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January 23, 2009

Its A Depression!
by David Chapman

This past weekend, visiting our local Chapters book store, we were struck with the large display up front of books telling us about the new depression, how we got there and how to survive it, books about the Great Depression and a host of others. Bemused by the entire display, we decided to purchase I.O.U.S.A. One Nation. Under Stress. In Debt (Addison Wiggin and Kate Incontrera, John Wiley & Sons, 2008). I.O.U.S.A. is also the name of a documentary film that was recently shown both in Canada and the USA and was nominated for the Grand Jury Prize at the 2008 Sundance Film Festival. The book comes from the folks who bring us The Daily Reckoning.

It should come as no surprise that there are those out there who believe we are headed into another Great Depression. It is also no surprise that there is an even larger body that are in denial of the collapse that has taken place and there are those still issuing rosy forecasts of a short painful downturn followed by a quick robust rebound.

Our original thoughts on this collapse were that it will be a long drawn out affair but not necessarily a full blown depression. That might still be the case but there are now growing signs that this could indeed turn into a depression irrespective of the attempts of the monetary and fiscal authorities to bail us out with massive spending plans and interest rates plunging to zero. There has been a number of write ups of late from what we would refer to as mainstream economists citing numbers that would support more the likelihood of a possible depression.

Still it remains to eventually have the numbers that support that thesis but irrespective those looking for a painful downturn followed by a quick rebound are also attempting to forecast that things are not as bad as it seems and our fiscal and monetary steps will bail us out. Quite simply that is as deliberately dream building as the gloomy forecasts are nightmare building. Our expectations now are that while we could still see a near term rebound there is now a real risk that this rebound will be temporary and eventually we could see new lows in the markets that keep us depressed for a number of years to come.

One such recent article came from Sprott Asset Management's December 2008 newsletter, entitled Surviving the Depression. Right up front it said: "we are in a Depression. That's right; it's the dreaded "D" word. And we are knee deep in it right now" (their emphasis, not mine).

Just like that, we are in a depression. Now we realize that Sprott Asset Management is often outside the box just as we can be but we certainly wouldn't be dismissive of it. While the economic numbers have definitely been dismal, we haven't reached any of the levels that would confirm we are in a depression. And in talking about a depression we are primarily referring to the United States and quite probably Britain and some other European countries. Canada is in far better shape haven taken many positive steps in the previous decade or so to put its financial house in order so there is some support that ours might be a steep recession but not a depression.

The second source we would like to mention was a missive from Reuters in London: "the United States' economy looks likely to enter a depression and China's could implode." This quote came from Societe Generale's asset strategist, Albert Edwards. He is predicting a rout in the stock market with a fall to 500 in the S&P 500. The Soc Gen report noted that "While economic data in developed economies increasingly reflects depression rather than a deep recession, the real surprise in 2009 may lie elsewhere" and "the Chinese economy is imploding and this raises the possibility of regime change".

So far we haven't seen any men in top hats and tails selling apples on the street. Nor have we seen any boarded up store fronts, long lines of shuffling men and women, or scuffles on the street between the unemployed and the police. Not yet anyway. Albert Edwards of Soc Gen is also well known for his bearish outlook.

One of the more compelling articles was in The Economist of December 30, 2008 (Diagnosing Depression). In reading it we quickly discovered that great minds think alike, as we beat them to it by roughly a month in our Technical Scoop of November 24 (A depression or not a depression). Both of us examined some past depressions; The Economist concluded that a depression is an economic decline that exceeds 10 per cent and lasts more than three years. Scoop noted the decline of more than 10 per cent but not the three years of decline.

Both of us certainly noted that the Great Depression qualified, as the 1929-33 collapse saw USA GDP fall by over 30 per cent and it lasted 43 months. A secondary depression hit in 1937-38 with a further GDP decline of between 13-18 per cent. The Economist noted that the Great Depression was not the longest; that honour went to a "Greater Depression" of 1873-79 that lasted 65 months.

That depression was interesting for a number of reasons, coming as it did after the US Civil War and reconstruction. Strangely enough, some of today's themes were present. Following the war there was a massive period of overexpansion primarily centred on railways and canals (the infrastructure projects of the day). In 1861, in order to finance the war, Lincoln set up what was in effect a central bank and issued money (specie) not backed by gold. This led to a rapid increase in money supply.

Following the war, all the money floating around led to a period of excessive speculation prior to the financial panic of 1873. There was a gold panic when speculators tried to corner the market, only to be snookered by the Government who released gold into the market (The Black Friday Panic of 1869 - for us the high tech/internet bubble followed by the collapse into 2002). There was also a natural disaster (the Chicago fire of 1871 -- we had Hurricane Katrina 2005) and a biological attack (the equine influenza of 1872 - for us the SARS influenza of 2002/2003).

But it was massive speculation in railroad building that did the real damage. This time around it was the housing boom. A comparable infrastructure/railroad boom was also taking place in Europe, particularly Germany. In all it was the usual story: too much debt and too much capital chasing too few stocks creating a bubble followed by a massive bust. In September 1873 a Philadelphia bank, Jay Cooke & Co, collapsed into bankruptcy. The government of the period, instead of allowing the money supply to rise (remember in those days money supply was primarily tied to gold), contracted it instead. The massive expansion suddenly collapsed.

By the time the dust cleared the New York Stock Exchange had closed for a short while, dozens of railroads went bankrupt along with numerous banks, tens of thousands of workers were laid off, factories closed and thousands of businesses failed. In Europe the devastation was worse. Exacerbating the problem was that governments had moved to protectionism. Protectionism had already begun under Lincoln and was another cause of the Civil War, as high tariffs fell heavily on the South, who were heavy importers.

Speculation, easy money, overexpansion - these are the things that all financial panics and eventually depressions are made of. What happened today is little different than what happened in 1873. But do they all have to end up as economic depressions?

The Economist premised that the USA's GDP may have fallen by an annualized six per cent in the fourth quarter of 2008. If true, such numbers could certainly lead us into depression. And this is not just idle speculation. Most economists are dismissive of the likelihood of a 1930s style depression or even a repeat of Japan in the 1990s. But a six per cent contraction (and The Economist is not the only one who has premised that) is beyond anything that happened to Japan during the 1990s (worst peak-to-peak trough in Japan was a 3.4 per cent decline). But there certainly could be a 2000s style depression, whatever that may turn out to be.

What we are facing is in essence global insolvency. This has been caused by the collapse of the biggest asset and credit bubble the world has ever seen. The names of banks that are in trouble or have failed already make a Who's Who of the global financial world. The entire Icelandic banking system went under, taking the whole country with it. Bear Stearns, Lehman Brothers, National Rock PLC, Royal Bank of Scotland, HBOS PLC, the latter three a core of the British banking system, Wachovia Bank, Washington Mutual - we could go on (and on).

Ireland is nationalizing banks (see Allied Irish) and through the TARP program the large US banks are also being nationalized in all but name. Many US banks (Citigroup, Bank of America) are on their knees as are a number of British banks (Barclays). Citigroup has already announced in excess of $1 trillion of losses leading the way for the walking dead banking institutions.

The KBW Bank Index has fallen roughly 80 per cent from its highs of February 2007. To put that in perspective, the Dow Jones Industrials fell 89 per cent from 1929 to 1932. There are three financial components in the DJI. American Express (AXP/NY) has fallen 77 per cent; JP Morgan Chase (JPM/NY) has been the star, down only about 60 per cent. The dog has been Citigroup (C/NY), down an astounding 95 per cent. Bank of America (BAC/NY), not a DJI component, is down 88 per cent. The three DJI financial components could all go to zero and the DJI would only lose about another 300 points. Such is their reduced influence now.

Canadian banks have fared relatively better. Recently only the Bank of Nova Scotia (BNS/TSX) and Royal Bank of Canada (RY/TSX) have hit new lows. None of the others are hitting new lows and may actually be trying to form bottoms. The TSX Financial Index is down a relatively modest 47 per cent from its highs. When compared to US banks, the Canadians are a safe investment. Of late all have been raising capital through preferred share issues and seem to be successful doing so.

We are showing a chart of the KBW Index and the TSX Financial Index. Despite the collapse there are some positive signs emerging that we could be poised for at least a correction to the recent collapse. But in looking at both these charts while a correction is clearly possible we still do not see any signs that they have made their final bottom.

But the fact remains that everywhere we go, the numbers are grim. The most recently published US unemployment rate is 7.2 per cent. Under the Clinton administration they removed discouraged workers from the unemployment rate. With these workers included the rate is closer to 12 per cent, according to economist Robert Reich. The report on discouraged workers is put out by the Bureau of Labour Services (BLS).

Shadow Government stats (www.shadowstats.com) shows that unemployment could actually be closing in on 18 per cent. SGS estimates on discouraged workers are higher than those reported by the BLS and also include marginally employed workers, many of who would take full-time jobs if there were something available. While it is argumentative as to whether one should include marginally employed workers as part of the unemployment numbers still all of these compared to the officially released numbers paint a much grimmer picture then is being reported.

Auto sales and housing starts are two important measurements of economic activity. Auto sales are down 38 per cent from a year ago, at 10.2 million units - 1982 levels. The prior year it was 16.4 million units. In Canada auto sales are down a more modest 20 per cent. The latest US housing starts showed 550,000 units. This was well below the expected 605,000 and 15.5 per cent below the previous month's 651,000. We are down 45 per cent from December last year. On average, housing completions in 2008 were down 25.7 per cent from 2007. As the Sprott article noted, these are depression numbers, not recession numbers.

We are showing how badly the real estate indices have fared below. The PHLX Housing Sector Index (HGX) is down 75 per cent from its highs of 2005. In Canada the TSX Real Estate Index is down a more modest 48 per cent from 2007. Like the bank indices shown above we may be in the process of trying to form a near term bottom. But we emphasize like the bank indices it may only be a corrective rebound that occurs as we are not showing any clear signs of a bottom.

We hardly see a day go by now without job layoffs being announced. It is a relentless depressing beat. First-time claims were reported at 589,000 in the most recent weekly report; a 26-year high. Industrial production is predicted to be down 7.8 per cent for 2008. Consumer confidence is at the lowest ebb since the recession of the early 1980s.

2008 saw world stock markets as measured by the MSCI Index fall 47 per cent. This wiped out some $22 trillion of market capitalization. This is liquidation on a massive scale. Below we have a chart of showing this liquidation. This does not address the capital wiped out due to the global housing collapse, which would add even more trillions of dollars.

Losses at global financial institutions are reaching epic proportions. Some estimate a final total of $10 trillion. We noted earlier that Citigroup has already absorbed losses of $1trillion. At www.bankimplode.com they have listed some $3.2 trillion in write-downs for global financial institutions. The world's central bankers and fiscal authorities are trying to solve the problem by lowering interest rates to zero, or close to it, and by throwing unlimited amounts of money at the problem. In Canada official interest rates are down to 1.0 per cent, while in the US they are zero to 0.25 per cent. There are estimates from the Conservative government in Canada that deficits will hit $34 billion: a mere two per cent or so of GDP. By comparison the US is talking of budget deficits of $1-1.2 trillion, which would be eight per cent or more of GDP. While Canada's budget deficit is quite manageable after several years of surplus, the US deficit would fall into the realm of third world countries and economic basket cases.

It might only last for a year, but fiscal managers have indicated that deficits of this size may last more than a few years. The danger is that a liquidity trap will develop. This occurs when interest rates are lowered to near zero and there has been an increase in the monetary base but it does not stimulate the economy. Instead of spending any of the money, households prefer to save or pay down debt. None of that contributes to economic stimulation. Banks are generally unwilling to lend in this environment as they are nervous about whether borrowers will be able to repay. We are already seeing that happening and that is a major contributor to deflation. We can see the massive increase in the monetary base in the Federal Reserve chart below as a sign of the massive monetary stimulus. We have never seen anything like this.

With forecasts from major economists of a six per cent contraction in the fourth quarter for the US and a forecast of a 4.8 per cent contraction in the first quarter in Canada (Bank of Canada Governor, Mark Carney) it is optimistic to think that the rebounds they forecast will be as strong as they say. Given the structural damage and mounting unemployment, it will take a lot longer to get out of this mess then the monetary and fiscal authorities are telling us. The massive monetary stimulus is in the long run very inflationary. How it manifests itself is difficult to say but we have noted in the past that monetary stimulus eventually results in the creation of another bubble. Our suspicions this time as to the benefactor - Gold.

Several US States are either bankrupt (such as California) or are wavering (New York). Many states will need bailouts. California has suspended tax refunds and welfare payments in order to save money. Rising homelessness and the potential for social unrest are certain by-products of the deteriorating situation. Speaking of social unrest, there have been reported economic protests and riots in Iceland, Latvia and Bulgaria. Could they come here as well? Economic and social unrest, protests and riots were a staple of the Great Depression. There is no particular reason for it not to happen here as well as unemployment, homelessness and bankruptcies rise.

What is an investor to do? Cash pays nothing or next to nothing but would at least ensure that you don't lose. Bonds have been strong performers in the past year, but with mounting forecasts of deficits and growing debt, the ability to raise funds without also having to raise interest rates is highly unlikely. Bonds are now very expensive and are a potentially risky investment. While the US dollar has enjoyed a strong rally over the past several months, the rise has been largely artificial as it has been due to repatriation of funds from forced liquidations.

Despite the weakness in the markets seen this month, we continue to expect a rebound in the stock market of some substance. The rebound may not be as strong as expected and may only last about a quarter. Investors will certainly have to be nimble to survive in that environment. The S&P 500 is still showing positive signs for us. We may be forming a large head and shoulders bottom pattern. Another way of looking at this is the 2002 bottom played itself out as a series of three bottoms - July 2002, October 2002 and finally March 2003. While the time frame this time is shorter our bottoming may be somewhat similar. Still we need to not see new lows and we need to break above what may be the neckline near 925. Targets would be at least 1200/1300.

The real danger is that the lows of November 2008 break. Then there is serious potential for all hell to break loose as the markets plummet to new lows. This cannot be ruled out. Following past cycles as we do only gives us some sense of direction, not necessarily magnitude. The first part of the 2009 does have positive cycles but the cycles do turn negative again once we get past April. Investors should be looking for a positive sign of a turnaround but be very aware of the danger that lies below with new lows.

A number of sectors have shown us positive signs in the past few months such as consumer staples, infrastructure, preferred shares particularly of the Canadian banks, and some recession proof areas in some business income trusts and pharmaceuticals. These are areas that we see as having some positive moves in the coming months. And the well capitalized Canadian Banks are also on our radar screen but not the potentially bankrupt US banks. Investors should be seeking yield and generally avoiding stocks that do not pay any dividends.

One asset that we fully expect to hold its value and to move higher is gold bullion - and, by extension, its junior sisters silver and platinum. Gold is money and has been proven to hold its value in periods of both deflation and inflation. Our chart below (from Bullion Management Group Inc.) shows the performance of gold versus equity markets in 2008. While Gold in US$ terms rose only five per cent in 2008, the Dow Jones Industrials fell 38 per cent. In Canada and Britain it was even more dramatic. Gold rose 31 per cent in Canadian dollars as the TSX Composite fell 35 per cent; in Britain gold in British Pounds rose 45 per cent as the London FTSE fell 31 per cent. China and Japan were the only two countries where gold fell in their currencies, as both the Yen and Yuan were strong in 2008 outperforming the US$.

Gold continues to be maligned by many and the world's exposure to it remains very low. The conditions that we are seeing develop have never been more bullish for gold. Sprott Asset Management said in their December letter that "we have never been more bullish" on gold. It may be the only place left to hide as we go into 2009. The conditions are deteriorating even faster than we expected. What started as a potentially bad recession is now showing signs of turning into a full-blown depression. But the massive monetary and fiscal stimulus being created by the authorities almost guarantees that going forward Gold and bullion will be the key place to be. Investors should now have at least 25 per cent of their portfolios invested in Gold and Bullion.

The evidence is mounting that the economic downturn will be severe. We are only awaiting the numbers to show that indeed we might be able to say "It's a Depression". Not a pretty thought.

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

DavidChapman.com
Technical Scoop

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)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: 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.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2009 David Chapman

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