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Danger Ahead!

David Chapman
Oct 17, 2005

It is October and the markets are falling. Not unusual you say because everyone knows that October has had its share of scary drops in the past. Think October 1929 or October 1987. Indeed for an interesting comparison I have attached a chart that was sent to me by reader Brad Parkes showing some interesting comparisons between the market of 1987 and the market of today.

Some other interesting comparisons with 1987 are the solar and lunar eclipses. In 1987 there was a solar eclipse on September 23 coinciding with a short-term market bottom on September 22. The market topped on October 2 and started its collapse on October 6 generally coinciding with the lunar eclipse on October 7. This year we had a solar eclipse on October 3, 2005 that has thus far coincided with a short-term top. The lunar eclipse is on Monday October 17, 2005. While the chart below has suggested a collapse to 8000 on the Dow Jones Industrials we don't believe that is realistic at this time. More realistic would be a drop to the 9800 zone where there would be considerable support. A collapse to 8000 or even lower is not anticipated until sometime in 2006. But patterns may remain very similar.

It is possible that the tops and bottoms have been reversed from the 1987 pattern and we may see a low sometime around October 17 this time or it may signal the start of an acceleration that doesn't bottom until sometime around October 31 through to November 4. At that point we could reach our potential targets of 9700/9800 on the Dow Jones Industrials. This would put the S&P 500 down somewhere around 1050 and the lows seen in 2004. The key support levels in the interim are at 10000 for the Dow Jones Industrials and 1150 on the S&P 500. The lower levels only become possible on a sharp break below those support levels otherwise lows could be made in that area.

If the stock market's falling were not bad enough the bond market has also been falling. We note that we have failed to make any new highs in the recent up cycle. This is not unusual as we note that since the major low was made at the height of the 1970's inflationary period in September 1981 that the bond market has made interim lower highs on three other occasions before moving later to new all time highs. We have labelled our key highs and lows since those lows in 1981. Lows are generally more predictable occurring on average every three years (1981, 1984, 1987, 1990, 1994, 1997, 2000, 2002, and 2004). It may be that the recent series of lows roughly two years apart is a slight departure and we would expect that the next significant low in bonds will occur sometime in 2006.

The key is that the low remain within the bull channel that has formed since 1986/1987. The bottom of the channel is currently around 102^08. Minimum objectives on a possible symmetrical triangle top are to around 92 well below the line. If we were to collapse to those levels it would tell us that the great bull market in bonds that has been in place for over 20 years is over. Holding above 100/102 would tell us that another run to new highs above the June 2003 highs at 124^12 was quite likely.

With two prime asset classes (stocks and bonds) under pressure investors well be harried as to where to hide. It certainly won't be in property, as rising interest rates and falling stock markets will also pressure the housing market. There is evidence beginning to emerge that the housing market has now topped as well with prices in the bubble blown property values of New York City reportedly have now fallen for three consecutive months.

Helping to push the markets lower is weakening economic numbers. This past week alone has seen the CPI come out higher than expected (inflation), the trade balance remain very high at $59 billion, retail sales, capacity utilization, and industrial production and consumer confidence all came in below expectations. With the hangover from high gas prices and the dual hurricanes keeping the pressure on oil and gas prices with oil and gas wells shut in and refineries still not up and going as well as rising unemployment (initial claims were above expectations again) it is no wonder that consumer confidence is sagging. All of these items are negative for bonds, stocks and property.

If the technical picture looks dangerous the fundamental picture is starting to look downright scary. The most immediate problem that has developed is the Refco collapse. Refco just happens to be one of the major players in the global futures commodities markets. Its clients are some of the largest financial institutions in the world. Refco Securities has advised that it is now in wind down. This followed the closing of Refco Capital Markets. But psychologically it is impacting Refco Inc. and its commodity futures trading arm including subsidiaries such as Refco Futures (Canada) Ltd. Refco Futures (Canada) Ltd. is as noted a separate subsidiary and as a member of the Investment Dealers Association (IDA) and the Canadian Investment Protection Fund (CIPF) they are fully protected.

At this time there are no indications that the futures units have been impacted nor in theory should they. But that hasn't stopped a potential huge problem because of the sheer size of Refco. Following the resignation of their Chairman over possible securities fraud lawyers and firms are also scrambling as a recent bond issue has plunged trading as low as 21-23 cents on the dollar an incredible drop from issue and raising serious questions about the due diligence that was done. This collapse, however, could reverberate through the entire banking and investment dealer world that do these transactions.

While the collapse of some of the arms of Refco have caught the markets by surprise not so the potential for death by a thousand cuts for numerous companies whose debt is poised for downgrades. It is estimated that over 600 companies are poised for downgrades by S&P against only around 300 for upgrades. The recent bankruptcy of Delphi Corporation may be just the tip of the iceberg. Hertz Corporation and Clear Communications are expected to be downgraded to junk status. More recently General Motors, Sears Holdings and Eastman Kodak had their debt downgraded to junk. General Motors has been talked about as a candidate to join Delphi. The same could be said about Ford Motor. With more firms being downgraded spreads have been widening between government bonds (highest rated) and junk bonds. Funds dump the bonds and hedge funds that traditionally play the junk bond game are being pressured because there are effectively no buyers in a falling market.

The hedge fund industry holds over a trillion dollars in assets and has often been cited as being a significant part of the daily volume in stock and bond markets. Problems in the hedge fund industry would reverberate throughout the entire financial system. Recall that in 1998 a hedge fund Long Term Capital Management (LTCM) was alleged to have almost brought down the entire financial system when it was in trouble highly leveraged in junk bonds and foreign government bonds particularly out of Asia and Russia. The collapse of one hedge fund company was in the end containable. Numerous hedge funds going down at once would be a far greater problem.

As avian flu spreads into Eastern Europe and Asia Minor (Turkey) the fear of its spread grows. That the H5N1 strain does not spread easily from birds to humans does little to slow the growing fear. That Europe (and North America) does not have the level of birds (poultry) in the front yard as in Asia or Africa does little to calm the fear. The real fear will occur if the H5N1 strain were to spread from human to human instead of the bird to human that has kept the numbers infected and deaths low to date. Nonetheless what has become clear is that if a serious pandemic broke out anti-viral drugs to fight the disease are limited. The economic fallout from a global pandemic would be huge as economies would literally grind to halt. At this stage it is psychological but nonetheless a negative one.

Of bigger concern should be the growing scandal in the White House. The scandal known as Plamegate threatens the potential for criminal indictments against Karl Rove, George Bush's top political advisor and Libby Lewis Dick Cheney's Chief of Staff. Despite testifying four times prosecutors have given Rove no guarantee that he will not be indicted over the leak of CIA operative Valerie Plame's identity. Plame was the spouse of Joseph C. Wilson IV. In mid-2003, Mr. Wilson, a former diplomat, became an outspoken critic of how the administration had used prewar intelligence about Iraq's weapons programs to justify the invasion.

A scandal in the White House will grip the nation and cause political paralysis. Criminal indictments over Plamegate would be similar the Watergate scandal that paralyzed the White House and the stock market fell 50% or more in 1974. Scandals for second term Presidents have been very common over the past 60 years. Adding to the problems is the plunging popularity of President Bush over the War in Iraq and the handling of the hurricanes. As well the infighting in the Republican Party has become very public over the appointment of Harriet E. Miers to the Supreme Court. Miers was President Bush's personal lawyer. And to make it the perfect storm two top Republicans House Majority Leader Tom DeLay is under criminal indictment and Senate Majority Leader Bill Frist is under investigation from the SEC.

This weekend is the important Iraq constitution vote. No one obviously knows how it is going to turn out. Iraq is an ungovernable country given the animosity between its three main ethnic groups. As reported in Stratfor that Iraq is in a constant state of shifting politics is actually undermined further by the occupation of the US, the Sunni insurgency and the probable involvement of both Iran and Syria. That both Iran and Syria have had a long relationship with Iran is insoluble given the US occupation. The Iranians have very close ties to the majority Shiites where a number of their leaders spent time in exile in Iran. The Syrians are Sunnis just like the insurgency. In the north the Kurds have never hidden their desire for a separate country. That of course would be unacceptable to Turkey who has a significant Kurdish population themselves.

A positive result on the weekend on the Iraqi constitution would of course be helpful to the beleaguered Bush Administration. Its rejection would just add to its woes as they become more bogged down in Iraq and under siege at home over the growing scandals. None of it of course is good for markets that may reel further.

Amongst all this potential for market carnage one thing is standing out. And that is bullion. Gold, Silver and Platinum have been holding up or rising in the face of all these problems. Our chart of the Dow Jones Industrials/Gold ratio shows that after more than two years of sideways trading the ratio has broken down in favour of gold. To date the ratio has fallen to around 21 and the current target is down to around 16. Gold has been favoured over bonds now for the past two years. With rising bond prices the ratio has faltered but the uptrend remains intact. There is, however, a possible ascending wedge forming so that ratio bears close watching.

The dangers that lie ahead is showing up in increasing instability and it is showing up on the charts. Investors would be wise to heed and increase use the current consolidation in bullion prices to add to positions. Targets remain on gold to over $500 and up to $550. Silver prices looked poised to soon break out over the former highs near $8.20 and target at least to $10. Platinum prices should soar over $1000.

Oh and one more warning. Over the past year we have had a tsunami (water), hurricanes (wind), and most recently earthquakes (earth). Our advice. Make sure you do not live in the shadow of a volcano (fire).

David Chapman
email: david@davidchapman.com

Charts created using Omega TradeStation or SuperCharts. Chart data supplied by Dial Data.

David Chapman is a director of Bullion Management Services, the manager of the Millennium BullionFund www.bmsinc.ca.

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.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.


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