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The only circumstance that sets the present environment
apart from the absurd peak in 2000 is that Gross Domestic Product has expanded
by roughly 35% since then. The economy is substantially larger and
apparently can continue to support an ongoing mania for the present.
At the March 2000 peak, GDP was less than $10 trillion. GDP is now
more than $13 trillion. But the real news as far as we are concerned
is that Dollar Trading Volume is now on track to set another brand new
all time record. That's right, higher than ever before.
Dollar Trading Volume in 2000
= $32.65 trillion
Dollar Trading Volume in 2006
= $33.61 trillion (AT CURRENT PACE)
Our first chart tells you all you really need to
know about U.S. stocks. The mania never ended and merely took a time
out. It is certainly worth mentioning that when DTV measured 133%
of GDP in 1929, a mania drove public participation. The same was
clearly true in 1999 and 2000, when stocks traded 328% of GDP. What
can we make of the situation today, when stocks are trading at a pace that
is 258% of GDP, nearly double the pace in 1929?!
Not only are we still in the
midst of a mania,
we are still in the midst
of the greatest stock market mania of all time.
We also measure Dollar Trading Volume versus total
stock market capitalization. Incredibly, at the current pace, we
will exceed trading in 2000 relative to market cap. This is hugely
significant because total market cap was nearly 8% higher in 2000 and was
close to 13% higher at the March 2000 highs.
This means that no lessons
were learned in the
45% collapse in price from
March 2000 to October 2002.
This means that fear is no
the stronger emotion in the
Greed has overcome fear.
$99 Trillion And Still Counting
WE'RE ON THE SUBJECT OF A MANIA, HERE'S YET ANOTHER MANIA,
ONE THAT NO ONE, BUT NO ONE TALKS ABOUT - DERIVATIVES.
IS THE FULL ARTICLE THAT ORIGINALLY RAN IN THE FEBRUARY 27, 2005 ISSUE
Subscribers have access to our newsletter archives
and are advised to check out the June 20, 2005 issue ("Well, Not Really")
for what was possibly our strongest commentary of the year. It's
that long since we covered the derivative scene in print, and high time
that we did again. The charts presented today are created from data
through the third quarter of 2005, so this is not even a glimpse of year
end activity. Still, it's another brand new record and by a lot.
Total notional values in derivatives for U.S. banks increased at least
12.4% last year to just under $99 trillion. That's right, trillion,
99 followed by 12 zeroes. The phenomenal growth in derivatives dwarfs
the stratospheric rise of the major stock averages into the mania’s peak.
Notional values have nearly tripled since the end of 1999 and are 6.9 times
the size of total stock market capitalization, versus less than double
market cap six years ago.
The first year we have data for is 1991, when notional
values were only $7.3 trillion. Since then, average annualized growth
has been an amazing 20.4%. Growth barely slowed in the last six years
to 19% and bear in mind, the fourth quarter of 2005 still hasn't been reported.
At the end of 1999, ten weeks before the stratospheric blowoff in Nasdaq,
notional values were 3.7 times the size of Gross Domestic Product.
They are now 7.8 times GDP. As the Long Term Capital Management fiasco
showed in the fall of 1998, growth in derivatives has far outpaced our
ability to monitor the size and effectiveness all derivative instruments.
Although risks for one party are typically counterbalanced by an offset
for the party on the other side of the transaction, risks cannot be laid
off in perpetuity. Somewhere along the line, the risk of the transaction
must be borne - if necessary, by the market (read the financial system).
As we have maintain so many times before, systemic risks cannot be totally
arbitraged away by counter parties or otherwise removed entirely from the
GM' s $30 billion in debt is linked to about $200
billion in derivatives (see http://tinyurl.com/fk3k6).
As Henry Sender's WSJ article states, "But because such derivatives don't
trade on an exchange, nobody knows for certain how much credit-default
swap protection has actually been written on GM. And nobody can say with
confidence that they even know who is on the other side of the trades that
they have entered into." If GM defaults in a bankruptcy, someone
is going to get screwed. As noted by Goldman Sach's E. Gerald Corrigan,
"One of the areas that needs watching is that the volume or value of deliverable
bonds is smaller than the value of the potential claims."
If only 1% of the total of $98.78 trillion in derivatives
represents real credit risk in a worst case scenario, the potential fall
out of nearly $1 trillion has the capability to collapse the entire financial
system. Clearly, we came close in 1998. The Fed was forced
to “invite” all the major banks and brokers to a closed door meeting (see
When Genius Failed: The Rise and Fall of Long-Term Capital Management by
Roger Loewenstein - ISBN 037550317X) in order to plan a $3.6 bailout to
save the hedge fund. As Publisher's Weekly surmised, ".... questions
arose about why usually independent banks would band together to save a
single privately held fund. The short answer is that the banks feared that
the fund's collapse could destabilize the entire stock market."
It is with some measure of alarm that we report
the derivative market is now three times the size it was when LTCM ruptured.
The ten-sigma event that led to the near collapse was inevitable.
Despite the apparent "safety" of extremely low odds events, the passage
of time always assures they will occur! In the June 20, 2005 issue,
we related how GLG Partners suffered hugely when an eight standard deviation
event disrupted a trading model. The odds of the event were so rare
that the model claimed the consequences could be ignored. Ignored?
One look at the chart below should be sufficient to question how worst
case scenario consequences could ever be ignored, no matter how remote
the possibility. Essentially, 96% of derivatives are suffering an
average credit exposure of 343% of risk based capital.
The picture of notional values vs. total assets
is equally disturbing. Perhaps giant JPMorganChase considers the
company adequately hedged on all transactions (and we're certain they do),
but as LTCM and GLG and countless others in the last decade showed, worst
case scenarios and extremely low odds events do occur and they occur all
too often. We can only wonder where derivative growth may be headed.
Ten times market cap and GDP? Twenty times? What will happen
when the inevitable $100 billion blow up occurs? Can the Fed broker
a deal that large? More importantly, will we ever see total transparency
in the market? As Henry Sender's quote in the third paragraph of
this article clearly implies, if ".... nobody can say with confidence that
they even know who is on the other side of the trades that they have entered
into," then clearly, no entity can ever be in a position of totally avoiding
The risks are huge and they
are growing every day.
The Dead Zone (Reprised)
THE APRIL 24, 2005 ISSUE OF CROSSCURRENTS
Twice each year, we examine a most unusual phenomenon
that has ruled the stock market for well over 50 years. Simply put,
virtually all of the price gains in stocks have come during the months
from November through April. The phenomenon has been written about
extensively by Yale Hirsch, Norman Fosback, Sy Harding and your Editor,
who first covered what we call the "Dead Zone," perhaps 15 years ago.
In chapter seven of his book, Riding the Bear (ISBN: 1-58062-154-6), Harding
describes the seasonal phenomenon in depth. The chapter is titled,
"The Best Mechanical System Ever" and the author even shows how, with a
few logical and tiny tweaks, the seasonal effects would have generated
fantastic gains. Harding graciously included your Editor's own research,
which confirmed this most amazing dichotomy.
Since 1950, from May through October, you might
as well have put your money under the mattress and you would clearly have
been better off in a simple bank savings account. The statistics
are indisputable. Measured via the Dow Industrials, if you had invested
$10,000 in stocks solely during the period from November through April
each year since 1950, you would now have nearly $540,000. However,
if you had done the same solely from May through October each year, you
would now have a mere $10,549. The good six months generated a 15%
return, whereas the bad six months generated a tick more than nothing.
And consider the following; inflation would have taken a harrowing toll
on any monies invested in the Dow solely from May through October since
1950, a stake of $10,000 would be worth less than $1300 today, measured
in 1950 dollars!
Our featured chart illustrates the seasonal dichotomy
with astonishing clarity. Is there any doubt at all that stocks have
not been for all seasons, in contrast to what Wall Street would have you
believe? Even more distressing is the tally of returns during a secular
bear market, like the one that endured from 1966 to 1982 (see page two,
chart at bottom left). Although the so-called "Nifty Fifty" did indeed
go on to record gains into the end of 1972, the Dow topped out at just
over 1000 for the first time in 1966 and was only a few points higher at
the January 1973 peak (and didn't pass the 1000 mark for good until 1982).
Most stocks had seen their peak a half dozen years earlier. Then,
from 1966 to 1982, even the good six months averaged only a 4.5% upside.
During the Dead Zone, prices declined by an average of 3.3%. Our
chart amply illustrates just how investors suffered during the stock market's
weak season in the last secular bear market lasting 16 years, a total
of 56% in nominal terms.
Dead Zone returns actually peaked in October 1965,
more than 40 years ago! Over the last four decades, the Dow has declined
by roughly 33% during the Dead Zone! Adjust those results for inflation
and the decline becomes a staggering 89%! Is it not amusing that
Wall Street covers up this phenomenon?*** Considering our next chart
at bottom right, we can only wonder why inflation is not a more well considered
factor when viewing the longer term prospects for stocks. Clearly,
inflation adjusted returns were under 3% for a very long time, March 1974
to January 1996 - a span of 21 years 10 months! If returns could
stay that low for so long, they can certainly return to those levels.
Ironically, if that same 3% inflation adjusted return was indeed achieved
this year, the Dow would trade about 18% lower, precisely in line with
our forecast of a high probability of a 15%-20% correction this year!
Chalk up more credibility for our forecast.
Will the Dead Zone continue to work? We cannot
say with complete certainty, but the apparent reasons why the seasonal
phenomenon exists have not changed. January and April have been the
best months for stocks for as long as we can remember and it is obvious
that the primary reason is that mutual fund inflows have been the highest
in those two months. In our next issue dated May 8th, we will examine
these factors again in depth. Stay tuned.
***Since this statistic is so sensational,
we should probably back it up with the math. Our theoretical $10,000
invested solely in the Dead Zone period in 1950 peaked at $15,159.89 in
October 1965. The CPI then stood at 31.7. The CPI as of last
October was 199.2. Thus, inflation had eaten away all but 15.9% of
the 1965 dollar (31.7/199.2=15.9%) and the Dead Zone investment is only
worth roughly two-thirds in nominal dollars what it was worth in 1965.
Multiply 67% by 15.9% and the result is 11% of the original investment,
equating to an 89% decline in purchasing power.
Thus, not only are we still
in a mania, we are still in an environment where seemingly no one is concerned
about the historical record that amply illustrates no money has
been made between May and November in the last 55 years.
Complacency on a startling
Great Paper Chase Is Ending
EXERPT BELOW IS REPRINTED FROM THE APRIL 3, 2006 ISSUE OF CROSSCURRENTS]
IS UPDATED -
Demand for hard assets in
the future could be staggering. The chart of the Dow/Gold ratio below
illustrates the shift from paper assets is clearly underway. “Resistance”
at the prior low of 22-1 in February 2003 was broken so conclusively and
substantially that we can only infer a super bull market is now in place.
This ratio averaged 16.08 during the decade of the 90s and has averaged
12.77 since 1975. The ratio is now 19.08 and if we are correct, has
much further to go. We believe the two aforementioned ratios will
be tested in the next few years to come and we should eventually expect
a return of the levels experienced before the mania for stocks commenced,
at least a 10 to 1 ratio. Since our worst case scenario for stocks
is now the 5% regression line for the Dow (see the January 9, 2005 issue
of Crosscurrents), we can easily extrapolate the possibilities for Gold.
Bear in mind our low target for the Dow will increase at 5% per year from
8483 this year to 10,827 in five years. A Dow/Gold ratio of 15-1
would place a worst case for bullion between $565 to $722 per ounce.
A Dow/Gold ratio of 10-1 would place a much better case for bullion between
$848 to $1083 per ounce. What if the Dow trades higher? That
would mean even higher gold prices. Interestingly, in our view, these
are modest extrapolations. Given gold’s volatile past, a 10-1 Dow/Gold
ratio may severely understate the case for hard assets. If it is
a super bull market, practically anything is possible.
IF YOU WISH TO SEE THE ENTIRE
ARTICLE, PLEASE CONTACT US
AND WE WILL BE HAPPY TO FORWARD
THE APRIL 3, 2006 ISSUE TO YOU.
Six years later, nothing
has been learned from the 45% collapse in prices from 2000 to 2002.
Dollar Trading Volume is on pace to establish a brand new record high.
But the many commodities bull markets are ample evidence that the great
paper chase is in the process of ending.
stock market mania of all time is ending.
We have now
established a new secondary secular bear market low target of no lower
than Dow 8000 and more likely, Dow 8500. These levels equate to SPX
980/995 & Nasdaq 1750/1775. Caveat: these levels could
be achieved several times in the next few years and it might be
another decade before a new secular bull market is capable of taking all
of the major averages above the peak achieved in 2000. While the
Dow clearly maintains the best chance of achieving new highs, the SPX is
still 23% away and Nasdaq is 134% from the all time highs.
Targets for 2006
Dow 11,670 /// SPX
1326 /// Nasdaq Composite 2375
Targets for 2006
Dow 9300-9400 ///
SPX 1050-1060 /// Nasdaq Composite 1800-1900
Odds favor that the
highs for 2006 have already been achieved
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again. If you know anyone who might be interested in seeing what
we have to offer, we'd be happy to have them visit as well!
Alan M. Newman, May 26, 2006
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