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Is The Bull Market On Its Last Legs?

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Stock Market Continues to Top

Everything we are looking at tells us that the market is continuing a topping process that began with the NASDAQ topping in late January. Since then the tops have been rotational with the Dow Jones Industrials topping in mid-February, the S&P 500 in March and the TSX Composite in April. All of them made at least short term lows around May 17, 2004. Not surprisingly numerous sectors have also seen rotational tops. In Canada that process started with tops in the gold and mining sectors last December. Since then only one sector, Consumer Discretionary has seen slight new highs.

An interesting indicator is the Volatility Index or VIX. The VIX is an indicator favoured by some market technicians. The VIX is developed by taking the weighted average of implied volatility for the S&P 100 Index (OEX) calls and puts and measures the volatility of the market. As the market rises the VIX falls and of course as the market falls the VIX rises.

The market is considered overbought if the VIX is trading under 20 and oversold above 30. Currently the VIX is around 15. At the recent lows in May it reached barely above 20. The VIX did reach a reading of around 22 at the time of the March lows so there is a small positive divergence with the May lows. The absolute lows were seen in April at 13 when the market failed to see a higher price high giving us a negative divergence. At important market lows in 1998, 2001 and 2002 the VIX reached over 50. Even at other lows over the past decade the VIX often went over 30. At the March 2003 lows the VIX was still around 40. The recent lows in the market don't even qualify as a correction based on the VIX.

The VIX continues to give us overbought complacency readings and the divergences being seen are at best neutral. Not an overwhelming endorsement for a new bull run. The US markets continues to struggle at significant levels of resistance. The bell weather S&P 500 has been topping along the 4 year MA over the past few months and is in the vicinity of the tops seen in late 2001/early 2002 and the 1998 top. The NASDAQ is running into a comparable massive resistance zone around 2000. The Dow Jones Industrials has performed considerably better but is trading in the massive congestion zone formed between 1999 to 2001 in the range of roughly 9900 on the downside and 10700 on the upside. The TSX Composite performed the best of them all but put in a double top in March/April above its 4 year moving average and above the 1998 and 2001/2002 tops. Targets on the double top are at least 7900. The low in May was just under 8100.

Grant you not all technical indicators are negative as ones like breadth and the advance/decline line have been supportive to the recent up move. But sentiment indicators remain uncomfortably high and even in the most recent up move from the May lows the market has often shown weakness in the latter part of the day. This suggests that the smart money is exiting the market. Volume has been lagging as well and without any significant influx of volume, any rise in the market is limited. Insider selling has been evident for months and has recently run 2 to 1 in favour of sales.

Many point to the surging economy as a prime reason for the market to move higher in the coming months. The most recent job numbers have been strong on both sides of the border. But the US numbers are, in particular, strong on the quantity but weak on the quality. Fully two-thirds of the job creation has been in low wage, part time, and service industry jobs. These jobs are also quick to go if things slow down. If employment growth had been normal over the past few years we would have 8 million new jobs instead of the 1 million in the last three months. Wage growth has been essentially flat while the consumer has propped up the market by going deeper in debt whether through consumer credit or through mortgage refinancing.

But recent consumer credit growth is showing some clear signs of slowing suggesting that the consumer may be tapped out. And the mortgage market remains high risk. The Economist, June 3, 2004 pointed out the real risk in the housing market with rapid growth in prices not only in the US but globally propped up by cheap money much of it at variable rates. Borrowing against rising housing prices is another form of leverage and has allowed spending to remain at high levels outpacing income growth.

But there is now a real risk to rising interest rates. Even Alan Greenspan has indicated that he may need to increase interest rates because of inflationary risks. But we believe that this is a red herring as the real risk is not inflation but remains deflation on a massive scale because of the huge overhang of debt. Rising interest rates may be forced on Greenspan as the market is already pricing in interest rate hikes. But Greenspan knows that in an overleveraged economy that rising interest rates is the last thing the market can handle. Already rising long term rates are forcing hedge funds, investment dealers and the banks to divest themselves of the carry trade (carry trade is when one borrows short rates and reinvests the proceeds in higher yielding securities in either domestic or foreign markets).

The debt situation in the market with the consumer, corporations and government is very vulnerable to rising interest rates. At current low levels, levels, which are below the rate of inflation, would be devastating just doubling. Of course what is needed is ongoing low interest rates and pushing the money supply to even higher levels in order to stave off a problem. Over the past few months the money supply growth (M3) in the US has been rising at over 10%/annually and is on pace to increase over $1 trillion in 2004, an unheard of pace. Rapid monetary growth is of course poor for the US$ and good for gold.

The world is awash in debt and the US has become the world's biggest debtor. Somehow there is this (unproved) belief that the world will continue to finance this debt instead of recognizing that instead it is an Achilles heel. There are already banking problems out there in Japan, China, and Russia but while these areas are of grave concern the real focus should be on the leveraged US financial system. The Hedge Funds (and other funds as well) are making no money this year. Huge leverage in a rising interest rate environment and the need to unwind risky carry trades will continue to put pressure on them and increase the risk of a failure in an environment that is sure to get more volatile (similar to the failure of Long Term Capital Management (LTCM) in 1998).

And as we head into the summer election period volatility should remain high with Homeland Security increasing the threat of a terrorist attack; the risk of further destabilization in Saudi Arabia and elsewhere in the Middle East that could lead to higher oil prices; and, a new one in the risk of political instability with the Senate threatening contempt charges against John Ashcroft for failure to release information regarding the Iraqi torture scandal that points to a possible cover up all the way to the top. This is coupled with reports from Washington leak sheets (Capital Hill Blue) that point to increasing unstable behaviour in the White House comparable to the Nixon White House.

The biggest risk to the stock indices lies in the heavily weighted Financial Sector. Our chart of the TSX Financials shows that we have broken down under the prior lows seen in March. The current rally has taken us only back to those levels on weak volume. Our top short choice is the Royal Bank of Canada (RY-TSX, NYSE) (www.rbc.com, 416-974-8393). The problems of the Royal Bank have been put front and center with the recent computer problems that left customers without information or access for almost a week.

The second key area, which appears very vulnerable, is the Information Technology sector. Here our chart is showing a roll over pattern with the potential for a growing series of lower lows and lower highs. Here there are high profile problem companies such as Nortel Networks (NT-TSX, NYSE) (www.nortel.com, 905-863-1103). Nortel remains a prime short candidate as the company remains under SEC and potential criminal investigation.  As well one high flyer Research in Motion (RIM-TSX, RIMM-NASDAQ) (www.rim.net, 519-888-7465) now appears to be topping out recently giving us a sell signal with significant negative divergences.

Other TSX sub sectors that are either breaking down or look vulnerable are Utilities, Health Care, Industrials, Real Estate and Telecommunications. Despite the cry that the market is climbing a wall of worry investors should worry and be aware that the risks are rising and that the market continues to show signs of topping out.

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