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Terror in the Aisles

"Terror in the Aisles" was the title of a 1984 documentary on horror films disguised as a schlock film despite the efforts of its able hosts Donald Pleasance (Dr. Sam Loomis in "Halloween" (1978)) and Nancy Allen (the prostitute pursued by transsexual killer Michael Caine in "Dressed to Kill" (1980)). The premise here was that the audience goes to a horror film to be scared and Hollywood has complied in spades over the years so sit back relax and be scared.

In real life of course no one chooses to live a horror film. When we think of real life horrors what immediately comes to mind is the horror of the Bernardo/Homolka serial murders as an example in the specific sense or in the more societal sense the horror and terror of the World Trade Centre attack of September 11, 2001 and more recently the Madrid train bombings of March 11, 2004 (curiously 911 days apart not counting the leap year).

These of course are examples of real life terror that involves death and destruction both on a personal and societal basis. During the three year stock market bear that too was often described as a horror as well as other words such as tech wreck and crash which have connotations of a disaster. And certainly the word was used frequently for investors opening their monthly brokerage statements. Stories abounded in the real estate crash of the early 90's of "real estate horror stories". So terrorism does not have to be limited to the latest alleged Al Qaeda bombing because terror can be wreaked on the financial markets and individual investors as well.

And terror begets terror. The recent terrorist bombing in Spain started the sharpest stock market decline we have seen in months. The fact that the market was overvalued overbought and overdue for a correction was beside the point as the terrorist attack begat a horror on the stock market. The potential for terrorist attacks are going to remain a fact for the markets going forward irrespective of whether for example top Al Qaeda leaders or even Osama Bin Laden were captured tomorrow. But real terrorist attacks aside what other potential horrors are lurking behind the scenes that could wreak havoc on the markets and investor's portfolios?

While the most recent job creation numbers were certainly a surprise to market pundits (both in Canada and the US but for our purposes we will centre on the US) what is not highlighted is the high number of discouraged workers dropping out of the market. Apparently numbers show that upwards of 400,000 workers dropped out of the labour force alone in February. When one considers that officially there are 8.2 million unemployed there is estimated to be over 3 million that have dropped out of the labour force plus another 5 million at least who are working part time when most would prefer to work full time. This pushes the real unemployment rate over 10% when one adds these together.

A jobless recovery? The word was first coined in the early 90's when the moribund economy was starting to grow but employment lagged. But eventually employment caught up and grew as the 90's progressed and the authorities are hoping the same thing happens again. This is questionable because the economy did not have to deal with the threat of terrorist attacks in the 90's the first World Trade Center attack aside. As well the word productivity growth is constantly used, a euphemism for growth using fewer workers. Workers are always the highest cost to any employer. Profits, as good as they have been of late, have been the result of the falling dollar particularly for global corporations. Couple this with cost cutting which usually falls on employees being relieved of their jobs and you can add considerably to the bottom line.

But the jobless situation is only a part of the problem. The real problem of course lies in the policies of the Federal Reserve determined at any cost to maintain a low interest rate environment coupled with very loose monetary stance to maintain liquidity. The grease of low interest rates and liquidity is having a perverse effect which in the short term is positive but longer term is an accident waiting to happen or as our theme points out a horror waiting in the wings.

The grease of low interest rates and massive liquidity injections has fuelled both another stock market bubble (albeit not to the same extent as 1995-2000), a housing bubble and debt bubble. All of these are a perverse form of inflation that does not show up in the monthly PPI or CPI stats. Nor for that matter has the rise in oil prices and other commodities over the past few years seemed to have impacted to any great extent the inflation numbers. Pundits sit back each month and declare there is no inflation and the jobs are slow to recover, so the policy of low interest rates and liquidity injections is the right one.

The fact that the pundits particularly on CNBC could be so wrong is also perverse. They just don't get it and part of the disconnect that exists. All of this has had a negative impact on the US Dollar which has fallen some 27% from its highs in 2001. Of course the White House administration wants the Dollar lower to see if will bring back some of the massive job losses sustained since 2000 many of them gone forever to India and China. But a falling Dollar is also inflationary as goods from many countries become more expensive particularly oil which is now resulting in record high prices at the gas pump. Of course with the US running trade deficits in the range of $400 - $500 billion annually not only is it dangerous it adds to the ongoing debt problem.

But the perversity continues with the consumer who it seems regularly spends more then he earns. While personal income was up a paltry 2.8% in the past year, total consumer debt (mortgages and credit cards) has grown 10.4%. And personal spending has grown almost 5%. Housing prices are up 15% and the consumer has continued to borrow against his house value to spend on "things". Savings which used to be the backbone of a positive growth economy actually fell almost 5% in the past year. The low interest rates environment contributes to this perversity but so does the policy of mortgage interest tax deductibility. But what if housing prices fall as may well happen when the bubble bursts as it surely well and has it has so often in the past?

In other recessionary periods including even the 1970's, 1980's and early 1990's there was a point when a credit crunch hit. The credit crunch was caused in part by rising interest rates. This time we have avoided the credit crunch because of the rapidity of interest rate cuts coupled with massive liquidity. This has set up an environment where everyone thinks that nothing can go wrong and that the Fed will always bail everyone out. At some point though this bankrupt policy will fail and the results will be far worse then if they had from the outset cleansed the system of its excesses. Sure we pricked the stock market bubble of the late 90's but they have allowed even more dangerous bubbles to manifest themselves.

Today the debt burden of the US is over 3 times GDP (debt of $34 trillion versus GDP of $11 trillion). In 1933 debt was about 2.5 times GDP according to studies. Even corporate debt is at record levels while the US government seems determined to add to the debt at increasing alarming levels of $400 - $500 billion annually as they fight their foreign wars and ramp up National Security. No wonder the US Dollar sellers are alarmed. But as long as Japan and China and others are concerned about protecting their own currencies by re-cycling their US$ from trade back into US debt the US can continue these bankrupt policies. Recently the Japanese indicated they might not be able to continue their former level of intervention which if they did not only would a major buyer of US debt not be there to support them US interest rates would have to rise to compensate. Few others would be willing to step up to the plate and that will result in a lower US Dollar and higher interest rates in order to finance the debt.

Another potential terror lurking in the background is the derivatives monster. Putting aside that a good one third of global derivatives sits with one institution (J.P. Morgan Chase), stories continue to abound about a possible derivatives blow up at Fannie Mae (FNM-NYSE). Fannie and her kissing cousin Freddie Mac (FRE-NYSE) have together made major contributions to the mortgage bubble. On February 25 Fed Chairman Alan Greenspan told a Senate committee that Fannie Mae could cause a "systemic" crisis if it failed (Executive Intelligence Review – March 19, 2004). Seems that Fannie (a $2.4 trillion behemoth) has vast exposure to credit derivatives. Independent studies have suggested that Fannie could be sitting with some $24 billion in derivatives trading losses. These potential liabilities have not been recognized. And Fannie and Freddie, backed as they are by the US government, watch their stock prices go merrily along as if nothing were really amiss.

And guess who holds a vast number of these credit derivative exposures. Yes, J.P. Morgan Chase and of course numerous other banks. A Fannie or Freddie failure would dwarf the famous collapse of Long Term Credit Management (LTCM) of 1998.

Massive debt, a jobless recovery, derivatives three potential financial terrors that could send a stock market not only back to where it started the great rally of 2003 but even to new lows. And all it might take is another spark of a real terrorist attack even closer then Madrid, Spain. Then Investor's will truly experience "terror in the aisles".

Note: In our last write up "Rich man's gold" we overlooked Anooraq Resources (ARQ-TSXV) (www.hdgold.com, 604-684-6365). Anooraq is in a major drilling program in South Africa with Anglo Platinum in an area with platinum group metals as well as gold and nickel. Anooraq is to be listed on the AMEX under the symbol ANO.

Chart created using Omega TradeStation or SuperCharts. Chart data supplied by Dial Data.

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