We can only hope that the last half of 2004 is not the low volatility, narrow range of the first half of the year. It must be frustrating for both investors and traders alike. Grant you volatility works both ways. Up and down. The TSX Composite has been the star so far up about 3%. But the TSX topped out in April and the range for the year so far has been a narrow 10%. It has been no better elsewhere as the S&P 500 (up around 2%), the Dow Jones Industrials and the NASDAQ (both roughly flat) have all been very uninspiring and as with the TSX their highs were seen earlier this year.
The bulls have been very upbeat this year following the success of 2003. The US economy seems to be humming along at an anticipated growth rate of around 4.5%; retail sales are flying up 8.9% annually to the end of May; around one million new jobs have been created in the past three months and the unemployment rate is down to 5.6% from 6.1% a year earlier; profits have been good to generally above expectations; industrial production rose 1.1% in may the biggest monthly gain in nearly six years; and, consumer confidence continues to improve rebounding in early June after slumping in May.
The only sour notes have been rising inflation with both CPI and PPI levels the highest since 2001 which in turn is putting pressure on long bond rates and probably will result in the Fed hiking rates at its upcoming FOMC meeting; the ever widening trade deficit which hit a record $53.2 billion in April and is threatening to grow to almost $600 billion on a year over year basis and current account deficit that grew to $144.9 billion in the first quarter; and the mind boggling budget deficit that could exceed a half a trillion dollars this year after almost $400 billion last year. The triple deficits are so alarming that even the IMF has issued warnings that it threatens the financial stability of the global economy if not reigned in. The White House and others have dismissed this as so much fear mongering and that in a global economy it doesn't matter.
So maybe the stock markets treading water is not so surprising after all given the balance of a growing economy offset by the very troubling debt situation. The bulls believe of course that the deficits are not a major problem as even Japan has bigger budget deficits in relation to the size of its economy and that the trade deficits are just a sign of success of the US economy that it can absorb the world's goods in a global economy. While certainly the best of the current bull may be behind us in 2003 there should be enough left to carry us into 2005 and even the threat of higher interest rates is just a by-product of the growing economy.
Should we be so sanguine? We don't think so but we do acknowledge that as long as the stock cycles remain up and that the environment of low interest rates and sufficient liquidity can carry this market higher. Unlike Japan of the 1990's that was criticized for not cutting interest rates fast enough and providing sufficient and massive liquidity to buoy the economy, the Fed under Alan Greenspan has shown no such shyness. Indeed it has been its signature and many believe that is what has prevented what might have been a far steeper recession then what was experienced.
We are not arguing with that but the policy of low interest rates and easy money is instead creating another problem. The biggest potential growing problem is the housing bubble. Many would argue there is no housing bubble. But the evidence begs otherwise. Housing prices have soared in many parts of the country and in Canada as well fuelled by easy mortgage terms not only to 100% of the value of the property but even to 110% and 125%. The premise is that housing prices can only go up and the growing equity and improving economy will allow home owners thrive.
Seems that they have forgotten the devastating housing collapse (and even deadlier commercial property collapse) of the early 90's. And the banks lending the money must have the shortest memories on record forgetting that it was their own profligacy that gave us the third world debt crisis in the early 80's, the Savings and Loan scandal in the late 80's and the ensuing housing and commercial property collapse in the early 90's. With consumer bankruptcies, delinquencies and foreclosures running at record levels through 2003 and 2004 the current mortgage mania verges on both insanity and stupidity. Even the esteemed Economist has noted the concern over the housing bubble in two consecutive issues. Confounding the growing housing bubble was the announcement this week that new home sales were way above expectations at 1369 thousand for May.
Our second major concern is the rapid growth of the money supply (M3) during 2004. Three months growth to May 2004 has been at the rate of 11.3% and for the six months to May 8%. Of course the year over year is only 5.4% but that includes the negative growth of the latter part of 2003. So why the sudden surge? In the past surges in M3 growth was a response to recessions (the early 90's), particular events (September 11, 2001, the Asian/Russian collapse and the subsequent collapse of Long Term Capital Management 1998) or planning for potential problems (Y2K, the Iraq War). This time there is no recession as the economy is supposedly gangbusters, and there is no crisis or any pending crisis that we are aware of.
Or is there something brewing? If not then the massive liquidity injections in the face of a growing economy is pure recklessness. As our title notes we are entering a crucial time frame over the coming week. At the FOMC meeting it is widely expected that the Fed will raise rates by a quarter point. The market could receive doing what is expected positively and it might rally. A fifty-point hike would, while some expect it, come as a surprise and the market would sell off. Similarly doing nothing would send the wrong signal and it could cause problems for both the market and bonds. Gold on the other hand would soar, as the US Dollar would fall.
The second event in this time frame is the handover on June 30 to the new Iraqi government. The handpicked government has little support in Iraq and even polls? show that upwards of 90% of Iraqis want the US out. Insurgent attacks are already increasing attacks as we approach the June 30 deadline as witnessed by the deadly attacks on June 24. Despite the handover on June 30 the authority of the new Iraqi government is extremely limited as full military authority lies with the US forces. As well in light of the Abu Ghraib prison torture scandal agreements are in place to ensure that US forces are exempt from any prosecution. Questions surround the remaining thousands of prisoners who according to the Geneva Convention should be set free. With little support from the Iraqi people and the US forces remaining in charge the handover is purely symbolic and changes nothing. Attacks will intensify.
The danger is that something will happen that will rock the markets particularly the already vulnerable oil markets. Tensions are also growing with Iran over what is clearly support for the Shia factions in Iraq from Iran, the recent seizing of the British naval boat and the ongoing dispute over the extent of Iranian nuclear facilities. The danger is that the tensions with Iran will escalate as we go forward and this would shake the markets. Already the rhetoric from the White House concerning Iran sounds eerily like what we heard in the lead up to the Iraq invasion. How it is sold will be important given the revelations of what some deem to be outright lies to justify the war in Iraq.
The third event is the upcoming July 4 celebrations. Expect Homeland Security to raise the terrorist level to at least Orange. Red is highly unlikely as that would in effect put martial law in place throughout America and end any celebrations. Our 1934 cycle that we have generally followed this year did show a rally into about June 27 followed by a sharp sell off into the first week of July. Another sharp rally followed into the second week of July then the market plunged into month end.
The last event is not really an event at all but something that does have the potential to grow and become a major problem for the markets. Notwithstanding the release on June 25 of Michael Moore's scathing Fahrenheit 9/11 there are growing investigations into the Abu Ghraib prison scandal; directives on 9/11 that had stand down orders on US air force planes that could only be put in place from Donald Rumsfield and the Pentagon – the orders never came and when they did they were too late; an investigation in the Plame case of who illegally leaked Ambassador Wilson's wife; and, an investigation into the claims that Iraq was involved in 9/11 in conjunction with Al Qaeda and the lack of WMD. The latter was a legal justification for the war in Iraq and evidence according to the 9/11 commission does not support the claim.
All of these issues are getting more and more press. There have been musings that at best VP Dick Cheney may not be on the upcoming Republican ticket unless he can quickly clear his name. At worst impeachment proceedings could be started against both Bush and Cheney although support does not seem to be there for that yet. Cheney has other problems as Halliburton is under investigation for a scandal in Nigeria and there have been calls for the appointment of a Special Prosecutor in the case. Bush has hired a private lawyer in the Plame case. Bush's support despite the problems remains firm with his core but polls indicate that he trails Kerry.
The record of war Presidents is, while mixed, generally dominated by one term Presidents or they died in office. The last three war Presidents, Harry Truman (Korea), Lyndon Johnson (Vietnam) and George Bush Sr. (Gulf War) were one term Presidents. Others such Abraham Lincoln (Civil War), and Franklin Roosevelt (WW2) died in office (Lincoln assassinated). While brief the Spanish American War happened under William McKinley and while he was re-elected in 1900 he was assassinated in 1901. Woodrow Wilson (WW1) was a successful two term President although the US did not enter the war until 1917 well into his second term. James Madison was successful two term President through the War of 1812. James Polk (Mexican American War) was like others a one term President. Given the growing legal problems for both Bush and Cheney history does not support them for another term.
The market behaviour in the final years of the last three War Presidents is also interesting. Johnson in 1968 saw a very weak market into March but a sharp improvement particularly when it was determined he would not run. The market did not get a good rally going until after the election although it was improving into the election with thoughts of a Nixon victory. The market for George Bush Sr. in 1992 was very weak into October but rallied after the Clinton election in November. Truman also faced a very weak market going into 1952 that held into May but after it was decided he would not run the market rallied in the summer but fell sharply into late October before the election. After the election the market had a strong rally.
One final note. Michael Jenkins of Stock Cycles Forecast has noted that the S&P 500 topped on March 24, 2000 at 1553. 1553 days from March 24, 2000 is today June 25, 2004. A Gann square out in time. We are making a top just like in March 2000. We are looking for a top. Our chart of the S&P 500 is below.