Calm before the next storm?

The crisis is over. The huge liquidity injections appear to have worked (injections over the past couple of weeks were well over $400 billion coupled with a lowering of rates for the discount window). The markets are rising again as they are supposed to. All is well. Or is it?

A week or so ago everything was in a panic. The Dow Jones Industrials fell a swift 10% and others fell even more. The Gold stocks as measured by the Gold Bugs Index (HUI) fell a sharp 23% from its recent highs although they have now bounced back roughly 12% recouping almost 40% of the recent drop. And remember the precious metals markets had nothing to do with the recent financial crisis triggered by the meltdown in the sub prime mortgage market. The baby as they say was thrown out with the bathwater. Heck they threw out several babies. Gold itself also fell although at its worst it was only off about 6% considerably less than the gold stocks and the rest of the market. In what now seems to be becoming a broken record we heard rumours once again of central bank sales during the crisis. Enough to make one wonder whether these are timed or deliberate.

We can only guess that the last thing that Fed Chairman Ben Bernanke wants to hear is the word “Bernanke Put”. The Greenspan Put was made famous under former Fed Chairman Alan Greenspan who once declared that he would love to be Fed Chairman during the next Kondratieff Winter so that he could go down in history as the one who prevented the next Great Depression. Yes Alan Greenspan was a believer in the Kondratieff cycle and also followed Elliot Wave Theory. The Kondratieff cycle was named after Russian Economist Nicholas Kondratieff who showed that Western Capitalist economies went through long term cycles of roughly 54-60 years. Each cycle subdivided into four smaller cycles that included early inflation (Spring), inflation (Summer), early deflation (Autumn) and deflation (Winter). Kondratieff wrote about his theories in the mid 1920’s and his reward was banishment to Siberia by Stalin. Stalin apparently couldn’t deal with the part that said that after the Kondratieff winter that the capitalist economies would rise once again. I guess he didn’t understand cycles. At the time the Kondratieff cycle fitted nicely with about the life span of a man so it is possible that today the cycle could stretch to 72-77 years.

The last Kondratieff winter ended with the Great Depression and war and most Kondratieff analysts put the last winter as lasting from 1929-1949 (Ian Gordon). Others say it ended with the market lows of 1942. We have always counted ours from 1949. The most recent spring was 1950-1966, summer was 1967-1982, autumn (and the traditional blow off in the stock markets) was 1983-2000. We and others suspect that the most recent Kondratieff winter got underway in 2000 and is not expected to end until at least 2012 or as long as 2020/2022. We have always been struck by the similarity in the patterns of this decade with the patterns of the 1930’s (70 years). Ray Merriman another cycle analyst we follow has noted what he believes is a 72 year cycle (+/– 12 years) and even a 90 year cycle (+/– 15 years). The last instance of both the 72 and 90 year cycle was 1932 so that would put the 72 year cycle at around 2004 and the 90 year at 2022. So both cycles are falling right into our current Kondratieff period.

In comparing the 1930’s to today we can’t help but note that stock markets topped in September 1929 (January/March 2000); a major collapse got underway that didn’t bottom until 1932 (2002), an explosive rebound took place in 1933 (2003); a sideways market was seen in 1934 (2004); the rally resumed with a vengeance in 1935 and continued well into 1936 and didn’t make its top until March 1937 (while we generally continued the sideways market in 2005 the market had a strong up year in 2006 and continued into 2007 and may have topped in July 2007). What followed was a devastating bear market that didn’t bottom until 1938 and after some chopping around over the next few years didn’t bottom for good until 1942. The reason we go until 1949 is because the entire pattern from 1929 has a very distinct ABCDE shape to it with the A wave bottoming 1932, the powerful and impressive B wave topped in 1937 (and note B waves can even go back to the old highs or even higher), the C wave bottomed in 1942 with the D wave topping in 1946 and the final and usually short E wave bottoming in 1949.

All financial collapses are credit and debt collapses. Every long term cycle is a huge build up in debt and a widening of the wealth advantage. This period has been no different except that it has gone on so long and wealth disparity is wider than it has ever been. All periods of massive debt build ups need to be cleansed. These are a normal part of the cycle. Except of course in this cycle they are trying to bail the system by flooding the system with liquidity and rapidly cutting interest rates. We have seen the massive liquidity injection and there has been rumours of an interest rate cut beyond the discount window cut we have already seen. So will it work?

Already on this rebound we are instantly hearing how the crisis is over and it is an excellent place to pick up bargains. Others are noting the usual array of indicators that say the market has made a major bottom. The fund managers who are buy and hold are all saying this is merely an interruption in a long term bull market and the economies are sound and while growth may slow slightly the long term remains intact. But then they all have their own book to talk. So do the bears for that matter and that is why you have to look at it realistically.

The uptrend from the July 2006 lows has been broken. A gentler uptrend from August 2004 remains intact and on the S&P 500 that line does not break down until we fall under 1300-1325. Daily and weekly indicators have fallen into bear modes but the monthly indicators remain up. So we know the short and intermediate trends have turned down but the long term up trend remains intact. The monthly indicators turned positive for good in the latter part of 2003 and have remained that way thus far. Since the markets turned up in 1982/1983 there has only been three periods where the markets turned negative on the long term and that was during the 1987 stock market crash that lasted into early 1989 and again briefly in 1990 and of course through the 2000-2002 bear market. The 2000-2002 bear market broke the long term up trend from the 1982 lows on the monthly charts and that told us that the great bull market of 1982-2000 was over. Many claim that the rally from 2002 to recently was a resumption of the long term bull. We disagree it has merely been a correction in the first leg down of a new bear market that will last several years as we note above.

The recent breakdown may be signalling the start of the next major leg to the downside. But we can not confirm that until we break down under 1300-1325 S&P 500. Then minimum targets could become at least to 900. Worst case targets could be 500. But in the interim as long as we remain above 1300-1325 we could regroup and go to new highs although cycles do not suggest that will happen but it remains a possibility. The S&P 500 regaining above 1505 would shift the short term back into an up mode and above 1525 we could make an argument for new highs. But in an environment where the concerns over the collateralized debt obligations remain intact then the odds of us regaining those levels above are remote at this time. Major resistance will be seen at 1480.

If anything this crisis threatens to get worse. Which is why we are probably hearing about Fed discount rate cuts if not soon then at the meetings on September 18. Trouble is we are not hearing of others willing to cut at this time. The US$ reacted appropriately and after hitting our key resistance zone at 82 immediately sold off. That lifted gold and silver bullion prices. Already the job losses related to the crisis are beginning to mount. In August thus far some 24,000 job losses including some at a Lehman Brothers mortgage subsidiary. This may be merely the tip of the iceberg. And remember these are not low end jobs but rather high end financial jobs. And major problems remain in the commercial paper market.

The commercial paper market is the source of funds for the best names in the industrial and financial sector. And on the other side hundreds of corporations, financial companies, mutual and pension funds buy paper to park short term money. In the US some $1.1 trillion roughly half of the commercial paper market has been linked to these structured finance notes. And here in Canada there is estimated to be at least $40 billion. Indeed the companies holding the bogus paper covers the realm from Barrick Gold, to Dundee Bank to Nav Canada and tour operator Transat to pension and mutual funds. So did all of these companies suddenly lose their mind and decide to buy billions of dollars of bogus paper? No they listened to the rating agencies DBRS here in Canada and S&P in the USA and they said it is R1 high and A1. This is quality paper and safe. Well no it is not. Certainly not any more. So everyone is running around covering their ass because at the end of the day a lot of people are about to lose their jobs. At DBRS, at S&P at NAV at Barrick at Dundee we could go on. There is game playing with National Bank buying $2 billion to bail out their funds. There is talk of converting it to long term debt. Long term debt? They didn’t buy long term debt they bought short term debt because they have obligations to meet, plans to execute. That is what buying short term paper is all about. Oh and Coventree Financial Group (COF-TSX) who has gone on a wild ride falling precipitously from over $16 to near $2 then back up to $4 when they announced a plan to save the financing for the firm and then suddenly again they can’t roll their paper and poof right back under $2. Do we hear 0 coming up. Okay 10 cents.

US money centre banks have been into the discount window grabbing funds like crazy mostly to try and bail out names like Country Wide Financial (CFC-NY). Okay Countrywide hasn’t fallen as precipitously as Coventree only going from $45 to $15 but the trend remains the same – down. Trouble is no one knows what this paper is worth any more. Converting it to long term debt is not going to solve the problem merely shuffle it around and pretty it up trying to pretend that it is better than it is. And many of these companies are now going to have financial problems because funds they thought were safe and there for a rainy day are no longer there. For financial institutions converting to long term debt will have a negative impact on capital ratios. And what if they need to raise more capital? Will they might but the prices of their stocks will have to fall further – a lot further. Everyone is still frozen and unless the Fed (and the Bank of Canada) are prepared to bail everyone out then someone has to fail and ultimately someone big and important is going to fail. If risk is an element in the markets then they can’t be bailed out or there will be a Bernanke Put and of course at the end of the day it will become a taxpayer bailout to save financial companies from themselves and their own follies.

And attached to a lot of this structured finance or collateralized debt is derivatives. These derivatives are all over the counter (OTC) not exchange traded derivatives. It includes credit swaps and others and now all of those markets are imperilled as well. The industry employs thousands of people to create all of these games and all of them are high end jobs. There will be a lot more job losses. Then ultimately it overflows into the general economy as the banks tighten credit and credit the lifeline of the economy dries up for everyone. While everyone talks of a discount rate cut the reality is that rates might actually rise in a credit crunch even as the official rate falls. Money becomes expensive. And don’t forget that the vast majority of those ARMS mortgages and other adjustable loans have still not come to the forefront yet. Over the next year there are tens of thousands of these loans coming due. The crisis rather than being over is merely in its early stages.

And don’t forget that with the all this paper no longer of credit quality many funds can not by their own laws can not hold this paper. But they can’t get rid of it. There is no market for it. So who is going to buy it? All of this translates into less money for expansion, less money for future investments and a massive credit crunch of major proportions. Oh it will not all come to the forefront at once and the Fed and Bank of Canada and other central banks will pump money like crazy to try and prevent an all out collapse or the allow the collapse in stages. Every government and every central bank in the world will be going all out to prevent a collapse.

So where does one hide? We continue to believe gold remains a core holding. Gold suffered less in this then most other assets. A falling US Dollar will be excellent for gold and central banks pumping money like crazy to prop up the credit unwind is also good for gold. Short term we may have some more work to do here as our cycles remain somewhat negative but by September/October we should be seeing signs of a bottom. Our worst case scenario remains a sudden collapse under $600 to the $550/$560 level. Our best case scenario is that the we just continue to muddle around in the $640-$690 zone until we get ready to break out to the upside over $700. Gold stocks as measured by the Gold Bugs Index fell to long term support at 285 and the rebound has been impressive but we need to break out over 330 on the HUI to give us some sense of comfort that the worst is behind us. Worst case scenario there is a drop to around 240 where very long term support comes in. Another drop under 300 would suggest a test of the 285 area and a possible drop to lower levels. Above 330 we should start working our way back towards 360/370. Gold remains in a long term uptrend since the lows of 2001 despite the year plus longer consolidation corrective period. Seasonally gold has its best period in the last quarter because of the Christmas season and special seasons in India the world’s largest consumer of gold.

Oil prices are also in a weak period. Natural gas prices broke there recent lows and now appear headed for $5. Note we did this last year as well in this time period but the bottom was made in late September. This is a weak period seasonally for both oil and gas. NG has huge support down at $5 and even more down to $4.50. We fell to the $4/$4.50 zone last year. Oil has broken its uptrend from the lows near $50 seen last January. There is support here at $67-$69 but under that level we would fall to $64/$65. Significant support lies at $60/$62. Risk of war remains in the Mid East and we can’t help but note that the Iranian Revolutionary Guard, Iran’s elite military unit some 125 thousand strong has been designated a terrorist organization by the United States. This would be akin to naming the USA’s elite marine units terrorist organizations. Starting a war in the Mid East would be a huge distraction if we really were in a major financial crisis meltdown. While there remains some downside risk in the near term for both oil and gas the next two months is typically a trough period. If a major hurricane heads for the gulf of Mexico that would put upward pressure on energy prices. Oil needs to regain and breakout over $74/$75 to tell us we are headed for new highs. For NG we need at this stage to overhaul $7 with initial resistance now at the $6/$6.50 range.

The current corrective period is a calm before the next storm breaks. This crisis rather than being over is merely at one of its many periods of calm as the market tries to sort out what is really going on. This current period could certainly hang on into the first week of September or we could test lower now and then rally into the mid September. September is traditionally a weak month for the markets indeed its record shows it is the worst month. In 1937 markets had a secondary top in August then another attempt at a top in late September before it fell off the rails completely. In 1987 we had a secondary rally back in September that lulled everyone to sleep before the stock market crash of October. Actually a low in the first week or so of September would be good as we have often noted lows occurring roughly 55 days from an important top (note: in 1987 the market topped on August 25 and bottomed 55 days later on October 19). The top was July 16 for the S&P and July 19 for the DJI so we would look for a low around September 9-12. Then we would get a secondary corrective to the upside. Resistance on the S&P 500 is clear at 1480 and a sell signal would be seen under 1425.