Have Currency Investors Gone Loonie?
(December 18, 2005)
Dear Subscribers and Readers,
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. At this point, this author has no position in the stock market - although one strategy that he is seriously thinking of implementing is buying fundamentally strong stocks that may be subject to tax-loss selling in the next couple of weeks. Please keep in mind that the final day to do any tax-loss selling is December 28th, as stock trades take three business days to settle. A couple of stocks that I am currently looking at is SNDA and SAFM - but please note that my research on these two stocks is still very preliminary at this point. As always, this should not be construed as specific investment advice.
So is the recent price spike in natural gas due to manipulation of prices - as many lawmakers in the House have contended? Well, that depends on how one defines "manipulation." Make no mistake; the recent price spike in natural gas definitely does have some fundamental basis. While storage levels are still above its five-year average at this point, the bulls would argue that an extended cold spell would render storage levels below its five-year average, given that over 20% of Gulf Coast production (around 2 Bcf/day) is still shut in at this point. At the same time, the bears (like me) would argue that at current prices, many of the industrial demand have already been destroyed. Moreover, the cumulative production loss due to Hurricanes Katrina and Rita are now over 500 Bcf - suggesting that storage levels would be another 15% higher than the historical five-year average had there were no production loss. While prices in the short-term are notoriously volatile and unpredictable, the current natural gas price of the March 2006 contracts and beyond are - in the views of this author - definitely overvalued.
Of course, markets are inherently known for its volatility and irrationality. Throw in the fact that natural gas prices have historically been three times as volatile as crude oil prices and you have a real recipe for a price spike during a colder-than-expected winter. We had first discussed this possibility in our July 31, 2005 commentary. Going forward, however, this author sees significantly lower natural gas prices for 2006 and 2007 - assuming we don't experience a similar shut-in experience in energy production going forward. This is my fundamental view. Such a view is not fool-proof (is there anything such as fool-proof in life), however, since going forward in the next few years, the amount of money that will be invested in commodity funds are expected to at least double or even triple from current levels. In such a scenario, both oil and natural gas prices could continue to rise even if the market is well-supplied, given the inherent "inelasticity" of demand in energy commodities. All barring a U.S. or world recession, of course.
In our commentaries over the last few weeks, I have discussed that a significant top in the stock markets won't be 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." I still subscribe to this view. Interestingly, the DJIA 11,000 level was the recent subject of Mark Hulbert's editorial on Marketwatch.com. Once this last "wall of worry" (the worry that the Dow Industrials is still not able to surpass the 11,000 level) has been removed, then all the bears and sideline investors would be sucked in - thus setting up for a significant top in the stock market.
Let's now get into the heart of this commentary. As many of subscribers know, the "Loonie" is the unofficial nickname of the Canadian Dollar. Given the rise in natural gas, oil, and gold prices over the last few years, investors should expect no less than a sharp rally from one of the world's premier "commodity currencies." The Canadian dollar has not disappointed, as it has been the best performing currency in the developed world over the last 12 months. That being said, let me pose this question to our subscribers: How hot is hot? That is, at what point do we conclude that prices are out-of-line with fundamentals, even though those fundamentals are justifying a high price in an underlying currency, commodity, or stock market index? Let's first take a look at the following long-term monthly chart of the Canadian dollar from 1977 to the present:
As one can see from the above chart, the Canadian dollar (cash prices) is now on the verge of surpassing a 14-year high - to a level not seen since early 1978 - when OPEC threatened to take over the world and during the tail-end of the last secular bull market in commodities.
Again, the relatively high price of the Canadian dollar may or may not be fundamentally justified. As investors in the financial markets, what we should be asking is: How hot is hot? We also know that the uptrend in the Canadian dollar is now three years old - which indicates that least a "breather" is due even if the Canadian dollar is supposed to rocket higher in the longer-run. What we also know is that on a purchasing parity basis, the Canadian dollar is now significantly overvalued compared to the U.S. dollar. While this is not a great timing tool per se, it does indicate that the Canadian dollar rally is now getting overstretched on the upside. We are now near the point where the Canadian dollar has historically reversed back to the downside.
Okay Henry, all that is well and good - but when can we expect the trend to stall out or even reverse? In other words, being a good professor/economist is one thing, but how many of them have made money in the stock or financial markets? Can you give us more information timing-wise?
These are all good questions, and I do not expect anything less from our very own subscribers! As I have mentioned, the Loonie is one of the premier "commodity currencies" of the world - the other major two being the Australian dollar and the South African Rand. As many currency "investors" should know, however, both the Australian dollar and the South African Rand have already peaked during the late 2004/early 2005 period. That is, despite escalating gold, natural gas, and commodity prices in general, two of the three major commodity currencies have not confirmed on the upside by making a concurrent multi-year high against the U.S. dollar. Should investors in the Canadian dollar be worried about this? You bet they should.
The non-confirmation of both the Australian dollar and the South African Rand on the upside is one indication of how lop-sided the rally in the Canadian dollar has become. Another clear indicator (that is, one which does not involve any conjectures or guesses) is by looking at the Commitment of Traders report on the Canadian dollar futures contract being traded on the Chicago Mercantile Exchange. Following is a weekly chart courtesy of Software North LLC - showing the net short and long positions of large speculators (e.g. hedge funds), small speculators (e.g. retail investors), and commercials (entities that usually take the other side of the large and small speculators) throughout 2005:
As can be seen from the above chart, the net long positions of large and small speculators are now unprecedentedly high - as exemplified by the extremely lopsided positions in the Canadian dollar futures contract. Five years ago, the large speculators could have been termed "sophisticated money." Today, with currency funds being started everyday and with so much money flowing into the commodity sector, that is no longer the case. That is, this author does not have a problem in viewing both the large and small speculators as contrarian indicators in this case.
From a trade standpoint, the largest export to the United States (in value) that originates from Canada is natural gas, followed by crude oil, and then lumber. Following is a list (in order of value) from Canada to the United States from 2000 to 2004. Please note that in any analysis of Canadian exports to the United States, we should always exclude the exporting of motor vehicles and other heavy equipment, as they are merely goods that have been assembled in Canada (either imported from the United States or other countries) to be re-exported to the United States.
As readers can see, it is not surprising that Canada has been the sole "commodity currency" making multi-year highs vs. the U.S. dollar - as both natural gas prices and natural gas export volumes have been recently making all-time highs. That being said, it is this author's contention that natural gas has recently peaked at slightly over US$15/MMBtu, and that crude oil peaked at $70/barrel in the wake of Hurricane Katrina and Rita. Come March of next year, Gulf Coast production of both natural gas and oil should be near full capacity once again. Moreover, there is a good chance that Canadian export volumes of natural gas will yet again grow less than expected - as recent (over the last few years) new drilling have been disappointing and as the production of newer wells continue to decline quicker than expected. Moreover, the importation of natural gas via LNG tankers is expected to double over the next 18 months - thus potentially easing any possible upcoming shortages in natural gas supply. In addition, given the recent demand destruction at $15/MMBtu, this author does not believe this will pose a problem at least over the next 12 months.
Finally, there is a good chance that the U.S. homebuilding boom has peaked or in the midst of peaking. Of course, this does not mean new housing construction will freeze overnight. What it does mean is that new homebuilding growth will be dismal or actually negative in the next few years - suggesting a lesser need for the importation of Canadian lumber going forward. For reference purposes, fully $3.5 billion of the $8.1 billion October trade deficit with Canada was due to the importation of natural gas. This is with the average October spot price at approximately $13.50/MMBtu. That is, it will not take too much of a decline in natural gas, crude oil, and lumber prices in order to significantly cut our trade deficit with Canada over the next few years. More importantly - in the world of currency trading and movements - it is most probably more important to focus on speculative flows, especially since the relatively minuscule trade deficit of $8.1 billion could easily by overwhelmed by speculative money flowing out of Canada. Given that many speculators (as evident by looking at COT futures data) are now on the long side of the Canadian dollar, it will probably not take much to reverse the trend. Once a new trend starts in a currency, it tends to run for months or even years - and since U.S. interest rates still offer an advantage to Canadian interest rates, any reversal here should be viewed with authority (it is interesting to note that the Canadian dollar actually declined after the publication of her large $8.1 billion trade surplus with the United States).
Speaking of commodities, this author is still pondering about a potential trade in the copper markets sometime this week. At this point, what I do know is this:
- It is highly likely that there is no 130,000 ton short position that needs to be delivered by the SRB on December 21st. Mr. Simon Hunt, who has over 30 years of experience in the copper industry and who now works in China, has previously communicated to me that rather, the short position is actually spread out over the next few years. Moreover, China also has an inventory of over one million tons which do not show up in the LME warehouse statistics. The lack of a huge short position has also been confirmed by many LME spokespeople - as they have gone on record stating that they have no knowledge of any positions that may impact the functionality of the copper market on the LME.
- The recent all-time highs of copper prices - while having been confirmed by highs in aluminum, lead, and zinc - have not been confirmed by higher prices in nickel, tin, and especially silver. Such a dichotomy between the prices of base metals is not common.
- Both the October and November copper import volumes into China have been very subdued, as indicated by the following chart courtesy of Barclays Capital:
It is highly likely that China will continue to sell copper from its inventories in order to depress the importation of copper onto China's shores in the coming weeks. Such a widespread selling of its inventories may just be enough to depress the price of the March 2006 contract, especially if speculators and hedge funds found out that there is no 130,000 ton short position to be delivered by December 21st. Unfortunately, there is no comparable COT data to be found that is published by the London Metals Exchange, and therefore, we do not really know the exact amount of long or short positions that are being held by hedge funds and small speculators. On the other hand, the COT data for the NYMEX does not reveal either a high open interest or a dichotomy between the positions of large/small speculators vs. the positions of the commercials. We will just have to see.
Let's now turn to the most recent action in the stock market. In last weekend's commentary, I mentioned the still-relatively oversold condition of the stock market per the NYSE ARMS Index, given that the 10-day moving average of the NYSE ARMS Index was still at 1.146. I argued that the stock market will not top out until this indicator gets more overbought (even though many of our other technical indicators were already signaling an overbought condition in the stock market), and that I would like to see the 10-day moving average decline back to the 0.90 level (or optimally, below) before I would be willing to at least call for a shortable top in the stock market. For bears who were hoping for a more overbought condition in the NYSE ARMS Index this week, we got our wish, as the 10-day moving average declined from last week's reading of 1.146 to this week's 0.936. Following is a daily chart showing the 10-day and 21-day moving average of the NYSE ARMS Index vs. the Dow Jones Industrial Average from January 2003 to the present:
While the decline of the 10-day moving average of the NYSE ARMS Index to the 0.90 level is good news for the bears, it is by no means a "shoo-in" if one is to short the major stock market indices here. First of all, this author is still looking for the Dow Industrials to surpass the 11,000 level (which is currently "only" 125 points away) before shorting. Such a "confirmation" on the upside by the Dow Industrials should pull in more investors that are currently sitting on the sidelines. Second of all, a 10-day ARMS of 0.936 is still not as oversold as many of the readings we have witnessed in 2005, and certainly not oversold compared to the levels (those came in below 0.80) that we saw during late November. Moreover, this author would still like to see more of a confirmation of an overbought condition in many of our sentiment indicators (as well as the latest NYSE short interest and margin debt data), which I will discuss shortly.
For now, let's continue with our discussion of the most recent action in the stock market and wrap up our commentary, since it is again getting late on this Sunday evening! While last week saw the Dow Industrials and the Dow Transports effectively wiping out the losses from the week before, it could basically be interpreted as a further extension of the consolidation phase that began three weeks ago. In the short-run, the stock market still remains overbought. If the stock market rally is to resume at these levels, then chances are that the rally ahead will not be a sustainable one. Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:
For the week ending last Friday, both the Dow Industrials and the Dow Transports continued their consolidation phase - with the former rising 97 points and the latter rising 40 points. In the short-run, the market remains overbought, but since we are now approaching year-end, anything can happen given the low volume and the increased dominance of retail investors during this period. If the market is to rally here for the next couple of weeks, then there is a good chance that this author will be shorting the stock market come the last trading day of this year or the first trading week of 2006. For now, this author is still targeting the psychological 11,000 level in the Dow Industrials before implementing any meaningful shorts - with a possibility for a spike up to the 11,300 level before shorting? We will just have to see.
Let's now discuss our most popular sentiment indicators. In a nutshell, our most popular sentiment indicators are still consolidating at recent overbought levels, although the Market Vane's Bullish Consensus is now getting sufficiently overbought (on a weekly and four-week moving average basis) in order for the bulls to start to worry here. Most of the evidence at this point suggests higher prices over the intermediate term, however. Let's now start with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials. During the latest week, the Bulls-Bears% differential readings in the AAII Survey decreased from 31% to 24%. The readings over the last few weeks are still consistent with a stock market that is in a neutral to up trend:
Meanwhile, the ten-week moving average ticked up slightly from a reading of 19.1% to 19.2% - which is still effectively a neutral reading and suggests more room to go on the upside. Like I said last week, this author would not call an imminent top in the stock market until we see at least a 25%+ reading in the ten-week moving average of the Bulls-Bears% differential in the AAII survey. More likely, however, I would like to see a reading in the ten-week moving average of 30%+.
The Bulls-Bears% Differential in the Investors Intelligence Survey increased from 34.3% to 37.2%. Meanwhile, the ten-week moving average increased from 24.4% to 26.1% - again, suggesting a continuation of the current intermediate uptrend. However, bulls should keep in mind that the ten-week moving average is now starting to become overbought:
From a probability standpoint, a continuation of the consolidation phase that began three weeks ago continues to be the most likely scenario. That being said, the last two weeks of the year is seasonally bullish, and given the lack of volume and the relatively high dominance of retail investors during this period, anything can happen. Should the market choose to rally from current levels, however, there is a good chance that this author would be shorting the major market indices come the end of this year. For that to happen, however, I will need to see an upside confirmation by the Dow Industrials (by surpassing the 11,000 level). Once we get such a confirmation (and hopefully a subsequent further spike up), then this author will go 50% short (our maximum allowable short position) in our DJIA Timing System.
The Market Vane's Bullish Consensus continues to surprise on the upside - by remaining steady at 70% in the latest weekly reading. Bulls should be very careful here - given that the reading of this survey has now registered a 70% reading for two weeks in a row. Meanwhile, the four-week moving average increased from 67.8% to 69.3% - which is the most overbought reading since April 1998 (at the same time the NYSE A/D line topped out in the late 1990s bull market). Given the relatively mild ten-week moving averages of the AAII and the Investors Intelligence Survey, however, this author is not calling for an imminent at this top, despite the 70% reading in the Market Vane's Bullish Consensus over the last two weeks:
While this author is getting relatively uncomfortable with the highly bullish readings in the Market Vane's Bullish Consensus, readers should keep in mind that most of the longer-term averages (four-week and ten-week moving averages) of the three popular surveys are still sufficiently oversold to give us further upside in the major market indices. Like I have mentioned before, we are currently still looking for the Dow Industrials to make a new cyclical bull market high, as well as pierce the 11,000 level for the first time since June 2001 before making an imminent top. Again, bears should continue to stay on the sidelines for now, given that the last two weeks of the year usually favor the bulls (along with hedge funds that choose to squeeze the bears in stocks that have relatively high short interest).
Conclusion: While there are good fundamentals for the Canadian dollar rally since the end of 2002, this author contends that this rally is now getting very overextended, at least on a short-term to intermediate-term basis. The combination of a high speculative long position and a further correction of natural gas and oil prices should add pressure to the Canadian dollar in 2006. Given that trends in currencies tend to last for months or even years, and given that the interest rate differential is still in the favor of the United States, this author's position is that the Canadian dollar (the Loonie) is now officially a "sell" - especially since the Canadian dollar responded to the record trade surplus report with the United States on Thursday of last week by reversing and closing down for the day.
At this point, this author is also still very much interested in a potential copper trade - given that the huge purported short position of 130,000 tons is supposed to be delivered to the LME on Wednesday, December 21st. From what I have gathered from my sources and intuition, the probability definitely does not favor the bulls right now. This trade is still currently in development, so I may not ultimately end up with any position in copper come December 21st (even if I do, it will be in the March contract and not the December contract). Meanwhile, the intermediate uptrend in the stock market continues to remain intact, although the major market indices have certainly gotten more overbought since our last weekend commentary. For now, we will remain completely neutral in our DJIA Timing System, and if all goes according to plan, we will establish a short position again sometime within the next few months or soon after the Dow Industrials pierces the 11,000 level.
Henry K. To, CFA