Volume I, Issue 45

BASE-BUILDING PROCESS HAS PRODUCED STRENGTH AS US BAILOUT MEASURES ARE ENACTED. ASSET PRICES ARE STILL DISTORED AND COULD SNAP BACK CLOSER TO NORMAL ANYTIME. A RETEST OF THE OCTOBER LOWS IN A FEW WEEKS IS STILL POSSIBLE.

The Oct. 15 update was one of the earlier reports to state that investors had likely seen the worst of the declines and that North American stock markets were transitioning to a base-building phase. That is exactly what has happened since the Oct. 10 lows. There have been some gut-wrenching declines as recently as last Monday, but they have been followed by huge advances. While this October was the worst in 10 years, last week the DJIA had the strongest advance since 1974. The TSX had stellar gains for three days in a row -- something that has not been seen for awhile.

There have been some fundamental improvements as well. After approving a bailout package weeks ago, the US government invested $125 billion in healthy banks, which equates to $1.25 trillion in lending capacity. On Oct. 27, the Fed's Commercial Paper Funding Facility opened and $100 billion of commercial paper was issued last week. This has improved liquidity and continued to reduce interbank lending rates even though they are still at distressed levels. A half point cut in US interest rates on Wednesday was another attempt to throw gas on a smoldering flame. Week ago, I mentioned that as a problem gets worse, more and more energy is devoted to solving it. Authorities have now done much of what they can do to improve liquidity. The focus is now shifting to helping the economy. While the US economy has been okay up to this summer, US stock markets have been declining since October 2007 and have fallen as much as they would if a very severe recession had occurred. Therefore, it is most likely that the worst-case scenario has already been factored into current stock prices, even if the US economy continues to deteriorate into 2009. Tomorrow's election will also improve the investing climate, as an issue of uncertainty is resolve.

Green indicates an uptrend and red indicates a downtrend in this short-term trend chart of the SP 500 Index. When this turns green it will issue a short-term buy signal. This short-term indicator should be used together with the following two longer-term indicators for confirmation.

So far, equities have followed a pattern very similar to the financial panic of 1907. That liquidity crisis occurred after US and British insurance firms were unable to cover the losses when an earthquake destroyed San Francisco in 1906. If markets continue to follow that path, there should be further major advances in the coming weeks with only small declines along the way. US equity markets recovered most of the losses of 1907 in 1908. Canadian markets usually follow the trend of US markets.

On the other hand, in a normal correction scenario, the markets should advance for another week or two and then retest the Oct. 10 low in the latter half of November. However, the successful retest of the Oct. 10 lows on Monday, Oct. 27 may mean that another retest in late November is not needed anymore. Either way, the coast should be clear for a major advance by the end of November, if not before.

It is interesting to observe that the period of 1900 to 1914 was one of relative prosperity in spite of the financial crisis in 1907. This shows that a financial or liquidity crisis, on its own does not always hurt the economy. The crash of 1987 did not hurt the economy very much either.

This has been one of only a few times in history when the price of almost every asset type has fallen sharply. The main exceptions are the US dollar, the Japanese yen, and short-term Government Treasury Bills, which have spiked higher. The Japanese government has warned currency markets that it could intervene to try to lower the yen because it is causing problems. One month US T-Bills yield only 0.12% (yields actually dropped below 0% in October), when one year yields are 1%. That spread is far too wide. It is very obvious that the price of assets, such as the yen and short US T-Bills, are distorted to the upside. I would suggest that the US$ is over priced as well. If these assets are overpriced, it only makes sense that the prices of other assets are distorted to the downside.

Another example is Canada. The IMF reported that the Canadian banks are the safest in the world. Canada has low inflation, a trade surplus, and has had budget surpluses for years. It has just been reported that of all global governments, the Canadian government is least likely to default on its debt. Does it make sense that the CAD$ should decline 20% against the US dollar in October?

This long-term trend indicator has been negative for the SP 500 Index since it peaked last fall except for a brief period this May. It will take some time or a big rise for this to turn positive again. US markets make up over 50% of global markets and are usually the first to rise up from a low and lead other world markets higher.

At some point, the hundreds of billions parked in 30-day US T-Bills is going to move where it can earn more than almost 0%. Of course no one wants to be the last to move. When this massive shift occurs, it could produce violent moves to the upside for assets that have declined and violent corrections in the US dollar, short T-Bills and the yen. Don't stand in its way!

Bonds - The buy signals given for Canadian bonds on Oct. 20 and US bonds on Oct. 27 are on hold temporarily. This is a very rare occurrence, which is likely due to quick, extreme moves. The slow growth in US money supply has been starving the economy for years so the truckloads of liquidity now being added may not produce as much inflation down the road as some expect. This is positive for bonds.

Commodities - The long-term oscillators have turned positive for gold and energy stocks but not gold or oil. History shows that precious metals and energy stocks can be influenced more by the direction of equity markets than by the underlying commodity. The previous comment about US money supply not producing inflation could have negative ramifications for gold too.

Currencies - These are signs that the US$ and yen could be peaking. More confirmation is required for most indicators.

The long-term oscillators usually give very good buy signals when it declines to the oversold level of 0.2 on the left hand scale and then turns up. It usually gives two signals at year at correction lows. It bottomed and turned up on July 17, 2008 after the financials bottomed as the short financials/long resources trade profits peaked. After a rise to the end of August and decline to the end of October, this indicator has now turned up for US, Canadian and most other global markets. Although a double bottom later this month can not be ruled out, this indicator suggests that the markets should rally for at least a month and up to six months.

If you look closely at the top right corner by the number 42, you will notice that the indicator (the black line) for the Volatility Index (VIX) has peaked at the second highest level since 2004 and turned down. This is very positive for equities as it suggests that volatility has peaked and should be declining. This confirms the positive signals the indicators are giving for the SP 500 Index and global markets.

The short-term trend chart for oil turned red, giving a sell signal on July 17, 2008 when oil was at $129. It will take more time or a rise in the price of oil above $75 for this to turn positive. When this happens it could have positive ramifications for other commodities too. The long-term oscillator has not turne dup for oil yet.

The short-term trend chart needs more time or a bigger rise to turn positive for gold. The long-term oscillator has not turned up for gold yet.

The long-term oscillator has bottomed and turned up again for US and Canadian gold stocks. When the oscillator turned up from these low levels in 2004 and a double bottom in 2005, gold stocks performed very well.

US and Canadian energy stocks are very oversold. The long-term oscillator has turned up after a double bottom. This bodes well for energy stocks and the TSX Index. As proven in September and October, stocks can follow the markets more than they follow the underlying commodity.

This shown in graphic detail the unwinding of the carry trade where investors borrowed money from Japan at interest rates close to 0% and invested the money elsewhere for a higher return. The euro collapsed and the Japanese yen soared and investors reduced risk by selling investments and buying the yen to pay back those loans. When this turns green again, it will indicate that the selling and unwinding could be over.

The long-term oscillator for the euro/yen has turned up after a double bottom. When the short-term indicator shown above turns green it will confirm that a new uptrend could be starting for the euro.

This US$ had a huge advance against most other currencies after being in a downtrend for years. When this turns red, it will be one of the indicators that the US$ has peaked compared to the Canadian dollar and perhaps other currencies as well. It could turn red soon.