The world has divided itself into two camps. How dangerous and meaningful this is going forward is difficult to say at this time. Based on the early sniping that has taken place it in itself does not bode well going forward. In a fascinating editorial in the Globe & Mail on March 20, 2003 Timothy Garton Ash has described the world as dividing itself into camps reminiscent of George Orwell's Nineteen Eighty-Four. Eurasia that includes France, Germany, Russia and (China) and Oceania that includes the United States, Great Britain, Spain, (Australia) and I might add Japan. At the more local front the pro-war and anti-war camps are sure to intensify their feelings in the coming weeks with the anti-war movement in particular sure to step up the protests that have been ongoing now for months.

We have often said that the Kondratieff winter is not just about a darkening economic cloud. That includes the political as well. And wars are a major part of the fall out from both dysfunctional economics and dysfunctional politics. At this stage though the political (war) is overwhelming the economic. But one of the reasons we are where we are, is the deteriorating economic picture. A war, where the focus shifts to its successful implementation and support for the forces, can always mask economic regression. It is amazing listening to pundits who believe that a successful execution of the war will result in bringing back the happy days of yore. But the economic deterioration was happening long before the war started. The war and the terrorist attacks of September 11, 2001 are not the reason the markets are falling but they are obviously both a byproduct and an aide in the markets malaise.

At the risk of sounding repetitive and as well borrowing what other more worthy scribes have as well pointed it is important to keep ourselves on the reasons as to why we are where we are and why the ending of this particular phase of the war (and this is merely another phase of a war that could eclipse this decade in many different forms) will not change anything except for a short term rebound that indeed could last a few months. We are summarizing below a number of the issues both past, present and future.

• We are coming off of one the biggest stock market bubbles in history. At its top in 2001 the Price Earnings (P/E) ratio on the S&P 500 reached well past 35. In 1991 when the decade got under way the P/E ratio on the S&P 500 was in the 15-17 range, which was more in keeping with the long-term average. In peaks seen in 1929, 1966 and 1987 the P/E ratio only reached to around 20-22. Bear market lows have traditionally been seen at a range of 7-10. Today after the market falling for three years the P/E ratio of the S&P 500 is still in the 28-29 range. Dividend yields also fell to one their lowest levels in history near 1.25%. At bear market bottoms yields might rise to the 4-5% or even higher.



• The Great Bull Market at the end of the century was fuelled by a massive increase in liquidity as measured by money supply growth (M3) that grew from 8-10% per year after 1995. As well debt was growing at roughly the same rate. These rates of growth were generally twice as fast as economic growth as measured by GDP. But debt growth was largely the consumer and corporations as governments generally were paying down debt at the end of the decade. The banking system, which had lobbied hard to have reserve requirements eliminated, played a big role in the expanding the debt and money supply with the Federal Reserve providing the accommodative stance. Much of this money was unproductively invested in the sharply rising stock market. At the same time, savings rates collapsed to near zero (and occasionally negative). Savings rates remain dangerously low.



• As a result of the massive debt growth corporations and consumers are now holding unsustainable levels of debt that will need to be cleansed as unemployment rises and the economy slips into recession. There have already been numerous high profile corporate bankruptcies particularly in the technology and telecommunications sectors. Consumers are going through a period of record bankruptcies and record home foreclosures. A rising housing market has resulted in re-mortgaging. As the housing market tops and prices come down this massive amount of mortgage debt will become vulnerable. Already there are serious capitalization problems at Fannie Mae and Freddie Mac two of the largest US mortgage lenders.



• The world economy is slowly rolling over. The Euro area is barely growing up 1.3% in the past year. There are few signs that improvement is in the offing. Japan continues its decade long malaise. While the past year saw some improvement there are signs that Japan is once again beginning to slide. The fast growth Asian economies have slowed down and rising fuel prices and possible trade problems could hit their export dependent economies. There have been country bankruptcies most notably Argentina. There are some bright spots most notably China but if everyone else slows then China will suffer as well. Another bright spot has been Canada. But a slowing US economy and possible fall out from the war could impact Canada negatively.



• While the worst in Corporate wrongdoing may be past (Enron, WorldCom etc) there still may be more. Corporate wrongdoing was also major characteristic of the Great Depression. Reforms have been put in place and a number of former CEO's and officers were indicted. But there has also been foot dragging and a lack of real commitment to putting teeth in the reforms.



• The world's banking system is shaky at best. Japanese banks remain buried in their decade long malaise with many of them bankrupt. Japan has still not moved sufficiently to recognize these bankruptcies and clean up the mess. In Europe banks and insurance companies are increasingly showing signs of severe stress. In North America banks have taken a battering in write offs but they still haven't reached the levels seen at the bottom of the early 90's recession. A large potential overhang in consumer debt and more corporate plus the potential for a liquidity crunch that has not as yet materialized will limit any growth potential in the sector and leave them very vulnerable going forward.



• US banks have some the world's largest derivatives exposure with one bank J. P. Morgan Chase having derivatives exposure of $25 trillion or higher in a global exposure of upwards of $150 trillion. While that is notional amounts the actual potential exposure in Morgan's case is still in the area of $50 billion. Many derivatives are over the counter transactions where there is often no direct offset. Warren Buffet has described the derivates market as a ticking time bomb. It was derivatives and structured finance deals at the heart of the Enron collapse. In 1998 a large hedge fund Long Term Capital Management (LTCM) collapsed because of huge mismatches in their highly leverage portfolio. A large bankruptcy yet to come or uncontrolled world events could yet cause a derivatives nightmare that many have talked about but few can in any specific put a finger on the problem.



• The world's airline industry is for all intents and purposes bankrupt. High fuel prices and sharply reduced travel due to war, terrorism malaise and heightened security are making the words "profitable airline" an oxymoron. After the Gulf War in 1991 a number of airlines disappeared. But this is an ongoing one and the current war is only going to add to the malaise. If ever an industry needed a short resolution to the war it is the airlines.



• The decade of the 1990's was one of collapsing currencies. The British Pound, Mexican Peso, the Asian currency crisis were amongst the currency woe highlights. But the US Dollar, the world's reserve currency while weak at the beginning of the decade ended the century on a high note. Now the US$ is falling. The US has a trade deficit that is currently running at $450 billion annually and rising and reaching to 5% of GDP. Trade wars are a real threat in a world of declining currencies as each country scrambles to protect their industries and their positions. Already volleys have been fired particularly in the steel industry. The deterioration of relations at the United Nations threatens to intensify trade disputes. Boycotts are underway and there have been threats of retaliation against those that did not support the US in its war efforts in Iraq. Trade wars in the 1930's were a major contributor to the Great Depression.



• In the 1990's the US brought huge budget deficits under control as did numerous other countries. But now budget deficits that might have totaled $5.6 trillion over the next decade have now turned to budget deficits that might total $1.7 trillion. This past year the budget deficit reached a record $300 billion in the US. Many US States are also running huge budget deficits that will either have to be covered with service cuts or tax hikes. Proposed tax cuts will add to the budget deficit malaise rather than improve it. There is an unknown cost to the war that has not been factored into the current budget deficits. The combined effect of unsustainable trade deficits and growing budget deficits are both a drag on the economy, crowd out other borrowers and a risk to the bond market with rising interest rates.



• The collapse in the stock market is taking its toll on pension funds and the mutual fund industry. Effectively they are trapped at considerably higher levels. The pension fund industry is in the US estimated to be under funded by upwards of $300 billion. This shortfall will be a drag on profits for years and indeed many pension funds may never recover leaving the pensioners with decreased payouts. Many funds and insurance companies are using creative accounting to try and maintain an illusion of holding their own. Therein may lie the next corporate scandal. The mutual fund industry has been facing constant withdrawals for upwards of year now. The recent RRSP season here in Canada was one of the worst in memory. While consumer sentiment is clearly very low, fund managers as a group remain quite bullish.



• The security pall that is casting its shadow over the North America from Homeland Security and elsewhere is a longer term unknown. The constant coloured alerts raise anxiety levels and dampen sentiment. While trade has been slowed it has not come to a complete halt. In a world that is dependent on trade and ongoing globalization it is potential negative that combined with the potential for growing trade disputes could be debilitating down the road.



• Finally the war that has progressed well in the early stages could yet face severe problems going forward. The early stages have in a way gone pretty well as expected, as the Iraqi defenses are not concentrated in the South. The specter of torched oil wells has already reared and may be portent of more to come. The fast bullish elation in the markets on an expectation that has not as yet been fulfilled is a sign of complacency that may leave itself exposed to a disappointment.

Note: Charts created using Omega TradeStation or SuperCharts. Chart data supplied by Dial Data.

Our weekly chart of the S&P 500 shows the fast rally that has occurred since the mid-March lows. It has covered over 10% and 100 S&P 500 points in barely two weeks. The measurement of fear and greed, the volatility index (VIX) remains almost unchanged in the mid-thirties. Despite the massive bullish elation that has come into the market on an expectation that has not yet been completed the VIX may be quietly telling us that the bear move is not as yet over. We have run right into resistance in the falling 40 week moving average and above lies the both congestion resistance and the neck line of a massive head & shoulders top. The market is clearly expecting more than can be delivered. It is saying that a quick end to the war will signal that happy days are here again and we will soon be back at 1500. Need we remind them that the reason we are here in the first place is to coin an old phrase "it's the economy stupid".

The market may well still move higher here before it is finished. We do have major turns next week and some time back we expected them to be lows. Could the low be in? Well, yes but the resistance above assures that we will soon get another test of the lows again. At that point we will be able to determine the true nature of this fast rise. Certainly the fundamentals of the economy say any further up move is dubious at best and wishful thinking at worst. The growing world polarization does not lend itself to positive economics going forward as the risk of trade wars looms larger. The massive head & shoulders top on the S&P 500 still points to a target of 300-400 eventually but it will take some time to play itself out. In the interim next week should begin to tell us whether this has any real potential or just turn out to be short-lived war elation.

24 March 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.