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Henry To

Henry To

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…

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Nothing is Obvious - and 50% Short in Our DJIA Timing System

Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. Since July 14th, the major market indices has more or less stayed flat - but in recent days, I have witnessed many negative divergences - such as the breakdown of the large caps like Yahoo, Intel, Microsoft, and now potentially Google - and many other indicators which I will outlined later in this commentary. Of course, we all know that the small caps and the mid caps have continued to rise, but history has shown that such a rise is not sustainable until the large cap indices (and a blue chip index like the Dow Industrials) confirm that rise as well. We will be switching to a 50% short position sometime this week - possibly as early as Monday if we experience an initial "pop" in Monday's trading.

Note that I am still looking for a "blow off" rally to occur later this year, but this can only occur after the market has experienced a significant correction. I anticipate this to be a very "quick" correction (possibly last for a couple of months only) and therefore I urge most of our readers to say in cash and use this "down time" to research potential long ideas instead of trying to outwit the very short-term movements of the stock market. Remember: Over the long-run and for the majority of investors, the big money is usually made on the long side.

I hope you all enjoyed Mr. Peter Richardson's views on the economy and on his going-forward views of the stock market featured on our Thursday's guest commentary. A few of our readers have expressed a great interest in seeing more of Mr. Richardson's writing going forward - and I will definitely ask him to do another guest write-up sometime down the road. In the meantime, you can contact Mr. Richardson by surfing to his investment blog where you can post comments, etc.

The big news over the last week was the surprise revaluation of the Chinese currency (the Renminbi, the Yuan, the People's Currency, or whatever one likes to call it) on Thursday evening (China as a country is generally 12 hours ahead of the United States). Readers must be sick and tired of hearing this now but "in a single stroke of the pen," the peg was changed from a US$ peg of 8.28 to the dollar to a multiple currency peg (the composition of that basket of currencies is being kept secret) effectively at 8.11 to the dollar as of last Thursday evening - a rise of approximately 2.1% from the old level. Since the Chinese Renminbi is now tired to a basket of multiple currencies, this level of 8.11 to the dollar is now allowed to fluctuate on the market each day - with the actual value of the Renminbi being allowed to trade within a 0.3% range of this official "peg."

As the title of this commentary implies, however, "nothing is obvious." The current consensus is that in the long-run, the Renminbi will appreciate against the dollar - in the order of 15% or so or even up to 40%. That may very well be true, but in the short to intermediate term, the market can do anything. Moreover, even as China is running huge trade surpluses, it is not obvious to me that foreigners would want to invest in China going forward given the huge overcapacity and the lack of profits in its domestic industries. That is, even as the U.S. is running a huge trade deficit with the rest of the world, it is very conceivable to me that the influx of foreign money could outpace the trade deficit - thus causing the U.S. Dollar to continue to rise from the current depressed levels. The opposite is true, however, for China. For a good indicator of profits in Chinese run companies, one can look no further than the performance of the Shanghai Composite. What good does it do if sales (GDP growth of 9.5%) are increasing exponentially if you can only make a little to no profit? And as John Mauldin indicated in his latest commentary this past Friday, Apple was directly responsible for $1 billion of that deficit last year - but is that necessarily a bad thing given that the market capitalization of Apple rose $20 billion in the same timeframe?

Some commentators have argued that the dollar will "crash" here given that the Chinese Central Bank will now purchase less U.S. Treasuries going forward - thus ending the "subsidy" for the U.S. consumer at the same time. However, please keep in mind that Central Bank buying of U.S. Dollars is only one part of the equation. More importantly, the Chinese Central Bank had already been diversifying from U.S. Dollars. There have been many speculations on the amount of U.S. Dollars they now hold but estimates now place it at around 70% - the same percentage as the Hong Kong Monetary Authority is holding. This is the same story as the rest of Asia, where the average percentage of U.S. Dollar holdings has now declined to approximately the 50% to 60% level - a historically low reading - and a reading which most probably do not require any further diversification away from U.S. Dollars.

Another big but unknown factor in all this is the US$ carry trade from 2001 to 2004. You had Chinese peasants exchanging their Dollars for Chinese Renminbi. You have coal mine owners borrowing money in dollars, exchanging it for Renminbi, and then buying local real estate using money from their loans denominated in US$ - hoping to enjoy both the appreciation of the Renminbi and the rise in local real estate. The Taiwanese and the citizens of Hong Kong have been doing that to a great extent as well. In essence, there is a huge "US$ short position" and a huge long Renminbi position - where investors have borrowed money in US$ and exchanged it for Chinese Renminbi - anticipating a run-up in the Renminbi going forward. What happens if that does not materialize in the next couple of months and investors start to unwind their short dollar/long Renminbi position? For a much better analysis of the Chinese Renminbi revaluation, I urge our readers to read the latest commentary from Mr. John Mauldin on this issue.

One can very well tell what private investors are doing with their U.S. Dollars by glancing at the assets (U.S. Treasuries and Agency Securities) of foreigners held in the custody of the Federal Reserve. Effectively, when foreigners want to hold U.S. Dollars, less of it winds up at the Fed; conversely, U.S. Dollars are dumped at the Fed if foreigners suddenly developed distaste for U.S. Dollars - as was what happened during mid 2001 to 2004. I have previously shown this chart before - following is a monthly chart showing the historical relationship between the annual change in the U.S. Dollar Index vs. the annual rate of growth in foreign reserves (second derivative). Throughout the weekend, I have done historical data searching on this indicating and had realized that I had not counted the amount of Agency Securities in my previous data - suggesting a revision is in order. The inclusion of Agency Securities held in the custody of the Federal Reserve only began in February of 2000. Instead of the data showing a gradual increase in the amount of Agency Securities over the years, there was basically a huge jump from zero in January 2000 to over $83 billion in February 2000 - thus somewhat distorting the data (this really tells you that finance and economics is really part art, part alchemy, and part science).

I have chosen to show the old U.S. Treasuries data only data along with the U.S. Treasuries plus Agency Securities data - the former from January 1982 to May 2005 and the latter from February 2005 to the week ending July 22, 2005 (this data is now updated on a weekly basis although as you can see, I am only showing monthly data on our chart). Going forward, I will only show the data containing the sum of the U.S. Treasuries plus Agency Securities. Please note the historical inverse relationship between these two indicators:

As one can see, both the old data and the new data pretty much tells the same story. When foreigners showed a distaste for U.S. Dollars during the mid 2001 to 2004 period, there was a huge influx of U.S. Dollars to the Fed, thus causing a decline in the U.S. Dollar Index (note that the U.S. Dollar Index axis is inverted in the above chart). More recently, as investors started to change their minds regarding the U.S. Dollar (as shown by the orange line going into negative territory), the U.S. Dollar Index has risen. However, as the above chart shows, the short-term rise in the U.S. Dollar Index may not be over yet. A further short-time rise in the U.S. Dollar Index makes all the more sense given that the U.S. Federal Reserve has signaled that they will continue to raise the Fed Funds rate.

In short, nothing is obvious - and the irony of all ironies would be to see actually see the Chinese Renminbi depreciate against the U.S. Dollar in the coming weeks! Now, let's go ahead and turn to the markets. As our readers know, this author has been a student of the Dow Theory for many years - and valuable insights can be gained just from watching the action of the Dow Industrials vs. the Dow Transports. Most recently, the commentators are once again calling for the demise of these two major indices, as neither of them confirmed the recent high in the S&P 500, as well as the recent outperformance of the S&P 400 and the S&P 500. Such a view actually makes me more confident in calling for a near ST top, as a ST top has historically materialize in the face of such talk. Historically, the underperformance of both the Dow Industrials and the Dow Transports has been a great warning to investors - as was the case in the October 1966 to December 1968 cyclical bull market (when most investors were ignoring the Dow Industrials and the Dow Rails - choosing to invest in small caps instead as the Barron's Low Priced Stock Index kept on making all-time highs week after week), the all-time high in May 2001 (not confirmed by either the Dow Industrials and the Dow Transports and immediately before a huge four-month decline in all the major indices), as well as the all-time high made in April to May 2002 (again, not confirmed by either the Dow Industrials and the Dow Transports and immediately before a 30% decline in the S&P 600 as shown below). One can clearly see the May 2001 to September 2001 action along with the May 2002 to July 2002 action in the S&P 600 in the following chart courtesy of Decisionpoint.com. If one only looks at the following chart, there was hardly any warning of an impending decline during both the May 2001 and the May 2002 tops - that is, unless you had kept track of the lagging performance of the Dow Industrials and the Dow Transports:

The most recent market divergence can also be witnessed in the performance of the NYSE and the NASDAQ McClellan Oscillator, as well as the number of new highs vs. new lows on the NYSE and the NASDAQ. Moreover, can the major market indices continue to rally without the support from its best brand name stocks and the institutional favorites, such as GE, MSFT, INTC, YHOO and GOOG? Coupled with an underperforming Bank Index and an overbought condition in most of my technical indicators, then there is a good chance that the market will suffer a significant correction in the coming weeks. As for the most recent performance of the Dow Industrials vs. the Dow Transports, one has to look no further than the following daily chart:

As shown on the above chart, both the Dow Industrials and the Dow Transports are severely lagging the major indices - including the S&P 500. Are these two major two indices not relevant anymore, as many market commentators have claimed? Or is the underperformance of these two major Dow Indices signaling a warning - a warning which has historically been worth heeding? My guess is the latter, and we will back up this view of ours with a 50% short position in our DJIA Timing System - possibly as early as today or later this week.

Let's now turn to our weekly sentiment indicators - starting off with the Bulls-Bears% differential readings in the American Association of Individual Investors (AAII) Survey:

The Bulls-Bears% Differential in the AAII Survey tanked as quickly as it rose two weeks ago - from 44% to only 13% in the latest week - a violent down move any way you look at it. Is the latest one-week decline of precursor to come or is it just a temporary decline? Given that the rally is still officially intact, I will need to give this survey the benefit of the doubt and suggest that a further rally IS possible - at least a rally that will turn this indicator into an overbought indicator once again.

The Bulls-Bears% Differential in the Investors Intelligence Survey is also confirming my thoughts on the AAII survey - in that the readings from the Investors Intelligence Survey is now not as overbought as it was last week:

The question is: Could we see more overbought readings coming out of the Investors Intelligence Survey before we see a ST top in the major market indices? Yes, we definitely could, but it is not a guarantee. Moreover, given the historical volatility and the fact that these two surveys have really not been too "accurate" over the last 18 months, I am choosing not to give the readings of this two surveys too much weight - although I definitely acknowledge them. Let's now turn to the "most correct" indicator of all - that of the Market Vane's Bullish Consensus (at least over the last 18 months anyway):

The Market Vane's Bullish Consensus is once again telling us to be careful, as the ten-week moving average is now at 67.5% - the most overbought since late April of 1998. Barring a huge decline in the market this week, the ten-week moving average is set to further increase - thus setting another seven-year record high. Given the readings in the Market Vane's Bullish Consensus, probability is not on your side should you choose to go long here.

Conclusion: The long Renminbi/short US$ trade has been one of the most touted "sure trades" by the mass media over the last 18 months - and given my experience and what I have just outlined above, I believe these speculators who have chosen to engage such a trade would be sorely disappointed over the next 12 to 24 months. The continuing decrease in growth in foreign reserves is also suggesting that the intermediate term uptrend of the U.S. Dollar Index is still intact - with the Euro being most "overvalued" out of all the currencies in the U.S. Dollar Index currency basket. Our stance on crude oil remains the same: We continue to be ST (next 12 to 18 months) bearish on crude oil prices, although going forward, we are still structurally bullish - with a price target of $80 to $100 barrel within the next four to seven years - barring no major supply disruptions within that time frame. In a major supply disruption scenario, this author would not be surprised if we see a WTI oil price close to $200 a barrel (FWIW, Matt Simmons of Simmons & Company International remarked that $200 may actually be low in a supply disruption/"peak oil" scenario).

Finally - the message for the equity markets remains the same from last week: The Summer/Fall correction that I have been looking for is still in play. The combination of several negative divergences, a hugely overbought market, and continuing tightening by the Fed is not going to be friendly to the markets going forward in the coming weeks. That is why we are currently 25% short in our DJIA Timing System, and looking to switch to a 50% short position sometime this week.

Signing off,

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