The Tipping Point
March 22nd 2005
By Ian Gordon
I have often wondered what the catalyst will be to tip the economy back into a recession or worse; that is, the point from which it becomes obvious that the Kondratieff winter is underway. Following the stock market crash in October 1929, there was a Federal Reserve induced recovery in stock prices and the economy into the spring of 1930, much like we have just experienced. This time, however, the Federal Reserve’s response to the stock market decline has been much more panicked than that of its predecessor. Hence the recovery in stocks, the economy, and consumer confidence has been much stronger than that which occurred at the onset of the previous Kondratieff winter, but so has the amount of debt that has been added to the economy. In my opinion, it’s the debt that will ultimately destroy the economy and put a perilous financial system under horrendous pressure; but what is it that will force the issue?
I think that it will be the resumption of the bear market in stocks, much as it was in April 1930. More than 50% of American families are invested in the stock market and are dependent on stock investments for their retirement funds. This is a significantly larger proportion than the 5%-10% American families invested in stocks in 1929. Therefore, it is likely that the winter bear market will have much larger ramifications than it did between 1929 and 1932, when the stock market lost 90% of its September 1929 value.
It looks like the bear market has restarted. There’s an old investment rule which says ‘three steps and a stumble’. This means that when the Federal Reserve raise rates three times in succession the market should fall. The problem for this rule is not that it is an inaccurate forecaster, it is, but it’s the lag time between the signal and the ensuing stock market decline. According to Norman Fosback in his book Stock Market Logic, “Eventually all sell signals have led to substantial price declines-about 30% on average, although in some cases a long delay has ensued before the decline has materialized.” The rule is now in force. The Federal Reserve has now raised rates not three times in succession, but six and with another increase due this week.
Raising interest rates to save the dollar was also tried during the previous Kondratieff winter, but at that time the dollar problem was nothing like it is now. Then the United States was the world’s largest creditor nation, today it’s the world’s largest debtor. Confidence in the monetary role of the dollar is now in rapid decline. In the early stages of the last Kondratieff winter depression the response in Europe to developing monetary troubles was to send gold to the United States. Following Britain’s abandonment of the gold standard in September 1931, there was a growing doubt about the reliability of America’s credit and gold flowed out of the United States back to Europe.
During 1930, the Federal Reserve had steadily lowered interest rates from 4.5% at the beginning of the year, to 2% at the end, and finally down to 1.5% in mid-1931. However, the dollar crisis later in the year forced the Federal Reserve to raise the discount rate to 3.5%. To offset this, the central bank still increased the money supply.
‘What’s good for General Motors is good for America’, so we are led to believe. If that’s the case then things don’t look good for America. The world’s largest car manufacturer announced a loss of $1.50 per share last quarter. As a result its $300 billion + debt trades near junk status and that reality is threatened by the rating agencies. That debt is 2/3rds of Canada’s debt. The ramifications are not pretty. Junk debt not only means higher borrowing costs, but means that it becomes an ineligible investment in many funds. General Motors doesn’t make any profit on the cars that it sells, but relies on its financing arm to provide the revenues. That obviously didn’t work in the last quarter and probably won’t again, because the economy is deteriorating and the US consumer has probably financed all the SUV’s he wants anyway. Soon GM’s finance arm will be in repossession mode. Harley Davidson is now worth more than General Motors. All this spells serious trouble for this car company and also its sister, Ford. Does bankruptcy loom for both and many other high debtors as winter gets colder?
The share price of General Motors has lost 70% from its bull market high at $94.62 on 29/04/00. However, there are reasons to believe that this price deterioration is likely to get a lot worse. For a start, as I show below, the stock bear market likely resumed last week. If this is so, then it would seem highly unlikely that the share price of General Motors, given its fundamental problems, could rise in the face of an overall stock market decline. An initial price target is $25 per share or even the October 1992 low of $22.62. This would bring the share price close to the October 1987 crash low near $19.50. It doesn’t look good to me.
Another important company indicating deteriorating chart conditions is Fannie Mae (FNM/NY). If it wasn’t for the mythical belief by many investors that Fannie Mae is guaranteed by the US government, its share price would likely be a lot lower, given its significant derivative losses and management scandals.
Fannie Mae has just reintroduced the 40 year mortgage to make housing more affordable. This according to Eric Englund is a desperate measure to keep expanding its own balance sheet in order to maintain its solvency. The company has a debt to equity ratio of 43-1, which is massive leverage. Fannie Mae retains a $900 billion mortgage portfolio and in addition guarantees $1.3 trillion in mortgage backed securities. Eric believes it is a matter of when, not if, the credit bubble bursts and mortgages go into default, Fannie Mae’s equity position would be decimated. “In the end the boom-bust cycle (as brought on by central banking) cannot be repealed. When the bust hits, Fannie Mae’s extremely leveraged balance sheet will collapse like a house of cards - forty-year mortgages be damned.” Ibid. 1.Fannie Mae Resurrects the Forty-Year Mortgage in an Attempt to Remain Solvent. Eric Englund. www. financialsense.com
Fannie Mae (FNM/NY). Closing Price $55.01; March 18 th, 2005.
Fannie Mae’s share price closed 32% below its record high recorded at the end of December 2000 at $89.37. The stock price has formed a large declining broadening top that appears to be in danger of breaking down. A weekly closing price below $48.00 would confirm this breakdown and suggest that FNM would move to the next area of support just below $20.00. Technical indicators suggest that $48.00 will not hold. In this case the share price descent should become much more rapid.
US stocks are in the Kondratieff winter bear market. Not that you’d know it. Most investors and investment advisors have been persuaded by the recovery in stock prices following the initial bear market low in October 2002. However, in my opinion the recovery has been engineered by the panic response of the Federal Reserve to the initial stock market sell-off. If you don’t think 12 rate cuts since April 2001 from 6% to just ¾% by November 2002, combined with the added cash infusion of trillions of dollars, isn’t panic, I don’t know what is. Anyway all that it has done has added massively to the credit bubble, which is most apparent in real estate and to a lesser extent, the recovery in stock prices. Alan Greenspan has apparently been forced to reverse his low interest rate policy to induce foreigners to continue lending money to the USA. Rising interest rates are not good for stocks or the economy. They weren’t, after the Federal Reserve raised rates from 4.5% to 6% between August 1999 and May 2000, nor were they when rates were raised from 3.5% to 6% between 1928 and 1929. How soon we forget. No one seems to be talking about rising rates now.
I must remind you that there are several reasons why I believe that the rise in stock prices since October 2002 is a countertrend rally in a bear market and not the beginning of a new bull market.
Bear markets are images of the preceding bull market. Massive bull markets like the one experienced during this Kondratieff autumn from 1982, when the DJIA was 777 points, to January 2000, when the Dow topped at 11,750, are followed by massive bear markets. The previous autumn bull market took the Dow from a low of 66 points in 1921 to a high of 381 points in September 1929. The winter bear market took the DJIA down to its bear market low in 1932 of 41 points. That’s below the point from whence the autumn bull market began and 90% below the bull market peak.
The Kondratieff winter bear market is as vicious to share owners as the preceding bull market was generous.
Bull markets begin from a point of extreme investor pessimism. Indeed they begin when most people hate the very word ‘stocks.’ We are nowhere near there. Confidence is far too high.
Bull markets begin when the media is absent. There’s no CNBC; no ROBTV. Newspapers give little attention to business and to stocks. Investment Funds won’t be advertising on television. Most of them will be fighting to survive. No one will have an interest.
New bull markets begin from very low valuations. That’s low PEs, low book values, etc. We are at extreme highs; common at bull market tops, not bear market bottoms.
High dividend yields are evident at bear market bottoms; something in the order of 6%-8%. The current S&P yield is a paltry 1.60%. That’s common at market tops.
Technical indicators are overbought, but have not yet given a sell signal. The key point reversal high (a higher high but a close below the close of the previous weekly bar) given the week ending March 12th, is a reliable indicator of trend change. Fundamentals are getting more bearish (rising interest rates; GM earnings; dollar etc), and are likely to be supported by the market to the downside. Stocks are oversold, which suggests a short term bounce to the upside, which should be contained at the 10,800 level. When minor support at 10,360 is broken, the low at 9708 will act as support. Thereafter the initial bear market low at 7200 becomes the target. Through that level the chart shows little support until about 4000, but 5000 might be the target for this next leg down. The ultimate low targets are considerably below this level.
Conclusion:
I am often called an extremist. I guess I am, since I understand how extreme a Kondratieff winter is likely to be. It will probably be extremely bad for the economy and for stocks and extremely good for gold.
It takes things like General Motor’s troubles or South Korea’s determination to reduce dollar holdings to shake complacency and force a general shift in perception from positive to negative.
This shift in sentiment changes investment mood from bullish to bearish.
Evidence suggests the resumption of the winter stock bear market. Since this will be the third leg of the bear market, it is likely to be vicious.
The continuation of the bear market in stocks is likely bullish for gold. Gold and paper always act opposite to each other.
Vancouver, March 19th, 2005
Rogue
AI
