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The Beginning of the Scary Season

It's September and the market is starting the scary season. One problem though. It is not always scary. Our colleague, Don Vialoux of Tech Talk www.dvtechtalk.com in a recent column noted the myths and facts about September. Seems that the myth that September is the weakest month of the year is just that, largely a myth. While the odds do favour weakness in September (31 Septembers of the last 53 saw declines) the average loss was a pretty miniscule .5%.

But generally, whether September is an up month or a down month is pretty random. And it is just that for the most part for other myths as well including October crashes, Santa Claus rallies and the January effect. Not to deny that these events are not favoured during these periods it just that one can not take it directly to the bank.

Even the "Scoop" is being disingenuous in titling our article "The beginning of the scary season". About all we can say for sure on the scary season is that Halloween occurs on October 31 and even that is merely an example of feigned scariness. And undoubtedly some Hollywood studios will trot out yet another sequel to Resident Evil, Friday the 13th and Scary Movie. Oh the horror of it all.

For real scariness we have to turn to terrorist attacks in Russia and Israel and ongoing bombings in Iraq. The terrorist attacks barely register in the financial world but that doesn't mean that they should just be ignored. And of course there is a great deal of hand wringing over the terrorist attacks. But one does need to maintain a perspective.

The attacks in Moscow, North Ossetia and the Russian airline attacks are in response to the ongoing civil war in Chechnya where over 100,000 Chechnyans have been killed and Chechnya largely wasted in attempts by Russia to suppress the break away state. That Chechnya is Muslim and at one time was armed by elements of Al Qaeda and that puts them on the wrong side of the "War on Terror" is incidental. What Chechnya has is the oil in the upper Caucasus. And in installing yet another Russian puppet to run the failed state that only fans the counter attacks by the Chechnyans. But Mr. Putin is part of the war against terror so the fact that he too terrorizes the population of Chechnya to suppress the population is ignored.

In Israel the bus bombing was the first in six months. With increased security and a wall it has cut down on the number of attacks. But almost daily attacks continue on Palestinians where the differentiation between alleged combatants and the civilian population is incidental as the drive to crush the resistance continues. And Ariel Sharon's own party does not want to give up the settlements in Gaza while expansion is planned in the West Bank. All fodder to ensure that attacks and counter attacks will continue.

In Iraq the death toll of Iraqis is not even counted but is estimated to be around 20,000 of which two-thirds of them have been civilians primarily women and children. An attack on an alleged militia stronghold in Fallujah kills women and children and little else. It fans the counter insurgency against the US led occupation and does nothing to bring either peace or security. The stench of the Abu Ghraib prison scandal lingers with the claim that it was rogue elements completely discredited with clear evidence leading into the office of Donald Rumsfield. Beaten, stripped and humiliated the counter insurgency fights back with the only thing it knows how to do in a country that was heavily militarized even before the US invasion in March 2003.

But lest it leaves the impression that populations are being completely suppressed by the military might of Russia, Israel and the US we are reminded that governments across the sphere of the Middle East, Asia Minor, the Caucasus and Central Asia are riddled with corrupt, dysfunctional and in some instances gangster governments that do a good job of keeping their populations often ignorant, poverty stricken and suppressed. That they may also be a client state of one of the powers of either the USA or Russia is incidental. The prize of course is control of the energy and mineral wealth that are needed to feed both their societies and their military machines. For Israel one could argue it is its existence but that cause is weakened with the relentless unfettered expansion of the settlements.

While the US sits astride a number of these countries thus controlling to some extent either directly or indirectly the energy and mineral wealth there remains numerous opponents. Whether one wishes to call them terrorists or rogue states is irrelevant. What it does is ensure that the entire region will remain a flashpoint for years to come and depending upon the course of events it will weigh heavily on the financial markets for as long as it exists.

From the US side it is the sheer cost of maintaining this huge military presence. With a military presence in some 138 countries the US spends more than all of the next 15 to 20 states combined. While at home healthcare and social security can get squeezed the budgets of the military and homeland security are guaranteed to grow. As a result the US is running the biggest deficits ever known and their consumer and business manufacturing base has migrated primarily to Asia (China, India) while they chalk up trade debts and need the rest of the world (again primarily Asia - China and Japan) to finance them.

The result of this is a world awash in US dollars and a US awash in debt. To those who think that the US Dollar can go up we are reminded that with so many US Dollars floating around the world supply is exceeding demand; demand is falling as countries particularly China and Japan become concerned about the huge amount of US debt they hold and signs are recently that they are pulling back a little; the commodity based countries are adjusting their prices upward (oil) as the US Dollar falls to compensate their loss of purchasing power; while the invasion of Iraq and its aftermath remains popular with a certain large segment of the US population it is generally unpopular around the world and this lessens the demand for US Dollars; numerous countries are trying or would like to diversify their reserve holdings out of US Dollars into Euros and some oil producing countries are accepting payment of for their oil in Euros rather than US Dollars - remember Iraq prior to the invasion would only accept Euros as payment for their oil; and, finally as the US Dollar falls further it feeds upon itself to get out of Dollars and into something else.

And as to the debt it today exceeds GDP by over 3 to 1 with the business and consumer community alone accounting for nearly 2/3rds of the debt. By that measure business and consumer debt is twice the size of GDP. Never in history has debt/GDP levels been at these levels even exceeding those of basket cases such as Argentina that collapsed. It is naïve then to believe that the world will continue to come to the rescue of the US to finance their debts and that the Federal Reserve can staunch what could eventually become a major collapse particularly if an event such as a major terrorist attack on US soil or an outbreak of further wars were to occur.

The current biggest threat to war right now is Iran. Here the US rhetoric is rising that Iran is building WMD through its nuclear facilities or wants to acquire WMD. As well Israel has made threats towards both Iran and Syria for the support of alleged terrorist groups such as Hamas and Hezbollah. That many of the same words we are currently hearing are similar to what we heard prior to the invasion of Iraq is irrelevant. Or that support of groups such as Hamas and Hezbollah has been going on for years. But keep in mind that right now Iran is considered a rogue state (part of Dubya's "Axis of Evil") and it is surrounded right now by US military presence in both Afghanistan and Iraq. The US is committed to regime change in the region and of course Iran has oil.

Undoubtedly Iran has been supporting the Shia militants in Iraq. The fear in Iraq is that if true democracy broke out its face might be religious Iranian backed mullahs from the 60% Shia majority. Instead what we will get is some sort of sham democracy to ensure the right side wins and then a continuance and escalation of the violence that permeates the country.

Another place to keep an eye on is Russia. After going through one of the most spectacular economic collapses ever in the 1990's following the break up of the Soviet Union, the Russian bear maybe stirring in his den. Indeed the economic collapse in Russia was so deep that the population actually fell as did life expectancy. A humiliating come down. Russia is, we believe, a wounded bear. And a wounded bear is a dangerous bear.

Setting aside the Yukos affair, the shaky banking system, and the ongoing war in Chechnya Russia is in the process of rebuilding its military power. A KGB President, humiliated Generals still smarting from the end of the cold war, and gangster capitalism could come together to attempt to regain Russia's influence in the Caucasus and Central Asia. While publicly they would never admit it the Russians are clearly not happy with the growing military presence of the US in Central Asia and the Caucasus.

Russia's hands are clearly behind the ongoing conflict in the breakaway Georgian provinces of South Ossetia and Abkhazia. They stand in the way of the building of the US backed Baku/Turkey pipeline. That the breakaway provinces are also havens for gun smuggling, drugs and other gangster activities is incidental. What is good for the US here is bad for Russia and vice versa. And so it goes throughout the region. Russia is also being seen in Iran where they are building alliances with the mullahs. It is mutually beneficial as both see the growing US presence as a threat to their interests and further Iran views the US presence as a threat to their existence. Could a military alliance be far behind?

A wounded humiliated Russian bear, a huge US military presence in the region, a US administration full of old cold war warriors (Rumsfield, Cheney etc.) with the massive oil and mineral wealth in the area at stake. All of this is potentially explosive. And it may take less time to come to head than one thinks. By most calculations serious oil shortages could be seen as early as 2006 so control of the region of the Caucasus and Central Asia is paramount.

Since mid August the market has been in an upswing despite record oil prices, a mixed economic picture and threats of terrorist attacks. Seems the huge amount of liquidity poured into the markets during the first half of the year by the Fed is doing its trick. It is keeping the markets afloat. But recent numbers suggest that the massive liquidity injections are coming to an end as the money numbers actually fell in the most recent reporting period. As well the Fed, who has been accused of keeping interest rates artificially low now for months, is being pressed to increase rates.

The liquidity injections coupled with low interest rates has exacerbated the debt bubble. Worse the trade and budget deficit picture just keeps getting worse. Despite that the US$ has continued to hold up but after peaking in May it has been largely just marking time. Recent action has been mixed but generally like the stock market there is distinct downward drift forming. Both the US$ and the stock market are nearing key resistance zones. We have noted some recent caution on the US$ being issued by noted analysts Adam Hamilton (US Dollar Bear Intact - August 27, 2004) and from Ned Davis (Dollar Outlook and Implications - September 3, 2004, Chart of the Day). We would pay attention.

The stock markets, as measured by the S&P 500, are rapidly approaching major resistance in the 1120/1125 zone. While the bulls would like to believe that we could burst through and make a run to possible targets all the way up at 1250 we doubt it will happen. We are entering the scary season and indeed the next 9 weeks is known as the crash season. The jobs numbers remain anaemic even if they did come in today as expected. The market remains quite complacent (VIX Volatility indicator still in the 14/15 area) and bullish sentiment remains high. These are not positive indicators for a major bull market.

But over there where conflicts continue on a daily basis the scary season it seems lasts all year long. It is a slow rising crescendo but it is one that is building even if most have paid little attention to it. It deserves more paying attention to and what is going on behind the scenes as eventually it may come back to haunt us all.

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