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PIVOTAL
EVENTS
FRIDAY, OCTOBER 4, 2002
BOB HOYE
Market Lore: Speculative action is fungible. Whether in stocks,
bonds, or commodities, excess has similar and measurable characteristics
as does its consequent unwinding of suddenly and chronically unsupportable
positions.
Any veteran of the formerly notorious Vancouver Stock Exchange would note
that no matter how preposterous the story is, as long as the trend is up
it will be ardently believed and will enjoy spreading circulation. Then
when the trend breaks, sobriety and chagrin prevail until the play is
utterly abandoned.
Of course, within the lengthy liquidation process there are brief short
squeezes and what has occurred with collapsing Vancouver schemes has
occurred in New York a few times lately - a very dynamic rebound that
lasts for a day and a half. The week enjoyed another such day and a half
winning streak.
The Record: Last month was widely reported as the worst September
since 1937. In looking at the monthly chart, all of the biggest bars have
been to the downside. Since 1900, these have also occurred in September
2001, November 2000, April 2000, August 1998, October 1987, May 1940, and
September 1931.
The latter is the most pertinent as it was a September of Year 2 after the
climax of a new financial era. Ours dropped 12% while the 1931 example
clocked a 31% plunge. However, the cumulative declines are similar with
the Nasdaq down 77% at the end of 3 Qtr. Year 2 and the Dow (speculative
index then) down 75% to the equivalent 3 Qtr. Year 2.
Hey, we are just the messengers - not editorial writers or investment
bankers. Our product is research, not paper.
The Model: For 2 Qtr. 2002, the high was expected for March and
that it would be the high for the year would be confirmed by the
ChartWorks registering important "overboughts" (4) with a sharp plunge in
April (4).
New lows for the bear were expected in June, but were not accomplished
until July 23. Then, after some recovery until late August-early
September, the decline would resume and set the low for the trend and for
the year by December.
Outlook 2003: Due to the unprecedented continuation of the boom in
the median home and big cars, the economy is not as bad as the action in
stocks and credit spreads. On October 2, the WSJ observed: "Tumbling
share prices may have hammered portfolios. But, instead of limiting the
damage by saving more, many Americans have retreated into an orgy of
spending." However, veterans of the markets, rather than contrived
economic theories, know that the compulsive action inevitably reaches
saturation.
The editor's alert to this failure has been unrequited since April. But
the reversal in the treasury curve to steepening and in Fannie's changing
fortune suggests that the speculative anomaly could pop.
Every cyclical or secular bear market in history has been eventually
accompanied by the equivalent in business activity and we do remain alert
to this.
In spite of this, the rally out of this hole until around May could merit
an increase on equity weighting.
Asset Allocation: When our boom indicators reversed in February,
2000, the advice was to reduce equity exposure from 60% to 40%. Then, when
the models worked out so well on the rally to May, 2001, the advice was to
reduce to 35%, which would be the minimum. The Indicators remain unchanged
at the very concerning -11 and, should the car and house boom fail, it
would drop another notch.
Nevertheless, some technical and historical work has been calling for an
important, and possibly cyclical, low for around November-December and it
seems appropriate to increase weightings from 35% to 42% equities.
One Model: The ChartWorks "post-euphoria" patterns following the
extravagances of Dow 1929, Gold 1980, and Nikkei 1989 have provided
outstanding guidance on the main trend as well as on the intervening
trades. We have also called the model "Road Maps" and these have led us to
a significant low for the late October to early January window, from
which, on each example, a cyclical bull market ensued.
Historical: This approach has been based upon all of the five new
financial eras since the first big one ended in 1720. The first thing to
understand is that the bear markets have been a consequence of the
speculation and not due to policy error by central bankers. The
post-bubble contractions strongly suggest systemic inadequacy rather than
policy error.
Now that cause and effect have been cleared up, the next importance is
that, using the two most recent examples as they occurred in the U.S.
(1873 and 1929), the bears lasted 5 and 3 years respectively.
The rule seems to be that all of the unsupportable speculative positions
will eventually be liquidated. Following 1929, it was intense, but being
on a sound money basis may have fostered the rapid clearing of that
hangover.
However, since 1934 the U.S. has suffered a "flexible" currency (as it was
originally touted) and, while it didn't change the duration of our new
era, it seems to be moderating the rate of post-bubble liquidation. In
May, we noted that the period from mid-year to December could be as
broadly severe as in the post-1929 contraction or, more generally,
moderate as in the post-1873 example when the U.S. also suffered a fiat
currency. (In this regime, the government insists the note is a dollar,
but the market determines what it will buy in tangible assets or, until
recently, in financial assets.)
As events rolled, the stock and spread markets have been very bad, but the
economy has been supported by the "buying orgy" in homes and cars. On the
observation that the economy has to get as bad as the stock market before
the contraction can conclude, this one is not over.
The upshot is that the stock market is due for a rally that will likely
have little to do with the near-term condition of the economy.
This is the first increase in the equity weighting since the Indicators
turned positive in early 1999, but this one is not based upon any
improvement in the Indicators. An increase from 35% to 42% equities could
be completed by early January - it's time, at last, to "buy the dips".
COMMODITIES
As we have been outlining, there has been some strength in commodities
that may not be signaling a robust global economy. Since the low of 878 in
March, our grain index soared 45% to 1272 on September 11. It has been the
worst drought in a generation. However, a tested high is in and the extent
of the downtrend will depend upon the 3-year drought ending.
Because of the consumer "buying orgy", the 350 target by December for our
base metal index has been deferred. Crude oil prices have recovered from
24.12 in June to 30.8 on Tuesday. Our target has been a seasonal high for
early October and this is being met. Once the top is in, our view has been
that the decline would be mainly due to seasonal forces joined by
declining global business activity. Of course, the U.S. raid to assist
political reform in Iraq would briefly pop energy prices.
The rise in the Baltic Freight Index has been extraordinary and there have
been a number of explanations, with this week's shutdown of West Coast
ports adding to the list. An old fashioned short squeeze still seems to be
the best explanation.
However, the steepening yield curve and widening credit spreads are doing
a number on the banks and financials. Although this ominous condition may
ease in the next month, it doesn't augur well for international trade.
INTEREST RATES
Credit Spreads: After March, widening was expected to resume and
reach dislocating conditions in December. However, pressures became
overdone last week with some stability evident in junk, emerging debt, and
the bellwether 10-year swap rate. This, along with a stabilizing stock
market, could prevail for 4 or 5 weeks, making for a choppy but flat
October. This could be disquieting to those who are adamantly bullish or
bearish.
Yield Curve: As part of the credit stringency likely to resume
after early September, the curve has been expected to steepen. This has
been the case and the pundits' tout about steepening being good for bank
stocks is not working. It shouldn't be, as severe steepening is integral
to a post-bubble deflation. From the August 22 high of 963, the BKX has
dropped 34% to 640, which is threatening the July low of 636.
Short rates were expected to rise until around March (4)
and then begin a lengthy decline to eventually around 1.00% for the 90-day
bill.
The Bond Future: The September 20 ChartWorks showed some similar
patterns that, once an "upthrust" was accomplished, a tradable price drop
would follow. On that week, falling below 112 ˝ would be the trigger and,
as the September 26 memo noted, the failure would be at 113^19.
Naturally, part of the rally has been due to slowing business activity
since mid-year as well as to recent stock market weakness. However, as we
have been noting since July, is the highly unstable refi convexity trade
(in engineering terms - positive feedback mechanism). Lower rates (on
schedule) prompt refinancing of mortgages. This is for financial advantage
and funds have been employed to upgrade the house, buy a second one, a
bigger car, or even cover margin calls.
On the refi, mortgage holders are paid down, who then position in
treasuries, which adds to declining yields, which stimulates more refi,
etc. This has now become compulsive action and, where the advantage was
substantial, as from a 6 ˝% to a 5% yield, it is now being done for a $40
reduction in monthly payments.
As with any positive feedback system, it goes parabolic until it fails
catastrophically. This is not to say that the long end of the treasury
curve can get trashed, but it does mean the refi speculation will
collapse. Mortgage default rates have been soaring.
COMMENTS FOR METAL PRODUCERS
Base Metal Prices: Obviously - no instability in this sector, which
is in a long-term decline in price and eventually a flattening of the
growth rate of the consumption curve to zero (0).
The weak point for the year could be set late in November with the next
slide in the stock market likely to begin in early October and end around
Christmas. The usual seasonal recovery to March-May could be constrained
by the collapse of the median home and big car "buying orgy".
Gold: The last low for gold's nominal price was 306.6 on August 22,
which was also the last high for the stock market. The stock market is not
the only item marked down in gold terms. Relative to commodities, our
index troughed at 228 from August 21 to September 12, from which it has
recovered to 250.
This reversal has been tested and it is likely that the correction
expected after May has been accomplished. This has been accompanied by
appropriate steepening of the treasury curve and widening spreads.
So far, the relative price has gained 9.6% while the nominal price is up
4.7%. This was the case as from October, 2000 to January, 2002 as both the
relative price and gold shares outperformed gold's nominal price. Then, on
a knee-jerk basis, the goldbugs became impetuous just in time to set the
forecast highs in May, 2002.
After September, gold's real price has been likely to start the next move,
which should be substantial and lengthy. However, liquidity problems in
the broad stock market could depress gold shares. Strong buying on such
weakness is recommended.
Gold/Silver Ratio: Our June 7 edition noted that silver was at an
important top, from which a long bear market in nominal terms, and
relative gold, would follow. Silver's high was 510.1 on July 15 as the
gold/silver ratio set a low at 62.5. The piece concluded with "Rising
through 70 would anticipate the next phase of credit distress. Our long
term target remains around 110.".
This ratio is not only the oldest price series in history, it also has the
characteristics of a credit spread. In rising to 70.9 in early September,
it anticipated developing distress. On September 26, it broke 71 and, now
at 70.8, bank and financial stocks are very weak.
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