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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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Market Overbought But Not Out

Below is an extract from a "subscriber's only" commentary originally posted at marketthoughts.com on 11th December 2005.

Dear Subscribers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. Even though the market is still overbought at this point, this author does not believe the top has been achieved yet. This author may be far more convinced once he has seen the new NYSE margin debt numbers (due to be out in the next week or so), as well as the short interest numbers (due to be out a couple of weeks from now). My longer-term views of the market, however, have not changed over the last week. I still believe the market is in the midst of tracing out a top - given the declining global liquidity in the midst of huge speculation in the stock and commodity markets, the continued underperformance of the Philadelphia Bank Index, the relatively long life of this current cyclical bull market, the significant divergence of the NYSE A/D line and the Dow Jones Utility Index. For now, we are still completely neutral and in cash and urge our readers to do the same in general - unless one is very familiar with a certain sector or individual stock. At the same time, this author does not believe a top is complete without the Dow Industrials overtaking the 11,000 level and luring many of the "sideline investors" back into the stock market - thus completing this last "blow off" phase of this cyclical bull market.

From a trading volume standpoint, the next three weeks should be a non-event for the stock market, as many traders and fund managers take off early for the Christmas Holidays. That being said - whenever trading volume has been low - the market has tended to be on the volatile side. For any subscriber who currently has a position in the markets, I would like to ask you to "be careful." Going forward in the next three weeks and into 2006, this author believes that increasing volatility will be the order of the day, as global liquidity continues to decline amid the recent "euphoria" in the commodity markets and international markets, such as the recent rise in precious and base metals prices, natural gas prices, as well as Japanese equities and the continued rise in U.S. mid caps and small caps.

In last weekend's commentary, we mainly focused on the declining liquidity both in the financial markets and specifically in the stock markets. I argued that declining liquidity is bearish, but more importantly, I wanted our subscribers to experience a "sense of urgency" - given that we are concurrently experiencing an increase in speculative activity in the financial markets amid a decline in global liquidity. This weekend's commentary will be more of the same. Like I said in our previous commentaries, I believe the market is now in the midst of tracing out a significant top - a top that has a high probability of signaling the end of the cyclical bull market that began in October 2002. As the title suggests, however, it is still too soon to call a top at this point (and this is very important for subscribers who want to short stocks, the major market indices, and commodities), and I will now illustrate why there should still be some more upside to go in the major market indices in the short to intermediate term.

As I have said in our commentaries many times before, this author is inherently a cautious individual. We all know that many of the world's largest economies had been pumping great amounts of liquidity into the world financial system with the bursting of the technology bubble in 2000 and after the horrible events of September 11th. Much of this liquidity flowed into the emerging markets (think China and India) and the domestic housing sector. The resultant boom in emerging markets helped drive up energy commodity prices and boosted investments in energy-exporting countries, such that equity markets in Dubai in Saudi Arabia, for example, are now whipped into a speculative frenzy. At the same time, we also know that much of his liquidity had been having a very difficult time in finding a "home." As we are currently speaking, the hedge fund industry has grown to an "asset class" of $1.2 trillion, private equity firms had gone on a buying spree, and year-to-date, the Nikkei 225 has appreciated over 35%. Both the precious metals and the base metals have been on a near-exponential uptrend, spurred on by huge amounts of fund buying. But how long can this last? Since 18 months ago, the Federal Reserve has been gradually (or as least, has tried) removing liquidity from the world's financial markets - which could be witnessed in the dismal growth in the St. Louis Adjusted Monetary Base and foreign reserves held in the custody of the Federal Reserve. Most recently, the Japanese monetary base has also been experiencing dismal growth. At the same time, speculative activity has reached a fever pitch. The Chinese keeps on buying raw materials even as costs are skyrocketing and even as 50% of all steel companies in the country are losing money. Same with automobile companies here in the U.S. - the more cars they sell, the more money they have been losing. Something sure does not "smell right" here. When borrowing costs are low and monetary policy is loose, everyone is encouraged to borrow no matter how feasible one's idea is (think the negative profit margins in China). As Warren Buffett says, it is only when the tide goes out that we find out who has been swimming naked. More importantly for us, the immediate effects - I believe - are most probably a deflating commodity market as well as a deflating stock market, although the U.S. stock market should perform relatively well in such a scenario compared to international and emerging market equities. My guess is that we will find out over the next 12 months.

From a liquidity standpoint, most of you may already be getting tired of this indicator, but since our last update in last weekend's commentary, our proprietary MarketThoughts "Excess M" (MEM) indicator has continued to deteriorate. A recap of how to quantify or interpret our MEM indicators is as follows.

As most of you know, the MEM indicator consists of two components - that of the St. Louis Adjusted Monetary Base and that of the M-3 monetary aggregate. In our November 10th commentary, we tried to quantify and explain the consequences the four possible scenarios that the MEM can fall under. These four scenarios are:

1) Monetary base rising, M-3 declining
2) Monetary base rising, M-3 rising
3) Monetary base declining, M-3 rising
4) Monetary base declining, M-3 declining

How does "monetary velocity" (i.e. the amount of speculative activity) fit into this? Well, we know, BY DEFINITION, that the monetary aggregates in the "outer parts" (M-3 excluding M-2) of M-3 have inherently higher turnover. That is, assets in this component are inherently more risk-seeking, and thus when assets in this component or when the growth of M-3 is increasing, we know the market is starting to get frothy. Of course, this is not a complete measure, but it is probably one of the best measures we have - at least one that can be useful for investing and speculative purposes (much more real-time than the Fed's Flow of Funds, for example).

A rising M-3 is usually OK, as long as the monetary base is increasing at the same rate or higher. This is important, since the monetary base is the only aggregate that the Fed possesses direct control. A rising monetary base means the Fed is trying to be accommodative, which in turn suggests that they are encouraging investors and speculators to take risk. In a bear market in real estate, for example, the decreasing volume of transactions in the real estate market will be reflected in declining M-3 numbers, as debts are paid off and thus money is destroyed. In a bear market in houses, the reluctance to take on new and increasing mortgage debt will decrease significantly. Not only that, there will also be a rush to conserve cash and pay off debt, which will in turn decreases the growth of M-3 (or plunge it into negative territory).

A rising M-3 COMBINED with a declining monetary base is very bearish (scenario 3 above). This is basically the scenario we currently have. It means that even as speculators are now very bullish (think the rise in natural gas, gold, silver, copper, stocks, international equities such as Japan, orange juice, etc.), the Fed is now severely discouraging such speculation. Moreover, except for the European Central Bank, we are also now seeing continued tightening from the Bank of Japan - meaning that there will be no Yen carry trade to significantly feed liquidity into the world financial system. At this time, I doubt that speculators are fueling a Euro carry trade, given that the Euro has held up so well even as the economies in the Euro Zone continue to slump. That is, global liquidity is now drying up - and yet most investors continue to be very complacent by driving up precious and base metals prices, energy price, stock prices, real estate prices, etc.

Following is a weekly chart of our MEM indicator vs. the Monetary Base vs. M-3 from February 1985 to the present:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-3 (February 1985 to Present) - 1)  Markets did well during the 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade!  But now, the BoJ is tightening as well... 2) Speculators continues to be aggressive in the face of the Fed reining in the monetary base.  Our MEM indicator again stretched further to the downside in the last two weeks from negative 4.06% to negative 4.30% - the lowest since Jan 2002.  This does not bode well for the markets going forward.

During the latest week, our MEM indicator continued to plunge - declining from negative 4.06% last week to 4.30% this week. A further plunge below negative 4.41% would take us back into territory that we have not witnessed since the days immediately before September 11th! What we need now and what this author believe will happen is a huge deflationary correction in both the commodity markets and the stock markets sometime next year. The new Federal Reserve Chairman, Ben Bernanke will then open the "floodgates" - which should put us back in scenario one above (monetary base rising, M-3 declining). This will be immensely bullish, and is now the scenario I am looking for before I commit hugely on the long side (not only in stocks but in energies, metals, and alternative energies as well).

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