Our Position on the U.S. Dollar and an Update on Energy Prices
(August 14, 2005)
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. As of Friday at the close, the Dow Industrials stood at 10,600.31 - giving us a slight gain of approximately 15 points. No potential new signals this week - while the number of offerings should be muted this week, the combination of ever-rising energy prices and the poor performance of the large caps and brand name stocks should continue to put pressure on the major indices in the next week or so. The coast should be clearer as we head towards the end of this month and towards early September. For now, we will advice our readers to tread carefully as this market is still pretty overbought (although you won't see it judging by the Rydex Cash Flow Ratio).
I encourage our readers to keep track of the demographics situation and its potential impacts on savings and the financial markets going forward. The behavior of the aging population in the developed world and in China is going to have profound changes in the years ahead - and most strategists and governments have not fully prepared for this. For example, most market strategists have continued to forecast typical bull market performance for the stock market during the next five to ten years, despite the following:
- As the baby boomers begin to retire throughout the developed world, the savings of the general population will not be sufficient to support current market valuations as the former begin to liquidate a substantial part of their equity holdings to finance their retirement and to reduce their risks.
- The savings and potential savings of China, India, and Eastern Europe will also not be sufficient to support this "shortfall" in savings - even if these three countries/regions continue to grow at their current rates in the next five to ten years. The position of Dr. Jeremy Siegel that these countries will finance this shortfall in savings and in the current account deficits of the developed world (Japan is forecast to shift to a deficit situation by the end of this decade) just does not hold too much water - even if the Chinese, Indians, and Eastern Europeans whole-heartedly want to.
Combined with our lack of energy policy and lack of fiscal discipline and it is not difficult to envision a scenario where the secular bear market reasserts itself within the next few years - unless Western Europe and Japan implement major economic and structural reforms - which may still take a few years to play out even if they do happen. While I am definitely not predicting the end of this current cyclical bull market as of yet, we are definitely nearer to the end than the beginning.
Okay, I apologize for being so pessimistic - especially on a Sunday evening - I sincerely hope that I am wrong on this, but if we are to continue on our current paths, then it is very difficult to envision a more optimistic scenario ahead for the financial markets. For those who are prepared, however, this will be a great time to pick up undervalued assets, as well as being able to enjoy the immense productivity and technological gains that globalization will have wrought. Despite our current lack of fiscal discipline and domestic savings, I still believe the United States will be the best-prepared when it comes to the developed world - as Americans have historically been very self-reliant and responsive to change (think the relative lack of a welfare state and the economic dominance of very young companies such as Yahoo!, eBay, and Google) - traits which will be very important as we move forward in the 21st century.
All this - quite appropriately - serves as a basis for our discussion of the U.S. Dollar. Whether the Federal Reserve intended to or not, the latest series of rate hikes should serve to increase the savings rate (it is now essentially zero) and to partially restore the integrity of the U.S. Dollar. Make no mistake - as pointed out in our Thursday commentary, there will be a scramble and significant competition for savings among the developed countries within the next two decades. Hiking the Fed Fund rate now will help the U.S. accomplish these two purposes - at the very least, it is a good start. Moreover, the U.S. Dollar is not totally out of the woods yet, and so raising ST rates here will continue to make sense, if one's objective is to restore the integrity of the dollar. Historically, the direction of the Fed Funds rate has led the performance of the U.S. Dollar Index by 18 to 20 months, as shown by the following chart:
Please note that the latest "end-of-month August" data is actually dated as of August 12, 2005. The latest correction in the U.S. Dollar Index from the 90 to the 87 level is merely a correction, in my opinion. Ever since we communicated our bullish position in the U.S. Dollar in our May 1st commentary (when the U.S. Dollar Index was at the 84.44 level), we have experienced significant ups and downs - and the latest correction from the 90 level is no different. Going forward, there will continue to be many consolidations, but if current consensus in the level of the Fed Fund rate play out (i.e. a Fed Funds rate of 4.00% or 4.25%) by the end of this year, then there is no question in my mind that the U.S. Dollar Index would be back at 90 or above again.
On a related note, GaveKal has done a lot of work on evaluating the amount of Central Bank Reserves and the U.S. current account deficit, and their conclusion is this: The amount of U.S. Dollar Reserves held in Central Banks around the world far outpace the combined their current account surpluses with the United States - suggesting that a significant amount of dollar reserves are actually borrowed reserves! It looks like the U.S. Dollar carry-trade is still alive and well - but at some point this will end as the costs of borrowing U.S. Dollars increase (and as the growth of Chinese real estate prices pauses). Anecdotally, this author is still getting a lot of ads in any given days telling me to open a forex account where I can make a fortune by leveraging up and buying one million Euros with only $US20,000 in equity, etc.
Now, a quick update on crude oil and natural gas prices. Ever since our bullish commentary on natural gas a couple of weeks ago, the commodity (looking at the spot price) has jumped nearly $1.50/MMBtu - which is energy-equivalent to a rise of $7.50 per barrel in crude oil prices (i.e. this is not something to sneeze at). Judging from the following chart showing the natural gas vs. the crude oil spot price, however, it looks like that natural gas prices (despite the recent upside spike) are still lagging crude oil prices:
Please note that the August "end-of-month" prices are actually as of August 12, 2005. This suggests a potential of a further rise in natural gas prices - especially if the United States experiences warmer-than-expected weather in the next few weeks. Going forward, however, the commodity is very vulnerable to a significant correction, given its overbought condition and given the continuing worldwide economic slowdown as indicated in our MarketThoughts Global Diffusion Index (MGDI).
Nowhere have we been more wrong in our analysis than our "prediction" of lower oil prices just up ahead for the last few months now. That being said, a more recent dichotomy with regards to crude oil has emerged, as indicated by the following chart showing the relative performance of the Dow Transports vs. the Oil Service HOLDRS (OIH), and vs. the price of crude oil since October 1, 2002 (with base = 100):
Readers please note the positive correlation between the Dow Transports, the OIH, and the price of crude oil since the end of the cyclical bear market in October 2002. Since that fateful bottom, the prices of these three indices/commodity have been moving in sync - that is, on the upside - with the exception of the last five months. On March 4, 2005, the Dow Transports made a new all-time high. Since then, however, both the OIH and the price of crude oil have gone on to make significantly higher highs, but yet the Dow Transports has failed to confirm. Is the recent weakness of the Dow Transports signaling weaker crude oil prices or a weaker economy just up ahead? My guess is a little bit of both, but in the meantime, crude oil prices can rise another $5 to $10 a barrel before topping out. That is, I would not touch crude oil right now. One has to wonder if a hedge fund or if a supplier of fuel (such as what happened to China Aviation Oil late last year) has been caught on the wrong side of the trade?
In the short-run, the bears in crude oil will still have to give the benefit of the doubt to the oil bulls, as the current bullish sentiment in crude oil is still nowhere as high as bullish sentiment in prior peaks in oil prices during 2004:
At some point, crude oil would be a short - but not before we see another spike in bullish sentiment or the announcement of the collapse of a hedge fund/an industrial company who was caught on the short side of crude oil (I don't believe the collapse of Delta will qualify here as a bankruptcy restructuring would further cut costs while negligibly reducing capacity in the airline industry). Given the non-confirmation of the Dow Transports of both the OIH and the price of crude oil on the upside, however, this author does not believe the current rally in oil prices can last much longer - but bears please be careful as I wouldn't be surprised if crude oil prices "blow off" another $5 or $10 a barrel before collapsing. Times are going to get interesting just up ahead, and I promise our readers that we will keep track of this situation on a near-daily basis.
The resiliency of the financial markets around the world continue to amaze - given the restrictive monetary policies here in the United States, in Japan, and in China, as well as record high energy prices (which acts as a huge tax for both corporations and consumers as the majority of world oil revenues flow to sovereign governments). In a post on our discussion forum last Friday, I stated (with regards to the usefulness of monetary policies in a deflationary economy):
"In a deflationary economy, consumers can defer their purchases of goods (computers, DVD players, plasma TVs, cars, etc.) and fully expect the corresponding prices to be lower three to six months from now. The rapid advances in technology is further accelerating this trend - along with the advent of the internet where price discounts can be and are rapidly communicated.
"That is, in a deflationary economy, the velocity of money tends to go down and stay down over time. What are the implications? It is this: Monetary easing by the Fed is now much more muted as a "jump start" tool for the economy than it was back in the 1945 to 1990 period. In an inflationary economy, one does not need much inducing to start purchasing goods. This is different in a deflationary economy. The monetary base can go up ten times and the consumer may still not take the bait.
"Conversely, if the Fed wants to put the brakes on the economy, it can be very simply done. Just put your foot on the monetary brakes and consumption will slow down dramatically. That is, in deflationary economy, consumers are very sensitive to monetary tightening but not sensitive at all to monetary easing. Combined with high energy prices and aging demographics, and one can argue for a significant slowdown in the economy during the next few years - perhaps even a full-blown recession. I think it is just a matter of time before the stock market responds to this worldwide monetary tightening."
The combination of a restrictive monetary policy (and the expectations that the Fed Funds rate will continue to be more restrictive going forward) and high energy prices should be producing strong headwinds for the market - but yet the market refuses to budge. The main reason has been the huge activity in cash acquisitions, stock buybacks, and the lack of offerings so far this year compared to last year. Indeed - as TrimTabs as outlined before - the market should be much higher (around 30% as measured by the S&P 500) if retail investors had also bought the same amount of equities they have been purchasing on a historical bull market basis. As we move towards the latter part of this decade, the aging of the population around the developed world will cause many more headwinds for the equity markets.
Looking at the Dow Industrials vs. the Dow Transports, one is currently still seeing a indecisive market - with both the Dow Industrials and the Dow Transports actually rising for the week despite ever-increasing oil prices:
One notable development from last week, however: The collapse of the brand name stocks continues - with both Cisco and Dell releasing disappointing earnings reports during the week. I will provide an update of the brand name stocks that I am currently watching on Thursday morning. For now, the market is still running on emotions, but I believe it is just a matter of time before investors pay attention to the restrictive monetary policies, high energy prices, and the continuing disappointments from the brand name companies. For now, we will continue to remain 25% short in our DJIA Timing System - given the continued underperformance of the large caps and specifically, for the Dow Industrials.
As for our sentiment indicators, it is interesting to see both the Investors Intelligence Survey and the Market Vane's Bullish Consensus in overbought territories - but with the readings of the AAII survey in an oversold condition. Since the Market Vane's Bullish Consensus has been "more correct" over the last two years, however, we should most probably defer to the readings of this survey. More importantly, it is interesting to note that the most dramatic of declines have almost always occurred while the AAII survey is in an oversold condition. Readers should tread carefully here:
The AAII survey by itself is signaling further gains in the stock market ahead, but taken together with both the Investors Intelligence Survey and the Market Vane's Bullish Consensus, it may actually be giving us a warning signal. Alas, no one said that this would be easy.
Like I mentioned above, the sentiment readings coming out of the Investors Intelligence Survey is now in overbought territory - with the latest reading rising from 34.8% to 39.8%:
It is interesting to note, however, that the AAII survey was in comparably overbought territory a couple of weeks ago. Given this occurrence a couple of weeks ago and given the current readings in the Investors Intelligence Survey in the Market Vane's Bullish Consensus, is it reasonable to assume that the sentiment indicators are already signaling a ST top in the stock market? We will find out more as this week progresses.
Our sentiment discussion concludes with the Market Vane's Bullish Consensus. Following is the latest weekly chart showing the Market Vane's Bullish Consensus vs. the Dow Industrials:
With regards to the above survey - last week, I stated: "Based on purely the above chart, the market is a "screaming sell" - as the ten-week moving average of the Market Vane's Bullish Consensus is now at an eight-year high (up from a seven-year high as of last week) at 68.3% - the most overbought ten-week reading since August 1997. However - like I have said many times before - tops are inherently difficult to call, and this author will definitely wait for an overbought confirmation from both the AAII survey and the Investors Intelligence Survey before switching to a more bearish position."
The question to ask now is: Have we just received confirmation from the AAII Survey and the Investors Intelligence Survey? There is a good chance we have - and the extremely bullish sentiment Market Vane's Bullish Consensus is definitely something to be reckoned with - especially in light of continuing monetary tightening, high energy prices and a continuing breakdown in the major brand name stocks. Since the Dow Industrials has definitely been one of the weakest market indices, we feel pretty comfortable with staying in a 25% short position here.
Conclusion: The uptrend of the U.S. Dollar Index is still intact - and the recent correction of the U.S. Dollar Index is merely a correction - not the beginning of a new downtrend. The continuing hike in the Fed Funds rate will mean the end of the U.S. Dollar carry trade in due time - and should give a good boost to the savings rate at least temporarily. As for crude oil prices, there are now more signs of a impending correction in the crude oil price - given the non-confirmation of the Dow Transports of both the OIH and the price of crude oil on the upside (despite them having moved in tandem on the upside ever since the cyclical bear market bottomed in October 2002).
As for the equity markets, I am getting very wary on the bull trend that began in April 15th - especially in light of continuing monetary tightening, ever-rising energy prices and a further breakdown in brand name stocks such as Cisco and Dell. We will remain 25% short in our DJIA Timing System for the rest of this week and will reevaluate next weekend.
Henry K. To, CFA