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February 26, 2009

Is A Bigger Nightmare Beginning?
by David Chapman

The rebound we had expected in the first quarter or so of 2009 is in trouble, or at least on hold. The Obama bounce has so far become the Obama bust. We suppose the signs were there earlier. November 5, 2008 - the day after the election - the S&P 500 dropped 5.3 per cent. January 20 (Obama inauguration day) it dropped another 5.3 per cent. It is an ominous start. Maybe the expectations were too high.

But the downhill ride started in the first week of January as the feeble rebound began to decline. Throughout the decline there have been concerns over the possible nationalization of banks (specifically Citigroup and Bank of America), the bailouts of General Motors and Daimler Chrysler, plus the stimulus plans and the funding for those plans, all set against the background of a sharply deteriorating global economy.

As bad as the economic numbers for the US is, the real danger is a collapse of Asian and European economies. In checking the latest issue of The Economist we note that while Industrial Production (IP) in January for the USA declined 10 per cent, Japan's declined 20.8 per cent in December. Korea's IP fell 18.6 per cent and Taiwan's fell a huge 32.3 per cent. While we couldn't find comparable numbers for eastern European countries, it was reported that Hungary's IP fell 23.3 per cent in December.

In Western Europe, we noted Germany down 12 per cent for December, Italy 14.3 per cent and Spain 15.4 per cent. Britain fell only 9.3 per cent for December. Canada's last report was for November; we were down 5.1 per cent. December will probably be worse. All these declines translate into declining GDP. Of particular concern is the problems in Eastern Europe where defaults to Western European banks would not only jeopardize the viability of these banks it is also breaking the economies of these countries. There are as a result serious concerns of a return to the nationalism that arose during the 1930's, ethnic tensions (always rises during periods of economic depression) defaults and the breakup of the European monetary union. We here in North America are not immune from similar tensions but in a different way obviously.

The global economy is unraveling. An Economist article (The collapse of manufacturing - February 21) pointed out that the cheapest quote for shipping containers is now $0 (plus fuel and insurance and handling). The Baltic Dry Index, a measure of global shipping, recently hit a high of 2,099 - up sharply from its low at 772 but well off its highs in 2008 at 11,793. The article notes that half of China's 9,000 or so toymakers have closed their doors, Taiwan's shipment of computers collapsed 45 per cent in January, and the number of cars being assembled in America is 60 per cent less than it was in January 2008. The lots are brimming with unsold cars. How does one justify proceeding with the manufacture of the 2009 model when so many 2008 models remain unsold?

Naturally officialdom remains quite upbeat, with rosy forecasts of good rebounds later in 2009. As if they are going to say anything different. It works, too. The day after the Dow Jones Industrials plunged 251 points (February 23) the market rebounded 236 points following comments from Fed chairman Ben Bernanke. Fedspeak is powerful (and promises to use all available tools to fight this severe contraction). Well, words are cheap, and there is little evidence thus far that the bailouts and stimulus packages will actually work. Bailing out bankrupt companies and stimulus packages loaded with pork will have little impact in a world where everything is interconnected and other key parts are in worse shape. And don't forget the billions that continue to be spent monthly on wars in Iraq and Afghanistan. The market promptly fell again the next day.

The rally that occurred from the November lows was one of the feeblest we have seen. Rather than it being the start of a more sustained rebound it has turned out to be merely another short term correction within the context of the huge bear decline. In earlier Scoops we documented some of these rallies. It is worth repeating them. Over the past century we have seen only four bear market collapses that exceeded 40 per cent (Dow Jones Industrials). They were as follows.

• * This was the first major drop of a much longer bear market. Following the November 1929 to April 1930 rebound the market began a long decline that ended on July 8, 1932 with a total loss of 89.5%.
• ** To date. The current bear market has not as yet ended.

The recent drop in this bear market has put us in record percentage drop territory, setting aside the ultimate drop of the 1929-32 bear. Welcome to a record. You have been a part of history. What is clearly not in place is a final low for this phase of the bear market. Forget about a rebound on the scale of the ones that followed 1907, 1938 or 1974. We haven't even begun a bull market rebound on the scale of the one that followed the first leg down in 1929 of the 1929-32 bear.

So when will this rebound get underway and where will it bottom? We had mistakenly thought the depth and the fear that accompanied the November 2008 lows would help set up the potential for a rebound of some substance. Over the following months we made little progress, but that was not a major concern as the formation of a bottom does come in stages.

The potential for a retest of those lows seemed to be underway with the collapse in January/February 2009. This retest was seen particularly at the lows in 2002-03 when we had important lows in July, October 2002 (the low), and the retest in March 2003. That thought was eliminated with the plunge to new lows this week. The Dow Jones Industrials took out the November 2008 lows and the October 2002 lows. This is a clear signal to us that we should see further lows down the road, and of the potential of a bigger nightmare getting underway for investors.

Stock markets live on fear and greed. Greed propels us to the mania market tops we saw in January/March 2000 and September 1929. Fear of course is the opposite, and usually at the absolute bottom we don't even notice it because fear is at such high levels. In fact the fear factor leaves and the bottom is made in a general absence of any interest.

Naturally these bottoms can play out in different ways. While the thought that we are breaking to new lows can be disconcerting, we notice some potential positive signs that could still result in a decent low and a rebound of some substance.

1. Indicators on both daily and weekly charts are making positive divergences. Of note is the VIX volatility indicator that is nowhere near its highs seen in October/November.
2. Technically we still have a potential double bottom play in progress.
3. At least for the moment neither the S&P 500 nor the NASDAQ (nor the TSX S&P Composite) has made new lows. The Dow Jones Industrials and Dow Jones Transportations are or have made new lows.
4. A series of three, whether at a top or a bottom, is not unusual. In this case we are making a third thrust to new lows for the DJIA, but in each instance the break to new lows is only slightly below the previous low and momentum is waning on each thrust to the downside.
5. We appear to be making a potential descending wedge triangle (bullish) on the DJIA.
6. We appear to be in the fifth wave down of a collapse that began with the top on May 19, 2008. The descent from the October 2007 highs appears to be unfolding in a large ABC drop. This is the C wave and our count has this as the fifth wave. A rebound now would be wave 4 of this fifth wave with one more drop to the bottom of the wedge triangle that appears to be forming. The current bottom of the triangle is around 6,500. Note: Elliott Wave is very subjective and subject to changes. While we try to do our best on Elliott Wave counts we do not consider ourselves an expert.

We have often remarked on the similarity between the market patterns of the 1930s and this decade. That may not be surprising given the possibility of a 70 to 90 year cycle of economic depressions. History may be repeating itself. But markets do not repeat exactly or line up perfectly. Still, the comparison is striking. We are reviewing that comparison below for the Dow Jones Industrials.

Given the comparison above, it is worth taking a further peek at the 1937 to 1939 market.

1. We note a five wave down pattern from the top in March 1937. Note the low made in October 1937 followed by a secondary low in November 1937 (just above the 3). This might be similar to the lows we saw in October and November 2008.
2. The rebound rallies topped on January 11, 1938 and January 6, 2008.
3. The market then began a decline that did not bottom until March 31, 1938.
4. We also note what took place in 1939. There was a market top on January 8, coinciding with our market top on January 6, 2009.
5. The market collapsed into late January, then started a rebound that topped on March 9, 1939.
6. The final collapse made its bottom on April 11, 1939.
7. In both instances following the March 1938 low and the April 1939, strong rallies followed.
8. It is these patterns we appear to be following.

What this is telling us is that given the similarities to the markets of 1938 and 1939, our final bottom may not be made until late March or mid April or so. Since we appear to be forming a potential descending triangle (not evident at this time on the S&P 500), we do know that this could unfold over the next month or two in an irregular fashion as we move towards a potential final bottom. Following that we would then get our more powerful rebound rally that will take us into the fall of 2009. It is, however, during this period that investors will get both a chance to recoup some losses and restructure their portfolios for the next phase of the bear market which will be sure to come. We do not expect the final low in this bear to be made any earlier then 2012 and could go out to 2016. And it could come substantially lower from current levels.

Despite the recent collapse in the bond market we note that bonds continue to hold up. This is in conjunction with continued strength in the US dollar. It appears somewhat counter intuitive that the dollar should be maintaining strength and bonds are holding up, as the US economy is weakening at an alarming rate and the funding requirements for the US are going to be huge over the next few years.

Bonds did recently react negatively to the huge funding requirements, topping out in mid-December 2008. The subsequent sharp drop tells us that the recent bull market in bonds is probably over. Following a sharp drop such as that there is normally a rebound rally back towards the top that may or may not see new highs. We suspect that we will not see new highs. A typical correction would see a rally of at least $7 or $8 and a recovery of 50 per cent of the previous decline.

Notice how the huge rally in bonds correlated well with the recent rise in the US dollar. Indeed it was probably a case of the dollar going first as funds were forced to liquidate to repatriate money home, and for safety reasons they poured into US Treasuries. As well the US has benefited as a safe haven despite the weakening domestic economy and the US being the originator of this global collapse. Oddly they may be the cause but the world still views them as the safe haven. Part of that may be that the USA itself is too big to fail.

There are two features at work here. The first is the US being viewed as a safe haven; the second is that despite the sniping between China and the US, they have a strange dependence on each other. The strange dependence that helped create huge global imbalances saw the US as the buyer of the goods from China's factories. The Chinese bought US Treasuries with the proceeds in order to help maintain low interest rates in the US and to prevent any undue rise in the Yuan. Historian Niall Ferguson called it Chimerica. We may have a crisis of globalization as world trade collapses but the symbiotic relationship between these two country behemoths means they depend on each other. Odd for two countries whose nuclear weapons could destroy the world and it is well known that the US and China are competing globally for the same sources of oil and mineral resources.

Despite Tim Geithner's comments about currency manipulation by the Chinese, and the sharp Chinese retort, it was all smiles when Hillary Clinton visited recently. Quite simply it is not in China's interest to pull the plug on the US, and so any babbling about currency manipulation (or human rights abuses) is strictly for domestic consumption. The two depend on each other. China can't afford to pull the plug and the US knows it. The result is that while China will do what it can to stimulate its economy and encourage domestic demand, there is no imminent massive dumping of US Treasuries by the Chinese.

Regardless of all of that, we suspect that the December 2008 bond top may indeed be the culmination of the 27-year bull market in bonds (the US bond market bottomed and rates topped in 1981). Our last major low was the double bottom in June 2006 and June 2007, targeting our next two-year cycle low for 2009 or a three-year cycle low in 2010 (counting from the second low in June 2007). But as we note, it may also be the absolute culmination of what has been an extraordinarily long-term bull market for bonds.

The US dollar also appears to be making a potential double top. When the dollar rally ends the US bond market will begin its descent. Despite the dollar's rise over the past several weeks, gold has also risen. This also seems counter intuitive; normally they move counter to each other.

Gold made its top in March 2008, roughly coinciding with the US Dollar Index's bottom. When the USDX was making its initial top in October/November 2008, gold bottomed and began its recent rise from $680 to $1,000. But the USDX last bottomed in mid-December and since then gold, instead of falling back again, has gone from around $836 to $1,000.

The last time we saw that happen was a low made in the USDX in September 2005; over the next several weeks both gold and the USDX went up. Gold rose from $437 to $486 as the USDX rose from 86.25 to 91.87. Gold's rise wasn't big, but it was up nonetheless. When the US dollar began its descent gold went on a serious rise, from $486 to $712. We have denoted these periods with the ellipse on the chart.

While gold began a correction here recently, we view this as a correction within the context of a bull market and not the start of a new intermediate bear. Of course a failure here for gold would bring out the bear views that a major double top is being made. Given the background conditions we doubt that very much. But we are sure we will hear once again that gold is trash on this pullback. Risk is down to around $900 with interim support at $930. A worst case scenario is a fall to around $860 and the 40-week MA.

The recent drop in the broad market has raised the specter of further declines and the beginning of a new nightmare. We doubt it. While we certainly can't rule out new lows, with the Dow Jones Industrials falling to 6,500, we believe that should help set up a bottom and the beginning of rally that will last several months.

The background news is increasingly gloomy, telling us that this bear market probably has years to run. But we are overdue for a rebound of some substance. We haven't had that yet. Even the 1929-32 collapse saw a 50 per cent rebound over a period of several months before the real nightmare got underway.

This recession is no garden variety recession. We suspect it will make the recessions of 1973-75, 1980-82, 1991-92 and certainly 2001-02 seem quaint by comparison. This is the worst crisis since the Great Depression and there is a serious chance that we may at some point technically register a depression (a cumulative decline in GDP of over 10 per cent). But for now at least the broader market is trying to find a bottom and we are getting closer to that bottom. We have few thoughts of a much deeper collapse at this time. Investors should remain vigilant but keenly aware of the risks over the next month or two.

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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