The old market cliché of "Sell in May and go away" is out in full force again. While it may be a cliché it is one that generally works. Records consistently show that the worst month is actually September but after that month is out of the way the market begins the fall rally usually at the latest by November and that carries us into the new year. The RRSP season is behind us (and in the US the 401K season) as well as tax season and the funds are invested. So with the summer holidays looming it is the time to go away and the markets usually generate a negative return during the period.
Last year was an exception as the market continued to rise into July before going into a two month pause and then no scary plunges in the September/October period. For the bears it was a tough year. The year before (2002) was a nightmare for the bulls as the market topped out in March then started a long collapse that did not bottom until October. So what does 2004 bring?
We have consistently noted that cycles for years ending in four are generally not strong years. To review, weakness prevailed through at least the first half of the year (as determined by the Dow Jones Industrials) and sometimes longer in 1894, 1904, 1914, 1924, 1934, 1984 and 1994 with a strong rise seen by year end. Bull markets dominated 1944, 1954 and 1964 while a devastating bear market prevailed in 1974. Thus far this year appears to be following the dominate cycles that have prevailed over the past 100 years. There are no signs that either the bull or bear years are dominate.
So if we are going to continue to experience a weak market through 2004 what is going to cause it? The most obvious of course is rising interest rates. The Economist's front page cover of its April 24, 2004 issue was "The end of cheap money". In the past several weeks bond prices have fallen precipitously triggered by higher employment numbers in the US and increasing concerns that inflation is creeping back in. Of course we have noted that commodity prices have been on a tear over the past year or two and that has to eventually have an impact on inflation. In particular energy costs are rising and US consumers are facing the highest gas prices at the pumps ever.
Rising interest rates make the markets a lot riskier. Credit spreads have already widened putting pressure on the junk bond market. Huge hedge funds that are major investors in these types of markets could be vulnerable. Remember Long Term Capital Management (LTCM) the giant hedge fund that collapsed in 1998 triggering a global financial crisis. Worse the Banks themselves have been taking on higher risk in order to maintain returns especially through derivatives and that leaves them vulnerable as well. Rising interest rates spill over onto numerous markets including income trusts particularly the REITS and business trusts, the real estate market, consumer goods, the consumer with his high debt levels and banks.
It will also prick the stock market bubble that has been created with the easy monetary policies of the Federal Reserve over the past year and half. But many point out that usually these things don't happen until the Federal Reserve raises short rates and thus far the line is being held here. Fed funds futures are, however, pricing in a 25 basis point rise by September and as well another one by December. The futures market is usually correct. In a fragile market that is still beset by numerous problems it might not take much of rise in rates to trigger a market collapse.
Long bond prices peaked almost a year ago in June 2003. But after an initial sharp plunge they bottomed out in July and began a six month plus rise. In the space of six short weeks, however, those gains were wiped out. Studies have shown that from the time of a top in bond prices it has taken anywhere from 5 months to 14 months before the stock market tops out. In the longer cases, however, the impact of secondary top in the bond market has brought a more immediate negative response in the stock market. We saw this happen in 1987 and again in 1989.
Now adding to the negative mood with the potential of rising interest rates is the sudden focus on China who are raising interest rates as well to cool their very high growth economy. Chinese banks could be very vulnerable to rate increases as the level of bad loans on their books make even the Japanese banks look solvent. It is feared these rate increases coupled with credit restrictions will cool their fast growing economy impacting everything including the high demand for raw commodities. The reaction in the market was vicious. China has arrived as a power.
But it is overstated as China's GDP growth (almost 10%) is driven by global export demand for its goods. We have no expectations that Wal-Mart for example will cool their ardour for cheap Chinese goods. But on the other side rising interest rates particularly in the US could have a negative impact on their exports. The recent US Dollar rally has merely taken it back to major resistance zones and it is still overvalued particularly when one considers the massive US deficits of $1 trillion/year in trade, budget and current account.
With the US needing $2.7 billion a day to finance their deficits and upwards of 50% of its debt now held by foreigners particularly China and Japan they can ill afford to have global competition for the money they need with interest rates going up in other countries as well. A rising US$ would be counterproductive to attempts to lower their trade and current account deficits so it is only a matter of time before dollar debasement takes over again and that is positive for all commodities.
Gold, silver and gold stocks took it badly with the negative news over the past few weeks with rising inflation signs, rising long term rates and now the China problems. But we have noted in the past that gold and gold stocks are generally negatively correlated to bond prices and the stock market and it is certainly negatively correlated to the US$. Gold responds positively to both inflation and deflation and as Gold rises other precious metals rise in tandem as they take on a larger monetary role.
While there are periods when the two are in sync longer term studies show they are more likely to go in opposite directions. Long bond prices are now testing their four year moving average while stocks despite an impressive year long plus rally have only generally reached back up to the four year moving average. Gold, silver and the Philadelphia Gold and Silver Index (XAU) all remain above their respective four year moving averages at $320, $5 and 70 respectively telling us that the long term bull market remains intact although we are clearly in a steep correction.
While "Sell in May and go away" often applies to the stock market we can't help but note that gold often has important lows in the month of April The current bull market in gold got underway in April 2001 and last year the lows for the year were in April. Gold regaining $411 and Silver above $6.25 would be positive developments. We view the scary plunge as a buying opportunity.
But in the "Sell in May and go away" mode the consumer discretionary and the financials are very vulnerable. Our charts of Canadian Tire Corporation (CTR.A-TSX) (www.canadiantire.com, 416-480-3660) and Bank of Nova Scotia (BNS-TSX) (www.scotiabank.ca, 416-866-6161) are rolling over breaking under there key 50 day moving average and appear headed for the 200 day MA support. These areas would provide buying opportunities in the coming weeks if they are around these levels when the fall and Christmas rallies start and the markets successfully survive the interest rate increases and uncertainties that appear to be on their way.