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Trouble, Trouble Boil and Bubble!

By: David Chapman

-- Posted Friday, 8 April 2011 | | Source:

 (Apologies to William Shakespeare - from Macbeth)




26 Wellington Street East, Suite 900, Toronto, Ontario, M5E 1S2


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In March 2009 the markets found a bottom from the financial panic of 2008. The collapse was of historic proportions, with only the Great Depression of 1929-32 being bigger.


But two years later the S&P 500 is still down almost 16 per cent in real terms from its nominal high seen in 2007. In inflation-adjusted terms it is down over 30 per cent from the real highs it made in 2000. By that measure, things are actually worse than they appear. The TSX Composite, thanks to its commodity base, has fared much better: down 7 per cent from its nominal 2007 high and down only 14 per cent from its real high, also in 2007.


Investors should count their blessings, though. The Tokyo Nikkei Dow made its nominal high back in early 1990 and today it is still down 74 per cent. Some have compared the current North American markets with Japan’s 21-year nightmare. Could it happen here?


Well, it is interesting to note that in April/May 2001 the Nikkei made a high still down 63 per cent from 1990. That is worse than the current position for the North American markets, but ten years later the Japanese market is down another 33 per cent. In inflation-adjusted terms the Japanese markets are without a doubt even worse. If you live in Japan this has not been a pretty picture.


Market sentiment, as measured by the Investors Intelligence Bull/Bear Ratio (chart below), remains quite bullish with readings still over 50 per cent bulls. It has come down from highs closer to 60 per cent earlier in the year. The events in the Middle East/North Africa and Japan have provided some cooling. Similar high readings were seen in the sentiment indicator in 2007 at the market highs. By the lows of 2008 the sentiment indicators had reversed themselves.


It is surprising that the stock market sentiment indicator is doing as well as it is, considering the weak consumer confidence. This is assessed monthly by the Conference Board in the US. It gauges consumer confidence about the outlook for employment, business and household income. It is watched closely by economists and Wall Street as a reliable indicator of consumer expectations and attitudes. Today it is some 50 points below its peak in 2007, which was just before the sub-prime mortgage collapse got underway. This chart is also shown below.







It appears that these two measurements of sentiment are at odds with each other. Stock market bullishness remains high, near the levels seen in 2007. Consumer sentiment, while off the lows seen in March 2009, is well below its 2007 highs.


They are reflecting two different views. While the wealth market has done quite well coming out of the panic and crash of 2008, the weak consumer confidence index reflects Main Street’s malaise, where unemployment remains high and the housing market is moribund. Over 11 million housing units (of a total stock of about 128 million) have the value of their mortgage higher than the value of the property. Some 4.6 million homes are more than 30 days delinquent. It is forecasted that there will be an additional one million foreclosures at least in 2011.


Housing prices have fallen relentlessly in the past few years and are now back at levels seen in 2002. New home sales are down roughly 70 per cent from levels seen in 2006 and there is over seven months of supply available. Existing home sales are down 25 per cent from 2006 levels and there is eight months of supply available. Housing inventory is roughly where it was in 2006.


On the employment front, job growth is the slowest on record coming out of any recession and is failing to keep up with population growth. The official unemployment number of 8.8 percent is from the Bureau of Labour Statistics (BLS) U3 report. The BLS U6 unemployment figure was recently reported at 15.7 per cent; U6 includes long-term unemployment and those working part-time who want full-time work. If unemployment were calculated as it was before 1994 the rate is closer to 22 per cent, according to This includes those unemployed for over one year. Since the recession bottomed in late 2010 these numbers have barely budged.


One of the more discouraging numbers is the average duration of unemployment. Before the recession started it was around 17 weeks. Today it is approaching 40 weeks and still climbing even as the U3 unemployment rate is falling. It has never been this high since reporting started prior to 1950. The U3 figure translates into 13.5 million unemployed but U6 is about 28.2 million. In order to bring unemployment back to six per cent, the US economy must add a net 360,000 jobs every month over three years. Current growth is nowhere near that level.




Other disturbing unemployment numbers are seen in civilian participation rates, civilians unemployed over 27 weeks and unemployed and discouraged workers. What these charts are saying is that the levels are the worse not only seen in years but going back 60 years. The participation rate has been falling despite the labour force remaining static to rising. Population growth would do that alone. The number of long term unemployed has never been so high and the unemployed and discouraged workers number some 9.5 million.









While the problems in the broader economy, in employment and the housing market, are well documented, the wealthy have actually increased their share of the wealth over the past few years. This has translated into a stock market that, while not back at the highs, has at least recovered most of the 2007-08 losses.


The Gini coefficient is a measure of inequality of income distribution – perfect equality is 0 and perfect inequality is 100. According to the CIA, the US has a coefficient of 45, which is higher than Russia, China and Iran, and on a par with Uganda, Jamaica and Argentina. These levels are for 2007; it is suspected that the Gini coefficient for the US has since risen. (The Canadian Gini coefficient is 32.1. The Scandinavian countries have the lowest, in the low to mid-20s). The Gini coefficient today is at or higher than where it was in 1929 just before the Great Depression. In the US the coefficient made its reported low in 1968 at 38.6 although it is estimated to have been down to about 37 following WW2. It is estimated today to be over 47.


Some 20 per cent of the US population controls 84 per cent of the wealth. High wealth inequality is often associated with unstable countries or dictatorships. Over 44 million Americans are on food stamps – 14 per cent of the population. This number roughly corresponds with the number living in poverty.


Major problems in the housing market, continued high unemployment and growing inequality of wealth is not a picture of economic strength, despite the reporting of seemingly growing economic numbers. For the fourth quarter of 2010 the Bureau of Economic Analysis reported that GDP grew at a rate of 2.8 per cent. According to it actually shrank by 2.2 per cent, and the US economy has been contracting since the fourth quarter of 2004 – a recession now stretching into its seventh year. The Shadow Stats number is adjusted for distortions in reported government inflation usage and methodological changes that have resulted in an upward bias to official reporting.


If all these issues weren’t enough trouble, debt levels remain extremely high. The US is the most indebted nation in the world and it has been suggested that US sovereign debt will never be repaid. It has been said that the US could raise the tax rate to 100 per cent and it would still be insufficient to cover all of the commitments made to Social Security, Medicare and Medicaid. It is estimated that unfunded liabilities are anywhere from $70 trillion to $200 trillion, with the best number being around $113 trillion. The US, not including the Federal Government, is estimated to hold roughly $77 trillion in assets. It is estimated that the total assets of the US economy is $188 trillion.


The US is just the largest of the debtors, but most of the western economies (US, Canada, European Union, plus Japan) are buried in debt that is unlikely ever to be repaid. The US is expected to see 1.6 million bankruptcies in 2011. Medical bills trigger over half of the bankruptcies. It is noteworthy that three years after the financial panic and crash of 2008 that countries still need to be bailed out the most recent being Portugal.


The US is facing a severe budget crisis and the need is chronic to raise the current debt level or the shutdown of the US government could occur. The White House Administration and Congress are facing off against each other. US corporations are flush with money but it should be noted that their funds are largely held offshore in the broader global economy. US States are struggling with debt and budget deficits. Attempts to close the gap are leading to clashes between state administrations and workers. There is fear of a US state default. Many domestic based corporations are also equally struggling. The domestic situation of the US is a huge disconnect with the global multinational corporations.


But potential even worse problems are bubbling elsewhere. The earthquake and tsunami that hit Japan on March 11 was a serious setback. Damage to refineries, power lines and water systems resulted. But the problems with the nuclear power plants led by Fukushima are threatening to push the problems over the edge. With radiation leaking into the sea and the land, fishing industries could be devastated and land around the nuclear plants poisoned for decades. There are few good estimates available about the extent of the damage. Japan has now been hit by another earthquake/tsunami of smaller magnitude then the one on March 11. It is unknown at this time what further damage this may cause.


As the Sendai region, which was most impacted represents only about two per cent of the Japanese economy the initial impact of the devastation would not appear to have been a huge problem. But it is the problems at the nuclear plants that may be the real killer. It has caused rolling shutdowns of power in Japan and it is having a major impact on large corporations.


Japan, like the Western economies, uses “minimum inventory” in running its plants. This includes the electronics and automobile industries. Already Toyota, Honda and others are announcing plant closings in other countries (Canada, US, India) because they can’t deliver essential parts to these plants. It could result in the layoff of thousands. While other car companies may be able to pick up the slack, they too depend on specialized parts that come from Japan. It could impact their plants as well, causing further shutdowns and throwing more out of work.


With jeopardized supply lines and low inventories, it won’t take long to feel the effects globally. The actual impact of the radiation leaks are unknown and may be worse than is currently being reported. Given the government’s propensity for under-reporting and corruption in the Japanese power industry, it would not be surprising if the news gets worse later.


Some of this might be more manageable if the Japanese economy were strong. But it is not. Its stock market has been in a 21-year funk, as noted earlier. Japan’s debt-to-GDP ratio is over 200 per cent. Not even the US has as bad a ratio. The US government debt-to-GDP ratio is near 100 per cent.


Japan has major assets to draw on; it holds over $900 billion of US Treasuries. Selling them could, however, put severe pressure on the US dollar and could cause US interest rates to rise. Japan also has substantial savings in its postal system, possibly as high as $6 trillion, which it could draw on.


In 1906 an earthquake hit the US at San Francisco. (The two earthquakes, while 105 years apart, were at nearly the same latitude – 37.75 N for San Francisco and 38.32 N for Japan.) The initial reaction of the stock market in 1906 was a sell-off. After that several months of denial set in, but it was eventually discovered that the damage to railroads and transportation systems was more severe than originally thought. Recovery from the damage was going to cause a severe economic contraction. This led to the financial panic of 1907. There were other issues at play, such as the over-use of esoteric financial instruments, but like in 2008 it was only when the economy contracted that these instruments were in trouble and exacerbated the crash. 


The destruction of transportation, factories and rolling blackouts for the Sendai region and other parts of Japan may have impacts that have not been considered yet. The chart below is the Dow Jones Industrials from 1903 to 1908. For some eerie similarities to today, note the crash low in October 1903 followed by a secondary low in March 1904. This time it was the crash low in October 2008 followed by a secondary low in March 2009. What followed was a huge rally that topped in January 1906, a period of almost two years from the March 1904 low. This time a huge rally has occurred that has rallied thus far to April 2011, a period of just over two years.


Bear markets often see two years down followed by two up years then followed again by another two years down although this can range from as short as a year to up to 30 months. In the past decade alone the top of January/March 2000 was followed by two years down to October 2002. A strong rebound followed until February 2004 followed by a rising consolidation that made its final bottom in June 2006.  The final top was seen in October 2007 then the panic and crash into October 2008.


The last major bear market lasted from 1966 to 1982. That market saw the top in January 1966 followed by a low in October of the same year then a top in December 1968. The low from the 1968 top was made in June 1970. Another long rally occurred that carried the market to highs in January 1973 followed by the devastating Arab oil embargo and Watergate crash that bottomed in December 1974. The rebound made its high in September 1976 followed by another long decline until March 1978. The rebound from that low was very anaemic and a two year sideways pattern followed with another significant low seen in March 1980. The rebound from that low was strong topping in April 1981 then the long final decline to the final low in August 1982.


The 1906 market made a good low in July, and then for several months moved generally in a sideways pattern. The market panicked and crashed starting in January 1907, making its final bottom in November 1907.


Chart created using Omega TradeStation 2000i.  Chart data supplied by Dial Data. 


If one thought that the destruction from the earthquake and tsunami and the nuclear leaks were insufficient to tip the world into a steep recession or worse, the turmoil in the Middle East/North Africa may prove even worse.  In a word at the heart of the turmoil is – Oil the engine of the world.    

The uprising that started in Tunisia in January 2011 quickly spread to Egypt, then Bahrain, Yemen, Libya and others. Oil prices at the time were around $90 a barrel. Initially the markets did not think there was much of an issue; over the next month prices mostly trended downward, bottoming on February 15 near $84. It was on that date that President Gaddafi of Libya used military force on protestors. On February 22 oil prices gapped higher from $86 to $95 and have never looked back. Oil prices today are over $108.


Libya holds the largest estimated oil reserves of any African country, at 40 to 50 billion barrels. It has the world’s tenth-largest reserve holdings, well behind Saudi Arabia, Venezuela and Canada. Libya produced about two per cent of global daily production, or 1.7 million barrels. But Libya produces the world’s lightest crude and it is highly prized. Its lost production can be replaced to some extent by Saudi Arabia, the only country with any real production room. But the fact remains that Libya’s oil is highly prized, and numerous foreign oil companies were operating there.


Demands that he step down were met with derision by Gaddafi. Libya threatened to expel the foreign oil companies. This would directly impact Western economic interests. On March 19, under the cover of protecting civilians and blessed by the United Nations, French war planes attacked Gaddafi forces to protect the rebels at Benghazi. Russia, China and Germany abstained at the UN vote and since then both Russia and Germany have criticized the operation, which has now turned into a NATO operation. Its end game is unknown.


Unrest has spread to Bahrain, Yemen, Syria, and even Iraq and Iran. Unrest is also being unleashed in the Palestinian territories against Israel. No attempt has been made to protect civilians in any of these countries. And it is not likely to happen. The Economist noted in its headline article of March 26 that “the West is locked into a military alliance with Bahrain – home to the US 5th Fleet – and its royal family’s protector Saudi Arabia.”


In Yemen, described by the Economist in the same article as an ungovernable snakepit, home to rival tribes, secessionists and a branch of Al-Qaeda, the US had been providing arms and backing for the Yemeni government. Yemen is mountainous and poverty-stricken.


But while eyes are on Libya, they should be on Bahrain. Here the majority Shiite Muslims (70 per cent) are ruled by an autocratic (and Sunni) constitutional monarchy. The Shiite majority do not benefit from the wealth of the country and are largely shut out of government. Saudi Arabia, an absolute monarchy, also has a significant Shiite population (20 per cent), mostly living in poverty. Despite both Bahrain and Saudi Arabia being countries of huge wealth, unemployment particularly amongst young people is quite high. Saudi Arabia sent troops to assist the rulers of Bahrain. According to such sources as Stratfor, it is suspected that Saudi Arabia did so with the approval of the US, and in turn Saudi Arabia backed the bombing of Libya.


Across the Gulf lies Iran, which is not a friend of the West. Iran has the world’s fourth-largest reserves of oil. Iran is Shiite. It is openly backing the majority Shiite population in Iraq, assisting Shiite Hezbollah in Lebanon, and has provided backing to the Shiites in Bahrain and Saudi Arabia.


At one time in history Bahrain was a part of Iran (Persia), as were parts of Saudi Arabia. There is long historical animosity between the Shiite and Sunni branches of Islam, and between Saudi Arabia and Iran (Persia). For centuries, Persia was the dominant empire in the region. Many of the current borders and even countries today were creations of the Western powers (primarily Britain and France) following the end of World War 1, the 1919 Treaty of Paris and the end of the Ottoman Empire. The countries and borders often had little to do with historical and tribal borders. At the centre of it all was oil.


The Middle East produces 56 per cent of the world’s daily oil needs. Much it of goes through two key choke points – the Straits of Hormuz that connect the Persian Gulf with the Gulf of Oman and the Arabian Sea, and the Bab el-Mandab between the Horn of Africa and the Middle East and a link to the Red Sea, the Suez Canal, the Mediterranean and Indian Ocean.


The Straits of Hormuz – only 21 miles wide at their narrowest – are between Oman and Iran. Some 17 per cent of the world’s oil passes through the Straits or 15 to 17 million barrels daily, limited to a channel two miles wide. It is the world’s most important oil chokepoint. The Bab el-Mandab is located between Djibouti and Yemen, two areas where there is now considerable unrest. The Bab el-Mandab is 18 miles wide at its narrowest, within which another two-mile channel sees an average of three to four million barrels of oil per day pass through.


The Middle East/North Africa Arab countries have been ruled by autocratic and sometimes despotic leaders for decades. The people have generally lived in poverty while the rulers often lived in obscene luxury. The economic base of most of the countries is oil, led by Saudi Arabia but also Iran, Iraq, Kuwait, the United Arab Emirates, Libya, Algeria, Qatar, Oman, Egypt, Syria and Brunei. Bahrain at one time had oil. Even Israel (a democracy amongst the Arab autocratic countries) has some oil and some potential huge reserves of oil and gas that lie off the coast of both Israel and Gaza.


The history of the region has been one of co-opting by the West, led by Britain and France following WW1, and later by the US. The story was played out in country after country of co-opting the leaders or assisting in setting up rulers from elsewhere. This was seen in Bahrain, whose Sunni rulers were originally from Kuwait and had co-opted the British in the early 19th century to protect their rule. Britain maintained its fleet in Bahrain until turning it over the US officially in 1991.


The likely outcome of the continuing unrest is unknown. The region is of huge strategic interest to the West, because of the oil. That they have supported and continue to support despotic regimes with little regard for their own people is well known. Unrest is nothing new to the region, particularly on Sunni-dominated Bahrain that has a history of unrest from the majority Shiite population.


The one major country not under the control of the West is Iran. Here, the West has claimed that Iran is trying to obtain nuclear weapons. (Iran is largely surrounded by countries with nuclear weapons: Pakistan, India, China, and Russia, the US in Afghanistan and Iraq, and Israel.)


With Iran openly and covertly supporting some of the uprisings, the risk of an accident in the Persian Gulf is real. That could trigger a broader war where competing interests of the west (US, Britain and France) could clash with those of Iran, Russia and China. And at the heart of it all is oil. Where oil prices would go in such a scenario is impossible to say, but even a spreading of the unrest to Saudi Arabia with its own restive Shiite population could shoot prices to $150 or higher. And if oil prices soared the Western economies could tumble into a steep recession or even depression, dependent as they are on cheap oil to run their economies.


Oil prices have had many ups and downs since the Arab oil embargo of 1973-74, coincident with the West losing its grip on the region it once controlled with little opposition. But the region is a bubble of boiling tribes and divergent interests with oil at its core. And that spells big trouble. A chart of oil since the early 1960’s is below.  


Chart created using Omega TradeStation 2000i.  Chart data supplied by Dial Data. 


A deadly cauldron of rising oil prices given the unrest in the world’s major oil producing region; an earthquake and tsunami that has turned into a deadly nuclear disaster, disrupting the world’s number two economy and others; the major Western countries awash in debt and the world’s reserve currency on a downward spiral. It all makes for a deadly brew of trouble that is boiling and bubbling. How it will play out is unknown. But given the current direction it is not pointing to a happy ending. No wonder gold and silver prices are soaring as a potential perfect storm of geopolitical and macroeconomic risk takes hold.



David Chapman is a director of Bullion Management Group Inc. the Manager of the BMG BullionFund and the BMG Gold BullionFund


Copyright 2011 All Rights Reserved David Chapman


General Disclosures

The information and opinions contained in this report were prepared by MGI Securities. MGI Securities is owned by Jovian Capital Corporation (‘Jovian’) and its employees. Jovian is a TSX Exchange listed company and as such, MGI Securities is an affiliate of Jovian. The opinions, estimates and projections contained in this report are those of MGI Securities as of the date of this report and are subject to change without notice. MGI Securities endeavours to ensure that the contents have been compiled or derived from sources that we believe to be reliable and contain information and opinions that are accurate and complete. However, MGI Securities makes no representations or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this report or its contents. Information may be available to MGI Securities that is not reflected in this report. This report is not to be construed as an offer or solicitation to buy or sell any security. The reader should not rely solely on this report in evaluating whether or not to buy or sell securities of the subject company.



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