Meltdown Dead Ahead?

By: David Chapman | Fri, Oct 22, 2004
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We are always surprised at the complacency of the bulls in the face of mounting evidence that may have got it wrong. Indeed we have listened endlessly recently to forecasts of how we have now survived through the worst month (September) and that traditionally markets often bottom in October (although sometimes as late as November) and then take off in the traditional late fall and Santa Claus rally. They might still be right but that doesn't mean they may not get a good Halloween scare first.

But complacency is what we have seen of late with the VIX at record lows while the indices were not even at the highs seen earlier in the year. Even recent sentiment numbers in the mid to high 50's and even low 60's suggests that the market was once again becoming overly confident. Of late the economic numbers while certainly not in the depressing range have been below expectations (see leading indicators). And job cut announcements just keep on coming the most recent from General Motors.

Grant you not all the job cuts with GM are in the US but still when you realize that thousands of job cuts have been announced recently beyond GM then there is a growing problem. The high tech sector in particular has seen very high job cuts of late with no particular up tick in new hiring. And it is being born out by the recent employment numbers where the non-farm payrolls came in sharply below expectations plus revisions to the downside in previous months. Couple this with the generally rising trend in the weekly claims report and someone somewhere is going to realize that the economic recovery is not all its cracked up to be. Is there a saving grace on the jobs front? It has been suggested that the underground economy is where the jobs are and is also behind why the retail sales numbers still look good.

But the underground economy aside job losses are just a part of the growing problem. The recent trade numbers came in at a deficit of $54 billion the second highest on record. We are on track for a $600 billion dollar deficit for the year or roughly 5.5% of GDP. In 1987 we had a stock market crash when the trade deficit hit 4% of GDP. So is this a problem? Well it is easy to rationalize away the deficit and say it doesn't matter because it is just a recycling of goods and dollars. Asia (China) supplies the goods to satisfy the demand for goods in the US and then recycles its dollars right back to the US to finance the deficits.

Trouble with that picture is that not necessarily do all of the dollars come right back into America. Nor does it always come back in the form of just financing the debt through the purchase of Treasury Bills and Treasury bonds and notes and/or the bonds and paper of US corporations and agencies. Some of it is used to purchase other US assets including buying other companies and real estate. And some it is going to buy assets in other countries. An example of that is the takeover attempt being made by the Chinese state owned MinMetals to buy Noranda Inc. (NRD-TSX) the giant Canadian zinc, nickel and copper, producer. China with its insatiable demand for metals needs to secure its own supply. And they have indicated it won't stop at Noranda.

To add to the deficits the recent budget deficit numbers came at over $400 billion or approaching 4% of GDP. Still low by some standards (Japan's is around 8%) but we are reminded that the only G7 member to run a surplus is Canada. The US budget deficit in percentage terms to GDP is not yet as bad as it was in the late 80's, early 90's under Reagan and Bush Sr. But in listening to the recent Presidential debates there seems little hope that no matter who gets in that it is not about to come down any time soon and indeed could get a lot worse especially given the growth rate under Bush Jr.

We are reminded that all US debt including future social security requirements is now well in excess of 3 to 1 to GDP an unprecedented number not even seen during the Great Depression. Even taking the more conservative numbers seen in the Federal Reserves Flow of Funds the number is roughly 2 to 1 to GDP but that number excludes future social security requirements. We wonder how the over leveraged economy will end especially for the over leveraged consumer. The consumer stands at the highest levels ever for debt to income of 125:100. In Australia a recent Economist article said that there consumer debt/income ratio was over 160:100. Seems that there are others that are even more profligate.

Oil (and natural gas) prices just keep ticking higher. Higher oil prices act like a tax on the economy not dissimilar to a hike in interest rates. The impact of higher oil prices can be delayed similar to interest rates. But oil is an essential in many consumer products besides automobiles. The world faces both a demand and a supply problem with growing demand, no new major sources coming on stream and threats to supplies due to attacks in the Middle East where 65% of all of the world's oil resources lie. Plentiful and more expensive sources of oil are available but many of them are in extremely environmentally sensitive areas, deep in the ocean or expensive to produce (Canadian oil sands, Venezuelan shale fields).

What is disconcerting concerning oil prices is listening to a large number of analysts that view the current rise as merely temporary and when this passes oil prices will fall back to the $30 to $35 range especially with the lifting of such temporary disruptions as the Gulf of Mexico stoppages due to the hurricanes. Offsetting this is bullish sentiment numbers for oil as high as 77% suggesting that there are very few bears out there.

But with a falling US$ another reason oil prices are moving higher (along with numerous other commodity prices) is to compensate producers for their declining purchasing power. The US$ has started what looks like another leg down with minimum targets projected down to major support at 80 on the US$ Index. Longer-term targets project down to the 60/65 levels with some analysts projecting down to 50.

For a number of months now we have consistently maintained targets for oil to rise to the $55 to $58 range. We are now at the bottom of that range. It is very possible that we could hit another temporary high here. But as quickly as we hit the zone and staged a reversal oil prices oil has reversed right back to the upside again and is threatening new highs. What could be the unexpected in this oil bull market with many expecting lower prices, is that it will surprise instead to the upside.

Amongst those soft-pedaling the rising oil prices is Alan Greenspan who insists that prices are nowhere near high enough to inflict the kind of damage caused by the 1970's oil crisis. Of course Mr. Greenspan is correct in that oil prices are nowhere near the inflation-adjusted prices of the 1970's, which would have to rise to $80 or higher to attain those levels. But these kinds of statements are whistling in the dark unless Mr. Greenspan knows that prices will never reach those lofty levels. In Iraq there have been numerous attacks and shutdowns on the oil pipelines during the ongoing war. What if an attack occurred on the Saudi pipelines?

But if a lower dollar, higher oil prices and job cuts are not enough to roil the markets the insurance scandal may what tips it over the edge. Since the bubble tech market of the late nineties burst the markets have dealt with numerous scandals including Enron, WorldCom and plus others in the investment banking and mutual fund industry. The latest target of Eliot Spitzer the New York attorney-general is been civil charges against Marsh & McLennan the world's biggest insurance broker. The scandal also appears to go beyond Marsh and could soon envelope numerous companies.

If there is one thing this scandal has accomplished is that it has pushed the Fannie Mae scandal into the background. It may be that it is in the background only because it takes so long to try and figure these things out. It may yet rear its ugly head and slam the markets not to say the potential for trouble in the US real estate market given Fannie Mae's pre-eminent position as American's biggest mortgage lender. But it could get worse. We are hearing rumours that the next major investigation is going to be in the Derivatives game. Could J.P. Morgan Chase the world's biggest holder of derivatives an area we have long suspected as being rife with problems be far behind being dragged into an accounting scandal?

And lest we forget to mention the Fed is slowly raising interest rates with at least two more hikes already priced into the futures markets. Rising interest rates raise the possibility of cutting off the cheap supply of money that has fueled the markets for the past few years especially for home mortgages. And long rates could rise as well as we were intrigued when Goldman Sachs one of the world's most pre-eminent investment banking companies announced that investors should reduce their bond holdings for the US from 25% to 10%. That's nothing they said to get out of Canadian bonds altogether.

Finally there is the uncertainty of the election. This campaign has made previous bitter, polarized negative campaigns look like a walk in the park. The level of rhetoric has risen to atrocious levels on both sides. The campaign is rife with personal attacks, lawsuits especially concerning touch screen voting machines with no paper trail and a history of computer glitches (and as an aside the largest manufacturer Diebold is a major contributor to the Republican party), and charges of fraud and deceit as vicious attempts are being made to keep or prevent key voting constituencies from voting or off of the voting lists. The polls are too close to call and we may wind up like we did in 2000 with a hung jury for weeks on end and lawsuits and legal action flying in every direction.

Given everything it is amazing the markets have held together. But then it is an election year and in watching the market action of late every plunge is met with buying to push it right back up again and every piece of bad news is offset but even the slightest good news as an excuse to rally. And all of this has taken place on pitiful volume. A bull would observe that despite all these recent problems of high oil prices, insurance company scandals, slowing economic numbers, job losses, hurricanes, hung polls and yes did we fail mention somewhere numerous profit results somewhat below expectations that the market has been extremely resilient. And did we forget to mention that terrorist alerts remain at a high level and may intensify as we near the election.

So what are we to think? Will the markets melt down or will the positive election cycles kick in and ride us into December and then get the traditional Santa Claus rallies that will take us onto new highs in 2005 where there has never been a down year in a year ending 5? Or will the markets break down recognizing the deteriorating economic situation, the growing scandals and be pushed over the edge with a hung election ala 2000 and a possible terrorist attack.

We favour the downside just because the markets have been so complacent and the negative divergences are becoming unmistakable. But then we can't rule out the upside either. The key levels to watch for on the S&P 500 as we go forward are the 1080/1090 zone on the downside and 1020/1030 on the upside. Any breakdown or breakout of these levels will lead us either to 960 or 1250.

As cycles analyst Michael Jenkins points out we have been dominated in the first years of the new century by the 1930's cycle, which for the most part we have followed reasonably faithfully. Of course while 1933 was a huge up year so was 1935 following the consolidation of 1934. We are showing that chart below. Note that the cycles turn up into November until January and then we correct into March before taking off for good.

The best hope for the bears is the Japanese 1990's cycle another pattern we have been able to remarkably follow thus far. That market topped in June 1994 (and we saw a high in mid June 2004 for our markets as well) but October saw only a minor high and after a rally in December (Santa Claus rally?) we went off the cliff straight down into July 1995.

We believe the growing negative news and high market complacency will lead us into a meltdown dead ahead into 2005. Not what the bulls would want at all. But until we break key levels on the downside the bulls cannot be ruled out. We may be on the verge of determining that direction.


 

David Chapman

Author: David Chapman

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