We are only a week or so from the lows of November 20 but seven weeks from the momentum low made on October 10. And we couldn’t help but notice that fewer stocks made new lows on November 21 than were made on October 10. This tells us that we are still trying to form a low of some importance. This does not rule out new lows or a test of the November 21 lows, quite possibly even in December, but we are seeing signs that things are looking up – at least a little.
The seasonals have shifted in favour of the bulls. If the old adage of “sell in May and go away” was particularly vicious this year, then quite possibly “buy when it snows” will counter some of that gloom. Okay, we have seen at least one decent snowfall. So we guess that counts. But the reality is that most bear markets end in November or early December. Tellingly, the famous 1974 bear market low was made on December 6. The momentum low was made two months earlier, on October 4.
So here we are, nearly two months from our momentum low. That is why we can’t rule out another test of the lows or even a new low, but once that is out of the way we should be into what is referred to as the best months of the year: January to April. What drives this investment pattern is not Santa Claus but strength from corporate and private pension funds, then the drive by the institutions, mutual funds, pension funds and banks as they place the funds they receive in the early part of the year. Given the devastation of the past few months, many are wondering about the likelihood of not only the traditional Santa Claus rally appear but also the early year market strength. Santa Claus failing to show up would be a signal that the bear will continue.
Last year was a disaster as the market topped in October and collapsed into November. After a brief rally in early December, and then another that made a lower high in late December, we were suddenly confronted by a collapse into January 2008. That January collapse gave true meaning to the January effect as the market is in the process of finishing up on one of its worst ever. Following another brief rebound we experienced a final collapse into March that ended with the disappearance of Bear Stearns into J P Morgan Chase. After another slightly longer rally into May we once again started a collapse that in a sense has not as officially ended.
But if this collapse has been historic, then the rebounds that follow historic collapses can often be equally dramatic. That means if you hadn’t sold before the collapse got underway, then selling into the carnage was absolutely the wrong strategy. Exceptions are those stocks that just go bankrupt. But it was not unusual to see good companies crushed along with the bad. Such is the nature of financial panics.
We have documented the major bear markets of the past century and the bull market that followed them. All data is for the Dow Jones Industrials (DJI) and we are only focusing on bear markets of 30 per cent or more (okay one is slightly under 30 per cent).
We can’t help but notice of the 15 bear markets of some depth 8 of them ended from October to December (assuming the current one ends with the lows seen on November 21). Indeed November leads with 4, October, December and July saw 2, while February, March, April, May and September had 1 each.
The 86 per cent collapse from April 17, 1930 was the Great Depression crash. It was interrupted by a number of mini bull markets ranging from about 20 to 30 per cent. The 1933-37 bull market that rivalled the one completed in 2007 was actually interrupted by a 23 per cent decline from February to July 1934. After that mini-bear was out of the way it was straight up to the highs of March 1937 for a market gain of 127 per cent.
Setting aside 1930-32, the key bear markets were seen in 1901-03, the financial panic of 1906-07, the war bear of 1916-17, the crash of 1929, the panics of 1937-38 and 1973-74. All of these bears lost from 45 to 49 per cent. All were followed by rallies that on average gained 77 per cent. The feeblest rebound was the one out of the 1937-38 financial panic where the DJI gained only 23 per cent. This was then followed eventually by the war years bear of 1939-42 that lost 40 per cent.
We have noted how throughout this decade we have remarkably followed the general pattern of the 1930s. Naturally it is difficult to predict confidently that we will now follow the period 1938 to 1942, but if we were to do so then the forthcoming rebound will not be particularly robust. We could follow some ups and downs but gain 25-30 per cent into late 2009 or even early 2010 before we embark on a more relentless move down that will take us into 2012. Whether that bear makes lower or higher lows is clearly difficult to predict. First we have to have the rebound.
A feeble rally of 25-30 per cent into 2009 is the worst case. The best case is a surprise rally that takes us up by 70 per cent or more. If the rally is to get underway, December is the ideal time. We could see an attempt at another low sometime in the first week or two of December but then the Santa Claus/January effect rally should get underway. Rallies may be led by better than expected Christmas sales results or even into the New Year with what we might call the Obama bounce. Despite last year’s weak market, odds favour this year returning to the more normal positive late year market. After the devastating collapse of the past few months any respite would be welcome.
In our Scoop of November 24 we noted some $4.3 trillion in commitments from various US government entities. Given the most recent $800 billion commitment in new lending programs, that number now soars to $7.8 trillion in direct and indirect financial obligations. According to an article in the New York Times (Tracking the Bailout – November 25, 2008), the rescue plan includes $1.7 trillion in loan commitments to Bear Stearns, AIG and others; $3 trillion in buying stock in banks such as Citigroup and others, as well as buying mortgages; and $3.1 trillion in guarantees for corporate bonds, money market funds and deposit accounts. It is roughly half the GDP of the USA.
Right now the focus and fear has been on deflation, but the reality is that ultimately this is inflationary and we have noted that it could imperil the credit rating of the US Treasury. It is also unknown just how much in losses the US taxpayer will have to face. The massive amounts of funds needed for these bailouts could trigger the first trillion dollar budget deficit and the US government crowding out other borrowers for cash. All of this with appropriate lags can only lead to a depreciation of the US dollar and a monetizing of or inflating away of the problem. This is a problem for bond holders.
The long-term bond cycle has been in an uptrend since the lows of September 1981 – a period of 27 years. This is very lengthy. Merriman (mmacycles.com) has noted that the bond market appears to exhibit cycles of roughly 18 years. This cycle is itself broken down into smaller cycles of six years and that sub-divides into either two-year or three-year cycles. Since we have been rising now for 27 years we can note that the last 18-year cycle undoubtedly bottomed in 2000.
Our long-term chart of US bond futures shows these cycles. The six-year cycle is shown with the lows in 1981 (1), 1987 (2), 1994 (3), 2000 (4), and the double bottom low in June 2006/May 2007(5a and 5b). This tells us that the next six-year cycle low is due 2012-13. If the 18-year cycle bottomed last in 2000, the next is not due until at least 2018. We have also marked the interim cycles. We note the three-year cycle lows in 1984, 1990 and 1997 (a) and the subdivision into two-year cycle lows in 2002 and 2004 (a, b).
The recent rally in bonds has been nothing short of spectacular as we soared from lows in October to new all-time highs in November. It is possible that we are seeing not only the top of the current six-year cycle but also the top of the entire 18-year cycle. We don’t know whether the current six-year cycle will break down into a pair of two-year cycles or one three-year cycle. If the former, the low is due next year sometime; if the latter, our low won’t be seen until 2010. We would expect in the next up portion of the cycle we would make lower highs. Another break of the 17-month moving average would confirm that a top is in.
For whatever reason we now seem to have a bubble in bonds. Interest rate instruments have fallen to almost unheard of levels. Ten-year bonds have dropped under 3 per cent to 2.93 per cent and even 30-year bonds have fallen to 3.45 per cent. Two-year notes are down to one per cent and three-month Treasury Bills are pretty much paying nothing. Even with the most recent CPI numbers the inflation rate is 3.7 per cent. At no point on the yield curve are rates above the rate of inflation. Clearly the expectation is that inflation will fall. Hence the current fear of deflation. Normally bonds should yield an interest rate of up to 2 per cent over the rate of inflation.
Deflation was the great bug-a-boo of the Great Depression. Today’s monetary authorities are fearful of deflation and will do whatever is necessary to prevent inflation. That can only mean one thing: massive monetary stimulus, which is exactly what we are seeing with the $7.8 trillion announced to date. The huge increase in the monetary aggregates (M1, M2) plus the huge increase in the monetary base seen recently are ultimately inflationary, not deflationary. Granted there is a lag between the monetary stimulation and an improvement in the stock market.
It seems particularly since the 1970s that it has taken increasing amounts of debt to generate another dollar of GDP. According to John Mauldin of Investor Insight, in the 1960s a dollar of debt bought $0.64 of additional real GDP. Stated another way that would be $1.56 of debt bought $1 of GDP. By 2007 that number was $6.67 of debt to purchase $1 of GDP. Today it would be even higher. Much of the massive growth of debt in recent years has been generated by the consumer to purchase homes or things. Neither is particularly productive for the economy. As we have said, the consumer has being living in a world of illusion fuelled by debt.
Bonds of course are considered a safe haven investment. But so is gold considered a safe have investment. Of late they have taken turns being the safe haven investment of choice. Our chart of the Gold/Bond ratio shows that in the early part of this crisis Gold was the preferred safe haven as the ratio rose from just under 6 in August 2007 to highs of 8.4 in March 2008 and 8.5 in July 2008. After that July high the safe haven investment of choice became bonds as the ratio plunged into lows in September near 6. Following a sharp rebound for Gold the ratio topped on October 10, 2008 (timing with the market low) at 7.9. Once again the safe haven shifted in bonds favour and on October 24, 2008 it bottomed once again at 5.8.
The past few weeks has seen a slight momentum shift back to Gold although it clearly has been choppy. A higher low on the ratio was seen on November 20, 2008 once again coinciding with the stock market low. Since then the momentum has shifted slight back to Gold’s favour. We would now not be surprised to see that momentum shift to Gold’s favour and we would definitely own Gold over bonds right now.
While things are looking up a little for stock holders as we search for a bottom of some substance, those holding bonds particularly longer dated bonds may wish to head for the exits.
David Chapman is a director of Bullion Management Group the manager of the BMG BullionFund, www.bmsinc.ca
Note: Chart created using Omega TradeStation. Chart data supplied by Dial Data.
Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.
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