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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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Worldwide Markets Rundown

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. So far, there has been no significant selling pressure in the major indices, although the market has been overbought for awhile now. We will continue to remain 25% short in our DJIA Timing System - as the DJIA has definitely been the weaker index. Again, since tops are inherently difficult to call, I am giving this market the benefit of the doubt - although we will still be looking to switch to a 50% short position within the next several weeks if the market gets more overbought and if we continue to experience negative divergences.

Again, please take some time out and check our the new board in our discussion forum - Trading Systems and Market Timing Models - which will allow our subscribers and readers to discuss and share their views on how to construct models and timing systems, as well as to post their predictions and results. I look forward to increasing participation in that board going forward.

The purpose of this commentary is to give our readers a brief rundown of what my views are on the various markets around the world - starting from a monetary standpoint and then shifting to more structural topics. I want to begin with a discussion of the Euro Zone - as it is (like Japan) definitely a very important region of the world to keep track of going forward. A world growth model based on an ever-rising U.S. current account deficit is most probably not sustainable (although economists have argued that the U.S. can "afford" to run a $1 trillion current account deficit indefinitely), and the Euro Zone will need to be more of an engine of growth (and to lead by example) for the developed world to continue to enjoy the prosperity and growth that we had experienced during the second half of the 20th century.

Unfortunately, the cries for economic and structural reforms have died down considerably since they had risen to a crescendo just a couple of months ago (since the French voted "non" in the new EU Constitution referendum). More recently, the IMF has again cut its growth for the Euro Zone from 1.6% to 1.3% this year and from 2.3% to 1.9% in 2006. Alas, the kind of reforms that is mostly being debated in Germany nowadays is the reform of the German language. In terms of monetary policy, the European Central Bank has been in a do-nothing mood (which even the Austrian economists would agree) for the last 26 months - and has still continued that way as of this morning (here in the U.S.). The latest M-3 year-over-year growth rate for June for the Euro Zone (the EU reports their monetary indicators with a one-month lag time) stands at a relatively high rate of 7.5%, so it is not too surprising:

Year-Over-Year Growth of M-3 in the 12 Countries of the Euro-Zone* (January 1980 to June 2005) - 1) Even though money growth has slowed in both the U.S. and Japan over the last 12 months, money growth has actually picked up for the Euro Zone since May 2004.  The latest 12-month growth of M-3 increased from 7.3% in May to 7.5% in June 2005.  This is a somewhat encouraging sign - despite high energy prices and the high costs of running the social state in most of these countries. 2) * The Euro Zone consists of the countries that have switched to the Euro, namely Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.

The British, meanwhile, has just cut their ST benchmark rate a quarter percentage point from 4.75% to 4.5% - despite the fact that broad money supply growth came in at year-over-year rate of 11% during June of this year. My guess is that the idea of a Euro carry trade may not materialize unless the Fed Funds rate rises to 4% or even higher by the end of this year. Moreover, while structural reforms have been set aside in France and Germany for now, there is no reason to not expect them to materialize once the elections are over in Germany next year and in France in 2007. The best chance for a structural Euro Zone recovery would be the period during the next few years. If such a recovery does not materialize by that time, the Euro Zone could very well experience a irreversible decline in world economic influence (potentially being overtaken by China or India).

Over in the Far East, the topic of interest that is currently generating the most talk is the potential privatization of the Japanese Postal System. When it comes to the power of bureaucrats and the reluctance of reforms, the Japanese government can run with the best of them. The modern Japanese economy has her basis in the Meiji Restoration of 1868 - the Japanese society and people has proven that they can continually change and adapt - my guess is that it's just a matter of time. The 21st century will increasingly be about self-reliance and taking responsibility for oneself - although this could be somewhat of a problem in Japan mostly because of demographics trends. From a monetary standpoint, the Japanese economy is not too inspiring, as the growth in the monetary base in Japan has pretty much stalled since the beginning of this year:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to July 2005) - 1) Note that Japanese money growth has been plunging since the end of 2003 and has thus far shown no signs of letting down.  In fact, the YoY growth is now at 1.46% and represents the slowest growth rate since February. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) is still in negative territory - although it turned up quite a bit since February. 3) Momentum of the Nikkei slightly diverging from monetary growth...

Please note that the second derivative (change in the rate of growth) of the monetary base is still in negative territory - suggesting that the growth rate of the Japanese monetary base should remain negative for the foreseeable future. This is not good news for the Nikkei - especially given the fact that the Nikkei is now bumping against its 18-month resistance level at 12,000. Don't forget that Japan is also the second largest importer of energy - that is, high oil prices and high natural gas prices are going to be more of a problem in Japan going forward than most other industrialized countries in the world.

As for the United States, the one thing that is continually worrying me is the current protectionist sentiment that is so prevalent in Congress. This may explain some of the current weakness in the U.S. dollar, although the correction in the U.S. dollar should be expected given how much it has risen over the last 12 months or so. As for the monetary situation, there is still no sign that the Fed will stop raising its ST benchmark rate - especially given the recent growth in the ISM index and in the manufacturing sector (and the rise in both oil and natural gas prices). The growth in M-3 is also confirming the slowdown:

52-Week % Change in M-3 (20-Week and 40-Week Moving Averages) vs. DJIA (January 1, 1982 to July 18, 2005) - 1) M-3 growth peaked in late 2001 and early 2002 and has continued to decline (with the exception of a slight 'bump up' in late 2003) since that time.  Please note that the recent uptick in M-3 does not even register on this chart - as well as the fact that the 20 WMA has now again declined below its 40 WMA. 2) Still a lot of 'monetary overhang' however!

As the above chart shows - despite the fact that monetary growth is definitely slowing in the U.S. - there is still a lot of "monetary overhang" from the "deflation-fighting" days during the 2000 to 2002 period. The traces of this monetary explosion is still very much with us - as evident by the rise in housing and the fact that the balance sheets of most U.S. corporations are very much flush with cash (although the idea of the "platform company" - high growth and high margins - is also very much behind this).

Conclusion: Hopefully, the above commentary has given our readers a better idea of some of the structural indicators I am currently tracking around the world. And while the U.S. still remains the country with the most economic dominance, we are running into some economic headwinds - said headwinds which are mostly coming from within than from external players.

Alas, it is getting late in the morning - and so I will need to send this out very quickly. For the subscribers who want to see more - I will be writing more tonight in our discussion forum. This is the beauty of this country - the acceptance of self-criticism! It is what keeps this country on her heels and what drives us to continually to improve ourselves every day of the week.

Signing off,

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