The Demise of the US Dollar
It has been five and half years since the markets topped in March 2000 and it has been two and half years since the market made a final (slightly higher) low in March 2003. In March 2005 the market made a high and six months later we are making another high. It is a high, however, where confirmations are lacking. The Dow Jones Industrials is not making a new high even as the S&P 500 and the NASDAQ made slight new highs. Worse the Dow Jones Transportation Index has been falling diverging sharply with the Dow Jones Industrials. Dow Theory says that the indices must confirm each other. Only the TSX Composite led by the energy sector has been making solid new highs and is now within 500 points of the highs seen in September 2000. Back in 2000 it was Nortel and the high tech stocks that led the way.
The fact that five and half years later we remain below the highs of 2000 should be of concern to numerous investors. We have noted that the market is being underpinned by complacency levels that were not even seen at the market highs in 2000 (The VIX volatility indicator remains well below the levels seen in 2000 at the highs and even sentiment indicators remain high). Since the lows of March 2003 the most of the gains were made in 2003. Since then the market has largely traded in a slightly rising flat that has only increased the expectations that the market will ultimately move higher not lower in the near future.
But five and half years is long time to see no new highs yet we are still being consistently told that the lows of March 2003 marked the end of the bear market and we are embarking on a great new bull market. Maybe investors thought that as well as the market struggled back in 1930 following the stock market crash of October 1929. But it took until 1954 a period of 25 years before we finally left those highs behind. Similarly while the market topped in 1966 and we either approached that level or took it out slightly (DJI) at least 4 times over the ensuing years it wasn't until 1983 a period of almost 17 years that we left those levels behind. On the other hand the highs seen prior to the stock market crash of 1987 were exceeded in 1990 and left behind for good in 1991 a period of only slightly more than 3 years.
So with no new highs now in five and half years and well into the four year cycle from the October 2002/March 2003 lows we wonder how much life the bulls might still have. This is a year ending in 5 and years ending in 5 have never in the history of the DJI in the last 100 years been known to have a down year. But most of 2005 has been spent making what appears to be a huge distribution pattern in the major indices and effectively churning around the unchanged level despite numerous stocks making new highs. Low volume, a declining A/D line and persistently high bullish sentiment are signs that all is not well in the major indices.
We continue to hold to our belief that the major indices made significant highs in 2000 that will not be exceeded for years as we work our way through the Kondratieff winter. What we have been witnessing since the lows of October 2002/March 2003 is a major corrective wave following an impulse wave to the downside. Corrective waves or B waves can go all the way back to the old highs as we are seeing with the TSX Composite. The S&P 500 recouped almost 61.8% of its drop at recent highs, but the NASDAQ has recouped barely a third of its losses. The Dow Jones Industrials at its highs near 11,000 had regained about 81% of its losses from 2000-2002.
But if stocks topped in 2000 a host of others were making significant bottoms from 1999 through 2001. The way has been led by commodities. The CRB Index representing a basket of commodities made a multi year double bottom in the 190's in both 1999 and 2001. The index now stands near 320. Major components such as Oil bottomed in late 1998 just above $10 and of course recently topped just above $70 almost a seven fold increase. Natural Gas prices bottomed near $1.75 in 1999 and then tested that zone again in 2001 and now stand over $11. A host of other commodities including copper, aluminium, nickel, lumber and others have shot up significantly in the past few years driven in particular by heavy demand from Asia. Gold made a multi year double bottom near $250 in both 1999 and 2001 and now is making new highs over $450. Silver also bottomed in 2001 near $4 and today it is over $7.
Overlooked in all of this reversal of fortunes is the US$ Index that made a series of tops from 2000 to 2002 in the 120 area and has since fallen some 27%. We believe it is now poised to fall lower. The rally that got under way early in 2005 that took us up to just above 90 we believe was the culmination of a larger corrective wave that originally started a year earlier in 2004. Both stalled just above the 90 level. We have long held that targets on the US$ Index down to 60/65. Minimum targets on the move we believe is now getting under way are down to around 70.
So what is going to drive the US$ lower? The rally in the past year in the US$ was helped by the Fed raising interest rates and the strengthening of the US economy in a low inflation environment. That is now changing. While many will point to Katrina as the reason that the US economy may fall into a recession into 2006 the reality was that there were numerous signs of economic weakness and teetering before Katrina even hit. Katrina may be, however, what tips it over.
Prior to Katrina employment numbers were sluggish at best; automobile sales were sluggish being kept aloft by continual discounting and leading to numerous questions about the survival of the US automobile companies; leading indicators were almost continually negative; the price of energy was rising consistently; budget deficits continued to grow as did the trade deficit despite some recent small improvement; capacity utilization at just under 80% remains below levels normally seen at this time of an expansion that would be closer to 85%; retail sales were falling even prior to Katrina; and sentiment indicators were beginning to slip. Housing remained one bright spot but even there, there were signs that the boom was flattening out as interest rates rose. While core inflation remained very low this is explainable because there remains considerable slack in the economy (see capacity utilization above and helped by cheap imports) and this keeps a lid on any wage inflation.
If the economy was beginning to soften prior to Katrina it may now tip over. One of prime reasons is sharply rising energy prices. While energy prices softened after the initial spike after announcements that oil and refined distillates would be released from strategic reserves this is a temporary measure at best. Gas prices at the pump remain in the $3/gallon range up a good $1 prior to Katrina. At least 5% of refinery capacity is out of commission for at least two months or longer. Workers at the plants are scattered unable to get to work and some may never return. Global refinery capacity was already stretched to the limits prior to Katrina. The heating oil season is approaching and heating oil prices are at their highest levels in years. Consumers are going to have to devote an increasing level of their budgets to energy and that means that while there may be some softening of demand with higher energy prices the real impact will show up in declining retail sales elsewhere and an inability to make up any difference with tapped out credit lines and inconsequential savings other than their house which may have seen prices top out. The consumer makes up at least 75% of the economy.
While upwards of a quarter of US oil and gas output is shut down possibly still for months (with the potential for more hurricanes to disrupt things further) this was offset to an extent by the release of strategic supplies. Unsaid of course is that irrespective of how much strategic reserves are released they will be going all out to replace them so the net impact on oil prices should be temporary at best. We are now targeting to $79/$80 for oil prices. We are seeing some immediate impact of higher oil prices with the bankruptcy of Northwest and Delta Air Lines and the squeeze on a host of transportation companies dependent on truck shipping and companies dependent on goods getting to them by both land and air. Do we see some resurgence in rail shipping?
Jobs growth, which at best was sluggish prior to Katrina, is now expected to fall. Unemployment claims jumped sharply in the past week by 68,000 and it is expected that claims will rise an additional 180,000 or more in the coming weeks eclipsing even the claims after 9/11. Upwards of a million people are effectively homeless and it is the biggest migration since the dust bowl of the Great Depression. People are now effectively scattered all over the US and even some are in Canada. Many will not return putting to question the so called building boom that will result out of the disaster. With the inability to get to jobs in New Orleans and area they will be looking for jobs elsewhere. There is also a spin off impact on jobs in other areas outside of New Orleans and the area devastated by Katrina. Factory orders are being impacted lower, business activity is falling below critical levels and they are all facing higher energy costs. The economic impact of Katrina may last longer then everyone expects.
Slowing economic activity is not positive for the US$. The Federal Reserve which meets this coming week is now between a rock and hard place. Inflation is surging because of rising energy prices but slack in the economy that was already there prior to Katrina keeps the core rate down and as a result keeps a lid on wage inflation. This is a dilemma for the US$ that was dependent on rising interest rates and continued good economic growth to rise further. Worse the trade disputes that existed prior to Katrina and the Chinese adjusting the Yuan slightly upward remain. China is now the largest exporter to the US surpassing Canada. There remains a risk of trade tariffs or sanctions on a host of Chinese goods that could set off a trade war.
Katrina is putting additional strain on the US budget deficit in addition to the costs associated with the war in Iraq that just keeps getting worse. Politically George W. Bush's popularity is at its lowest ever following the fiasco response to Katrina. And while he can't be personally blamed the Federal Government agencies particularly FEMA appeared horribly disorganized and bureaucratic burdened. How would they respond to a terrorist attack? Indeed when one looks back at 9/11 the response was superior to this one raising other questions given that 9/11 was supposed to not be predictable but the potential for disaster in New Orleans had been predicated for years.
Not to put all the blame on the Federal agencies, the State of Louisiana and the New Orleans municipality also were slow to respond indeed spurning help until it became obvious that it was a disaster and demonstrating a lack of planning and the implementation of pre-prepared emergency plans. Comparisons, fair or otherwise, have been made to third world countries in how Katrina was handled. Irrespective all of this is another negative for the US$ as there is a loss of confidence.
If the US $ is going to fall then gold (and silver with it) are going to rise. The correction in gold seen since December 2004 (a classic Elliot Wave ABCDE correction) appears to be over. Targets are a minimum $502 and the HUI Gold Bugs Index is targeting 330. Gold has broken out to new highs in both US$ and in Euro terms. This is a positive development. The US$ as we note appears to have completed a corrective move culminating in a rising wedge triangle that formed with the move from January 2005 and peaked six months later in July 2005. Targets as we note are down to at least 68/70.
Is this the demise of the US$? The US$ will probably survive for many more years but as we fall further the calls for a new Bretton Woods will get louder. The US$ is the world's reserve currency and like the British Pound who for more than 100 years had been the world's leading currency it too eventually lost its spot at the top. This is not necessarily a bad thing but the readjustment period to a different monetary world will be painful.