Back in ancient history, the Knights Templar were unseated and destroyed on Friday the 13^th by secret order of the Pope who had become fearful of their power in the finances of the Holy Roman Empire. It all started innocently enough: the Templars used their network of castles to protect pilgrims to the newly captured holy land and as a convenience offered to act as banker to the masses of people traveling through hostile territory en route to Jerusalem. By taking in gold in Europe and giving it back along the network of castles, the Templars became the world’s first ATM machines. Since they invested the huge deposits until the time of withdrawal, often months or years later, the Templars become even richer than they were from plundering the Holy land. In those days, as it is today money equals power; the Pope couldn’t allow the Templars to control the Empire so it simply wiped out its key rival through deceit and force of arms. After confiscating all the Templars’ wealth, Rome was singularly rich and powerful with total control over the money supply of the day that was gold. Today the market is telling us something and it looks to be important. The dollar is breaking down through key LT supports at the same time that the Fed is quietly gunning the Money Supply via MZM growth.  

LT support for the dollar is now between 80.25 and 81.3 after failing at 82.60 – below 78.0 the buck could go into freefall

In any major crisis all the world’s markets correlate to one. This is a lesson learned by watching the effects of the last few financial crises around the world. Another is that inflation and short-term rates jumping quickly always seem to precede the crisis. Perhaps the most important lesson of all is that all major crises devolve into a crisis of confidence in the highly leveraged financial system that underlies US hegemony in the world since the creation of the Bretton-Woods agreement in 1944. The value of the dollar is a reflection of the confidence in the Fed and the US consumer by international investors. In the last 4 years consumers have engaged in a spending binge like no other in history. It was fueled by low rates, which increased investor wealth, spurred the housing market into a bubble and sustained by huge foreign investment into US financial markets. 

In effect we could spend like crazy because lenders had few alternatives and with sharply rising real estate prices the collateral looked solid just as it did in Japan at the top in ’90 or in the US in ’79 ahead of the S&L crisis. This pattern of ruinous over-consumption continued until the average US household had debt to equity of 100% or more including home equity and about 200% excluding housing. With home ownership rising rapidly thanks to the a gov’t program that lent down payments to first time buyers, the proportion of households owning their homes jumped from low 60% levels to above 70%, setting an all-time record for America if not the world. The problems began when inflation crept into the equation following Greenspan’s Fed that used Money Supply as a tool to forestall any market corrections or economic weakness. Once price erosion kicked in, the lack of real jobs growth beyond absorbing college grads which requires roughly 270k/month of new jobs began to stagnate household wealth. At the point that consumers couldn’t afford to keep up with payments just to get by the entire house of cards built on multiple layers of leverage began to break down. 

The rich got much richer while the middle class lost decades of hard won gains – since Y2k this shift has become much more pronouced

Ironically one of the effects of WW-II was to break down the family unit by bringing women into the workforce and separating grandparents from the family also provided the surge in labor and consumption that transformed the US economy into a super power. The breakdown of the family unit meant that instead of grandparents raising the children with all the experience and skills born of two generations of practice, increasing proportions of families turned to day care and outsiders to raise the kids. This process then broke the chain of emotionally sound upbringing for the majority of Americans, a process that continues to falter to the present day where single parent families are now the large majority and the average child in the Country is obese and ill-prepared to function in society. Prisons have never been fuller with over 2.3% of the population incarcerated for crimes that would have been unthinkable only a generation before. Without the disciplinarian grandparents to instill values, parents struggled to just get by. At this point the American dream still seemed attainable but was eroding from the inside where it was largely invisible except for the rising tide of ‘problem’ children. In reality the emotional underpinnings of the economy were in fact breaking down. 

Family farms economically died in the 70’s as vastly more efficient corporate farms helped depress food prices just as land prices fell. The American family broke apart, creating the seeds of a major crisis that would show up a generation later. But with the distribution of wealth still holding close to LT historic norms of the top 1% of society owning 70% or so of total wealth, the middle class was on the rise even if its ability to properly raise children was falling apart. Fast forward to the present where those kids are now the parents. Incomes have suffered terribly from the Internet and globalization where 3^rd world countries can take away jobs that paid good livings and replace them with corporate and investor wealth. The middle class began to shrink even as it endorsed policies that would accelerate the destruction of the very American Dream that it was predicated upon. Depending on the study, the distribution of wealth in just one generation shifted from the mid-70% level to over 90% of all assets being controlled by as few as 1% or just 3m Americans, while over 50% of the population owns less than 2% of the nation’s wealth according to one Fed study. The implications of these changes in society may be pointing to major changes in the way Capitalism is allowed to function, just as in the 1900’s the era of the robber baron lead to programs intended to protect the poor from the power of the rich. The issue at hand, however, is what a significant breakdown in the value of the dollar might mean to the financial markets and how the impacts may come to pass.

LT econ growth is about 3% - the Fed is growing MZM at 16.6% and rapidly rising – Greenspan-style intervention tends to weaken the dollar

Once the dollar loses credibility in the global marketplace, several implicit failures will likely have already occurred. The US economy is all about the consumer to those abroad. The Fed is seen as the controller of the economy. For the dollar to fail key supports, inflation will have to be seen as out of control albeit at relatively low levels and the consumer will have to be perceived as no longer having adequate resources to continue spending lavishly. We have posited in the past that the Fed may be engaged in a tacit policy of disinformation to the public, calling it ‘Conversity’, the act of directing the attention of the nation to exactly the opposite of what is actually happening. Applying Conversity to Fed statements going back to the turn of the Century is a most fascinating and revealing process. When the Fed voiced its concerns about Deflation, Inflation was actually emerging that the problem most needing to be addressed. When Greenspan in ‘03/04 talked about the benefits of using adjustable rate mortgages (ARMs), the best advice would have been to do the reverse and lock in historically favorable LT interest rates. When the Fed told us in ’05 that Inflation was ‘well contained’ the truth turns out to be that it was anything but contained as commodity charts clearly show. The list goes on and on demonstrating that the best advice with regard to protecting and growing individual or institutional wealth is to do the opposite of what the Fed suggests. Finally polls show that the public no longer believes what the gov’t and more importantly what the Fed says.

Short rates typically turn up and run ahead of a currency problem – but this time it didn’t seem to help the dollar - Inflation!

Curiously it is not what the US public believes that matters anymore but rather what foreign investors perceive to be the truth about our economy and financial markets. Now that housing prices have begun what we believe will be a long, painful process of revaluation downward coupled with massive numbers of defaults and ensuing bank failures, the home equity ATM mechanism that drove such enormous over-consumption is no longer operative. Since jobs growth is essentially flat to down and incomes are not growing at meaningful levels due to the Internet and globalization, the ability of US consumers to pay off debt is limited. Unfortunately the discipline that was born of a generation of people who lived through the Great Depression no longer is operative in society. The ability of the older generation to pass on discipline and knowledge to successive generations may have been lost by the changes following WW-II when the family farm broke down into a nation of single parents. Where virtual children now are raising their own kids, but without the hard earned wisdom and experience of past generations. The result is consumers without the will or the knowledge to properly manage their finances, bringing about a situation where large portions of the gains made over the last couple decades may be wiped out by mismanagement and flawed judgment of an entire generation of Americans. The comeuppance will truly be a character test just as the Depression was, but then again the greatest period of US prosperity followed it once the debts were repaid.

That raises the specter of adult kids returning to live with elderly parents who retain what is now practically all the wealth of the middle class. That would mean vastly fewer households and therefore fewer buyers, which likely will set off another early 80’s style burnout in housing developments where overbuilding leaves empty units that shifts undue burden onto the current resident owners. The costs of maintenance and taxes often become onerous if not ruinous as the percentage of vacancies rise in a development. The early sellers are the only winners history shows, except for the final buyers who usually get the land and whatever residual value remains after the burnout for pennies on the dollar. The big losers are the owners who really believe in their home and community. They stay too long and spend too much to keep the dream alive, allowing more pragmatic sellers to get at least some of their money back. Unfortunately over the last 2 yrs 50% of the loans had no money down and were not up to minimum underwriting standards according to the MBA, which means that most people simply walk away from their loans leaving the more prudent buyers stuck in a death spiral investment. It is all very tragic but comes about from lax lending standards following excess liquidity financing questionable projects. All this goes along until something causes the liquidity to freeze up, killing good and bad projects in process and dooming many buyers to incur major losses. New bankruptcy laws passed last year make workouts much harder to achieve meaning that more banks will go under as more people are forced to lose everything in their financial lives. It is a recipe for pain and suffering but at least wont leave the US will a 15 yr recession. History says it is better to get the pain over with and then rebuild more prudently.

Double top? The RSI isn’t matching price – suggests a failure and reversal – perhaps sub-prime is hurting consumers

The Fed has backed itself into a corner where if it eases or guns the liquidity to try and forestall major housing defaults that appear to be already in motion, then the dollar will react negatively forcing a crisis of confidence. If the Fed doesn’t ease then the recession comes as the housing market takes its next leg down causing spiraling defaults and vacancies. A banking crisis is almost certain to follow making the Fed take action or risk a crisis in the financial system which of course gets back quickly to the dollar. Even sitting still doesn’t seem to work with inflation running at increasingly high levels despite economic slowing when it should be simmering down. The vacancy rates in major cities is perhaps the next aspect of the housing crisis to hit the headlines as lawn care costs start to weigh down neighbors and city gov’ts that have to pay them or risk further defaults from falling housing values as vacant homes deteriorate. Crime is rising as well as entrepreneurs use empty homes to make money and squatters move into otherwise healthy neighborhoods. 

Ultimately the Fed has to act and soon, but there doesn’t seem to be a good course of action. If we had to make the choice (and thank heavens we don’t!) then we would choose recession and get inflation back under control, washing away unsustainable excesses and quickly setting up a stable basis for the next recovery. But giant debt incurred in the US over the last 5-7 yrs makes it questionable whether any course of action other than hyperinflation is viable – Conversity tells us that means Fed speak that it is being vigilant about inflation first and foremost! Sound familiar?

The SPX as we move into 1Q earnings season is close to all time highs yet the growth rates of sales, margins and profits are clearly on a declining trajectory in the software spaces if not the market in general. Foreign markets have largely completed the big wedge patterns we noted early in the year by running to new highs, if only just in the last day or so. The US senior avgs haven’t gone that route which is interesting indeed, though secondary indices show the same patterns as int’l markets. The heavy int’l exposure of the SPX stocks versus the domestic focus of the broader indices might explain the difference. The NYA and RTY both look almost identical to the DAX and NKY, having formed big wedge patterns with throwovers hitting new highs and surpassing upper wedge resistance lines at least temporarily, while the SPX, Nas and Dow look like the end of a wave-2 bounce off the highs in late February. The May ’06 highs marked the start of the big wedge patterns but for SPX, Nas and Dow the structures look like the wedges got too wide in late February, invalidating the patterns by our rules. Instead they may be finishing the early stages of a bear market pattern with the top in February and the recent highs marking the top of a corrective wave-2 bounce. If so then the next week should bring downward movement across the board both here and abroad. 

Most of the measurements for the wedges look done or very close to complete. The wave-2 charts also measure to completion but could wiggle a little more before succumbing next week. The earnings reports or the CPI could do it Tuesday morning, April 17, which is tax day by the way! There may be more to the tax angle as well since IRA’s and 401(k)s have been major drivers of stock appreciation in the past, but will become the first source of liquidity for families in distress either by borrowing against them for ST relief or by electing not to contribute this year. The market will no longer have that impetus for upside starting Tuesday, a fact that could weigh heavily as key economic data comes out as well. The bears for now have the field and are in larger numbers and stronger mindsets than has been the case for a great while now. The February spill acted to encourage the disbelievers and the recent data has done nothing to dissuade the bears from selling into strength. Earnings season will provide a good look into the fundamental state of growth of the companies in the stock market. From what our ongoing channel checks indicate, there could be a wall out there that is causing CEOs to back off from normal guidance out of fear that demand could stall after taxes are due. We have seen several significant software players pare guidance but provide little explanation.

The ST wave-1 to wave-5 measure on SPX now comes in at 1453, about the high on Friday trading. The alternate wave-3 to wave-5 puts the top at 1454.85, slightly above the intraday high. So the expectation at present that makes the most sense is for a turn down to occur in the next several trading hours. Still we cannot rule out the wave-5 run to new highs yet with the same patterns counting as just starting a new sub-wave-3 up! With lots of significant economic data out today and tomorrow including CPI, the market seems to be toned for a pullback on disappointing news. Also after the close earnings reports impact the market sentiment in the near term. 

RTW

SPX has some upside room still but is at .618 of the prior wave up suggesting it could turn soon

A big Double-top shows up in a lot of places lately – with negative RSI divergences…

SPX has surpassed all resistance but the big one at Y2k highs – but momentum has been diverging since ’04 highs!

Just like Asia and Europe, US small and mid-caps are forming a big wedge that could hit new highs 

NKY has formed a big wedge and only needs a new high to complete it – but RSI is negative here too!

DAX has now completed its major wedge pattern with throwover – it is leading the pack!

Oil prices could spike higher off this pattern – key resistance at $78 to confirm a new bull run

Empire shows further weakness – jobs falling, inventories rising – but the key may be that prices paid are running higher! 

Hourly SPX Supply/Demand Chart

Source: ICAP Research

Hourly S/D is finishing a Buy signal albeit a weak one

VAP is holding near its highs – RSI came on really strong but is topping now!

Housing is clearly hurting consumption – this is the real fear behind the weak dollar

S/D is back to extreme overbought levels – now a turn becomes increasingly likely 

VAP has backed off – RSI just missed scoring a new high but did make a higher high – a down turn is now likely 

Rate rallies continues to confirm on RSI but momentum isn’t what it could be!

Hours worked are deteriorating signaling a slowing economy

Weekly S/D needs only a fast move lower to become operative below SPX 1390

VAP is rolling over and Momentum lagged badly before turning lower itself – a correction is indicated

A/D line is consolidating despite higher price highs – that is a bearish divergence signaling weakness

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© 2007 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
ICAP Enterprise Software
Jersey City, NJ
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