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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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The Times They Are a-Changin

Dear Subscribers,

Before we begin our commentary, following is an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on June 24th, we are neutral in our DJIA Timing System (subscribers who want to go back and review our historical signals can do so at the following link). While it would have worked out well if we had continue to hold our long position since May 8th, we decided to exit our position at that time since there were many signs - including most of our valuation, sentiment, and liquidity indicators - that the rally was getting tired. We continue to stand by this position. However, we currently do not plan to go short in our DJIA Timing System - not even in the midst of the latest Bear Stearns hedge fund crisis - at least not until/unless the Dow Industrials manage to rally to the 13,800 to 14,200 area. At that time, we will reconsider. Again, while equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S. equities are now at its most expensive level since May 2006, despite the correction we witnessed the week before last. Combined with the liquidity headwinds that we have previously discussed, stocks are definitely not too attractive at this point, especially as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase. Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th.

Now, let us continue.

Change is in the air. For the majority of the population, the turning point of a society or the stock market is only clear in retrospect, but those who have been paying close attention can often sense it - although curiously, these same folks usually do not react until someone else has. Why is that? The big reason is just human nature, as 1) human beings tend to extrapolate the recent past into the indefinite future, and 2) human beings don't usually want to stand out from the crowd, and preferring to follow and only opine on a view until someone else.

This curious observation has manifested itself over and over again in the financial markets. From the 1906 San Francisco Earthquake, to the declaration of war by Austria-Hungary on July 28, 1914 (which ushered in World War I), to the international debt crisis of 1982, to the 1997 Asian Crisis, to the 1998 Russian/LTCM crises and to the 2000 peaking of the technology bubble, Wall Street usually does not immediately react. That is why peaks in the stock and financial markets usually come relatively slowly - but there are now signs that the market will have a relatively tough summer this year. What might those signs be?

As everyone and his neighbor should know by now, the subprime problem is not going away anytime soon - as exemplified by the collapse of two Bear Stearns hedge funds that invest mainly in CDOs last week. Even if Bear Stearns managed to "paper over" its problems with a $3.2 billion bailout, that by no way means its problems have been solved, as both Wall Street and the general population now know that the CDOs that many hedge funds and investment banks are holding are actually worth less than half of what they are now generally recognized. Essentially, this has now turned into a game of musical chairs - but with no chairs. To further compound the problem, the majority of central banks in the world today is still in the midst of tightening - and even at this point, the Federal Reserve has gone on record and stated that it is concerned about inflationary pressures more than anything else, despite the fact that it is also keeping a close eye on the Bear Stearns situation. Finally, given Merrill's response to Bear's bailout plan last week, it is also evident that many Wall Street banks is now significantly pulling back from crediting liquidity within the financial markets and from taking on significant risks. This is exemplified by the fact that many Wall Street banks are now hiring bankers and lawyers that specialize in buying or dealing with distressed debt. In other words, the vultures are already circling above their preys - and my guess is that Wall Street is now significantly pulling back because they don't want to become preys themselves.

For the first time since the Japanese boom of the late 1980s, Wall Street is now dependent on Asia (and to a lesser extent, the Middle East) as their main source of liquidity. Indeed - even as yields across Europe and the US were rising over the last four weeks, yields in much of Asia remained relatively stable. Moreover, the Hang Seng Index actually rose nearly 5% last week, despite a 2% decline in the S&P 500. Many other Asian markets also rose - with Thailand rising nearly 4%, Taiwan, India, and Malaysia over 2%, and Singapore approximately 1%. Going forward, these Asian countries should continue to be a significant provider of liquidity to the US and Europe, especially given that China is now in the midst of relaxing its capital controls on its domestic citizens from investing in overseas markets. In the meantime, as far as we can identify, the main Asian provider of liquidity in the US and European financial markets is the Japanese - or more specifically, Japanese institutional and retail investors who are currently trying to benefit from the Yen carry trade.

We have discussed the concept of the Yen carry trade extensively over the last few months, so I will not repeat them here (please see our free archives for our past discussions on the Yen carry trade, along with a whole variety of different topics). Suffice it to say, the Yen carry trade has continued to expand since our last discussion in our June 10th commentary ("Market Not Close to a Bottom"). In that commentary, I stated that one reliable indicator of these "animal spirits" is the strength of the Yen carry trade.- and that given the weakness of the Yen vs. the major currencies in the world today, there is no doubt that risk aversion among hedge funds and retail investors alike remains relatively low. Following is a chart showing the performance of the Yen against the Euro, Pound Sterling, the Australian Dollar, and the Canadian dollar from January 2, 2007 to last Friday:

Yen Cross Rate Performance (January 2 = 100) (January 2, 2007 to Present) - 1) Major risk aversion during the late February to mid March decline! 2) So far, we haven't witnessed any similar risk aversion in the Yen carry trade just yet, despite the fact that Japanese 1Q GDP growth is greater than both U.S. and the Euro Zone. In fact, all the Yen cross rates featured in this chart have gone on to make new highs.

The last time we showed this chart to our subscribers (in our June 10th commentary), only the Australian Dollar was at a new high vs. the Yen. However, since that commentary, the Canadian Dollar, the Euro, and the Pound Sterling have turned around significantly and embarked on further new highs. As a matter of fact, both the Euro and the Pound Sterling closed at a new high vs. the Yen last week - with the Canadian Dollar not too far behind. The lack of risk aversion is especially apparently when one compares the recent action of the Yen to action during late February and early March - when the Yen rose anywhere from 6% to 8% against these same currencies during that period. Given this weakness in the Yen, there is no doubt that both the US and the European markets are now hugely dependent on Japanese institutional and retail investors for marginal liquidity - and that any turnaround by either the Japanese or Chinese/Taiwanese/Korean/Singapore investors could wreck havoc on global equity prices.

In the meantime, we probably haven't seen the bottom in the Japanese Yen just yet - as Japanese retail investors are now preparing to invest their semi-annual bonuses out of Japan en masse over the next few weeks. Furthermore, given the light volume surrounding the July 4th holidays, there is no telling what the market may do. In the meantime, I would not be surprised if the markets retest its all-time highs over the next few weeks - or even surpass them. Should that happen on light volume, and should that be accompanied by a Barnes Index reading of over 70 and/or a non-confirmation by the Dow Transports, then we will most probably initiate a short position in our DJIA Timing System.

However, for the majority of the population, the most dangerous forces they will face in their lifetimes will not be the liquidity-constrained financial markets over the next six months. Nor will it be homegrown or foreign terrorism. In an older commentary that I penned on August 29, 2004 ("Economic Survival in the 21st Century - the Three Key Questions to Ask"), I stated that there were three important issues that U.S. investors and citizens alike will face over the coming years - those being 1) the combination of a U.S. aging population and globalization, 2) an era of significantly more expensive energy prices (at the time I wrote that article, crude oil was trading "only" at $45 a barrel), and 3) figuring out what type of investor you truly are, as I had believed at the time that the stock market will continue to remain a tough place to invest in for the foreseeable future. In many ways, these three issues are just the most recent manifestations of significant changes that are going on across the world today. As stated in the beginning of this commentary, "the times they are a-changin."

Since I penned that commentary on August 29, 2004, these three issues have served to be my "talking points" whenever I had wanted to "light a fire" under our subscribers (or ask our subscribers to light a fire under their next of kin) and whenever we had wanted to do some fear mongering! Not anymore. While these three issues will continue to remain important talking points going forward, I now want to add a fourth issue - with that issue being technology.

More follows for subscribers...


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