2% of the second quarter growth following a 40.7% share of the first quarter growth. Given the recent massive expansion of the US budgetary deficit this should come as no surprise. US budgetary deficits are expected to go over $500 billion in the coming year a truly astounding number. Still that represents only about 4.5% of the GDP well below the 6% figures that were seen in the 1980's when the US went into massive deficits to finance the cold war.

But this is not the cold war with a well-known and well-defined enemy that was eventually won because the other side went bankrupt first. The so-called war on terrorism is ill defined, open ended against an unknown and unseen enemy. But is there any one to bankrupt except the present one spending all the money? So why all the fuss over the GDP numbers?

In examining the GDP numbers seasonally adjusted in the most recent Federal Reserve Flow of Funds Accounts GDP growth was only .99% in the second quarter versus an increase of .94% in the first quarter. Hardly, as Mr. Richebacher pointed out, much movement at all. But in looking at the components it was easy to note that consumer spending actually was slower in the second quarter versus the first ($83.1 billion vs. $87.1 billion). Other components of GDP also fell. The big boost from Government spending went a long way in boosting the numbers. Even the much ballyhooed growth in business spending was when inflation and seasonally adjusted barely a blip rather then the big rise touted. Other things such as the ongoing massive trade deficit continued to subtract from GDP. With the trade deficit soaring to over $500 billion this is actually a significant drag on the economy.

But one area that showed little hesitation in growth was debt borrowing up an astounding $1.08 trillion in the quarter from the previous quarter. Grant you a huge part of this was the government. But the consumer continued to borrow as well up some 19% in the quarter from the previous. Mortgage lending also leaped by 28% from the first quarter. It seems massive amounts of borrowing can fuel anything it wants to. This is supposed to engender confidence?

The massive increase in borrowing particularly from the government to finance their growing deficits is starting to have an impact. Long-term interest rates bottomed in June and have been rising ever since following a pause over the summer. A falling US Dollar and rising commodity prices are also fuelling the rise in long interest rates. The rise in commodity prices is being cited by the bulls as the sign of the global recovery. Much of the growth and demand is being led by China. But a falling US$ also contributes to rising commodity prices as they are all priced in US$. In other currencies the commodity prices are often relatively unchanged.

Interest rates were also raised recently by both Australia and Britain reflecting growth concerns in those countries. Rising interest rates will eventually bite into the cost of consumer credit and mortgage rates slowing the unprecedented rise in borrowing and resulting in reduced consumer spending. Strong trade flows have also contributed to world growth but protectionist measures against China and others may result in unwanted and unwarranted trade wars.

A recent WTO ruling for steel tariffs went against the US. A wide range of tariffs are being proposed in particular by the European Union against the US if the steel tariffs are not removed. A movement to trade wars and protectionism would be deadly for the world economy just as Smoot-Hawley and trade protectionism was during the 1930's contributing significantly to the Great Depression.

There is the ongoing war in Afghanistan and Iraq. It seems that the lessons of history are never learned. The British and the Russians learned that Afghanistan could not be tamed let alone conquered. In ancient times both the Greeks and Romans eventually retreated from the area known as Mesopotamia (today's modern Iraq) having failed to quell ongoing revolts behind them. And following WW1 the British faced numerous revolts as they set to occupy the area largely to control the oil resources. They too eventually retreated and the weak leaders they left in their wake eventually led to the rise of the strongman Saddam Hussein.

The war has manifested itself in a series of guerrilla/terrorist attacks that results in ongoing rising body count, sapped morale and rising costs. It is the costs that eventually bankrupt a nation as Russia eventually learned in its misbegotten war in Afghanistan in the 1980's. What Vietnam failed to do in the 60's and 70's the rising costs of the war in terrorism may do that to the US in the first decade of the new millennium. There also remains the high possibility of another attack on American soil that if it occurred would devastate the economy and the stock market.

And there are other risks. The Price Earnings (P/E) ratio of the S&P 500 is in the mid 30's below the peak of 2000 but well above the lows seen a year ago. Long-term P/E averages are still only about 15 with bear market lows of 8-10. Over the past few months reports indicate that insiders are selling more than they are buying with numbers we saw for July 2003 indicating record insider selling. October numbers showed that insiders sold at a ratio of 59 to 1. A 20-1 ratio of selling over buying is considered very high. Bullish consensus numbers according to Investor's Intelligence are at 54.1% of Investment Advisors and upwards of 70% for investors. These are extremely high and unsustainable.

Despite the recent improvement in the jobs numbers the US economy has still bled almost 3 million jobs since 2000. Many of the recent job improvements have been in so called McJobs. We have noted in the past that the US unemployment numbers are undoubtedly grossly understated, as it doesn't count new workers, dropped out workers nor those whose employment benefits have ceased. I have personally received numerous emails from well educated Americans formerly employed in good paying full time jobs today struggling to make ends meet underemployed in part time jobs. This is the reality and the elation over the improved numbers papers over the real situation.

The technical picture looks no better. The stock market has been elation and bullishness rising on easy money, easy credit and anaemic volume. Our chart of the S&P 500 shows a potential bearish rising wedge formation. This very bearish formation once it breaks tends to return to where it started which implies at back to the October 2002 and March 2003 lows. Numerous indicators are showing increasing negative divergences as market internals deteriorate. The breakdown is currently near 1035 S&P 500 that currently coincides as well with the 50 day moving average. Comparable bearish formations are also showing up on other major indices as well as numerous stocks.

The US Dollar picture also remains quite bearish and may be in the throes of another descent. Targets here are to the bottom of the bear channel near 85. This is very positive for gold that maintains targets from $425 to $460. Once achieved however the US Dollar may embark on a significant correction and gold would also follow with a significant correction. We may be gold bugs but taking at least one third of positions off to protect profits once targets are being achieved allow investors to buy back in later. We do have potential significant cycle lows in gold in late December through January. If there is any danger here is that massive intervention to prevent the US Dollar from falling coupled with a grand stand at attempts by gold to break through $400 or somewhat above that level could allow this scenario to start sooner than we might expect.

So what are investors to do? One area of ongoing stability has been in income trusts. While many talk of a bubble in the sector we have seen little sign of one. Our top choices have been in the oil and gas income trusts particularly those with a significant gas component. Some excellent examples are Advantage Energy Income Fund (AVN.UN-TSX) (www.advantageincome.com), Shiningbank Energy Income Fund (SHN.UN-TSX) (www.shiningbank.com), Focus Energy Trust (FET.UN-TSX) (www.focusenergytrust.com), and Paramount Energy Trust (PMT.UN-TSX) (www.paramountenergy.com). If investors just want to play it safe in a diversified fund the Sentry Select Diversified Income Trust (SDT.UN-TSX) (www.sentryselect.com) is a good example. Just remember though that these investments are not risk free.

I remain an unrepentant bear. The bear market that started back in 2000 has not as yet run its course. The rally in the market over the past several months is at best an impressive counter trend fuelled by easy money, easy credit and massive budgetary deficits. It is sound and fury signifying nothing except setting us up for the next big fall.


 

David Chapman

Author: David Chapman

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

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