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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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Keep Your Head Straight

Dear Subscribers,

From a political and economic standpoint, the biggest news item of this weekend is the New Yorker article on a possible pre-emptive strike on the nuclear facilities in Iran. Following the publication of that article, numerous folks have come out and tried to discredit the contents of the New Yorker article, including the Foreign Secretary (Jack Straw) of Great Britain. Obviously, the Administration wants every option available on the table - but to suggest a tactical nuclear strike at this point is a bit irresponsible. At the same time, there is no doubt that the U.S. Administration would never tolerate a nuclear Iran.

We switched from a 25% short position to a neutral 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. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,120.04), this position is 250.04 points in the red. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 - giving us a gain of 89 points. In our mid-week commentary three weeks ago, we stated that we will remain 50% short in our DJIA Timing System until at least the March 28th Fed meeting. Whether we were slightly early or not, this was not to be - as we subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. As of Friday evening, this position is 154.96 points in the black. This was also communicated to our readers on a real-time basis. For readers who did not receive this "special alert," please make sure that your filters are set appropriately. We are now 75% short in our DJIA Timing System.

As of Sunday evening, April 9th, this author is still looking to get out of our March 20th 25% short position in our DJIA Timing System in order to control our risk and our volatility in our DJIA Timing System. I apologize to our readers for having to trade so much in our DJIA Timing System recently, but even as this author believes that the market is in the midst of forming a top, I am still not totally convinced that the Dow Industrials has made its final top yet. At this point, a 50% short position in our DJIA Timing System is bearish enough, especially given the short-term (somewhat) oversold conditions in the current stock market. We will reenter on the short side again should the Dow Industrials rally further in the weeks ahead. We will let our readers know on a real-time basis once we have exited our March 20th 25% short position. We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: "A Change in our DJIA Timing System").

In the short-run, however, the market should continue to trend down - given the lack of an oversold condition subsequent to Friday's decline. Moreover, corporate buying and cash takeovers during the first week of April has slowed down to a trickle. At the same time, the supply of common shares has been increasing - as the dollar amount of both primary and secondary offerings during the last week hit its second highest level for this year. Moreover, the bond market has continued to act horribly (see our March 12, 2006 commentary, "Rising Rates Now a Given"). Readers should note that in a typical post World War II demand driven economic cycle, bond prices (and the Dow Utilities) have typically led equity prices anywhere from three to 12 months. Given the phasing out of the "quantitative easing" policy of the Bank of Japan over the next two months, U.S. long bond prices should continue to decline going forward. Readers who want a "refresh" on the reason why should go back and read/study our March 12th commentary. However, this author believes that a quick update is now in order. Following is an update of our original monthly chart showing the yield of the 10-year Japanese government bond vs. the 10-year U.S. Treasury bond from January 1999 to last Friday, April 7, 2006:

Yield of Japanese 10-Year Government Bonds vs. 10-Year U.S. Treasuries (January 1999 to April 2006*) - 1) The Bank of Japan began its 'quantitative easing' program in March 2001. From a level of 1.27% in March 2001, the yield of the 10-year Japanese government bond started to decline in earnest until it bottomed at 0.53% in May 2003. The action of the 10-year U.S. Treasuries followed a very similar pattern - declining from 4.89% in March 2001 and finally bottoming at 3.33% in June 2003. 2) March 2001 to March 2006 correlation: Nearly 70%! 4) Now that the Bank of Japan has officially ended their 'quantitative easing' policy, the yield of the 10-year JGBs should be more in line with economic growth going forward - probably somewhere north of 2%. This has increase upward pressure on both European and U.S. 10-year yields and should continue to do so for the foreseeable future.

Please note that the yield of the 10-year JGB (at 1.88%) is now near a seven-year high. Typically, the peak of Japanese buying of U.S. Treasuries occurs in April. If the Japanese fails to come to the party in the next two weeks or so, then the latest decline of U.S. bond prices may go further than anyone could currently imagine. Note that prior to the implementation of Japan's quantitative easing policy in March 2001, U.S. ten-year rates were closer to the 6% level whenever the yield of the 10-year JGB came close to its current levels (approximately 2%).

Okay, we all know that the bonds are oversold now - so at some point (it could be a few days, a few weeks, or even a few months) going long the long bond for a trade could potentially be a very profitable endeavor. At this point, this author still does not see a very good risk/reward ratio yet, given the following:

1) The gradual phasing out of Japan's "quantitative easing" policy is still not over yet. That means Japanese demand of government bonds across the developed world is still going down - at least for the foreseeable future (next two months). Moreover, the lack of meaningful demand from Japan during the seasonally high-demand month of April continues to bother this author. Finally, the Japanese equity market is showing signs of life for the first time in six years - and there is a very good chance that domestic investors (such as Japanese pension funds and households) will finally shift more of their holdings from cash and bonds to domestic equities. This is significant since relative to the United States, Japanese investors have typically shunned domestic equities as an investment class for the last few years. For example, following is a chart comparing the weighting of various asset classes for Japanese and U.S. pension funds as of the end of 2005 (source: Bank of Japan). Note the significant overweighting of bonds (which includes domestic as well as international holdings) of Japanese pension funds relative to U.S. pension funds:

Financial assets held by pension funds (End of December 2005)

2) The lack of evidence suggesting U.S. pension funds will load up on long-dated bonds in order to "better match" their long-term liabilities (whose value is more or less dependent on long-term treasury or corporate bond rates). Sure, our UK counterparts have adopted this "immunization" strategy, but so far, U.S. pension funds have chosen to instead diversify into hedge funds and private equity funds (which is not totally surprising). If across-the-board demand of Treasuries fails to show up among U.S. pension funds soon, then this huge pillar of support for U.S. Treasuries will also go away.

3) Sentiment of the bond market is somewhat oversold - but not enough to suggest a sustainable bottom per the HBNSI (Hulbert Bond Newsletter Sentiment Index) as compiled by Mark Hulbert of Marketwatch.com, and the amount of assets in the Rydex Juno (Inverse Government Bond) fund. In fact, the latter has been suggesting that we may be due for a sustainable rise in interest rates since at least the middle of last year, as shown by the following chart courtesy of Decisionpoint.com:

Rydex JUNO (RYJUX) - 1) Huge inflow into the Rydex Juno fund during 03/04 - suggesting that individuals were getting too bearish on bonds. 2) Individuals starting to give up on rising yields in the middle of last year. From a contrarian standpoint, this is bullish for interest rates and thus bearish for bonds.

As mentioned on the above chart, retail investors were very receptive to the idea of a rising yield during the latter part of 2003 and the early part of 2004 - and they put their money where their mouths were by "investing" heavily into the Rydex Juno Fund starting in late 2003. Fundamentally and logically, this was a high probability scenario - but in retrospect, it was not to be. Retail investors actually hung in there for a little over a year, before they finally started giving up during the middle of 2005. Since that time, the cumulative net cash flow into the Rydex Juno Fund has declined by 40%. More importantly, this has continued to decline despite the recent rise in yields - indicating that retail investors don't yet believe the latest rise in yields is sustainable. From a contrarian standpoint, this is bullish for interest rates (and thus, bearish for bonds).

Rising yields should continue to weigh on the market going forward. Again, at some point, I believe there will be at least a trade on the long side of the long bond, but for now, the risk-to-reward ratio still isn't there yet.

Again, while I don't believe the Dow Industrials or the S&P 500 have made a final top yet, we are definitely getting very close. Glancing at the Investors Business Daily Top 100 list, one can see a very long list of small cap, low float speculative stocks on there - suggesting that speculation has now taken over the markets. One can also witness this in the relentless rise of the commodities (despite a continuing rise in "carrying costs"), the narrowing of the markets, the rise of the cash-crunching airline sector, and the continuing huge inflows into emerging market and international stocks (even after the bursting of the Middle Eastern stock market bubble). As implied by the title of this commentary - it is very important to "keep your head straight" during such emotional times. Readers should be reminded that it has never been profitable to "fight the Fed." Monetary policy has always operated with a lag (readers should be reminded that many commentators were claiming the Fed was "pushing on a string" - right before this cyclical bull market began in force during October 2002). At some point, the Fed will get its way. Even during the 1994/1995 tightening cycle (a rare instance when the market took off right after the Fed has finished tightening), there were many significant corrections and sell-offs at that time. So far, we have not had a single 10% correction in the S&P 500. Moreover, investor sentiment during the 1994 cycle was extremely pessimistic - contrary to what we are currently experiencing.

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