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"IT DIDN'T HAVE TO BE THIS WAY"

The Commerce Department released their final revisions for fourth quarter GDP this morning showing growth of 3.8% following consensus expectations of 4.0% growth. The report also showed two closely watched inflation gauges moving higher with the final revisions. The price deflator was adjusted from 2.1% to 2.3% and the personal consumption expenditures index was adjusted from 2.5% to 2.7%. The report initially caused bonds to sell-off, but they came back to remain slightly positive throughout the trading session. The weaker than expected GDP revisions applied modest downward pressure to the U.S. dollar, but had little effect on stock prices. Overall for 2004, the Gross Domestic Product of the USA grew by 4.4%, but notice the trend is declining with only 3.8% growth in the fourth quarter. Stocks are beginning to see the slowdown with this first quarter of 2005 being the worst quarter for stocks in the last two years. Since the beginning of the year, the Dow Industrials are down nearly 3% and the NASDAQ is down by more than 8%.

The party began for stocks today when the price of crude oil came down roughly $1.50 per barrel after the Energy Department released the current inventory data. Crude oil inventories were expected to rise by 2.5 million barrels, but instead rose by a whopping 5.4 million barrel, the biggest increase in the last six months. Unleaded gasoline inventories were expected to decline by 1.8 million barrels, but actually fell by 2.9 million barrels. With crude off by about 3% today, unleaded gas is only down about three cents to $1.55 a gallon. Most folks are expecting higher prices during the summer driving season, so we are not seeing gasoline prices come down as much as crude. We have lots of crude (9% above last year’s level at this time) and though gasoline inventories have declined the last few weeks, we are still 7.4% above year-ago levels. If we have any more explosions at refineries, the price of unleaded should fly even as crude oil inventories continue to build. Refineries are running at full capacity all around the globe just to keep up with demand.

Crude oil’s decline gave a lift to stock prices today that were already due for an oversold bounce. The major stock indexes are looking pretty ugly for further declines, but they won’t go down in a straight line. After this bounce higher, I expect to see a deeper decline in the broad stock averages. Higher interest rates and higher energy costs will slow consumer spending, slow the economy and subsequently produce lower corporate earnings and lower stock prices as the year progresses. That’s my nutshell version of the fundamentals for the broad stock averages, so let’s take a look at some very basic technical analysis to see if the technicals confirm the fundamentals. I’ll use the S&P 500 Index as a surrogate for all stocks.

On the six-month daily chart, notice the divergences in price and momentum. The blue lines depict a rising price with falling momentum that led to an imminent decline. Subsequently, we have another divergence after the January correction with yet another higher price logging a lower value in the Relative Strength Index. The same is true on the weekly chart. From the chart you can see that stock prices have struggled to higher levels over the last year, but Relative Strength actually topped-out back in January of 2004. On the weekly chart also notice the last five quarters have produced an ascending wedge formation that is considered a bearish reversal chart pattern with a 76% chance of resolving to the downside. The average decline from this formation is 19% with the most likely being 15%. Once the downside break occurs, the price target of 15% to 19% decline is reached 63% of the time. Based on the probabilities, the S&P 500 has a 48% chance of hitting 980 on the next decline. Since doing the math on the possible breakdown of the rising wedge formation, the number 980 for the SPX really rang a bell in my head.

I remember this SPX level as being the neckline of a huge five-year head and shoulders pattern the was broken to the downside back in the summer of 2002. The SPX broke-out above the neckline about a year later in the summer of 2003. That was a very rare event for the S&P 500 index, since market history tells us that once the neckline of a head and shoulders pattern is broken to the downside, there is only a 5% chance of moving back above said neckline. Here’s a ten-year weekly chart to see the entire picture. I believe we are headed for a test of the neckline which is also very close to the psychological support of SPX 1,000. Once the neckline is broken, we could easily move on to re-test the lows below 800. Stock prices could easily lose 30% of their value through the balance of the year. From an Elliott Wave perspective, we just might be at the very beginning of wave three down for stocks. Today the Dow Industrials added 135 points to close at 10,540, the NASDAQ Composite made it back to the psychological 2000 level by gaining 31 points to 2005, and the S&P 500 moved 16 points higher to 1,181. I don’t expect this bounce to last for long. Tomorrow Martin Goldberg is going to show the charts of the component stocks that make up the Dow 30 Industrials and just how bearish the individual stock charts appear, with a few exceptions.

Bond prices have been moving lower to reflect rising interest rates, but have stabilized over the last five days since Alan Greenspan bombed the bond market with his warnings of increased inflationary pressures. There was very little volatility today with bonds and the dollar, as the U.S. Treasury was busy again with an auction of $24 billion of two-year notes. According to Bloomberg, “In pre-auction trading, the new notes yielded 3.87%. The Treasury hasn’t awarded a yield higher than that for a two-year note since July 2001.” It’s provocative that we have to go back to July of 2001 to find a comparable yield for a two-year note, since it was November of 2001 that the Treasury stopped issuing 30-year bonds. Ever since then the Treasury has been refinancing their debt to shorter and shorter maturities.

The Feds have been borrowing heavily at the shorter end of the curve in two and five-year debt, and even resurrected the three-year note in order to have more supply at the short end. This has worked to reduce the interest expense on the existing debt of the U.S. government, but now we are in a rising interest rate environment, and will have to refinance the debt at a more rapid pace since the maturities are shorter. Most investors have viewed the higher interest rates as being dollar-positive, but what happens to the federal deficits when they have to refinance existing debt at higher market rates? As the biggest debtor nation in world history, rising interest rates will make it very expensive to refinance our old debt and borrow enough to offset the current deficits. Further down the road I believe higher interest rates will become dollar negative as our costs increase to service the existing debt. One thing that could temporarily save the bond market would be a major decline in stock prices as I detailed above. When money runs scared from stocks it usually finds its way to shorter maturity bonds. Then, when bonds continue their decline to reflect higher interest rates, the precious metals sector will be the go-to place. Higher interest rates with falling bond prices will be gold friendly, not like the spin you are hearing from the financial markets today.

The Mortgage Bankers Association said its application index rose 2.4% with the purchase index higher by 5.5% and the re-fi index lower by 2.0%. The 30-year fixed rate moved from 5.95% to 6.08% and one-year ARMS moved from an average of 4.12% to 4.39%. Here’s the mind-blower…applications for adjustable rate mortgages jumped from 33.5% to 36.6% as a percentage of all applications. I hope these folks have an exit strategy for their variable rate loans or they could be in big trouble a few years down the road with significantly higher monthly payments.

Now wait just a minute!!! Are we really going to see higher rates? Most analysts I read don’t believe the Federal Reserve will follow through with significantly higher rates. They will talk a tough story of fighting inflation, but in the end, we need a lower dollar. The Fed’s job is to create inflation, but in a controlled manner. It’s funny to hear analysts talk of inflation heating up, when in fact the inflation has already happened. Inflation happened when the Fed decided to inflate the supply of money. Now all we have to do is wait and see if the monetary inflation will work to keep the financial markets inflated as happened all through the Nineties, or if the monetary inflation will show up as higher commodity and consumer prices as it did back in the Seventies.

From Stephen Roach:

“The Fed tightened by 25 basis points on March 22, only to find that a day later the annualized core Consumer Price Index accelerated by 10 bp. In fact, the acceleration of the core CPI from its early 2004 low of 1.1% y-o-y to 2.4% in February 2005 has offset fully 74% of the 175 bp increase in the nominal federal funds rate that has occurred during the current nine-month tightening campaign. At the same time, America’s current account deficit went from 5.1% of GDP in early 2004 to a record 6.3% by the end of the year -- a deterioration that begs for both higher US real interest rates and a further weakening of the dollar. The response on both counts has paled in comparison to what might be expected in a normal current-account adjustment. Behind the curve? You bet." 

Later Mr. Roach went on to say, “Unfortunately, that takes us to the ultimate trap of global rebalancing -- a realignment of the world that requires both higher US real interest rates and a weaker dollar. Should the Fed fail to deliver on the interest rate front, I believe that the US current-account correction would then be forced increasingly through the dollar. And that would redirect the onus of global rebalancing away from the American consumer onto the backs of Europe, Japan, and China. Call it a “beggar-thy-neighbor” monetary policy defense -- pushing the burden of adjustment onto someone else. It didn’t have to be this way. The big mistake, in my view, came when the Fed condoned the equity bubble in the late 1990s. It has been playing post-bubble defense ever since, fostering an unusually low real interest rate climate that has led to one bubble after another. And that has given rise to the real monster -- the asset-dependent American consumer and a co-dependent global economy that can’t live without excess US consumption. The real test was always the exit strategy."

From Jim Puplava:

“As far as a hard call on interest rates, I don’t see it. The US economy has too much debt that needs to be sustained. That debt is price sensitive more so today than it was in 1999 and 2000. Another point or less in rate hikes is all we will get before things start falling apart. The US economy is like a drug addict, addicted to easy credit. I doubt if the drug dealers or suppliers of credit are about to deny that credit. The money supply and the monetary base are still in an expansion mode. Our asset markets and wealth creation are narrowly balanced on a thin margin of low interest rates. It will remain that way for a long time. To deny credit or make it more expensive as the Volker Fed did in the late 70’s is out of the question. The economy and the financial markets have become far too levered. The Fed risks collapsing the economy and the financial markets if it gets too aggressive; it is one reason why it has allowed the money supply to grow. Look for the Fed to try another tactic as it appears a rise in interest rates has run its course. The next tactic will be to bring the dollar down.”

From Adam Hamilton:

“To summarize, low and negative real rates drive great gold bulls since bond investors can’t earn any real returns on their capital. In order to entice inflation flight capital back out of gold, real rates have to rise back up to 3% to 4% and stay there long enough to convince savers to expect these favorable conditions to persist. But if the Fed pushes nominal rates high enough to hit 3% to 4% above inflation, then it risks collapsing the entire US real estate market and hobbling two-thirds of the US economy.”

In a nutshell, the Fed will keep talking tough as an inflation hawk, but won’t do anything about it. They intend to stay “behind the curve” so that inflation WILL be created and the dollar will fall enabling those burdened with debt to hopefully pay off those debts with cheaper dollars. When you get right down to it, the Fed is stuck somewhere between a big rock and a very hard spot. They created the bubbles, now they are scrambling to keep the stock, bond and real estate bubbles inflated without having inflation show up in commodities and consumer products. The Fed has always erred on the side of inflation…when in doubt, create more money. If there is a crisis, more liquidity…a really big crisis, more liquidity and an emergency rate cut!!! This has been their only answer in years gone by, so why should it change now. The dollar route will continue until serious policy changes are made to correct all the global imbalances.

I was pleased to see the price action for silver today. The dollar closed down today by only .05%, but silver gained 2.48% to $7.15 an ounce. The latest Commitment of Traders Report showed the silver open interest falling 2,627 contracts to 96,722. I read the declining open interest as short covering by the commercials. Bill Murphy recently reported that Morgan Stanley was a recent buyer “of size” as they work to reduce their short position. I often wonder if AIG was ever able to get out of all their short silver positions, as they used to be the ring-leader of silver shorts. With all the scandal at AIG right now, I would not be one bit surprised if they have a huge derivatives problem in the silver market. Enron was used to manipulate the energy markets, and it is my belief that AIG was used to manipulate the silver market until they got out of silver trading about a year ago…Morgan Stanley has been carrying the torch for AIG ever since their abrupt exit from the silver market (just when you were starting to believe they were an insurance company). It looks like all of America is turning into one giant hedge fund! Once one of the big boys goes down, the derivatives daisy-chain bombs will begin to trigger one after the other. That is probably why J.P. Morgan and Goldman Sachs yesterday formed a “Counterparty Risk Management Group.” Things are getting dicey out there folks. One reader sent me an email from Texas last week and basically said that he agreed with me, but why was I wasting my time and energy to warn people when most folks choose to remain in denial of our current monetary and economic situation. He told me to buy gold and ammunition; because it won’t be long before I’ll need both. Like Stephen Roach so succinctly put it, “It didn’t have to be this way.”

Have a Restful Evening!

Mike Hartman

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