Market at the Crossroads
The change of the seasons often brings not just the obvious change in the season but as well a change in the market. It is often a subtle change and the real move in the market might not get underway until just after the beginning of the following month. If you were to go back and look at just the past 5 years you would be able to note a series of mostly minor tops or bottoms occurring around the time of the equinox or solstice but sometimes taking until around the first of the following month to complete its top or bottom. The major top in 2000 was made on March 24 a few days after the spring equinox. People might also recall that the bottom following the September 11, 2001 attacks was made on September 21 the autumn equinox.
In this past year we saw a minor bottom made on the winter solstice 2004 with the actual top made on January 3, 2005 (the Perihelion) while the spring equinox brought us a minor bottom. So the change in the seasons is important. Because our top this year was made on January 3 we have been eyeing July 5 (the Aphelion) for a possible bottom to set up our second half of the year rally. Of course it is only now that we are making a pull back so we need to clearly see the action after July 5 to determine whether it might be a good bottom.
A few weeks ago we mused whether the markets might have "One more fling to the upside?" (Scoop - May 7, 2005). After all our cycles definitely favoured another up move as both our Dow Jones 1935 cycle and the Japanese 1995 cycle saw significant market moves occur after July 1, a true bulls dream. Couple this with the fact that no year ending in a 5 has been down and an up market appears as a lay-up. With interest rates remaining very low thanks to huge inflows of funds from foreign central banks trying to ensure their currencies don't rise against the US$ the conditions seem to be there for another sustained rise in the stock market.
Since then we have listened to countless bullish scenarios for the second half of the year. We note the sentiment indicators have very quickly become bullish again and we have watched the VIX indicator (a sentiment indicator measuring volatility in the market) fall to near record lows and finally RSI indicators move over 70 all indicating that there is considerable complacency in the market. So now the question begs can the market begin a sustained upward move even as both bullish sentiment and market complacency is indicating the opposite? If everyone who is bullish has already bought who is there left to buy?
The areas that do look positive are golds and energy. In the gold (precious metals) sector we have not reached the point of any mass complacency in the market. Indeed short positions still abound in both gold and silver while the recent rise in the metals and the stocks has not as yet reached any critical overbought complacent level. Probably because investors have suffered for the past two years in the sector after a couple of very good years from 2001-2003 and they remain more cognizant of the down market of the past twenty years. Similarly in the energy sector there continues to be some belief that the high prices (now approaching $60 for oil) remains temporary and that it will someday soon fall back to $30. Only recently have the oil and gas stocks come more alive after years of lagging the commodity price. They may in the very early stages of a more powerful move.
But make no doubt about it these markets along with metals and mining stocks are the true bull markets of the first decade of the 21st century. The one other area that has done very well in the first few years of the new century have been income trusts. The newness of the product is certainly a factor but it has been an ideal model for older stable businesses. We expect this sector to continue its good performance going forward. The risk to all of these sectors is a major market meltdown and even they too might suffer.
The broader market has since the lows of 2002 been going through a corrective move. Indeed despite the bullishness of numerous analysts the bulk of this move was made in 2003 with the last two years generally in a trading range flat. Witness the failure of the Dow Jones Industrials to substantially break through 10,500. The range during that period has been 9,700 to 11,000. We started 2004 at 10,450 and today the DJI sits well near 10,450. The broader S&P 500 has fared only slightly better as it started 2004 at 1100 and is now at 1200. And the NASDAQ, well it started near 2100 and today it is just under 2100. Only the TSX fuelled by the energy and the yield sectors of telecommunications, utilities, financials and income trusts has fared well rising from roughly 8,300 to 10,000.
The bulls would have us believe that the past two years flat is merely the forming of a new base that will fuel a new great bull market in the coming years once it breaks out. But we note that the numbers 100, 1000 and now 10,000 brought a number of years of consolidation for the Dow Jones Industrials. The DJI (its predecessors) approached the 100 level several times in the late 1800's finally breaking through in 1901. Still it took until 1915 for the DJI to leave it behind for good (setting aside the collapse of 1930-32 that saw it fall to 42). The market first crossed 1000 in 1966 but it took until 1982/1983 to leave the 1000 level behind for good. Now we find ourselves struggling at the 10,000 level and again we could be facing several years or even more than a decade to leave the area behind for good.
With the markets currently selling off following the triple witch option expiration last Friday and the summer solstice passing on June 21 it is clear that was at least a minor high. Key will be what happens going past July 5. It is possible that a low then will be the opposite of what occurred on January 3 and give rise to a stronger second half of the year as the bulls clearly hope for. Once again any rally, which would be strictly a trading rally, would be fuelled by the ongoing low interest rates and the supplying of an endless source of liquidity. But the Fed has been somewhat stingier of late. With rising short term rates we note that monetary growth as measured by M3 has not been particularly robust (up only 4.5% in latest 3 months and 4.3% over the past year). With money growth clearly slowing despite lower interest rates any rally could be quite laboured.
So even if we do go up in the second half of the year as so many now are predicting the risks are growing in the background. One risk that is talked about a lot is the potential impact of rising oil prices on the economy. While it certainly is a factor we don't believe it is the major factor. While oil at $60 is a record high we remain below the inflation adjusted peaks of 1980. Oil prices would need to rise to $90 or higher to equal those levels. But oil is just not as dominate in the economy as it was in 1980. Today it makes up less than 4% of GDP, up from 2.5% in rising 50% over the past year but still not dominate as say health care costs are in the US. Health care costs dominate the economy at 15.3% and continue to rise.
We see four dominate areas as offering very high risk to not only the US economy and the markets but to the world as well. They are the housing bubble, the hedge fund/derivatives market, trade wars and political instability. While the trade/budget/current account deficits and the huge consumer debt are at risk they will be merely part of the fallout as opposed to what triggers a collapse.
The housing bubble is becoming front and centre but it too may be just a victim of any fallout from a financial crisis. It was the headline on the latest issue of the Economist (After the fall - The Economist, June 18-24, 2005). The Economist points out that the current housing price boom has been greater than what occurred at the end of the 1980's and as well the Japanese housing bubble during the same period. The ratio of housing prices to rents has never been so high and is indicative that either rents must rise sharply or housing prices fall to bring this long term stable ratio back in line. In Great Britain and Australia the rate of price increase in housing prices has slowed considerably.
The hope everywhere is that even as they recognize that the current housing price boom is unsustainable is that they will flatten rather fall as they did in the early 1990's. Then they fell on balance by 20-25%. Today it could be even more precipitous as housing prices are more overvalued today then at any time; inflation rates are much lower; and far too many people have been buying houses as an investment. The investor's are the most vulnerable along with those that have bought houses with anywhere from a mere 5% down to even obtaining mortgages at 110% to 125% of value. As well upwards of 50% of houses are currently being purchased at variable rate mortgages and are highly vulnerable to rising interest rates.
The hedge funds/derivatives and credit markets are more complex. Last month these markets were shocked by the downgrade to junk status of General Motors and Ford even if it was widely expected. The Economist once again points out (Even keel? - The Economist - June 18-24, 2005) the credit markets were instantly hit as spreads widened on junk bonds and other collateralized debt obligations. But after a short spike that threatened some hedge funds who were caught on the wrong side of the trade the spreads came back in. So the market has held up at least for the moment.
But the junk bond market is very vulnerable. With GM and Ford on the ropes and downgrades to Ford Credit being discussed other companies are coming under closer scrutiny by the regulators. The number of downgrades has been on the rise over the past year a sign that despite the supposedly good economic conditions credit quality has been deteriorating. In almost every credit cycle banks seem to fall all over themselves to lend. What we have avoided thus far since the downturn in the early 1990's is a credit crunch. If another major downgrade were to occur it could be sufficient to tip the market over and a credit crunch would impact not only the corporations but especially the highly in debt consumer. The junk bond market would suffer a sudden collapse and some of the hedge funds (depending on the strategy) and a host of derivatives players would be at major risk.
The risk to the world economy due to trade wars can not be underestimated. This is probably why Federal Reserve Chairman Alan Greenspan (a.k.a. The wizard of Oz), said that a proposed 27.5% tariff on Chinese imports would kill rather than save jobs in America. It would also send the wrong message on trade to the entire world. Despite that Greenspan and Treasury Secretary Snow both agree that the Chinese Yuan should be revalued upward even as there is no evidence that would result in more jobs either. All of this seems to be falling on deaf ears in congress that is being pushed by protectionist policies and concerned constituents. As we noted in "China trade wars" (Scoop - June 10, 2005) the Smoot-Hawley Act of 1930 that raised trade tariffs was a major contributor to the Great Depression as global trade dried up. Greenspan is right on this one. The route being pursued by Congress could have an unknown devastating impact on global trade and result in the collapse of the US$ triggering as well a debt collapse.
The bid by CNOOC, the giant Chinese oil company to buy Unocal for $18.5 billion is also something that could embolden the trade protectionists in the US congress. The bid is now clearly the highest but it faces many hurdles the least of which is the US government may block the sale all together of a key US oil and gas asset to the Chinese. This comes on the heels of the Chinese bid for Maytag and its recent purchase of IBM's personal computer business. The purchase is being driven by China's huge needs for oil and gas reserves. Unocal has huge reserves in Asia so there is a fit from a business standpoint. But from the political standpoint will it fly? If the Chinese are clearly blocked for political reasons then there could be further fallout as with the trade sanctions.
The final risk we see is political. The War in Iraq is becoming increasingly unpopular. Bush's approval rate has fallen to around the 43% level a precipitous fall for a second term President. Approval for the war in Iraq has fallen to around 41% also at lows. The daily carnage from the Iraq insurgency is weighing on the public's mood along with the rising body count and the ongoing controversy of human rights abuses from the Abu Ghraib scandal and Guantanamo Bay prison and others. Approval ratings on the domestic economy were already low as well with the White House attempts to revamp Social Security proving to be very unpopular. With foreign policy joining domestic policy as a sore point with the US public this is making many congressmen even Republicans nervous. As a counterpoint Bill Clinton's approval rating following two articles of impeachment actually went up and was over 70%.
But low approval ratings from polls are not a threat to the US Presidency. The Downing Street memo might be. The Downing Street memo is a leaked British document dated July 23, 2002 from a meeting with British PM Tony Blair and his senior National Security Team. The memo was printed in the Sunday Times in May 2005. The memo states that the "intelligence and facts were being fixed around the policy". The invasion of Iraq was based on Saddam links to Al Qaeda and terrorism and weapons of mass destruction both of which have been proven to be false. The memo acknowledged that "regime change was not a legal base for military action" and that the only "legal bases: self-defence, humanitarian intervention, or UNSC authorization." It acknowledged the "first and second could not be the base in this case. Relying on UNSCR 1205 of three years ago would be difficult."
The Blair government has not disowned the memo. Representatives in the US Congress led by Representative John Conyers and 89 house members have demanded that the President explain the memo. The Bush White House has of course dismissed it. When Representative Conyers went to the White House to present the demands they were blocked from entry. The Downing Street memo is still back page news in the mainstream media but then over 30 years so was a break-in at the Watergate. It is of course illegal under the US Constitution to lie to bring the country into a war. The question is does the Downing Street memo have any legs that could lead to impeachable offences being drawn up against the Bush White House or will it die like so many other anomalies that have been documented since September 11, 2001? Impeachment is already under discussion in both the Senate and Congress in some quarters.
An impeachment crisis would of course paralyze the US (and the rest of the world) since this is based on very serious charges far worse than what the US experienced during the impeachment crisis of Bill Clinton over lying over sex. It would be more in line with the impeachment crisis over Richard Nixon that was part of the reason for a market decline for the Dow Jones Industrials by 45% in 1974. Richard Nixon had Watergate, Ronald Reagan Iran Gate, and Bill Clinton Monica Gate all in the second terms of the Presidency. Will lighting strike again against George Bush?
We leave you with two charts. The first is a monthly log chart of the Dow Jones Industrials that shows the huge rise since the 1980's and the possible huge topping action of the past five years. Below is a chart of the Dow Jones Transportation. For Dow Theory buffs note how the DJT made new highs earlier this year while the DJI still lies over 1000 points below its highs of 2000. This is a potential major divergence as a major tenant of Dow Theory is that the indices must confirm each other. The action on the monthly chart of the DJI is beginning to appear as a potential massive double top with measuring implications once the lows of 2002 are broken to at least 4,000 and possibly to 3,500. This would occur over the next two years if the patterns are correct.
Our second chart is weekly charts of Gold and Gold expressed in Euros. Gold in Euro terms has clearly broken out of a multi year consolidation pattern. Minimum measuring implications of this pattern is for a move to over Euro 400. The chart of gold notes a series of consolidation triangles being formed on the way from its 2001 lows. Each consolidation was followed by a substantial move to the upside. We are currently on the cusp of another break out to the upside. This chart implies a move to at least $490. What can not be ruled out until we do break out is another downside attempt to complete what might be a five wave abcde type of corrective pattern.
The message is clear. The market faces some serious risks. These risks are there in the background but they could explode at any time. If the bulls are right the may have another 6 months of time left but we believe that even if we do go up this summer and into year end it will be another laboured move. If the crossroads we are currently at proves to be a top then the drop could get underway this summer. The evidence should begin following July 5. Investors should, though, ensure they have bullion and some quality gold stocks in their portfolio as a defensive measure.