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September 20, 2006

Canadian Dollar Now the Lone Holdout
by Henry To

Dear Subscribers,

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I hope all our subscribers had a good week - and that none of you were "caught the wrong way" in both the stock and commodity markets. My New York City trip (for my day job) was very enjoyable, although it was definitely too short. I arrived at NYC on Sunday evening and had to fly out by Wednesday afternoon - just in time for an American Funds conference last Thursday. I loved what American Funds had to say - especially with regards to their Multiple Portfolio Counselor System - a system that is unique to American Funds and which effectively divides each of its mutual funds among six or seven different fund managers in order to achieve more expertise in individual companies and natural diversification. Within each mutual fund, there is also a subset that is managed by research analysts - which, as we were told, actually outperformed the portfolio managers over the course of the history of this system. This is no surprise, since many of these research analysts are career analysts who have actually achieved much expertise within their sectors or industries - unlike other mutual funds where research analysts cannot manage their own money and are expected to be transitioned to portfolio managers over time (where they lose their industry expertise since they will inevitably be responsible for too many stocks). That being said, I am not totally convinced that size is not an issue - as many of the mutual funds managed by American Funds have significantly underperformed over the last couple of years as asset sizes have increased significantly. Whether the American Funds group family will continue to shine in the future is a question that is still up in the air, and is certainly something to keep abreast of going forward.

Let us now take care of some "laundry work." Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 - giving us a gain of 290 points. In retrospect, this call was definitely wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). As of the afternoon on Thursday, September 7th, this author entered a 50% long position in our DJIA Timing System at a print of 11,385 - which is now at 175.77 points in the black. A real-time "special alert" email was sent to our subscribers informing them of this change. As of Sunday afternoon on September 17th, this author is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. I am also getting very bullish on good-quality, growth stocks - as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). The market action in large caps, retail, and technology have all been very favorable so far - and I expect it to remain favorable at least for the rest of this year.

In our August 20, 2006 commentary ("The Evolution of the Markets"), I had asked our subscribers to keep track of three indicators in order to get a sense of whether the rally was sustainable. They were (in order of importance): the Nasdaq Daily High-Low Differential Ratio, the Dow Jones Utility Average, and the U.S. Homebuilders ETF. Since that commentary, all three indicators have performed well - with the homebuilders finally breaking above its 50-day moving average and its early August highs early last week, as shown by the following daily chart of the XHB (the S&P Homebuilders ETF) courtesy of Stockcharts.com:

Not only was this breakout confirmed by the immense trading volume last week, it was also confirmed by the extremely bearish sentiment on the homebuilders among retail investors. Such extreme bearish sentiment could be witnessed in many informal surveys (one of which I illustrated last week), the talk of a "housing bubble crash" among many economists (such as during a gathering of the NABE last week - not to mention Nouriel Roubini's discussion on www.rgemonitor.com), and even extreme bearish sentiment among homebuilding executives. Apart from a few of these individuals among the three groups, most of these folks can be regarded as contrarian indicators. As an aside, I do not remember seeing any of these individuals calling for a top in homebuilders early this year, as this author had done in his April 13th commentary. Quoting our April 13th commentary, when the XHB was trading at nearly $44 a share: "It is said that the best investments are investments which will make you money when you are right but which won't lose money if you're wrong. In the current scenario, the shorting the homebuilders may actually fit this bill - as investors are still discounting rosy conditions even in the midst of a slowdown in the residential market - all within a backdrop of rising rates, rising material prices, rising labor prices, and the rising costs of acquiring new plots of land. Even if the secular bull market in housing is still well and alive ... probability still suggests at least a "mid-cycle slowdown" scenario..." To those who did not short homebuilders earlier this year, you have now lost your chance - and there is no way I would now touch homebuilders with "a ten-foot pole" on the short side.

The same could also be said for commodities - which include crude oil, gold, silver, copper, steel, etc. These include both the commodities themselves and the miners as well as the manufacturers of steel products and refiners of gasoline. The significant top in commodities is something I have been discussing over the last few months, and so far, both the downtrend (technicals) and the fundamentals remain intact for a declining commodity market. Readers who want a refresh of the long list of reasons could check out our past commentaries including our June 11, 2006, August 17, 2006, and September 7, 2006 commentaries.

That being said, many of the popular commodities have declined to rather oversold levels lately, including the commodities that I mentioned in the previous paragraph. Moreover, while two of the three major commodity currencies have decisively rolled over (those being the Australian and the New Zealand Dollar), it is interesting to see that the third and probably the world's major commodity currency - the Canadian Dollar - is still holding its own. Until the Canadian dollar starts to roll over, this author is not willing to call the end cyclical bull market of commodities just yet (although we are definitely getting close). Following is a monthly chart showing the year-over-year changes in the Canadian Dollar vs. the CRB index and the CRB Energy Index from March 1990 to September 2006. Please note that these indicators have all been smoothed on a three-month rolling basis and that we used September 15, 2006 data as the September month-end data:

As one can see on the above chart, the historical correlation between the Canadian dollar and the CRB and the CRB Energy Index has been quite significant (correlation of over 50%) over the last 16 years or so. Consequently, any breakdown of the major commodity indices without the confirmation of the Canadian dollar on the downside should be viewed as suspicious. At the very least, a non-confirmation on the part of the Canadian dollar should at least lead to some kind of bounce in commodities in general. Are we about to see such a bounce - given that the Canadian dollar is still holding on? Particularly in gold or crude oil? This author would not be surprised if either gold or crude oil bounce over the next week or so - but any buying in either gold or silver should be short-term only in nature and should only be bought if sentiment and technical indicators confirm, such as extreme bearish sentiment in the Hulbert Gold Newsletter Sentiment Index (HGNSI), declining assets in the Rydex Precious Metals fund, etc. As of Sunday evening, I still do not see any reason to buy crude oil or gold for even a short-term trade, although that may change should the prices or either crude oil or gold continue to plunge in the coming days (and which is unconfirmed by a declining Canadian dollar). Readers please stay tuned.

Long-term subscribers should know that there has been one popular commodity that we have "neglected" to discuss over the last 12 months or so. While "yours truly" did buy some silver coins back in 2001 when silver was trading at $5 an ounce, I had always been reluctant to discuss silver - given the opaqueness of the silver market - with one side shouting that the world is about to run out of silver and the other side stating that there is still plenty of silver, not just on the ground, but in inventories as well. Moreover, unlike crude oil, the industrial demand of silver has been declining significantly in recent years (the headline number for industrial demand did increase 0.7%, but that includes demand from electroplated jewelry), given the substitution of digital cameras for film cameras (silver demand from photography declined 14.2% last year to 208.2 million ounces, according to the CPM Group). In other words, unlike demand for crude oil, the demand for silver does not have to skyrocket even as the Chinese and Indian economies continue to industrialize and modernize in the next five to ten years. As a matter of fact, the demand for silver in the photographic industry can conceivably take another 100 million ounce hit in the next few years (which is significant given that total silver demand is projected to be 765.7 million ounces this year). Sure, silver can be treated as a currency in extreme circumstances, but it continues to remain a distant second to gold when it comes to being a substitute for the major trading currencies of the world (those being the dollar, the Euro, the Yen, and the Sterling).

So Henry, what is your reason for buying silver in 2001?

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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