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Election Over! Market Euphoria Continues

We can only guess that Wall Street must be pleased that the Democrats won on November 7 and took over both the House and the Senate (actually it's tied, but the two Independents have sided with the Democrats) for the first time since 1994. Maybe it is the perceived gridlock, with a Republican president and a Democrat House and Senate, that buoys their spirits. Or maybe it is fond memories of the stellar market from 1994 to 2000 under a Democrat president (Clinton) and a Republican House and Senate. Or maybe they still recall the roaring 1982-94 market under Republican presidents (Reagan and Bush the First) and a Democrat House and Senate.

Grant you, we are at a time of year when we often see markets put in their best performances, with an average 4.8 per cent gain from November 1 to January 31. The push comes from corporate and private pension funds This usually follows a dismal September and an often volatile October. Except that this year, the market just charged to the upside right through September and October. It was March to July that brought us our only serious correction this year. Since 1922 the mid-term elections saw losses half the time prior to the election (all data from the Stock Traders Almanac 2006).

Maybe it's the mid-terms themselves that have given rise to the continued strong markets? It is not unusual for the sitting president to lose seats mid-term. Indeed, gaining seats as we saw in 2002 is the exception. Since 1922 the market has made gains 15 times following the mid-terms, out of 22 elections. Good economic times and the fact that no war or recession had begun at least two years prior to the mid-terms were major factors in determining whether the market might be up for the balance of the year or not. Well, the war started over three years ago and we have certainly had no recession.

Most of the losses following mid-terms occurred during either wars or bad economic times or periods of political turbulence (e.g. Watergate, Teapot Dome Scandal). The housing market may be softening but it has not yet caused the markets to sell off. And the markets not only seemed to yawn at the results on November 7, they may have even cheered when Secretary of Defense Donald Rumsfeld resigned.

The resignation was oddly timed, coinciding with the election result, and just days after President Bush had insisted that Rumsfeld would stay for the rest of the presidential term, until January 2009. It begs the question: why now? Whatever the reason, it was nicely glossed over. Could John Bolton (US ambassador to the UN) and vice-president Cheney be far behind? Along with Rumsfeld, they are amongst the neo-cons who brought about the disaster in Iraq.

And what of George W. himself? After all, he was the president who led the country into an illegal war in Iraq (according to the UN and numerous international legal scholars). He was the leader as the US contravened the Geneva Convention with its treatment of prisoners in Guantanamo and the torture chambers of Abu Ghraib and elsewhere - including unauthorized transfer of prisoners for torture to prisons outside the US. And he authorized and supported illegal spying on and wiretapping of US citizens.

Impeachment seems not to be on the Democrat agenda. But that may not stop some from trying, and the markets would not like that at all. You can torture all you want, but we can't have the destabilizing effect of an impeachment crisis.

We can only assume that it must be the amazingly resilient US economy that keeps this market going. Many (including me) have been accused of being perma-bears and gold bugs. Huge trade deficits don't matter, we are told. It may matter for Argentina or some third world African nation but it doesn't matter for the world's largest economy. The countries that carry the huge trade surpluses are Japan and Germany of the major industrialized countries, and from the emerging industrialized countries, China and Russia and Saudi Arabia. It is a global world and the US is on top. They consume the others' finance. Dare anyone call their bluff?

Maybe, maybe not. But what about the budget deficits? The story here is the same. The US budget deficit is about four per cent of GDP - not that large by some standards, and certainly not for an economy the size of the United States. Japan's budget deficit is over five per cent of its GDP; Italy's is over four per cent.

It doesn't seem to be a problem as long as the Federal Reserve and the world's central banks maintain a high level of liquidity. The huge level of global liquidity sloshing around the world is the grease for the wheels of the global economy. US money supply as measured by M2 is up 4.4 per cent on the year; about in line with the rate of current annual inflation. The old M3 measure is not reported any longer, and we suspect it could still be maintaining an 8-10 per cent growth rate.

But global liquidity has some perverse effects. It creates bubbles and a "can't lose" mentality. All that money has to go somewhere. Since the massive liquidity expansion began in 1995 we have already seen two bubbles, first in the high tech and Internet sector and more recently in housing. Both were pricked, and we are now seeing the fallout in the housing market with rising foreclosures, falling prices, walkaways and bankruptcies. Oh, it still seems to be contained, but with the coming Christmas season we should see whether or not it is beginning to bite. The bulls of course are confident that the overall impact will be muted.

Maybe they are right and maybe not. What most investors don't realize is that the market is really a huge casino, geared to allow the big players to dominate. Michael Jenkins of the Stock Cycles Forecast harps on these themes constantly, most recently in his October 27, 2006 newsletter.

Anyway, think Goldman Sachs for example. Its former chairman, Hank Paulson, is now the Treasury Secretary. Talk about the perfect marriage between the corporate world and government. Of course, he now runs the "Working Group" (some call it the Plunge Protection Team) that would never allow Goldman Sachs (for example) to get into real trouble. Think back to last month, when the biggest IPO in history came to market for China Bank. Guess who led it. It was Goldman Sachs, which stood to make up to $4,000,000,000 on the offering.

With that kind of money you can buy and control billions of dollars' worth of stocks. You don't then have to do a lot to have the market go up every day, dragging the unsuspecting public with you. You concentrate your purchasing on a narrow band of stocks (along with all of the derivatives available to these firms where they can control billions of dollars worth of stock with very little cash down), and in doing that you can move the market any way you want.

That picture was seen in 1972 when the mutual funds, which were a powerhouse at the time, concentrated on a very narrow group of stocks. That was known as the "Nifty Fifty" rally. When it was over, the market was down for two years and 50 per cent. Of course OPEC embargos, Watergate and an impeachment crisis helped. But the key was that before the collapse, the market was manipulated upwards.

We suspect that today is no different. One can't help but notice that volume and breadth are lacking severely in this most recent rally. Maybe it doesn't matter in this day of ETFs and derivatives. The games that can be played are endless. And as a result, moving the Dow Jones Industrials 100 to 200 points in a day is not that difficult. But what happens when they pull the plug? What happens when an unexpected event comes along that smacks the market on the jaw? The exit then can be very narrow, and we can be assured that the major players will have their funds out before anyone else.

Long-term cycles are a fact. They do not repeat with precision, but they do repeat. The Kondratieff cycle of upwards of 60 years is known by many. This cycle was roughly a human life span. Today it may be extending upwards, and we are now 57 years into the current Kondratieff cycle (from 1949). Referring again to the Stock Cycles Forecast of October 27, Michael Jenkins reminded readers about how "W D Gann showed how the last digit of the year is often repeated in 10 year cycles". He recounted the story of how in 1835-36 there was a massive land rush in Texas, financed by foreign money, that resulted in the Mexicans invading to protect their territory and the Texan patriots (Minutemen?) defending. The Texans were defeated at the Alamo, and although the they eventually prevailed there was a real estate collapse and a resulting depression that lasted from 1837 to 1842.

That cycle was repeated 100 years later, with different causes of course, but the 1936-37 top resulted in a collapse and further depression that last from 1937 to 1942. The current cycle, while only 70 years from 1936-37, is 100 years from the 1906-07 top that led to a financial panic following the 1906 San Francisco earthquake. This time it is Katrina and the new Mexican invasion. Instead of Santa Ana's army, it is illegal's, with Minutemen (patriots?) patrolling the border and the desire to build a wall. And we have had a real estate bubble that is in the process of collapse. The top of 1936-37 was 30 years from the 1906-07 top, and here we are 70 years and 100 years from those two important market tops.

And 30 years ago we not only had the important Nifty Fifty top in 1972, with the subsequent collapse into 1974-75, but another (often overlooked) top in 1976-77 and a collapse into 1977-78. We are showing that chart. Note the steep rise that preceded the collapse in both instances.

We also want to show you the 1930s market and its remarkable similarity to today. The market has continually hung on, but all the manipulation in the world and all the money thrown at the market by the Fed and the central banks will not save the market from the coming panic. Just as the rise over the past several months has lacked rationality, financial panics also lack rationality. We can't help but notice that the Japanese economy is once again faltering. The Japanese, through the Bank of Japan, have been huge suppliers of the liquidity that has fuelled the markets over the past decade. But even that doesn't seem to be saving the Japanese from their own market meltdown.

Compare the Japanese market today with the same market in the 1990s. No matter how much money the BOJ threw at the problem, the markets refused to respond. Note the series of rises and falls from 1992 to 1998. Each one was steep (both up and down) and simple trend lines would have told you that the previous move was over. Today is no different. Steep rises are often followed by steep declines, and vice versa. Moves that have frequent corrections but make a good series of higher highs and higher lows in an uptrend are better than ones that seem to continually go up against all logic.

Since the lows in June/July 2006, the markets have been rising almost uninterrupted. The bulls are euphoric. Not even the election of Democrats has stymied the rise. The bears are feeling the heat. Could we go to 13,000 or 14,000 on the Dow Jones Industrials before this is over? Of course we could. But time and the cycles are running out on the bulls. If 2006 was an euphoric year for the bulls, the bears will get their payback in 2007. Stay tuned.


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