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The Perfect Storm

Could the Dollar, Real-Estate Market, the Stock Market and the Bond Market all be part of one massive bubble that will crash at the same time?

www.catapultresearch.com

The longer the trendline the more important it is. The more times it has been touched, the more important it is. And of course the slope of the trendline is important because the steeper the angle the less sustainable the price trend. A gently sloping angle, on the other hand, allows the price trend to continue longer. Pretty simple stuff actually but quite useful to "technical analysts", that strange breed of financial market analysts who pour over charts looking for weird patterns with names like "Head & Shoulders", "Saucer Bottoms", and "Ascending Triangles".

The trendline is one of the first tools used by most technical analysts and consciously or unconsciously by many participants in the market place. And yet how many actually stop to wonder why a trendline actually works? Very few, I would imagine. Technical analysts by and large don't care about the fundamental reasons why something works, so long as it works. They look for patterns that repeat and try to use those patterns to predict the price action into the future.

But perhaps some insight might be gained by reflecting on why a trendline works. For example on this weekly chart of the NASDAQ Composite Index, why should the market fail at the trendline the last 8 weeks in a row?

Why is that? Is there some magic going on here? No, not really. To understand why the Composite has found resistance at the trendline, failing to break above it after 8 repeated attempts, we need to understand what defines the slope of the line. The chart is defined by an X and a Y-axis which forms a relationship between "Time" and "Price". Without thinking about it, a technical analyst who draws a trendline is actually working with cycles "Time" is implicit in each trendline and what we are capturing is a momentary rhythm of the market. It won't last forever. No trend ever does. Other cycles and patterns of market activity will overwhelm it. W.D. Gann would have called it a "live angle" (an angle which shows active support or resistance). Who was Gann? Gann was the man! He was born in the late 1800's and began his research into charting the financial markets back at the turn of the century, writing many books on technical analysis and trading actively throughout the first half of the 20th century.

He was without a doubt the greatest technical analyst who ever lived, though perhaps few people appreciate this today. Gann took the humble "trendline" and turbocharged it. He gave meaning to the trendline by consciously defining the relation of "Time" to "Price". On the chart of the NASDAQ Composite Index, the relationship of one price increment (in this case defined as 32 points) relates to one time increment (in this case, one week). The line thus defined is called the 1x1 line. From the High, the line descends at a rate of 32 points per week. Gann normally defined the 1x1 as one point per day or per week. In Gann's day, he was not looking at markets like the Nikkei that could rally up to 38, 957 (the 1989 High). Therefore some accommodation to markets that can rise much higher than in Gann's day, means that a higher price increment must be defined at the start. Keep in mind what we are trying to do here is understand the rhythm of the market, the cycles, so we can determine when to expect a change in trend. Again, in this case a 1x1 defined as 32 points per week gives the best fit to the main trend of the Nasdaq Composite. From here we can add other lines to the chart with a steeper slope, such as a 2x1, which is just twice the price increment for each time increment. For the Nasdaq the 2x1 would be 64 points per week. Or we could draw a 1x2, which would be 16 points per week. And when a market has a very steep trend we can draw a 3x1 and for a very gentle sloping trend we can draw a 1x3. You get the idea.

But how does this help us to know when to expect a change in trend? Through his studies of price activity over time, Gann defined certain "natural cycles" which the markets tend to follow. Just as the seasons bring a change in the weather, a 90-day cycle can bring a change in the trend of the financial markets. If this sounds too simplistic, just test it out for yourself. Look at a bunch of charts of a whole range of markets. Count 90 days from the start of a trend. How often will you find a change in trend if it is all a game of chance? How often do you actually find a change in trend after 90 days? A lot more often than you would think based on chance alone. But don't take our word for it, prove it to yourself. And if a 90 day cycle works, would not a 45 day cycle, 180 day cycle, and a 360 day cycle also work? The answer is yes.

Now you have the basics of Gann analysis, the very basics! First you establish the rhythm of the predominant trend with the 1x1 line. Next you apply these natural cycles, counting the number of days, weeks, or months from the start of the trend, to determine when to expect a change in trend. And how is all this stuff useful? To answer that, let's go back to our example. A 45-week cycle is a natural time to expect a change in the larger trend and as it turns out, 45 weeks after the first low that came on May 24th, 2000, there came another low on April 4th, 2001. And if this particular cycle continues to work, then we should expect another low here in February 2002. It just so happens that the NASDAQ has been selling off sharply into February. Does this mean we buy the Nasdaq now? No, not yet. First we need to confirm the change in trend by a break above the 1x1 Gann line, (the same line it has failed at 8 weeks in a row). So although the cycles can suggest a change in trend, only the Gann lines can confirm a change in trend.

To really make technical analysis work, you have to use both "Time" and "Price" to make your investment decisions. Time filters Price and Price filters Time. In other words, we have seen the Nasdaq sell off as expected, but we must still wait for the Nasdaq to close above our price trendline (the 1x1) to confirm a change in trend. And when that happens, some time in March, the Nasdaq Composite will start a huge Spring rally which will carry tech stocks 500 or 1000 points higher into Mid-Summer.

So these technicals are nice, but what about some fundamentals......

What are the fundamentals behind the reflation of the Nasdaq Bubble?
What else can we learn from a study of cycles?
We can study the inter-relationship between markets. We know the tech-laden Nikkei is joined at the hip to its Siamese twin, the Nasdaq. As the Nasdaq goes on a tear, so will the Nikkei. A resurgent US stock market will draw foreign capital and thus the USD will also rally strongly. And in fact the Gann cycles do confirm a Major Turn for dollar/yen at the end of May. This "turning point" suggests that the "Dollar Bubble" will accelerate towards JPY 160 by the end of May. Against the Euro, the dollar may continue higher into July. But just because the dollar may peak by Mid-Year does not mean the bubble will pop immediately thereafter. It may be the dollar will record a series of lower highs into autumn and we won't see the real crash until near year-end, perhaps just after the mid-term elections in the US.

If that sounds shocking, then perhaps its time to wake up and smell the coffee, for we do live in interesting times. The Japanese government will no longer insure Japanese bank deposits beyond the first 10 million yen (about $75,000) after April 1st, 2002. This explains why some people in Japan have withdrawn their savings recently and begun to buy gold and short-term government guaranteed paper. This trend can only accelerate from here. Why keep your money in a Japanese bank uninsured, especially given the fact that Japanese banks give almost zero percent return on your savings?

Last year 50 Japanese banks went bust. Many more could go bust this year. To give you some idea of how worried the Japanese are about their savings, a recent 3-month & 6-month bill auction was 148 times oversubscribed, and this is for what rate of return?---Zero! The bidding drove the yield down to zero. But soon these investors will learn that Japanese government paper is no "safe haven" as the Yen plunges towards JPY 160. The rapid devaluation of the Japanese yen should help Japanese exporters but it will hurt Japanese investors who continue to invest conservatively at home-in yen. Once the Japanese realise they are about to lose their life savings to devaluation, they may begin to panic. To put this in perspective, note that what the Japanese do with their $11 trillion in savings matters quite a lot. If only one percent of that $11 trillion should move into gold, it would pull out of the market 41/2 times the current annual gold production. Is there any wonder why gold mining operations are in such a hurry to take off their hedges?

Recently the Japanese reportedly bought 20 tons of gold, which contributed to the January rally. But 20 tons is nothing compared to what they might be prepared to buy during a panic. Most people don't understand that gold is the only currency that cannot be devalued. Governments that get themselves into a debt crisis inevitably resort to "inflation". They monetise the debt away by printing money.

How will this tsunami of Japanese capital affect US markets? It will help to drive US stock markets higher again to ridiculously overvalued levels by Mid-Summer, which could very well be the high to the rally. (A range of cycles converges on the month of July, suggesting an important turn). President Bush just visited with Japanese Prime Minister Koizumi. Oh wouldn't it be nice to have had your ear to the wall. Never mind, we can guess what was said behind closed doors. Bush will allow Koizumi to devalue the yen to JPY 160 so long as Japan puts more money into US bonds to support the US bond market, which is in imminent danger of collapse.

The problem here is that as the US economy recovers and US stocks go on a tear, long-term rates will rise, which will cut short the rally in stocks, thus endangering an emerging economic recovery. And given the fact that this is an election year (mid-term elections in November), it is imperative for the Bush Administration to keep the bond market stable and the economy on track. Even if the Japanese do not buy US stocks, it is their continued support of the US bond market that will allow for a stock market rally in the first place.

The scenario here is the sudden reflation of the tech stock bubble. Keep in mind that we are only halfway through the Internet revolution. Many new tech companies didn't even exist before March 2000 when the Nasdaq bubble burst. This is the second wave. Recent IPOs such as PayPal have come to market with a surprising amount of investor interest. The Enron scandal drew attention to dubious accounting practices by major companies with off-balance sheet items large enough to sink the ship. Many investors may come to know that there is greater risk in the so-called "blue chips" than in the smaller newly emerging companies with great new ideas but less "sophisticated" (read: scandal-prone) accounting practices. This means the Russell 2000 will continue to outperform. And tech stocks will get a new lease on life. More successful IPOs are on the way. Also note that as the global economy reflates on a tidal wave of monetary excess, worries of "deflation" will quickly transform into newfound worries of "inflation".

Rising new tech stocks with productivity enhancing ideas will be in great demand as a hedge against inflation. The Dow will underperform because many of these older companies will have difficulty in raising prices even in the face of rising inflationary pressures. Companies that operate as monopolies and those companies that are pioneering new markets with new products (read: less competition) will be in position to raise prices. These are the fundamentals that explain why the charts are pointing to a 1000 point rally on the Nasdaq starting this spring.

The Dollar Bubble - is this the Perfect Storm?
If you're like us, you are probably a bit nervous at how all this is going to end. We know Greenspan's credit bubble fed the rally of the 1990's and caused the stock markets to rally to excessive levels. He reacted to the LTCM derivative crisis and the Russian meltdown of 1998 by cutting rates and pumping excess liquidity into the system. He later reacted to the potential chaos of Y2K by adding $100 billion to the balances at the FED just before the worrisome event, which in fact failed to materialise. Y2K turned out to be a non-event, but the excess liquidity created by the FED only added to the tech stock mania, a bubble that burst just a few months later.

So why didn't the dollar sell off with it and why did the economy hold up so well? Aside from 11 rate cuts and excessive monetary stimulus supporting the markets over the past year, something else helped consumer confidence. It was supported by yet another equally impressive bubble, the Real Estate bubble. 10% of Americans own 90% of the stocks, but over 2/3rds of all American households own their own house. This explains why you can see a wholesale destruction of capital, over $5 trillion vaporised in the stock markets, without destroying consumer sentiment and the economy. The consumer kept on buying even after the bubble popped because most Americans never owned stocks to any great degree. The largest asset for most Americans is their house, not their stock portfolio. What they may have lost in their 401k was more than made up by the rising equity in their house.

Over the last 5 years real estate has doubled or tripled in many parts of the country. Americans have also taken good advantage of the plunging rates to refinance their house, not once but numerous times over a series of rate cuts. The extra cash generated by "refi-madness" helped to keep the consumer afloat and keep those credit card bills at bay. But if last November brought the low in mortgage rates, it also means this is yet another support for the economy that will soon disappear. Equally, this flood of liquidity enabled corporations to reflate their own "economies" holding back unemployment and adding to the generally ebullient sentiment.

What could possibly go wrong? Plenty, it turns out. In a recent editorial, (2/20), the WSJ has drawn attention to the similarities between Enron and Fannie Mae & Freddie Mac. "These two government sponsored enterprises now account for the majority of all mortgages in the United States and have been growing their debt at an annual rate of 25% per year with outstanding debt of $2.6 trillion". Their increasing reliance on derivatives is causing concern. This story is actually not news. Warren Buffett was concerned enough about the rising risk of Fannie Mae to get out of this stock completely back in 1999.

The intriguing part of this story is not mentioned in the editorial. Everyone from Greenspan, Rubin, Summers, and now the Bush Administration have gone on record as showing concern about the unrestricted growth in Fannie Mae and Freddie Mac and the potential for the whole thing to blow up, leaving the taxpayer to pick up the tab. But are these politicians genuinely concerned or is it merely a case of CYA syndrome. It would appear most politicians know that Fannie Mae is a bubble waiting to burst, and they don't really want to be that close to it when it goes. But they do want to be on record as having warned the public.

The more interesting story is that the GSEs have become an integral part of the credit creation system (You can now buy a house in a couple of days with $500 down, and in some cases people finance more the value the house, allowing extra for home improvements). So while politicians don't wish to get tagged for having contributed to the coming GSE blow-up, neither do they want to do anything to reform these two agencies because the credit creation benefits are too large and too important to the growth of the economy.

Fannie Mae and Freddie Mac have rationalised the mortgage business, making it easier for people to buy a house with very little money down. What could be wrong with that? Plenty! There may be some similarities to Enron in terms of derivative exposure, but there is also an even stronger similarity to GreenTree Financial. GreenTree was a Ponzi scheme just like Fannie Mae. GreenTree made it very easy for blue-collar workers in the South to buy a trailerhouse, but they didn't do proper credit checks. The basic requirement was a pulse, and they sucked people into buying a trailer with very little money down in order to maintain commission sales.

Many of these people thought they were buying into the American dream on the cheap, but later found themselves upside down in a mortgage for two to three times the deprecating value of their mobile home, and they couldn't pay off the mortgage when they fell on hard times. Could it happen again on a much larger scale? If the dollar plunges, the economy contracts, and companies fire workers at a record rate, no doubt many people would not be able to pay the mortgage, and forced home sales would cause the real estate market bubble to pop. Owning your own home is supposed to be the American dream, but it could easily become the American nightmare.

When the "Dollar Bubble" pops, we will see how all the markets are so very interconnected. Does it not strike you as odd that every Treasury Secretary over the last 10 years has maintained the same "Strong Dollar" policy.

The current account deficit is now 4.4% of GDP and growing. Without the rest of the world financing the US economy, the game would have been over a lot time ago. Every Treasury Secretary has played the same game of talking up the dollar in hopes that the music will stop on someone else's administration. All of them know that once the music stops and the dollar bubble bursts, it will take the real estate market, the bond market, and the stock market down with it. There is no alternative to the strong dollar policy. There is also no solution to it. Every great Ponzi scheme has its own internal logic and inescapable upward momentum until it reaches its zenith, when suddenly everyone knows the party is over.

Once the dollar bubble pops, the consequences will be far-reaching. Commodities, which are mostly priced in dollars, will ratchet higher to the same percentage degree that the dollar declines. Note that this coming oil shock does not depend on a war in the Mideast. Most people believe that a Mideast War could lead to an Oil Shock. But in truth it could be the other way around. When the dollar crashes and commodities move higher in price, a war may follow. Wars have been fought for much less.

2002 will be remembered as mostly a good year, at least until 4th Quarter. 2003 will be a year most people will want to forget. An 18-year Sterling cycle comes due in 2003. Sterling correlates strongly with the Euro because Tony Blair is intent on taking the UK into the European Union. But this 18 year Sterling cycle means one thing for Tony: "Game over". Tony will not have time. Sterling will sell off with the Euro going into July, but by next year if not before, Sterling will begin to rally strongly against both the Euro and the dollar and Gordon Brown's five economic tests will need a lot of heavy conjuring to be dressed up for a referendum. Before Tony can achieve his goal the Euro may be no more.

Four million people in Germany are now unemployed, 8% of the population. Could that percentage rise to over 10% in 2003. Sure, no problem. The Euro has never really been tested as it will be this year and next. What would the Euro be without Germany. In effect, the Euro has been a beautiful smokescreen. Without the cover of the Euro, German politicians would by now have had to explain why the DEM keeps plunging. By substituting a new currency, it distracts attention away from the hard fact that Germany cannot afford its welfare state. Reform is not coming fast enough to stop the Euro from plunging. From here to July the Euro could plunge to .7600 or lower as the dollar bubble continues. Then later this year when the Dollar Bubble bursts, the whole concept of the Euro will come under severe scrutiny as European unemployment reaches truly astounding levels. Some time in 2003 it will just go poof!

"Poof" is not the scary part. we'd be more worried if the Euro doesn't go "poof"! Why is that? Because no self-respecting politicians will ever admit to a colossal mistake when they can easily resort to a bigger lie. By way of comparison, the moral of the Enron story is that they didn't tell a big enough lie. They actually had the chutzpah to compare themselves to LTCM, thinking they could play the "moral hazard card" to the Bush Administration and have government save their bacon. It didn't work, not for any moral reasons, but merely because they didn't come close to the scale of LTCM in their quest for the ultimate Ponzi scheme.

The Euro, which was created for political reasons, among them to cover up the failure of the Continental european welfare states, may survive by creating an even "bigger lie". The Euro is already a much bigger lie than either Enron or LTCM. European politicians may get away with the "big lie" because they will shift the blame for the Euro implosion onto currency traders, calling for stricter trading rules, stabilisation of the currency markets, increased regulation, and linking of currencies globally.

The end result will be to shift volatility from the currency markets to the bond market and the equity markets, creating an even bigger global mess. As all markets become more and more volatile, government officials around the world will compound their mistakes via excess government regulation in all markets. They will kill the goose that laid the golden egg. Speaking of gold, you might want to store a few golden eggs for the interesting times ahead.

James Smith
CEO & Founder

Bruce Allen
Director, European Office

Catapult Research Inc. 

All of the charts in this article are "produced on GannTrader, courtesy of GannSoft Publishing, Inc."

Editors Note: James Smith, C.E.O. and founder of Catapult Research, Inc. and Bruce Allen have been analysing market behaviour since the 1970's. Specialising in timing and long term forecasts, they have correctly forecast major market stock, currency, commodity and capital market events worldwide.

 

 

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