It's September and we are supposed to be into the worst stock market month of the year. Too bad that as much as September might at times be a nasty month it is not something that one can take to the bank each year. Here we are half way through the month and the S&P 500 is up 2%, the NASDAQ is up 4%, the Dow Jones Industrials is up 1.4% and the TSX Composite is up 1.3%.
Despite a background that should be anything but friendly to markets they have been rising. Given the low volume that has prevailed, however, the market has been more characteristic of a short covering squeeze then it has been more fundamentally driven. But that has not stopped numerous pundits advising us that the economy is booming and that the technical action is positive because the advance decline is making new highs. From the economic side the biggest booster is Fed Chairman Alan Greenspan who once again came up with an upbeat message to Congress and stated that the economic expansion has "regained some traction".
We can only assume he was referring to the very buoyant retail sales number that was a robust 0.8% in July. Impressive, but if one checks the consumer credit growth in July it was up a huge $10.9 billion in the month. The market only expected $5 billion. A disappointing August number that was down 0.3% followed the good July number. Pushing the numbers down was very weak auto sales. Auto companies have it seems been maintaining 0% interest and numerous other give aways to entice customers into showrooms for eons. If auto sales are faltering then it does not bode well for retail sales going forward. The general trend of retail sales over the past few months has been down. Retail sales it seems need consumer's credit cards working overtime to produce the desired result. Not a healthy way to run a booming economy.
Or maybe he was referring to the better than expected non-farm payroll numbers released in early September that showed that 144 thousand new jobs were created in August, higher than expected. And the previous months were revised upward by double. The unemployment rate fell to 5.4% from 5.5% further buoying the market. But the economy has lost over one million jobs since 2000 and needs to grow a lot faster to not only recoup those lost jobs but to absorb as well population growth.
The fall in the unemployment rate happened because the number of those seeking work dropped. If you stop looking because you are discouraged or your unemployment benefits run out you are no longer counted. A number of analysts believe the real unemployment rate would be over 9% if discouraged workers and others were included. Further we have always been struck that despite a so-called booming economy some 1.3 million Americans fell below the poverty line in the past year. A healthy booming economy?
Or maybe Mr. Greenspan was happy about consumer prices staying rather benign. The most recent CPI numbers released on September 16 showed that the CPI and the core CPI rose a measly 0.1% in August. This was a 2.7% year over year increase. But inflation is being kept low because US manufacturing has been moving offshore to low cost countries (China, India etc.) for years while wages are being checked in the US. Wages have been flat for years and the average wage earner has actually being falling behind inflation. But despite the flat wages it does not seem to stop people from spending. In the most recent reporting period personal income was up only 0.1% for July while personal spending rose 0.8%. See above and the huge growth in consumer credit to help explain why spending exceeds income.
Finally Mr. Greenspan noted some improvement in housing starts and sales that seemed to bounce back in July after showing softness in June. Mr. Greenspan has always skirted that there might be a housing bubble. But it has been his own policies of low interest rates and the sense that the interest rates would be kept low that encouraged the huge growth in housing sales with many taking advantage of the depressed rates to refinance and use excess funds to spur consumer spending. Mortgage refinancing appears to be slowing and indeed may explain part of the reason why money supply (both M2 and M3) has fallen in recent months.
We have noted a number of articles recently on the housing market. The Economist has noted that never before have real house prices been rising so fast in so many countries (The sun also sets - September 11, 2004). In the past year alone in the US house prices are up 9.4% but that is just across the country and hot areas such as New York and California housing prices are rising even faster. The hottest housing market in the world over the past year has been Hong Kong where prices are up over 28% in the past year.
But accompanying the hot housing market has been the highest vacancy rate since 1965 reflecting a fast rising supply of housing and record ratios of house prices to rent and house prices to income (26% above the average for the past 25 years). Far from being healthy the housing markets are overvalued and even a modest increase in interest rates could put downward pressure on housing prices because so many of the mortgages are of the floating rate variety. Over the past year defaults have continued at a record pace and if the economy turned down the pace of defaults could quicken. Further the states battered by the hurricanes could have problem as inadequate insurance coupled with severe damage could leave banks holding a high inventory of damaged housing.
So we have an economy that is anything but booming but inflation remains low and interest rates are benign with short rates still below the rate inflation and all of this is supposedly behind the market to rise for the third time this year. But so far the highs have generally been lower highs and each low has been lower than the previous one. The classic definition of a downtrend. It is a drifting lazy market that classically should end in a collapse. Sentiment has remained quite bullish with complacency as measured by the VIX volatility indicator recently making a new record low despite the fact that market was still well below the highs seen in January/February 2004. An interesting divergence of bullish sentiment running rampant even as prices make lower highs.
So is the bullish sentiment reflecting an overvalued market waiting for a sharp fall or is it a true belief that no matter what when we are finished the current correction and year we are about to embark on a tear? We doubt whether there is fund manager, institution or armchair stock market analyst anywhere that doesn't know that there has never been in the history of the modern stock markets a down year in a year ending in 5. The corrective sideways markets of 1934, 1944, 1984 and 1994 were classic corrective drifting markets followed by huge up moves in the subsequent year ending in 5. The key to all of those markets is that they never broke a swing low by any significant amount. Certainly sounds like this year.
If the cycle of the year ending in 5 comes true than it would seem to be a lay up that all one has to do is lay back go long on any pullback and wait for 2005 to start. You can't lose. Targets would be at least up to 1225/1250 S&P 500. In many other years ending in 5 the gains were even better than that. Is there a fly in the ointment anywhere or is it really that easy?
Many pundits would like us to believe that. We keep hearing from analysts that the markets will embark on a strong up move once the current correction is over and especially after the election. Here the candidate favoured by Wall Street, George Bush, will be re-elected or at least that is what the polls seem to lean towards despite the fact that it might be another nail biter as in the 2000 election. Kerry has failed to light any fires and the Bush campaign has kept the focus on a war fought thirty years ago with the questioning of Kerry's role. The counter attack to focus on Bush's hazy National Guard record during the same period has failed to ignite.
Meanwhile the current war that was premised on false pretences and has bogged down with a major counter insurgency that even the Pentagon is admitting might not be winnable gets scant attention. The cost of the war and increased security coupled with huge tax cuts is heavily responsible for the huge budget deficits but it also is receiving insufficient attention in the election. And as to the economy every positive number is seized by the Bush campaign as evidence that their policies are working even though what are supporting the numbers is merely a house of consumer credit cards and the unlimited chequing account of the Federal Treasury.
If there is a fly in the ointment of this seemingly bullish scenario for 2005 it is the Tokyo Nikkei Dow cycle of the 1990's. Here the drifting market of 1994 did end in a crash to new lows for the Nikkei. We have often noted the seeming similarity in the structure of the current S&P 500 from 2000 with the Tokyo Nikkei Dow from 1990. Will the 1990's Nikkei market cycle prevail or will the magic of the cycle of the years ending in 5 come through once again and make all of the bulls very happy. Can it really be that easy?
The risks are five fold as we see it. They are the ongoing trade and current account deficits that could lead to a collapse in the US Dollar; the huge and growing budget deficits primarily caused by the huge expenditures for the War in Iraq and Homeland Security; further disruptions to oil supplies beyond what has occurred so far with falling inventories and curtailed supply due to attacks on pipelines in Iraq and possibly even Saudi Arabia that could drive oil prices to the $70 range which would fulfill long term minimum targets; a sharp slow down in the China colossus as we note the stock market there has been constantly moving to new lows recently; and finally a major terrorist attack in the United States although it might accomplish the same impact even in Europe. The Economist cited these risks in "The risks ahead for the world economy" September 11, 2004. We echo the sentiments.
For the past year the US Dollar has managed to trade in a range while keeping downward pressure on gold prices that move counter to the US Dollar. A potential reason that has occurred has been the massive growth of holdings of US Treasuries by Central Banks through the foreign custodial account at the Federal Reserve. Dan Norcini detailed this phenomenon in a recent article entitled "The synthetic short dollar theory weighed in the balance" September 11, 2004. The Federal Reserve foreign holdings account has risen sharply from $700 million in 2001 to over $1.3 trillion recently. A big chunk of this was seen in the past year and may have contributed to holding the US Dollar together even as other figures indicated that there were net outflows elsewhere in the same period.
There have been some indications that foreigners are becoming less inclined to buy US treasuries at auction as they did in the past. This has negative ramifications for the US$, US interest rates (which will go up) and inflation, which will also go up. A falling US$ would also mean that commodity prices that are priced in US$ will rise to compensate for the falling purchase power. None of this positive but the full impact of this scenario has yet to occur. We point it out because the longer we go on the more likely it is to occur especially if the insatiable demand for funds continues from the US to finance their wars and security.
Indeed some pundits have noted that the US deficit shortfall could be even larger than it is. Even the US Comptroller General David Walker has described the budget outlook as "Chilling". The reason is that the budget deficits and debt ignores future liabilities of social security and Medicare. The estimate of this so-called "fiscal gap" is potentially as high as $72 trillion. The IMF has estimated the gap at $47 trillion and the Brookings Institute at $60 trillion. These are numbers so large as to be implausible but have been confirmed by a number of economic and budgetary think tanks.
We can understand why Alan Greenspan is so optimistic because if he stated the truth the markets would collapse. The bulls are buoyed by an upcoming year cycle that suggests that winning is a lay up and all one has to do is show up and you can take it to the bank. We don't deny that the Greenspan's upbeat take on the economy might be right nor do we deny that the magic of the year ending in 5 could once again make everyone happy but we do believe that everyone should be aware of the risks and that complacency can sometimes result in getting your teeth kicked in.