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The New Year

The new year has come in much like the old year went out with disasters both natural and man-made in the news or lurking in the background. The disaster most at the forefront of course was the natural disaster in the Indian Ocean off the island of Sumatra in Indonesia. The tsunami wave, which impacted at least 9 countries, is estimated to have killed upwards of 150,000 with thousands still missing and upwards of 5 million homeless many facing the potential of disease and hunger lacking basic services. Donor nations have leapfrogged each other and even themselves to provide support and relief from this disaster of biblical proportions. Individuals have opened up their wallets demonstrating that charitable giving has not as yet burned out.

Despite the human tragedy, economically it is barely a blip even in some of the countries impacted. While some estimates said damage was in the area of $13 billion one has to consider that is an estimate and nothing more. Donors have contributed upwards of $3/$4 billion thus far although it remains questionable as to how much of it will reach the needed areas some of which are still wracked with civil conflicts (Sri Lanka, Aceh area of Indonesia). The region is largely uninsured both for personal and property insurance; there were no major infrastructure or industries impacted. The damage is local; the impact is on basic farming, fishing and tourist industries in areas that were largely poor to start with. Rebuilding will fall largely on aid agencies and donor countries. As far as the stock market was concerned it was a non event.

The second natural disaster that continues into 2005 is the global AIDS crisis particularly has it has been playing out in Africa. This crisis flies largely under the radar screen but in Africa alone it has killed 15 million including an estimated 2.3 million in 2004. The death toll pales the tsunami disaster yet many people would be hard pressed to even identify the disaster let alone see it grip the world for upwards of two weeks as the Indian Ocean disaster has. Slow death for millions just does not have the panache that a natural disaster impacting millions at once has.

Economically it has been a significant drag on numerous African countries that are poverty and war stricken to begin with. Yet the relief being provided to deal with the crisis is not a whole lot more than the aid that has been pledged for tsunami relief. Unlike the tsunami disaster no one has suggested that the countries whose core population is being destroyed be given debt relief. Solutions are available yet the world has lacked the political leadership and not provided the financial resources for what is needed to potentially rescue millions of people. As with the crisis in the Indian Ocean the economic impact is local impacting poverty stricken countries. The impact on the global stock markets is zilch unless someone discovers a magic drug for AIDS and even then there would be battle over the patent and its ability to reach the people that really need it.

The war in Iraq of course is a man made disaster. If anything the Indian Ocean disaster pushed this one off of the front page. The war was premised on false pretences and according to numerous international legal opinions and under the charter of the United Nations it is an illegal war. The war has intensified over the past six months since so called "Iraq Sovereignty". The war has claimed upwards of 100,000 lives and has cost upwards of $200 billion. While the death toll has not reached the numbers seen in the Indian Ocean disaster or the AIDS pandemic, we are reminded that the country is littered with depleted uranium from spent munitions so a bigger health related disaster could hit years from now.

What is striking is the amount spent pales what is being pledged for tsunami relief or provided for AIDS globally. Estimated cost to the ongoing war is about $175 million/day or put another way the amount donated thus far for tsunami relief is about 2 ½ weeks of the war in Iraq.

And the stock market responds positively as there are numerous companies that benefit from the war that are listed on exchanges led by Halliburton (HAL-NYSE).

Since the invasion started in March 2003 the S&P 500 is up 42%. Indeed when the shooting starts and it appears that things will go well the market has always responded positively. In 1915 when a war boom began, the DJI put in its best year ever; in 1942 after the US won the Battle of Midway and the tone of the war shifted in favour of the allies the stock market embarked on a run that carried into 1946; in Gulf War 1 the market embarked on a rally following the start of the invasion that was quickly determined would be over in a short period. An exception to this was the top in the market in 1966 which also generally coincided with a massive build up and escalation of the war in Vietnam and signalled the start of the battling sixties.

If there is a risk to the market in the current war it is not so much in it continuing as it has over the past six months but that it spreads to other areas or countries such as Syria or Iran thus requiring a build up and escalation. Further risk is seen if a major disruption of oil supplies were to occur either in Iraq or Iran or a successful attack on the oil installations in Saudi Arabia. If that were the case a spike to $75 oil could not be ruled out. At those levels oil would then be approaching levels in inflation adjusted terms seen at the time of the Arab Oil crisis in the mid 1970's and again surrounding the Iranian hostage crisis. Then it would have a serious impact on the economy. At current levels in the low/mid $40 oil prices are not sufficiently high enough to tip the economy.

This leads us the potential or ongoing financial disaster in the making that lurks in the background. This too is a man made disaster. Of course many of us have been sounding the alarm of a financial meltdown in the economy and stock market for years and to date the Great Depression that some have predicted has not happened. We did get the tech meltdown and corporate scandals aided by the terrorist attack of September 11 but that bottomed in 2002 and it has been pretty good ever since or at least it appears that way. But the fact that a real economic meltdown hasn't happened despite the tech meltdown, war and terrorist attacks has given new life to the bulls. The bulls have been persistent in their belief that one just keeps investing and largely ignore all the bad noise in the background as it has always been there and the market always bounces back.

We all know that the reason the market and economy have done so well over the past few years is the huge monetary and fiscal stimulus that has been injected into the market. A rapidly growing money supply above the rate of economic growth; tax cuts; interest rates maintained at artificially low levels far below the rate of inflation; excessive spending to finance the war in Iraq and excessive spending by the consumer financed with mortgage refinancings and credit cards because of the low interest rates has given the illusion that all is well. Not surprisingly it has taken nearly $10 in new debt to purchase a dollar of GDP in this cycle. If a company added $10 in new debt to gain a dollar of revenue the market would punish the stock mercilessly yet the market instead views it as positive that the consumer and the government just keep spending even if they are just writing IOU's that may never be repaid even as servicing is maintained and there is an acceptable level of defaults.

Some view this as a vibrant economy. The US is running record trade deficits largely because of consumer spending on hordes of cheap foreign goods brought in as a result of the hollowing out of America's manufacturing base that has gone largely to China and India. Again these trade deficits are viewed by some as good as it is recycling of money. We buy their goods, they finance the US's debt and everyone is happy. With a trade deficit that is now 6% of GDP they seem to ignore that if this were any country but the USA the IMF would now be called in and a financial crisis of major proportions would be gripping the country and the currency would be in a free fall. And if the trade deficit isn't enough the budget deficit is now 4% of GDP and rising (and some numbers already suggest it is already at 6% of GDP and considerably higher than reported when one takes in all of the costs associated with the war in Iraq).

But the US currency has yet to go into a free fall and everyone is locked in the game of buying the US debt to prop up the charade because if they didn't continue there would be a financial meltdown to the detriment of everyone. They seem to forget that the law of averages says that one day an accident will happen and they won't be able to get out of the way. Why these countries continue to buy debt that does nothing but go down in value seems to be the height of insanity. But such is the nature of the game. It requires mutual insanity to continue.

The economy has been allegedly expanding but jobs have come reluctantly. By this stage of the economic recovery it should have created upwards of six million new jobs. Instead the US is barely back to the employment levels of 2000. Recent reports indicated that there were upwards of a million job losses in 2004 due to closings; layoffs etc. Yet the monthly non farm payroll indicates that jobs are growing not in decline. This of course is bogus as while there has been job growth and hiring's it may be lower than reported because the non-farm payroll includes assumptions for self employment growth based on economic growth.

Economic growth is probably overstated as well because the rate of inflation is reported as low when everyone knows that hosts of costs have been rising. But inflation is adjusted lower because it is assumed that if the power of computers increases then it is the same as a reduction in prices. Upwards of ¾'s of the inflation rate is calculated with these type of adjustments thus allowing inflation to be reported lower than it probably is and by extension reporting real GDP growth higher than what it really is. The US is the only country in the world that calculates inflation and job growth with these adjustments and assumptions making comparison with other countries impossible.

Readers would be well advised to seek out an article written by Austrian Economist Kurt Richebacher (The Richebacher Letter – January 2005) to learn more about how inflation and employment are really calculated. As Richebacher points out the belief is that the strength of the US economy is based its superior growth performance from its great dynamism or efficiency. Instead it is an economy that is driven by consumer debt that has soared at the expense of saving and investment and gorging on exports. As Richebacher says "to hail this as successful policy is preposterous".

So could the game continue into 2005? Of course it could. But the law of averages is shifting and the risks are rising. We are now entering the third year of our four year cycle. The big question on our mind is like the 1930's cycle can this one stretch beyond where it should go having it last 5 years before a collapse into 2007 or will we like the Japanese 1990's cycle go off the cliff first (1995) rise to new heights (1996) only to go right back off cliff again (1997). Remarkably we have followed either the 1930's cycles or the Japanese 1990's cycle very well so far in the first decade with tops in the year ending in zero and a huge collapse into the year ending in 2 followed by the rebound in years 3 and 4. Now what?

In the 1930's we topped in early January went into a shallow pullback into March then began another long rally that took us through 1936. In Japan it was the opposite. We started a collapse in early January and it just kept going down sharply for six months before another strong rally developed that retraced the entire collapse and more into 1996. In both scenarios though the year ending in 7 proved to be fatal for both markets. A variation on this theme is the 25 year cycle where a sharp drop in the first week of January was followed by a solid rebound for a top in February. The market then embarked on a sharp correction into March before taking off to new highs into 1981. A collapse followed that brought us to new lows into 1982. We are showing those three charts below and they are worth looking at because they contain clues as to what the market of 2005/2006 should bring us.

As a further clue as to what may happen we are showing you how the Europeans view the market. The rally of 2003/2004 of the S&P expressed in Euros is extremely anaemic. Indeed it may be tracing out a huge head and shoulders topping pattern. If this is correct then the scenario we would probably follow is the Japanese cycle. If instead it fails then the 1935 cycle will be alive and well and investors will enjoy another good ride. But no matter the risks of a disaster remains but the baring an unexpected financial (or political) accident we expect the Federal Reserve to maintain its easy stance and the fiscal stimulus will also continue. This will put the day of disaster just a bit further away. Think of these essays as an early warning system something the tsunami victims could have used.

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