Bill Cara has enjoyed a highly successful securities industry career in Canada and abroad. Today he publishes one of the world's most popular and widely acclaimed trading blogs ). His weekly column for ADVFN looks at trends and cycles at work in the US and Canadian capital markets.

Equity Bear Markets in Progress and Why

07/05/2006

My last article for ADVFN, dated March 22, was entitled, "The importance of holding cash". In April, the FTSE and Japan's Nikkei 225 topped out, and most other equity markets around the world have been falling since May 10. So, events showed my advice to have been timely.

On May 10, the Federal Reserve Bank reported the U.S. economy was slowing and inflation growing. That is a scenario that will cause theto fall, and to negatively impact exporters in Europe, the Americas and Asia-Pacific. And that is a good reason to be holding cash, while awaiting the equity market to rebalance potential rewards with the risks involved.

The Fed decision to raise the Federal Funds Rate to 5.00 percent in May had been expected. What was not expected, however, was the Fed's indication that growth and inflation risks were no longer in balance, and that growth would moderate due to higher energy costs and a slowdown in the housing sector.

Everyone now, it seems, is concerned about the plight of the American consumer, the lack of U.S. government fiscal restraint, and prospects for the $USD, and what that means for exports to America.

Global Market Summary :

International Equities:

For the most part, the equity markets of emerging economies and advanced economies peaked May 10, which I believe was the starting point of the 2006-xx Bear Market. Two of the three most important equity markets of the world [FTSE (UK) and Nikkei 225 (Japan)] peaked in April. The final important up leg of the 2002-2006 Bull Market started in October 2005 across the board, and that ended. The current and final upleg, which started this past week, is likely to be relatively muted.

So far this year, the leading Asia-Pacific equity indexes (Nikkei 225 and South Korea's KOSPI) are down, while Canada plus the three leading European equity indexes (FTSE, DAX and CAC) are up and so is the Bombay Sensex Index of India. But except for the FTSE, which peaked a couple weeks earlier, the whole lot of them peaked right at the time of the May 10 FOMC announcement.

U.S. Equities

In summary, I believe the U.S. equity market passed a peak in its long-run bull cycle on May 10, and has entered a period a declining prices, which following a brief intermediate-term bull cycle that started on the day of the last Fed meeting (June 29), shall not recover to the prior cycle high.

I believe new cycle highs for U.S. equities will not be set in the present rally. It is a rally where stocks will mostly be distributed. From these levels (11,200), the Dow 30 will likely decline by perhaps -21 percent. I forecast a Bear Market low of about Dow = 8800 in 2H06.

U.S. Sector ETFs

Eight of 10 U.S. sector ETF's I track were up over the first six months, but three were trading up less than +1.2 pct YTD (consumer cyclical XLY, utilities XLU and financials XLF), so without last week's rally (Thursday and Friday), it could have been 5 up and 5 down for the ETF's. The two big winners YTD were telco service IYZ (+11.7 pct) and energy XLE (+7.7 pct), while the two losers were semiconductor/tech SMH (-13.2 pct) and healthcare IYH (-5.0 pct). Following a Bear Market, I believe that the semiconductor/tech sector ETF (SMH) will be a leader on the upside.

U.S. Bonds and Interest-Sensitive Equities

Over the first six months, interest rates in the U.S. were continually rising, which meant that bonds and interest- sensitive equities did poorly. In fact the price decline in June was such that I almost issued a "Buy Alert" opinion but for the fact the bonds did not quite drop down to my Accumulation Zone. I think the recent buying of these instruments was short-covering only, and a lower price will soon occur, which will likely generate a 'Buy Alert' for U.S. bonds this summer.

Commodities

The commodities index ($CRB) started an intermediate-term rally on June 14 after reaching a cycle low of 329.61 on June 13. Except for the current rally, $CRB has been flat on the first half. For the commodities Bull be confirmed, however, $CRB must soon exceed the recent cycle high of May 23 (353.31), which is close at 346.39, and in a rising trend. Interestingly, every time (in the past three years) there was weakness in the commodities index, the technical support levels held up, and there was a confirmed higher low which went on to set a higher high. To sustain a commodities rally at this point (given a period of economic weakness ahead) will require a USD that weakens further, which appears to be the most likely scenario.

Oil & Gas

The U.S. crude oil futures index ($WTIC) jumped +265 pct (a gain of $44.13) from the 3Q03 low of 26.72 to a 3Q05 high of 70.85. But in the nine months since then $WTIC is up just $2.92, and traders are wondering if a global economic slowdown will cause oil prices to peak this year. At this point, it appears that $WTIC will trade close to an inversion of the $USD, i.e., as the USD weakens, $WTIC will strengthen, and vice versa.

Gold

The gold futures index ($GOLD) typically lags the oil price cycle, and is typically the last of the commodity group to reach a peak. Over the past three years $WTIC has clearly outperformed $GOLD, but that situation has reversed in the past year. I hold the view that $GOLD, like $WTIC, will trade close to an inversion of the $USD for the balance of this market cycle, except that $GOLD will outperform $WTIC on the upside. I believe that a new cycle high above $750 will be set within six months for $GOLD, which would be a gain of +21 pct or more. I also believe that between now and the next U.S. Presidential election (Nov-2008), the $USD will collapse further, based on U.S. economic and fiscal problems, and that $GOLD will rise to over $850, possibly over $1,000.

Goldminers

For the most part this year, the goldminer shares have performed well. Agnico-Eagle (+5.1 pct), Meridian Gold (+32.2 pct), Lihir (+28.2 pct), Glamis Gold (+27.3 pct) and Goldcorp (+24.9 pct) are among some of the mid-cap and large cap leaders. The small and mid-cap stocks in this sector have outperformed and will continue to do that because they have the best profit:gold price leverage in the latter half of a bull phase for the miners.

Forex

Trading in the $USD has been extremely volatile. One year ago, $USD hit an intermediate cycle peak of 90.77, which was followed to an even higher peak in the next cycle (Nov-2005) of 92.63. On May 15, $USD reached a cycle low of 83.60, which was reached again in early June at 83.72. Subsequently the $USD rallied to 87.05 before closing the first half at 85.17, following a two-day plunge after the FOMC announcement on June 29. I believe that what happened that day was that traders perceived a huge jump in the U.S. money supply was needed to keep the bond market yields from rocketing up, which would have been a disaster for the housing industry. With a Fed Funds Rate now at 5.25 pct, it appears to me that any further rate hikes will have a deleterious 'tipping point' effect on the U.S. economy that will send it into a tail spin.

The bottom line to the Administration's strategy for the past few years that increased spending combined with tax reductions was it failed because it caused too much money to be printed, which was invested/spent/wasted abroad, thereby causing the $USD to drop like a stone in a sea of liquidity. In retrospect, I think the Administration's policy would have worked had the Fed under Greenspan opted to start raising the Fed Funds Rate a year earlier, and stopping the hikes about six months ago, with a couple pauses in between. But frankly, Congress has to tighten the reins on spending, and the new Treasury Secretary and Fed Governor need to be successful in organizing an international (G-20) agreement only currencies . Until then, I think the $USD is headed much lower.

To Conclude

It is my belief that price motion in capital markets is caused by mostly natural phenomena that culminate in periods of rising and falling corporate fundamentals and quantitative results, and macro economic scenarios, all of which combine to impact market prices. While a matter of conjecture, how far prices rise and fall in cycles should not be our concern. Our focus should be entirely on the matter of trend, and with respect to equities, the selection of the shares of the best quality companies, with timely acquisition on the basis of technical indicators.

I believe that the long-term bullish trend in equity prices has reversed for reasons related to the U.S. . Until conditions are right for the $USD to trade in a narrow range for an extended period of time, enabling levels of international trade and capital expenditure to expand naturally to where wealth is created faster in America and also Europe, and at a slower pace in emerging economies (China, India, Brazil), I think the financial world will be in turmoil. It is after all, the health and wealth of consumers in the most advanced economies that put the capital markets on an even keel.

Until these issues are resolved, there could be a protracted period of extreme volatility ahead for financial markets. The forthcoming bear market in equities is likely to be just one small step forward.

U.S. Bear market rally may be over 09/07/2006 In a survey of 2,000 U.S. CEO's, the respondents stated they are less confident today in their company's future than at any time in the past three years. The problem they say is their inability to control rapidly growing costs, or to pass it through to customers. They also say that, at an acceptable price, it has become very difficult to recruit the staff they need to meet future needs. Today the U.S. Productivity and Cost data shows that Unit Labor Cost (ULC) points toward an annual increase in labor cost well above +4.0 pct, whereas the annual productivity increase has fallen to well below +2.0 pct. This indicator of inflation is not good news to those bond traders who, through the Labor Day weekend had figured inflation was dead. Not! U.S. bonds have been zooming recently, but if you look at the broad equity index charts lately, you'll see that as and when the bond market heads north or south, so too do equities. So, a falling bond market will not auger well for equities. A reader of my blog sent me a letter this morning that I think speaks to the point I made in my weekend report, which is that the U.S. equity market has been experiencing a bear market rally, which is a good time for traders to be selling into strength. The reader stated: "A curious development is that while nearly 80% of components are above their 50-day averages, less than 40% are above their 200-day. This is an unusually wide spread - over the past decade, only three times have we seen a similar thing - those being early May 2001, mid-August 2002 and late October 2002. All of those, of course, were classic bear-market rallies. Hmmm..." I think it's time to watch the stocks that have rising short-term prices (say prices that are above their 50-day MA's) that cannot break out above the higher, but falling, 200-day (40-week) MA's. The best technical evidence I observe today, from Moving Average and Relative Strength Index indicators, is that the Bear market rally may be over. The rally was fuelled by falling bond yields (rising bond prices) that were in turn caused by bond traders who were, at the time, happy with the inflation picture, and not unhappy with the corporate earnings picture. Now the focus will return to continuing inflation (ie, rising wholesale costs), and slowing economic growth (ie, inability to pass prices through to consumers). That means that the rate of growth of corporate earnings will decline. The earnings may even decline in absolute terms. Some refer to that as Stagflation. We last saw it in the latter part of the 1970's, and that was a time when stock and bond prices suffered, and precious metal prices zoomed. Yes, I think it's a good time for bullish traders to start to consider the bear case. The Bear that I say started on May 10 may have returned this week.

King warns of potential equity market crunch MERVYN KING, Governor of the Bank of England, has warned global equity markets could be in line for major falls, believing they have yet to feel the effect of the recent worldwide financial crunch. In a highly unusual move, Britain's leading banker said if major declines were to happen, it could represent a bigger risk to the global economy than the sub-prime mortgage-sparked crisis currently afflicting the banking sector. Despite three months of turmoil in the lending markets, the MSCI world equity index hit a record high at the start of the month and some Asian stock markets are up almost 50 per cent since the start of the year. And while the FTSE 100 index of leading UK shares is still around 300 points off pre-crisis highs of around 6700, the blue chip benchmark is around 500 points higher than its August trough of around 5900. The Dow Jones is also back above its summer lows, although only just. "It's striking that despite developments we've seen in the last three months, equity prices are on average higher now than they were in August," said Mr King. And he felt that stock investors were still seemingly ignoring the re-pricing of risk in many other markets. "This is true around the world and in emerging markets, they're 20 per cent higher. There must be some downside risks there," Mr King added. In terms of potential risk stemming from equity market slides, he said: "That's a bigger risk to the global economy than the narrower one focused on the banking sector." Rock move sparks growing share war NORTHERN Rock's leading shareholder, SRM Global, has cranked up the pressure on the Virgin Group's status as preferred bidder for the stricken bank by increasing its stake in the target for the second day running. SRM, a Monaco-based hedge fund run by multi-millionaire former UBS trader Jon Wood, raised its holding to 9.1 per cent from 8.5 per cent. It followed the hedge fund increasing its holding the previous day to 8.5 per cent from 6.84 per cent. Wood is famous for his £100 million Gadget Shop legal case against entrepreneurs Sir Tom Hunter and Chris Gorman two years ago. SRM said it had bought another 2.5 million shares in the embattled lender at 114.7p. That compared with a market-closing price yesterday of 120.7p, up 1.68 per cent on the day, the third consecutive day of the stock rising since Sir Richard Branson's consortium was confirmed as preferred bidder by Northern on Monday. SRM's stake-building is widely seen as evidence of Wood's determination that the bank will not be sold on the cheap. Nobody was available to take calls at SRM's HQ in Monaco. RAB Capital, another hedge fund and Northern's second-biggest shareholder with a holding of about 7 per cent, has previously called Branson's bid "cheeky" and too low. It is understood that RAB has not so far decided whether to increase its stake as well in a bid to derail Branson, among whose backers is Toscafund, an asset management group chaired by Sir George Mathewson, former boss of Royal Bank of Scotland. One source said: "The hedge funds clearly are irritated that Richard Branson [Virgin's owner] will just get a massively dilutive bid waved through because the government wants the Northern Rock debacle off its hands." Meanwhile, the Treasury declined to comment on reports that Luqman Arnold's private equity firm Olivant has been given an undertaking by the Tripartite Authorities - the Treasury, Bank of England and the FSA - that he will get as much information on Northern as Virgin had even though his proposal was not a full bid for the company. Instead, Arnold, a former chief executive of Abbey National, wanted to parachute in management to turn Northern around while taking a minority stake. A Treasury spokesman said: "It is a commercial process and sensitive. We would not talk about individual parties in a situation like this." But the Treasury did say it was "not ruling anything out at this stage". A spokesman said: "While the Virgin consortium's proposals are in line with the principles set out by the government, we are keeping all options open with regards to other bids and the future of Northern Rock." The Virgin consortium is offering to put in £1.3 billion of funds into Northern Rock in return for a stake of at least 55 per cent, with some of the funds raised by offering shareholders further shares at a discounted 25p each. The deal is thought to value Northern Rock at around £225 million - a fraction of the £5.2bn value seen in February before summer's crisis hit. EDINBURGH JOBS 'COULD BE REDEPLOYED' STANDARD Life will attempt to redeploy the majority of the 50 Edinburgh-based staff earmarked for redundancy following the decision to stop selling protection products in the UK from next month. Although the insurance and investment giant will continue servicing thousands of existing customers, the life insurance, critical illness and income protection plan business will close. Standard Life said the decision relates to the UK protection market continuing to be "price competitive". The current protection exposure is "sub-scale", the firm noted, and represents less than 1 per cent of all Standard Life sales. Figures from the Association of British Insurers show the firm's share of the UK protection market was just 0.6 per cent in 2006. Paul Kibble, a spokesman for Standard Life, said: "It makes more commercial sense to focus our resource and investment on other lines of business which are able to generate more profitable returns. "This is consistent with our corporate strategy of making the best use of capital in order to maximise shareholder value." Kibble said the difficulty in growing the protection part of the business was a reason for its demise. "The small size of the business meant it was unable to compete with other competitors and growth was slow. Clients can make alterations to their policy; they can still top up their cover. The change is just about new sales." The firm has some 400,000 protection customers on its books. Buchan to take over helm at SLI JANE BRADLEY ROYAL Bank of Scotland director Colin Buchan has been named as the new chairman of Standard Life Investments. Already a member of SLI's board, Buchan is to replace Hugh Stevenson, who is to retire from the post after nine years on the board. Buchan, an RBS non-exec and the former global head of equities at UBS Warburg and a member of the group management board of the Swiss bank, is also a director of Merrill Lynch World Mining Trust, Merrill Lynch Gold, World Mining Investment Company and Royal Scottish National Orchestra Society. Announcing the succession move, Standard Life group chairman Gerry Grimstone said: "I am delighted that Colin Buchan has been appointed to the board. He has been a very successful vice-chairman and will bring extensive experience to our deliberations." He added: "We will miss Hugh Stevenson greatly when he retires in May. He has been a great source of wisdom and authority, and has made a very significant contribution to Standard Life over the years. "Hugh has also played a key role in helping develop Standard Life Investments into the leading position that it holds today." Stevenson has been a director of Standard Life since 1999 and has served as senior independent director since 2003. He has been chairman of Standard Life Investments since 2004. Buchan is to take on the chairman's role when Stevenson steps down from the post at May's annual shareholder meeting. In a separate appointment, Lord Norman Blackwell is to become the company's senior independent director. Blackwell, who has been a director of Standard Life since 2003 and is chairman of Standard Life Assurance, will also take up his position at the conclusion of the AGM. Related topic Iomart hit by extra cost of datacentres INTERNET services group Iomart has seen half-year pre-tax profits reverse into the red following significant investment into its datacentres. Operating losses in the six months to the end of September were some £400,000, hit by the £9.6 million cost of acquiring the datacentres. The Glasgow-based firm said it had seen a "substantially improved" performance in its existing businesses which posted operating profit of £1.2m, excluding the datacentre operation in London, which Iomart noted was now fully operational. The datacentres provide the remote hosting of servers, for which demand has risen over the past few years as time lost from servers being down results in a loss of online sales. The company said it expected to meet end-of-year forecasts.