On Shaky Ground
David Chapman
With the markets and the world focused on the potential for war in Iraq we may have lost focus on why we are in this mess in the first place. The war is merely a distraction; grant you a serious distraction, which will not solve the ongoing financial collapse that has been working itself through world markets now for several years. The latter part of the 1990's gave us the bubble portion of the financial crisis spurred on by easy money and credit generously supplied by the central banks (The Fed) and the banking sector. Now we are seeing the hangover generated by the money and credit bubble. Brief enjoyment becomes long-term pain.
If the month of January was supposed to be the hope that we could have an up year it has surely disappointed. Everywhere markets were down. Dow Jones Industrials -3.4%, S&P 500 -3.3%, NASDAQ -1.8%, TSX -0.7%, Tokyo Nikkei -4.3%, Hong Kong -2%, German DAX -5%, Paris CAC 40 - 4.1%, London FTSE 100 - 9.5%. If things are supposed to get so much better than why is everything going down. Certainly in listening to numerous market pundits we sometimes wonder if there is even a bear market out there. The worst offenders are Lawrence Kudlow and crowd at CNBC who undoubtedly are the biggest (still) bull cheerleaders around. We wonder if they live on another planet.
While the bulls see joy in rapidly growing money supply numbers (+6.3% year over year M3 in the US) we see it as at best supplying liquidity to the market but at worst a continued attempt to monetize our way out of the problem. But key to continued monetary growth is lending by the banking system and that is beginning to slow. Consumer confidence continues to fall, recently hitting nine-year lows. Despite this consumer credit has grown in 2002 at around a 2-3% pace and mortgage growth has been gangbusters over 10%. But recent consumer credit numbers have actually shown a decline; clear signs that the consumer is beginning to ease up on spending. As well business spending and borrowing remains lethargic.
In the late 1990's the US government was generating a budget surplus. Now that has turned into a budget deficit. The most recent year saw a budget deficit of over $300 billion surpassing the budget deficits of Reagan /Bush Sr. in the late 1980's. It is projected that the upcoming year's budget deficit will also exceed $300 billion. A projected $5.6 trillion budget surplus over the next decade has been turned into a $1.7 trillion deficit. Numerous US states have also fallen into budget deficits and with no room to maneuver, and not being allowed to run deficits, they will have to slash expenditures or raise taxes.
Total debt as reported in the Federal Reserves Flow of Funds exceeds $20 trillion or 200% of GDP. Of that about $5 trillion belongs to governments. These numbers do not take into account the rapidly growing current account deficit that grows at $450 billion/per year nor does it take into account unfunded liabilities such as social security. The trade deficit alone is approaching if not surpassing the GDP of South Korea and reaching 5% of US GDP - a record. This massive transfer of money is effectively deducted from the country. While some has come back in the form of investments less and less is returning as both the US stock market and the dollar decline. Corporate profits alone fell on balance 10% in 2002 and are expected to be no better and probably worse in 2003.
Credit quality has been deteriorating now for some time. One need only look at the record number of bankruptcies. High profile ones included Enron, Global Crossing, WorldCom and others especially in the telecommunications sector, where over capacity continues to plague. Mortgage foreclosures are also continuing at a record pace despite the hot housing market that has been fuelled once again by easy credit and low down payments. As the housing market cools, and surely it well, the last vestiges of the credit consumer society may come unglued.
Massive risks abound in the financial sector through derivatives and structured finance deals. In the 1990's numerous financial innovations such as derivatives and structured finance deals as a way to grow fee business away from traditional lending has led to highly leveraged portfolios that put the entire financial system at risk if there was an "accident" that triggered series of defaults. This was seen in its most pronounced fashion first with the collapse of the hedge fund Long Term Capital Management (LTCM) at the height of the Asian/Russian crisis of 1998 and more recently with the collapse of Enron.
Even a conservative banking institution such as the Royal Bank of Canada (RY-TSX, NYSE) shows on their most recent annual report shows $18.8 billion in equity against $358.2 billion in liabilities and $2.1 trillion the notional value of derivatives (all amounts in Cdn$). Risk, as defined by replacement cost for derivatives is reported as $10.6 billion. When the potential for future credit exposure is added it grows to $24.2 billion. Net write offs as a % of average loans was 0.60% in 2002. At the peak of the last recession in the early 1990's it reached 1.63% (1994).
The bulls believe that by maintaining an environment of low interest rates, providing sufficient liquidity to the system through monetary policy and by providing fiscal stimulus through deficit spending and tax cuts that it will be sufficient to buy our way out of the problems. Trouble is that is what got us into the mess in the first place. With short term interest rates below the rate of inflation, excessive monetary and credit stimulus only giving us anemic growth and budget deficits threatening to once again squeeze out the other borrowers for increasingly scarce capital it can only result in a horrendous squeeze in the economy that will eventually tip it back into a more serious recession. It is the private banking sector that must turn on the taps to lend that will fuel the growth. But with credit problems abounding, and defaults and bankruptcies rising, credit spreads continue to widen and deteriorate, the banking system is slowly turning off the tap. This gives rise to a classic credit crunch.
The Japanese thought that the above recipe would be their panacea but as we have seen, it is merely bringing huge budget deficits and anemic or even negative growth. The banking system has few creditworthy counter parties to lend to and they themselves are saddled with enormous bad loans most of which is not collectible and has still not been properly recognized. But Japan still has a healthy current account surplus and a high savings rate, two key elements that are not present in North America.
And interest rates are vulnerable. Short-term interest rates are now below the rate of inflation (inflation -2.4%, 3 month Treasury Bills - 1.25%). Long-term interest rates are vulnerable on a couple of fronts. First is the notion that inflation is dead. In the last year the Commodity Research Bureau (CRB) Index has increased 29%. The CRB Index is a basket of 17 commodities often used to track inflationary trends in the economy. The CRB Index tends to move inversely to bond prices. Secondly the US dollar is falling. Again the US$ tends to move inversely to bond prices. Bond prices have so far held up quite well largely because it is believed that the Federal Reserve will not allow them to fall and bonds are often a recipient of funds fleeing to safety in the face of a falling stock market and war jitters.
Our chart of the CRB Index and the US Dollar Index shows the two moving in opposite directions. The CRB Index appears to have made a huge double bottom in 1999 and again in 2001. This could be significant as the 1970's inflationary cycle began with a low in the CRB Index in 1971. The double bottom projection is to around the 275 area. World commodities are priced in US$. The rising CRB Index is also reflecting the falling US$. The CRB Index has clearly broken the downtrend line from the mid-nineties top.
The falling US$ is problematic and with it now breaking under the up trend line that has been in place since 1995 a new bear market appears to be underway. A falling US$ is helpful to US exports and should slow the massive imports that the US has become so highly dependent on. In turn this should help the huge US trade deficit. But a falling US$ is also bad as capital flows out of the country away from the US bond market and stock market. With growing US budget deficits and virtually no savings this will put further pressure on interest rates as the demand for capital grows to finance the twin deficits and crowds out capital needed for the private sector to pull itself out of its slump. With the banks tightening credit the real fear is credit crunch that will put further upward pressure on interest rates.
With these long-term trend lines gone reversing the current rise in the CRB Index and fall in the US$ is nigh on impossible. As proven in the past efforts to stem a tide once it gets underway usually exacerbates the problem. As well the Japanese are now concerned that their currency will rise and they are desperate to keep it low raising the specter once again of "beggar thy neighbour" trade policies and competitive currency devaluations that always end badly as we saw at the height of the 1997 and 1998 Asian currency crisis and during the Great Depression. Already we are seeing numerous mini trade wars break out as each country tries to give their industries an advantage. In this type of environment only one thing shines and that is gold.
But rising gold prices aside the real concern for most people is the falling stock market. And the stock market has a lot further to fall. And a falling stock market is putting pressure on all sorts of financial entities. Pension funds have become under funded to the tune of an estimated $300 billion in the US. This will put immense pressure on companies to finance these pension obligations and in turn that will put continued pressure on falling profits.
Falling stock prices also put pressure on a host of institutions whose fortunes are tied to the stock market. Insurance companies, particularly in Europe who are in their own mess, banks, pension funds, mutual funds whose redemptions erode both the market and their viability monthly, are all very vulnerable to a further decline in the stock market. This is a situation that has been prevalent in Japan over the past decade yet each attempt to revive that market falls flat and it trudges to new lows.
And so the stock market moves lower. Indeed we are in the throes of possibly creating an interesting symmetry that bears watching. Our weekly chart of the S&P 500 shows the lows that were made in October 1998 and again in September 2001, roughly 3 years apart. The low in both cases was at 923 and 945 respectively. Notice how that line is now acting as a huge barrier to further advances. That is aside from what appears as a giant head & shoulders topping pattern on the S&P 500. Recent action has therefore been testing the neckline of that huge topping pattern.
Now go back to 1997 and notice the action on the markets just before it burst through to the 1998 top forming what appears as the left shoulder. That same zone (940-980) was roughly acting as a resistance level just before it burst through to the next level. Before that the rally that took us to the important low was the lows seen in April 1997. We are now almost 6 years from those lows. This has suggested to us that in order to complete the symmetry we could be seeing some important lows in the March/April period of 2003. The low in April 1997 was around 733. The low seen in October 2002 was 768.
Since our low seen in October 2002 (768) was considerably under the low seen in October 1998 (923) by March/April we should see lows under April 1997. Support areas to focus on are the lows of December 1996 near 743 but more interestingly the lows of July 1996 near 605. Ultimate long term targets for the S&P 500 according to the head & shoulders pattern is 330. The highs of the 1990 market were near 370. If the symmetry holds, however, we shouldn't see those levels until at least 2004, which would coincide with the lows of 1994 and the ten-year cycle.
Falling back that far has some logic to it as well as a major bear market tends to wipe out all of the gains of the previous bull market. Taking that to its extreme of course would suggest a fall on the S&P 500 to 100, which is where the great bull market at the end of the century began in 1982. We don't believe that will happen but the 300-400 level is certainly feasible. At that level valuations as measured by Price Earnings and dividend yields should be more in line with historical levels. If you don't think that a collapse all the way back to where things began is possible, may we remind everyone that Nortel Networks rose to $124 in 2000 and fell all the way back to $0.67, levels that it had not seen since the 1980's.
With the economy on shaky ground anyway a war, especially one not sanctioned by the United Nations, may be enough to tip us over to the next lows. Already the stock market is exhibiting crash pattern characteristics having fallen under the lows seen in December 2002 and failing to muster much in the way of rallies beyond one to three day wonders. A falling stock market was going to happen irrespective of a war. And the war is merely a distraction to make one forget about the weak economy and monetary system. So war is not an excuse for a falling stock market. Instead what should be examined is the system of money and credit that caused the false economics and the economic and stock market bubble in the first place. Then once we understand that then maybe we can start to figure out how to make it right again. Until we do we are headed ever lower. It is not something that should be ignored.
February 10, 2003
Charts and technical commentary by David Chapman of Union Securities Ltd.
69 Yonge Street, Suite 600, Toronto, Ontario, M5E 1K3 (416) 604-0533, (416) 604-0557 (fax) 1-888-298-7405 (toll free) email david@davidchapman.com
The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. Neither David Chapman nor Union Securities Ltd. take responsibility for errors or omissions which may be contained therein, nor accept responsibility for losses arising from any use or reliance on this report or its contents. Neither the information nor any opinion expressed constitutes a solicitation for the sale or purchase of securities. Union Securities Ltd. may act as a financial advisor and/or underwriter for certain of the corporations mentioned and may receive remuneration from them. David Chapman and Union Securities Ltd. and its respective officers or directors may acquire from time to time the securities mentioned herein as principal or agent. Union Securities Ltd. is an independent investment dealer and is a member of the Toronto Stock Exchange, the Canadian Venture Exchange, the Investment Dealers Association and the Canadian Investor Protection Fund.
Email this Article to a Friend 
Printer Friendly Version
