Martin Armstrong Doubles down on his July 20th call of a US stock market top (a forecast made in 1996). He is the head of Princeton
Economics and this is his November 30th Foreward analysis of whether
we will have a double top and if we go much higher in Q 1 1999 what
the implications of that will be for us all.
Happy reading and Best Regards,
John
The Battle between
Chaos & Order
The Fate of the Share Markets
By Martin A. Armstrong
November 30th, 1998
Princeton Economic Institute
As we approach the coming year-end, the question that rises to the top of the list is simple: Just where do we stand in the global
economy? There are but two courses the future may follow and the decision time is rapidly approaching. These two choices are either a
moderate correction into 2000 where the Dow holds 6,000 at worst, or a breakout to the upside on the back of a surge in global capital
flows to the dollar due to the Euro and Japanese Big Bang.
It is critical that we understand how major market tops are formed. Within the global economy, there is but one trend that distinguishes a
major "bubble top" in assets. At all major bubble tops, such as 1929 in the US or 1989 in Japan, one finds the greatest concentration of
international capital. Major rallies within a domestic market that do NOT simultaneously correlate with intense capital inflows, are
typically distinguished by a weak currency whereby assets rise in value due to pure domestic inflation. This type of domestic rally is the
recent experience in Malaysia once the currency conversion was eliminated.
Based upon the previous stated definition of major "bubble tops", it is clear that we have reached such a situation in Europe as well as
in emerging markets such as Russia. What troubles us now is focused on the US market and how it responds in the months ahead will
determine the future fate of the global economy as a whole. New highs in the US market basis the Dow and S&P500 going into 1999 will
warn that we may indeed be headed for a much more serious debacle than we had expected. New highs in the US market will NOT be a
signal that the worst is over but to the contrary that the worst is yet to come.
Thanks to the arbitrage players, the US broad market has NOT been pushed into a "bubble top" due to their shorting the US against
buying Europe. Arbitrage investment is quite different from normal investment. In the game of arbitrage, no single investment is made
without a corresponding opposite position on a similar market or instrument. Hence, arbitrage trading involves leverage of a much
higher degree than normal margin trading. The danger from this type of trading arises when the amount of trading escalates beyond
normal investment trends. Long Term Capital Management may have helped the convergence of European interest rates by buying
Italy and selling Germany, but they also transferred the intense capital flows to Europe by selling the US markets against long positions
in Europe. While this did prevent the US market from becoming a bubble top, the unwinding of such positions also distorts the recovery
rally in the US by creating the illusion that the US market can ignore the global trends. It is within this scope that we must now reflect
upon the dangers that face us in the months ahead.
All markets progress through sector shifts as they evolve through a bull market cycle. Phase I is typically differentiated by a blue chip
rally, which eventually shifts over into Phase II when the broad market finally begins to outperform the blue chip sector. Phase III is
distinguished by the "speculative" stocks. In the case of 1929, the blue chips that lead the market initially actually reached their peaks
during April/May. The broad market began to outperform the blue chips at the beginning of 1929 and did so going into late summer. The
speculation boom came toward the final hours of the major bubble top in 1929. For example, almost any new issue was pounced upon and
driven to new record highs of unbelievable levels. One of the last new issues to be floated at the peak in 1929 was Mausoleum
Incorporated. The next time you fly into JFK, take a look at the graveyards on the way into the city. That was the property of
Mausoleum Inc. Now when you can take a graveyard and turn it into a public offering, you have reached the peak in insane new issues.
In our current environment, we see the very same typical investment pattern. The Dow led the S&P 500 between 1994 and 1997. The
S&P 500 finally began to make new highs before the Dow in 1997 moving into 1998. The Internet stocks have now moved into a ballistic
rally with some stocks moving to PE ratios of more than 1,000:1. Some have rallied from $20 in October to $220 in November. This is
NOT the beginning of a new unstoppable bull market – it is the final stages before a serious crash and burn.
Nonetheless, we must respect the capital flows and how they work within the international sea of investment capital. ALL true bubble
tops take place in isolation. It is impossible to create a real bubble top without the concentration of international capital. For this reason,
all major bubble tops form in isolation. For example, the European share markets reached their highs for the most part in 1928. Japan
reached its high in 1921. Once the European markets reached their highs, the capital flows shifted to the US sending the dollar higher
along with the Dow Jones Industrials. This is the danger we now face and the Fed must be careful that its actions do not create the false
sense that the worst is over.
So far, July 20th has marked the intraday high both in the US market as well as within Europe. This situation is NOT the norm by
historical standards. While the European markets have crashed far greater than the US market in October, there is also evidence that
suggests that the bubble top formation may have taken place in Europe ahead of the Euro – (buy the rumor and sell the news). If the
pools of international capital are not willing to pause and regroup before going on another buying-spree, then we must be concerned that
should they turn toward the US market, then a pattern that would fit a 1929 scenario could possibly materialize next year. This would be
indicated NOT by new highs in the Internet stocks, but rather by new highs in the Dow Jones Industrials since international capital
prefers the blue chips first.
Basis the S&P 500, the last week of November has produced a very strong rally that has stopped just shy of a perfect double top with
July 20th. As long as the S&P 500 FAILS to make new highs above July 20th, then there is still hope for a sideways consolidation into
2000. New highs will also warn that we could move into a bubble top formation in the US market during 1999. This type of pattern would
warn much more so of a serious correction both in assets as well as in economic activity going into 2002.
The Fed is not stupid. Should we see the US share market breakout to the upside, the Fed is more likely to reverse its interest rate
policy and begin to raise rates once again due to domestic speculation. Based upon capital flows, the Fed could end up attracting more
capital to the US if it turns to fight a domestic speculative bubble. Keep in mind that the Fed's model is not PE ratios but the EP ratio.
This means that the Fed is concerned about future earnings leading to inflation. If the future expectations of continued earnings remains
strong leading to expectations of 15% growth in prices for 1999, the Fed will have no choice but to begin raising interest rates next year
and will continue to do so moving into 2000.
Given the fact that the Japanese economy has a serious risk of imploding during early 1999 due to its banking and brokerage sectors,
Japan may have no choice but to embark upon the monetization of its problems in 1999. With unperforming loans approaching 40% of
GDP, the problems are indeed significant. However, savings in Japan also represent about 40% of total global "cash" savings. This is
one reason why short-term rates are starting to go negative in Japan. What this boils down to is simple. If you fear the banks and
brokerage houses and you don't want the FX risk, you pay the government a premium to hold your cash thus creating negative interest
rates. There can be no better situation than this economic mix to create a wave of capital outflows when the trust fund products are
deregulated on December 1st, 1998.
Therefore, international capital flows are poised at a very delicate position. With civil war likely over the next 18 months in Russia,
Japanese Big Bang Phase II and the introduction of the Euro, the US could emerge as the safe haven for international capital. We must
also respect that the Euro is more likely to emerge as an overvalued currency on January 1st due to the fact that the treaty calls for one
ECU to be swapped at par for one Euro. However, the ECU has within its basket both the British pound and the Danish krone. This
means that the pound has risen from almost 2 marks to over 3 marks in the past 2 years. The Euro will not have the Swiss franc or the
British pound yet the Euro must be equal to one ECU. This means that no matter how you slice it, the Euro will need to be overvalued
into order to allow for the ECU to be swapped at par. This implies that with 31 days to go before the introduction of the Euro, we are
likely to see a major effort to drive the pound down on the crossrate with the Dmark. The more they can manipulate the pound down, the
less it will cost the new government when they are forced to swap an ECU for a Euro. In any event, the Euro may start out as an
overvalued currency that is coming under political attack from the start as the continent moves more left than right. The new "Social
Europe" proposals threaten to impose the worst uncompetitive labor laws from Germany and France upon the whole of Europe.
Combining the trend toward greater socialism with the drive to unify tax rates at the highest level rather than at the lowest level, and the
visions of the Euro bringing deregulation to Europe become unrealistic. Euroland, unfortunately, will not emerge as a strong new
economy. Europe's economic growth has lagged behind the rest of the industrial world by more than 50%. Imposing the new "Social
Europe" model upon the whole of EMU merely promises to perpetuate the sluggish economic growth into the future. There is no better
warning than the economic statistics from Germany itself. When corporate profits were at record highs in July, so was unemployment. In
a normal economic model, unemployment should be at a low when the economy is at a peak. The danger for Europe remains an economic
downturn when unemployment will have no choice but to rise even further. It will be this trend that not merely threatens to weaken the
Euro due to political pressure for easy monetary policy, but also could extend the risk of labor unrest throughout Europe as a whole. In
the end, the dream that once was Euroland can not possibly materialize in a competitive manner against not merely the US labor market,
but also that of Asia as a whole.
In conclusion, the idea that the stock market has entered a new era where every dip is a buying opportunity and that new highs are an
everyday event into they year 2007 is nothing but a pipe dream. The sharp rise in the NASDAQ is not a reflection of serious global
capital but only of retail over-speculation. If the Dow breaks to new highs above July 20th, then look out, for we may be creating a
bubble top in the US market for 1999. While there will be some good profits to be had for a brief shining moment, the danger of creating
a true major economic crash cannot be ignored. For this reason, let us hope that a double top holds followed by a consolidation into 2000
where at worst we see a 30% correction from peak to intraday low. This type of pattern will form a much more solid base for the future
and our computer models would then project a 7 year bull market becomes possible between 2000 going into the peak of the next
business cycle in 2007. Otherwise, a major low in 2002 may be followed only by a 50-60% recovery into 2007 for the broad market while
commodity stocks rally aggressively replacing the internet sector as the hot ticket into 2007. |
