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A Year-End Surprise in the Dollar?

Dear Subscribers,

Quick note: For subscribers or readers who still have questions relating to the defined benefits and defined contribution rules of the Pension Protection Act of 2006, please do not hesitate to email me. As I have mentioned before, I have been closely monitoring the development of the PPA of 2006 for the last 12 to 18 months and have studied the most recent rules - especially with regards to its effects on both DB and DC pension plans.

Thanksgiving is coming up - and this year, the stock market bulls definitely seems to have a lot to be "thankful" about, as over the last few months, the U.S. stock market embarked on a most convincing bullish performance since the recovery of 2003. As for Rex, my partner, and myself, we also have a lot to be thankful about, as MarketThoughts is now at the one-year anniversary juncture of its subscription model and is still going strong. Over the last 12 months and the many months before then, I have had the fortune to meet many knowledgeable investors, businesspersons, and intelligent people. Many of them are our subscribers - and we are indeed humbled and honored to be writing for you all. My partner and friend, Rex Hui, and I remain excited by the prospects of this website going forward. I intend to write for you all as long as the market is still here and functioning well - so please continue to stay with us and grow with us as we march forward. We would not be here today without your support.

And just two more notes: Our upcoming mid-week commentary will be written by Mr. Rick Konrad, who will be one of our regular guest commentators going forward (besides Bill Rempel). Rick is author of the excellent investment blog "Value Discipline." Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers. And finally, there will not be a "full-blown" commentary next weekend, as my partner/webmaster is heading to Bangkok for a quick vacation. I will attempt to follow up with a "full-blown" commentary during Thanksgiving weekend, but I am not going to guarantee that at this stage.

Before we get to the gist of our commentary, a little laundry work is in order. On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 - which is now 723.43 points in the black. On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505. That position is now 603.43 points in the black. Real-time "special alert" emails were sent to our subscribers informing them of these changes. Subscribers can refer to our DJIA Timing System page on our website for a complete history of our DJIA Timing System signals.

As of Sunday afternoon on November 12th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been way overblown. We are also very bullish on good-quality, growth stocks. We are no longer as bullish as Sysco, given its recent run-up since early August and given the inevitable rise in its food costs on the back of the current strength in the agricultural commodities.

The strong recovery of the major indices from the correction during the week prior to last suggests that the market is technically strong, even though it is still short-term overbought. Probability suggests that the market should still be in a corrective phase over the next couple of weeks - but any correction that develops from current levels should be relatively shallow to trade around. Moreover, even should breadth top out here, the major market indices typically should still have four to six months to run being forming a significant top (based on action in a typical bull market). And finally, many of the major hedge funds out there are underinvested and underexposed to U.S. equities in general (not to mention that a favorite trade of many "quant" hedge funds since 2000 have been short the VIX and U.S. stocks - a trade which started to unravel for the first time in July of this year) and as the end of 2006 approaches, many of these hedge funds will be in an unenviable position of trying to beat the S&P 500 - by either buying "high beta" stocks (such as growth stocks) or by leveraging up on S&P 500 futures. So again, while it may be tempting to take quick short-term profits here, I urge our readers not to get "cute" and to try to time this market on a short-term basis. For a good reason why, please refer to the conversation between "Old Partridge" and Elmer Harwood in the book "Reminiscences of a Stock Operator," the "fictional biography of Jesse Livermore by Edwin Lefevre.

As an extension to our commentary on the South Korean economy in our mid-week commentary, folks who complain about the "toughness" of the relatively new U.S. bankruptcy laws must be glad that they don't live in South Korea, as South Koreans are almost "criminalized" should they ever file for personal bankruptcy. In some cases, for example, folks who declare bankruptcy are stripped of their professional licenses, are unable to ever open a bank account, and sometimes would have to quit their job if they work for a public financial institution. While I am definitely bullish on South Korea going forward, this tough bankruptcy law definitely makes it difficult for entrepreneurs to start their own businesses or to take a risk and embark for the career or job that they have always loved. While South Koreans are as intelligent and resourceful as Americans are, this can act as a debilitating force in the development of new technologies and in commercializing those technologies. Moreover, the venture capital industry is backed by only a small base of institutional investors - as can be gleaned from the following chart:

Limited Partners of VC Funds by Type

As can be seen from the above chart (courtesy of the most recent IMF paper on South Korea), a significant portion of VC funding in South Korea comes straight from the government, and since the VC budget is reviewed on an annual basis, consistent individual VC funding from the government could only be viewed as uncertain at best. Moreover, the average lifespan of VC funds in South Korea is only five years, vs. ten years in the United States. Given the tough bankruptcy laws and given the lack of an institutional and sophisticated venture capital industry, it is definitely difficult to envision any "ground-breaking" or "paradigm-shifting" technologies or companies emerging out of South Korea anytime soon (despite the population's strong academic achievements and very high overall R&D spending relative to the rest of the developed world).

Let us now discuss the subject of this weekend's commentary - the U.S. dollar. I first wrote about the U.S. dollar in our May 1, 2005 commentary. For readers who have not been with us for that long, that was the first commentary in which I started discussing the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index. In that commentary, I stated:

Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.

Since our May 1, 2005 commentary, this inverse relationship has more or less still hold true, as evident by the following monthly chart showing the annual change in the U.S. Dollar Index. vs. the annual change in the rate of growth (second derivative) in foreign reserves:

Annual Change in U.S. Dollar Index vs. Annual Change in Rate of Growth in Foreign Reserves (Monthly Chart) - Should be converging! The surprise for the rest of this year may be a rising dollar - as the market starts to discount lower economic growth in the Euro zone and the major commodity economies.

Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that while the recent change in the growth of foreign reserves have been increasing and is now hugging the zero line (implying that the dollar should remain at the same level as it did this time last year), the U.S. dollar index has been even weaker, as the annual return is now less than negative 7% (the value of the U.S. Dollar Index at the close last Friday divided by the November 2006 monthly close). Historically, the action in the U.S. Dollar Index and our foreign reserves indicator does not diverge for long - suggesting that the U.S. dollar should now start to rise - all things being equal.

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