It's been a very hot summer. Hot hazy weather tends to slow us down. Good thing we work (or most of us anyway) in air-conditioned offices. But then with the sharply rising cost of oil and gas makes us look twice at our usage and maybe we set the levels on the AC a little higher. Indeed the sharply rising cost of oil and gas is the only thing that has been really hot in the stock market over the past few months. On the other side the rising cost of energy is beginning to show up in inflation numbers and it is impacting the profit (or outlook for profits) for host of sectors particularly the airlines, transportation and retail. The car companies (or at least the US car companies) in desperation to generate sales have dropped prices on their unsold inventories to the levels where employees buy them. That means effectively cost. And if that doesn't work? What's next - sell at a loss?
Everyone got excited because the market embarked on a summer rally. But then oddly the hot weather does for whatever reason start a summer rally. But overall it has been a pretty feeble rally energy aside. Just as we might have turned positive the market started to back off again. As of date the Dow Jones Industrials are actually down 2.1% on the year, the S&P 500 has eked out a 0.6% gain while the NASDAQ is down 1.8%. Some scorcher of a market. We call it churning. While the bulls got excited because of the rising 52-week highs and breadth they fell silent when it once again faltered. We should also say, "where's the beef" which in this case where's the volume. To be blunt it has been pitiful. What did we say, "Churning". Oh yes the TSX has been a scorcher up some 12.3%. But then energy is big component of the TSX and its up over 44%. The key financial group is up only 7.8% not bad but no great gains.
But all the action has not stopped the bulls. Investor sentiment rose to over 59% at its most recent peak lower then the 63% we saw last December but nonetheless at levels usually associated with a top. In the most recent survey the bulls were still at a lofty 57.3%. The VIX volatility indicator hit a low recently just above 10 but it has climbed to 13 over the past couple of weeks as the market has weakened. That's still well below the very bullish level of 15. Complacency abounds as the market just expects to hang in here and go higher. Oh did we remind you. This is a year ending in 5 and years ending in 5 have never had a down year or at least not in the history of the Dow Jones Industrial.
We have constantly pointed out that the market and the economy has been held aloft by record low interest rates and massive injections of liquidity from the Federal Reserve and the other world central banks. This has been the plan from the beginning of how Alan Greenspan would save us from the Kondratieff winter. But has he? We don't believe so but there are many who would disagree with us. We believe that all he has accomplished is to delay the inevitable and instead has contributed to keeping the stock market aloft when it should have been allowed to fall to more historical valuations levels eons ago.
The easy monetary policy has also contributed to financial bubbles first in the high tech sector in the late nineties and now the housing market. An equity loan against their homes to help consumers buy more "things" continues. This is dangerous because if we ever have a drop in the housing market or even if it levels off, savings rates remain abysmal and consumers have been using the equity in their house as their savings. A reminder that what goes up quickly can also fall quickly. No inflation? Check housing price increases. The housing prices to rents ratio remains at record levels and at some point there will be a reckoning.
An illusion is a more apt description of both the market and the economy. For sure the Federal Reserve has hiked interest rates 10 times in the past year but all it has done it bring it back more in line with the rate of inflation. Investor's in fixed income instruments struggle along basically breaking even or on an after tax basis losing money. No wonder pension funds have a problem, as it is impossible to grow under those circumstances. But rising interest rates are biting to some extent as we have noted a increase in the rate of personal bankruptcies. In the US they have changed to basis for going bankrupt in an effort to stem the tide. But irrespective if you can't pay you can't pay and if you have no assets then it won't matter. In the US most people go bankrupt because of medical bills they cannot pay.
The US continues to pile up incredible debts both budgetary and trade as well as the current account deficit. But as long as China, Japan and a host of other foreign central banks and financial institutions are willing to finance it while basically losing money this game will continue. But as with low interest rates and liquidity injections it is a game that gets more dangerous as time goes on. At some point it just doesn't work anymore or the financiers call the US's bluff. .
We have noted that money supply (M3) growth is only growing at a more meagre 5.0% over the past year. M1 in recent weeks has actually been declining a sign that all the monetary injections are just not working any more. Couple this with the non-existent savings it will only require a collapse in the housing market (that is already underway in Britain and Australia as well as in some European countries) and we have the makings of a serious problem. But the complacency out there still believes it won't happen. They were wrong on the housing market in 1990 as well. After all aren't the baby boomers nearing the end of their buying binge for houses? And then what with lower demand for the next 30 years?
We understand that following the July 7 bombings in London that the world's central banks flooded the system with money to prevent any market meltdown. But here we are barely a month later and we are once again faltering. The Chinese eased the pressure on the trade front temporarily when the revalued the Yuan upward by a mere 2% and set a small controlled floating peg. In the US the call for sanctions and trade measures against the Chinese has eased but we believe this is temporary as it should have only minimal (if any) impact on the massive US trade deficit and its growing trade deficit with China.
Trade remains a sore point. Here in Canada despite legal rulings that the US is out of line on the softwood lumber issue the US has refused to obey the legally binding NAFTA tribunal. Canada has walked out of talks and is now considering reluctantly trade tariffs against the US. As we learned in the 1930's through Smoot Hawley a collapse of global trade due to trade wars proved deadly. Based on past experience the US may encourage free trade but at the end of the day they make the rules irrespective of legal rulings. This is not the first time as there have been ignored WTO rulings against the US as well.
The political arena remains very murky and can and will have a major financial impact if things turn the wrong way. Bush's popularity has fallen; there are dissidents within the Republican party who are taking heat over the lies that took the US into Iraq (no WMD, no connection to Al Qaeda) and/or they are taking heat over the Plame affair (the outing of Valerie Plame the CIA operative and wife of Ambassador Joe Wilson who revealed the Niger cake hoax that first suggested that there were no WMD in Iraq); and anti-war protests are growing led by the symbol of Cindy Sheehan the mother of a soldier killed in Iraq decamped outside Bush's Texas's ranch.
The rhetoric continues against Iran as well. This is even as both the Chinese and the Russians have made it clear that an attack against Iran would not be met with approval. The US has drawn up plans to attack Iran in the event of another 9/11 type of attack on US soil even if Iran were not shown to be behind the attack. This became clear in a series of interviews conducted in Washington in late July that even got airtime on CNN and has been detailed in a recent issue of Executive Intelligence Review (August 5,2005 Vol. 32, No. 31). One can't help but notice the joint military exercises being carried out by China and Russia that appear to have nothing to do terrorism drills which is the supposed reason for the military drills. Is something bigger getting underway?
It is possible that none of this would make much of a difference but with the monetary bubbles of the past decade or so the financial system is masking over piles of problems underneath. Derivatives remain a huge problem as they are all generally lined up on the same side. If it goes opposite who will bail out the banking system? The institutions in the financial system are bigger than the Fed. The junk bond market remains very shaky particularly after the downgrade of GM and Ford. With these automobile companies desperate to make sales could further downgrades be coming? There are rumours of more problems at Fannie Mae (housing again). Creative accounting and hordes of mergers and takeovers can temporarily hide a lot problems. Most financial institutions have at least 3-5% bad debts on the books already. A housing market, junk bond collapse along with derivatives could mushroom the bad debts very quickly.
The next few months could help determine whether 2005 will maintain the record for years ending in 5. The expectations are so high one has to wonder whether we are being set-up. The month of September is the worst month of the year with the record on the Dow Jones Industrials showing it is a down month 70% of the time. August 12 marked the Fibonacci .618 point of the year and after August 12 the market often turns down. If we are being set up don't forget that in 1987 the market topped out on August 25 then drifted for several weeks before collapsing in October. If another 9/11 attack was to take place even on the scale of the recent British bombings (this year is the 4 th anniversary) the equation would change very suddenly and dramatically. The current market drift has us wondering if something bigger might occur that could yet turn this year ending in 5 into the first exception for an up year.
With all the illusion out there that everything is basically fine and under control investor's are reminded that no matter what hard asset commodities such as gold will maintain their value. At $US440/ounce it is still not historical expensive. This belief is irrespective of whatever short term gyrations one might see (even as the current short term gyrations are pointing to another pull back). Indeed the pullbacks are important in a bull market as long as they never take out an important previous low or a low of the previous year. For Gold that level is now $375. I feel more confident that the S&P will eventually break under 1060 (the lows of 2004) then gold will break under $375. Paper assets are just that paper no matter whether you are talking about stocks, bonds or currencies. But hard assets cannot be destroyed in the same manner so they can not go to zero.
We live in a world of illusions both monetary and political. Unless we miss our guess the next few years are going to prick these illusions. Complacency abounds and that is dangerous thinking. We leave you with a few interesting charts.