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April 02, 2004

Could the Bears Be Wrong?
by David Chapman

Can a bear be his own devils advocate and support the bull view? The answer of course is no but it is important to understand the bull view because as we have witnessed over the past year or so with the rise in the stock market is that the bull's view, irrespective of what the bears may think about it, has dominated.

Certainly when it comes to hyperbole the bears really know how to pour it on. Not only are there a few that are predicting the end of the world we even have web sites completely devoted to the bear viewpoint (www.prudentbear.com). But the bulls always say the market climbs a "wall of worry" and no one purports that view better than the big investment dealers, banks, mutual fund companies and other institutions whose business is predominantly in the global stock and bond markets, who to their credit, have a vested interest in seeing the market go higher.

After all they are in business to sell product and it is a lot easier to sell product in a rising market then it is in a falling market. It also probably explains why the internet has numerous independent bear web sites (or those devoted to gold as the offset to a collapsing market) while it is the institutional view that predominates for the bulls. And the institutional media tends to back the large institutions in their bull view. CNBC has often been accused of being nothing more than a cheerleader for the institutional market and after listening to Kudlow and Cramer for awhile you might even be convinced. 

But a steady diet of the bear view can also colour your views expecting the entire monetary system to collapse in a morass of debt and despair and riots in the street. It makes great copy but the truth is, as they usually say, somewhere in between the nirvana of the bulls and the depths of hell of the bears.

There are two bull views. The fundamental and the technical. The synopsis below centers on the argument for the USA, which as the world's largest economy, is key not only for the success of the US but also to the world.

The fundamental view is that we have come out of a short recessionary period; the excesses that built up in the late 1990's have gone through a much needed steep correction complete with corporate wrongdoings that are now under better control with stiffer governance and that now we should be able to move forward in a positive manner. Interest rates are low; the Fed is providing sufficient monetary stimulus and they are prepared to maintain the low interest rate environment to ensure that the economy grows and that we eventually move to the next stage of the recovery which will be a return of jobs as we did when we came out of the early 1990's recession. (Note: writing this as today's job numbers were higher than expected).

Further, the US Administration is, given the War on Terror and in Iraq, providing sufficient fiscal stimulus to the economy and that as the economy grows coupled with the tax cuts the current budget deficits will eventually disappear. The debt is not a major problem as it has not reached the levels that were seen in the 1980's fighting the cold war and that the debt as overall percentage of the economy is also not a problem and remains below countries such as Japan and Europe.

We are in a low inflationary period which is expected to continue as the cost of goods consumed by society keep coming down and should remain low going forward. Stock valuations are down from the highs that were seen in the late 1990's and given the outlook for earnings, valuations in many cases are fair and there is room for growth particularly as the high tech sector recovers and new technological innovations increase productivity which will allow stock prices to move higher over time.

Results so far on economic growth have generally exceeded expectations with the one major concern the very sluggish job growth. The other concern of the large US trade deficit is actual the result of the success of globalization and if the rest of the world grows it will ensure future positive growth for the USA.

Uncertainty on the war front remains but progress is being made with Saddam captured and efforts to capture Osama Bin Laden continue. While problems remain in Iraq with insurgents and remnants of Saddam's people fighting, a handover to an Iraqi council is to be completed by June 30 and life for most Iraqis is better than it was before with major reconstruction projects ongoing.

While the market has probably currently gotten ahead of itself a correction of 5-10% would cleanse things and we should be able to move forward especially given the ongoing low interest rate environment and low inflation. Perfect conditions for stocks.

As to the Gold market, gold is merely a commodity like zinc or cooper and has certainly had its moments since peaking over 20 years ago most recently in the 1993-1996 bull in gold and gold stocks but the current rally is no different then what happened in that period and once the current bull runs its course gold will return to its role as a barbarous relic and sink to new lows.

The technical argument plays on the fundamental argument. The last four year cycle low was in 2002 and ended a major correction to correct the excesses of the late 1990's. We are now undergoing a new bull market and in any four year cycle we skew to the left with the highs for the cycle coming late in the cycle often in the last year of the four year cycle. Advances are usually made in waves of five with three up waves and two corrective waves. Thus far we have had two advances off of the lows of October 2002 and we should now be undergoing the second correction to be followed by the third wave to the upside that will take the market to new highs.

The above scenario would and could be true if one also wishes to assume that current economic and monetary policies have defeated the possibility of longer cycles such as the popular Kondratieff cycle. Current Fed Chairman Alan Greenspan has said in the past that he would love to be Fed Chairman in the next Kondratieff winter as he believed that his ideas would be able to tame it and lessen its impact. Maybe he is right and the current period of low interest rates, monetary and fiscal stimulus and low inflation will work.

But Alan Greenspan has been nick named the "Wizard of Oz" for his flim flammery and "Bubbles" Greenspan for having created not only another stock market bubble but one in bonds and housing as well. The current period of low interest rates coupled with monetary and fiscal stimulus rather than being healthy has set in motion a period of rapid monetary and debt growth particularly for the consumer who has added record amounts of debt in the past few years both on credit cards and in mortgages. The boom in the mortgage market has fuelled a housing boom with often the excess mortgage money being used to purchase "things" or to maintain their standard of living.

While assets (stocks, houses) have been inflated because of the ample availability of cheap money giving rise at least on paper to a feeling of wealth, the level of savings in the economy is so low and the level of debt so high that even a small shift in interest rates or a further deterioration in the job market could cause a deflationary collapse of debt. Thus far and unlike the recessions of 1974-76, 1981-1983 and 1990-1992 we have avoided a credit crunch. But with the ongoing artificial feeling of "wealth" being created on the back of cheap money it is only a matter of time not if a crunch will occur and a steeper recession will follow.

The economy of the late 1990's and early part of the new century is a fragile one built on sand with disappearing jobs due to outsourcing or more correctly due to globalization and a move to part time "McJobs"  and the "Walmartization" of the economy. Even a recent improvement in job growth despite having some signs of being across the spectrum remains leaned towards in the service sector of the economy where these types of jobs dominate. Rising jobs no matter where they come from will put pressure on interest rates that will inevitably result in nipping any recovery in the bud.

What this is going to do over time is cause a slow deterioration in the standard of living of the western nations as everything reverts towards the lowest common denominator of wages and living standards in other emerging industrial countries. Over the past decade wages have been essentially stagnant even as the cost of almost everything particularly housing and energy keeps rising. We do not expect that there will be a sudden collapse impoverishing millions in one fell swoop as the worst of the bear scenarios entails but more one of a long steady deterioration. To keep the masses happy we will continue with "bread and circuses" that has dominated entertainment particularly in the past decade.

At the other end of the spectrum of course will be a proportionally increasingly smaller cadre of well paid jobs in professional areas of finance and technology that will remain the backbone of the economy. In between there will also be a massive build up of security jobs as a response to the ongoing threat of the "war on terror" and as a buffer between the well off and the increasing proportion of society that is the "have nots". Polarization of society, which has been ongoing now for the past few decades, will intensify.

In addition to the ongoing shift in jobs is the spectre of rising commodity prices due to increasing world demand and dwindling supplies. This is most pronounced in the energy sector where rising fuel prices and rising energy costs are already being seen coupled with dwindling supplies and increased global demand. Over the past year there has been a huge disconnect between the bond market and rising commodity prices. Bonds have been kept artificially low in yield due to monetary policies and due to heavy buying from foreigners particularly Asia (Japan). With the Japanese intending to discontinue their bankrupt policy of preventing the rise in the Yen by artificially propping up the US bond market there is insufficient savings in the US to buy the huge amounts of debt. This should put pressure on bond prices.

And rising commodity prices also means that gold and silver will continue to rise in price. Not only is there a dwindling supplies of both but demand is increasing for investment purposes. Gold and to a lesser extent silver have been reacting to the falling US$. Gold and silver have a long history of being money. The current fiat currency system with the US$ as the global currency is backed by nothing but promises. With a world flooded with US$, the US$ has only one place to go, and that is down and the corollary to that is that gold and silver will go up.

We believe we are in a secular bear market that topped in 2000. The secular bear market/Kondratieff winter will last from 12 to 20 years. Thus far we are only into the fourth year. Conditions for a primary bull market are not there saddled as we are with high levels of debt and high valuations in the stock market. We note from a recent musing from Ned Davis that he also points that to make a market bottom there must be a large pent up demand for goods. Currently there is an overabundance of goods cheaply available. A bottom in the market will come when the debt has crashed, stock valuations are at bear market lows and there is that large pent up demand for goods. None of these conditions currently exist despite the fact that we have low interest rates.

The 2000-2002 bear market was a primary wave down which we could label Wave 1 or A. That wave bottomed in October 2002. The rally that got underway at that time was the beginning of primary wave 2 or B. It is possible that after a lengthy shallow correction that we could rise further into 2005/2006 for a top. After all this was the cycle seen in the 1930's where after the collapse from 1929 to 1932 the market rallied strong in 1933 and paused throughout 1934 before resuming its uptrend. Our cycles suggest that as with 1934, 2004 should be a pause year.

But cycles only tell us that there will be a pause or correction it does not tell us the severity of the correction. At this stage we see a correction that should carry us to around 950 S&P 500. Any major breakdown under that level will tell us that the correction will be considerably deeper and will also tell us that it is not a correction to the up move that began in October 2002 but instead a new primary wave to the downside. If it is a corrective wave then we will have a third leg advance as some have called for but it may be a muted one given the very high stock valuations that already exist. Not even a drop to the 950 level will resolve the high level of valuations. That could take years to resolve.

The last Kondratieff winter (1929-1949) and Kondratieff summer (1966-1982) were characterized by in the former case with swings that lasted years but saw huge collapses and equally impressive rallies. Indeed it formed a huge triangular pattern during the period as the swings were increasingly smaller. The latter period was characterized by shorter swings closer together and with the exception of the 1973-1974 market collapse swings were generally balanced. What unfolded was essentially a 16 year flat. These patterns are our template for the current Kondratieff winter and since this is only our first rally after the first collapse we do not know which pattern will dominate.

So could the bears be wrong? No, the bears are not wrong but in the final analysis it will be a question of degree. A wild card in this scenario is the "war on terror" which could change things dramatically if there were another major terrorist attack on the US. A further trigger in this war could well be the assassination of Sheikh Yassin of Hamas. The world will not end but the dislocation will be painful. But the bulls are not right either and they will painfully find out that we are in a very different period then the preceding bull market period. The bear is a very tricky animal. He will want to trap as many bulls as possible and if he has to allow the market to go higher in order to get them, he will.

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 © 2002-2008 David Chapman

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