Chinks in the Armor?

Just when there is talk on Wall Street about the market finally “coming back” to its old highs, one has to wonder if the “come back” has not come and gone. Certainly, all appears well according to the news media, along with the economic figures coming out of our nation’s capital. Our current “bull market” is celebrating its 36-month birthday this quarter and one has to wonder what will keep it snorting. Frankly, there appear to be chinks in this bull’s armor and there are more reasons to believe equity prices may be heading down, rather than up. Let’s examine the evidence.

At this point we are going to borrow a paragraph from Aubic Baltin CFP, CTA, CFA, PhD whose piece “Why Hasn’t IT Happened Yet?” appeared on the gold-eagle web site ( in describing the factors that could send the stock market south, he lists the following:

  • Massive amounts of derivatives ($85 Trillion)
  • Over valuation of the Dollar
  • Overvalued stock market
  • Massive build-up of debt (personal and government)
  • Record low cash levels in mutual funds
  • Under-funded pensions plans
  • Housing bubble

These and our $800 Billion Trade and $500 Billion budget deficits are more then enough evidence to tip the balance to the down side.

At the end of January, the Federal Reserve will have Ben Bernanke as its new Chairman and he will continue, for the moment, to feed Main Street’s perception that the Fed is in control of our financial system. He will do his best to fight inflation through higher interest rates. Thirteen rate hikes from a very low rate level have had a steadying affect on the markets so far. Interesting to note that the word “accommodation” has been removed from the Fed minute meetings, but this does not mean that an end to the rate hikes is near. At best, the environment is still ambiguous. Look for rates to continue to rise to about 4-½ to 5% before the language changes from the most recent language to perhaps a temporary rate halt.

Although the dollar has had a good year we feel that it may begin to weaken as foreign Central Banks pursue a course of decreasing their dollar reserves and investing in other currencies such and the Euro and the Yen. In the past foreign Central Banks were buying U.S. dollars by creating more of their currency to do so. As rates were rising our dollar became more attractive. As this was happening our business relationship relative to the rest of the world was also becoming more attractive. The point at which rates stop rising is the point than foreign money will start to look for the better yield elsewhere on the globe. And most certainly, over time, the rate of change on our current account deficit is unsustainable; foreign money will not be able to continue to bear the burden of supporting the dollar by buying our Treasury bonds. This on-going scenario of financing our deficit will come to an end. As this comes into play, look for the dollar to weaken in relationship with other currencies.

Home equity financing has replaced the borrowing on credit cards during the late 1990’s stock boom. The American consumer continued to find ways coming out of the ‘90’s to keep up its spending, thus pleasing Chinese and Pac-Rim manufacturing. The main contributor was new home and existing home sales, which have been rising since mid-2000 when money started chasing hard assets. But, like all cycles, supply has caught up with demand as new home sales are falling as a percent of GDP. Over the next few years as housing slows, so will the withdrawals for home equity loans, leading to a slowdown in consumer spending. This will affect not just our domestic economy negatively, but our ability to purchase from our global friends. When the spending ceases, our global friends may go into a tailspin realizing that the U.S. market is not the “cash cow” it once used to be. As the world comes out of this debacle on the other side in 2008, look for the development of new alliances among other developing consumer economies that will leave the U.S. outside looking in. The good news is that interest rates will be cut during this debacle.

Speaking of new alliances, the Chinese are negotiating a deal to build a pipeline from the Alberta Canadian Sands to Vancouver in preparation of the coming consumer boom in China. Whether America goes “green” or not, China faces an unprecedented growth phase that will need existing energy resources. Energy poses a continuing concern. Natural gas prices will continue to rise faster than oil prices as American consumers start looking for substitutes. So far the East Coast has had a warm winter, but the rate of change in natural gas prices year over year is up significantly. Look for more of the same in the years to come. The energy markets are tight and cannot afford shocks. Hurricane Katrina is an example of an energy market being priced for perfection. Of the countries supplying the United States oil, more than a few are politically unstable; like Iraq, Iran, Nigeria and Venezuela. All it will take is one country deciding to stop the flow of its resources to our shores to push oil prices beyond the reach of most Americans.

Our readers who have followed these pages over the past few years know that our research has lead us to the conclusion that we are in a secular bear market that began in 2000 (see our Past Views). Within that secular trend there are several mini bull and bear markets. Following this theory we continue to believe that the market is close to the top of one of the mini bulls or cyclical moves to the up side. The S& P 500 index has returned over 50% over the past three years. But in 2005, the S&P 500 showed a decelerating rate of change in investment returns. What this could mean is the market is exhibiting price distribution which could point to a renewal of the secular bear market. Although 2006 will be a challenging year for investors, there is also good news. Not all stocks will go down and some industry groups will prosper and continue in a cyclical bull phase. Secular bear markets are always stock pickers’ market and this year is one that will separate the wheat from the sheaf or the good money managers from the rest.

Gordon B. Lamb
Carl C. Perthel

January 3, 2006