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January 07, 2006

Forecast 2006
by David Chapman

We decided to put out our annual forecast just after the start of the New Year rather than in December in order to take advantage of knowing the final results for 2005 and also to see the action in the first few days, a period that often signals turns in the market.

In last year's forecast and quite often throughout the year we noted how since the modern record of the Dow Jones Industrials (DJI) started back in the 1880's that there had never been a year when a year ending in 5 had a down year. Well that perfect record has now been broken. The Dow Jones Industrials closed down in 2005 by 0.6%. Of course the temptation is to just dismiss this as so much aberration because elsewhere the S&P 500 and NASDAQ eked out small gains of 3% and 1.3% respectively. The Dow Jones Transportation Index (DJT) performed even better not only gaining 10.5% but it hit new all-time highs as well.

Elsewhere the record was even more impressive especially the so called economic slow growth zone of Europe with the London FTSE, the German DAX and the Paris CAC 40 all up nicely at 16.7%, 27.1% and 23.4% respectively. The TSX composite added 21.9% and the big winner of the major exchanges was the Tokyo Nikkei Dow up an impressive 41.5%. So is the record meaningless?

We don't think so. First the record was on the most senior exchange, the exchange that contains the bluest of the blue chips. If the bluest of the blue can't put in an up year when everyone else is something is amiss. A negative divergence we call it. Second the DJI not only closed down it remains upwards of a 1000 points below its all time highs seen in 2000 whereas the DJT closed up and hit new all-time highs. For those Dow Theory enthusiasts the markets are not confirming each other. Oh maybe they will eventually but time is running out in this particular up cycle. The DJT started hitting new all-time highs in 2004 and in 2005 went higher. That is a major possible negative divergence. We are reminded that we saw the same phenomena of these divergences at the highs in 1999 (DJT) and 2000 (DJI) and again at the lows in 2002 (DJI) and 2003 (DJT).

Of course the fact that years ending in 5 had always been up years was random. But the negative divergence with all other markets sticks out and may eventually turn out to be a sign of trouble down the road. We provide below a record of the markets and other items of interest for 2005. It was a year of commodities with oils, metals and golds leading the way and all markets enjoying an up year. The clouds were rising interest rates, inflation and debt levels accompanied by record bankruptcies.

So what did we say last year for 2005? Well we noted that 2005 looked like the record was clear and 2005 is a "can't lose" year as all the cycles appear to be very favourable. If there is a note of caution it is the first half of the year. Cycles have shown that for the years ending in 5 the first quarter often stretching into the second quarter tend to be weak. We were not disappointed there as the market was down into late April/May followed by a rally into mid-summer further weakness into the traditional October period then a strong finish although December was generally weak. We also noted that it is important here though that the correction is shallow certainly not much more than 10% then if things fall into place we rally to new highs or even record highs as some have been calling for into the fall of 2005. The S&P fell 6% into April and the October drop only shaved 5%. Following the shallow drops the market did rally to new highs for the move up since October 2002. The DJT as we noted did rally to new all-time highs.

The record for years ending in 6 is definitely more mixed then for years ending in 5. The record of the DJI since inception is 7 up and 5 down. The key cycle years are 10, 30, 60 and 90. Both 1996 and 1976 saw strong gains of 26% and 17.9% but 1946 and 1916 were down years of 8.1% and 4.2%. 60 years is the master cycle (corresponding with the Fibonacci 61.8%) so we always watch that one. 1946 was an interesting year. While the market rolled around through February making a low there was considerable strength into May. After that the market dropped precipitously falling some 23%.

We have noted in the past that from 2000-2004 at least the markets did a remarkable job of following both the 1930-1934 cycles of the Dow Jones Industrials and as well the 1990-1994 cycle of the Tokyo Nikkei Dow. In 2005 we finally diverged from that cycle as the year seemed to bear little resemblance to either of the 1935 (DJI) or 1995 (TND). Or did it? 1935, while it certainly put in an impressive up year did have a low in March (vs. April in 2005) a rally into August (also August 2005) a shallow low into October (also October) and a rally into November/December (also again for 2005). The Tokyo Nikkei cycle did not materialize at all. That was just a strong down into July followed by an equally strong rally into October/November that recovered most of the collapse.

So 1936 might be worth a look given the continued flow with the 1930's cycle (70 years). In 1936 the market was weak in January, a feeble rally into March followed by a drop into April/May. After that the market rose strongly for the balance of the year topping in October. 1936 was a very strong up year although not as strong as 1935. The 10-year Tokyo cycle saw weakness as well in January, some strength into February followed by a collapse into March. The market then rallied strong into the summer topping in July. What followed after though was an utter collapse for the balance of the year sending the market to new lows that did not see its final bottom until 1998/1999.

Our call for this year after looking at all the various cycles is for weakness in January that may not bottom until February followed by a rally quite possibly to new highs in May or June then for a collapse in the latter part of the year and a year end rally. The current high positive sentiment of 58%-60% bulls is an area where highs are usually seen in the market. There is also a chance that the high year for year could be seen now particularly if events in March 2006 on the world stage play out as we note later. No matter what if the market is to hold up once again any downdrafts this year cannot be much more than 10%. Cycles do not favour that scenario though and we could be in for a steeper drop.

The longest suspected cycle is one of 72 years (Ray Merriman - MMA Cycles). Major cycle lows have been noted where the market lost 80% or more in 1784, 1857 and 1932. We remain in a period of a major 72 year cycle that could range anywhere from 1992-2016. Clearly the early part of the period saw no major low and while the 2002 low may have satisfied it only the NASDAQ came anywhere near an 80% loss.

There was no accompanying debt collapse as we saw in the 1930's and earlier cycles. The 72-year cycle subdivides into two 36-year cycles and the last one was 1974. The DJI lost 47% in that cycle and of course 89% in the previous 72 year cycle low. The next 36-year cycle low is due 2004-2016. The 36-year cycle subdivides again into 18-year cycles and that last occurred in October 1987 making the next one due 2002-2008. There is also the well known Kondratieff cycle. Consensus has that last bottoming in 1949. The current Kondratieff cycle is due to bottom 2000-2013 but could stretch as long as 2020.

So all these negative cycles overlap particularly given that the 72-year cycle and the Kondratieff cycle have not yet bottomed. We don't believe that the 2002 low is the bottom of the cycle. There is also the 4-year stock market cycle and the last occurrence there was 2002 so that cycle is next due to bottom in 2006. There is also the Presidential cycle (corresponding with the 4 year stock market cycle) and that usually bottoms according to Merriman 16-25 months after an election. That indicates that the bottom is due again sometime this year anywhere from March to December. With bigger negative cycles also in play that might be distorted into 2007 or even 2008.

These forecasts are for the North American markets primarily the US markets but Canada should follow the pattern as well although not to the same extent. Canada has been dominated by commodities (oil, metals and precious metals) and we expect them to continue to perform well in 2006. The commodities have long cycles of 20-25 years and in that respect the last down cycle we believe bottomed in 1999-2001. This cycle is only about 4-6 years old so it has years to run although within that there will be several bear markets.

Everyone wants to know about gold. While free trading gold does not have a long history it has demonstrated what appears to be 8.5-year cycle lows within the 20-25 year cycle. That last one bottomed (double bottom) in 1999 and 2001. The next one is not due until 2008-2010. The interim half cycle (4.25 years) is due anywhere from December 2004 to March 2006. Given the strong up move that started out of lows in June/July 2005 this cycle may now have bottomed and we are in a new up phase. Given that we have now exceeded initial targets of $480-$520 there should now be a continuation with targets up to $750-$850. This tells us that the while we expect some correction in the early part of 2006 the rally in gold has barely begun and it will also take precious metals stocks higher with it.

Despite the efforts of many stating that gold is a barbarous relic it is not. It has always been and will continue to be only about 25% a commodity and the rest a currency. Gold in 2005 broke out against all currencies telling us that the upcoming period will be a challenge to fiat currencies. The US Dollar in particular is vulnerable. The US economy cannot continue to defy the laws of economics forever despite the efforts of the Federal Reserve to keep interest rates low and flood the system with liquidity. Running deficits particular the huge ones in trade (approaching $700 billion) and as well budgetary ($400 billion largely to finance military adventures) is not a new era of nirvana. If this had been almost any other country they would already be forced into a painful adjustment.

Rising interest rates may also be a factor. While there has been recent enthusiasm that the Fed may be reaching the end of its rate hikes that cannot be ensured. With Bernanke taking over from Greenspan at the end of the month our sense is that he will want to show his inflation fighting credentials and will err on the upside. This suggests despite the markets recent enthusiasm it is probably misplaced and the Fed will hike higher than expected. This will certainly create a negative yield curve and negative yield curves have negative ramifications for the economy. The housing market is already showing signs of slowing. The housing market growth has been such a major factor in the economy over the past few years that even a slowdown where there is flat growth will shave upwards of 1% off of GDP. If the housing market actually falls it will lower GDP growth even further.

The bond market has held up remarkably well considering the rising short-term rates. This has been largely due to the huge ongoing flow of foreign funds into the US to finance their deficits. This too is showing signs of slowing as foreign creditors become increasingly concerned over the US deficits and as well a desire to diversify some of their funds elsewhere. This has been demonstrated by increased activity in attempts to purchase North American companies particularly in the commodity sector.

Bonds last major cycle low was in 1981. Bonds have demonstrated long term 18 year cycles that subdivide into 6-year cycles and further subdivide into either two 3 year cycles or three 2 year cycles. The last 18-year cycle probably bottomed in the huge bond bear of 2000. But since then it has been a feeble up so we are probably in the topping phase of longer-term bond cycles. Nonetheless this particular 6-year cycle appears to be subdividing into three 2 year cycles with lows seen in 2002 and again in 2004. This tells us that the current cycle is due to bottom sometime in 2006. The window for this low is throughout 2006 and into early 2007. The recent drop in bond prices is insufficient to satisfy that low and we suspect that higher bond prices will be seen this year. Rising bond prices coupled with rising Fed Funds rates will play negatively on the market during 2006.

The rest of the world particularly the Asian countries ( China and Japan) are now financing in excess of 50% of the US debt. This is a situation that cannot continue without also threatening their economies as well. A painful adjustment is still to come for the US economy. Record debt and this living in a dream world of low interest rates and endless liquidity are slowly coming to an end. The rest of the world will not suffer the same adjustment and we should continue to see strength in their economies particular Asia with Japan slowly coming out of its long winter and the still burgeoning economies in China and India.

If there is a risk to all of this is that the Asian economies have not as yet had their own shake out that must surely come as well. As well the global competition for dwindling supplies of commodities (oil, metals) will at some point in the future set in motion the potential for military conflict. The first major shot in this potential conflict was fired with the invasion of Iraq a country whose reserves are second only to Saudi Arabia and where there is untapped further potential. Iraq, however, was run by a regime unfriendly to the west. As well Iraq had made moves to only accept payment for oil in Euros and other countries were considering a comparable move. This was a clear economic threat to the US and the dominance of the US Dollar as the world's reserve currency.

The US faces a further challenge on that front from Iran whose oil bourse gets underway in March 2006 and it will deal only in Euros not US Dollars. This is also a threat to the US Dollar and it will not go unchallenged. This is aided by the belligerent attitude of the current Iranian regime and its dalliance with attempting to build a nuclear capability. Rhetoric between the US and Iran has been high for months and we suspect this will deteriorate further in 2006.

The US has never denied a possible strike against Iran and numerous stories have appeared in foreign newspapers outlining that plans are already under way. Stratfor (www.stratfor.com), a global intelligence strategic forecasting institution, has written extensively about the possibility as well of an Israeli strike against Iran but the odds are more favourable it would be a US strike. What the reaction of China and Russia will be is unknown but it is noted that they have substantial investments in Iran. Iran is a major oil producer and any attack on Iran will have very negative consequences for oil prices.

This story is we believe a key one for 2006 and would probably put on the backburner the various scandals that surround the Bush administration. The wiretap scandal is merely the latest in a series of scandals (the misleading behind the invasion of Iraq and the illegal outing of Valerie Plane are the others) any of which could result in impeachment proceedings being launched against either of Bush or Cheney in 2006.

Iran or the scandals could be reasons behind a market drop in 2006 and both bear close watching going forward. Mark March 2006 on your calendar for the start of the Iranian Oil bourse and as well the ending of the publication of M3, a move being made by the Federal Reserve that has raised considerable suspicions as to the why it is being done. Naturally if the Iranian situation and the scandals remain mere background noise as they did in 2005 then that will be more favourable for markets in 2006.

The other wildcard for 2006 is the Israeli/Palestinian conflict. With the massive stroke of Ariel Sharon events in the region could be severely altered. The conflict has not ended, we are no closer to a solution and the situation has once become more volatile. This could change the equation once again either for the better or for the worse but odds do not favour the former.

Long term down cycles coming to the forefront and a potential volatile global political scenario also coming to a head does not bode well going forward. This combination is however very positive for commodities and gold both of which are in major up cycles. We believe these areas remain key areas to be invested in during 2006 and Canada and Canadian stock markets will continue to benefit. But the down side is that other areas particular the consumer groups and probably the formerly bullish financial groups could suffer. The US living in its dream world of low interest rates and maxed out credit cards and home equity line of credits are getting closer to a major reckoning.

Ten-Year Stock Market Cycle
Annual % Change in the Dow Jones Industrials Average
Year of Decade

The Record of Second Term US Presidents during their Second Year

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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