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A Bird's Eye View of the Financial Markets

(February 16, 2006)

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.  We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday 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 at DJIA 10,900 – thus giving us an average entry of DJIA 10,870.  As of the close on Wednesday (11,058.97), our position is 188.97 points in the red.

As I am typing this, sentiment has gotten or is getting extremely bullish.  Recent trading volumes at both Charles Schwab and Tradestation have jumped significantly from last year – with January volumes jumping over 60% and 40%, respectively on a year-over-year basis.  As I mentioned in our mid-week commentary last week (“The Bank of England Financial Stability Review”), the game of “the search for yield” continues – but most importantly and most recently (over the last six weeks), the game has turned into “the search for appreciation” – as pension funds have gotten into the commodity markets and as bonds and equities in emerging markets continues to be snapped up by hedge fund and retail investors alike.

In these emotional times, it is imperative to take a “bird's eye” view of the stock market and detach oneself from the everyday action and emotional chatter about the financial and stock markets.  In the book “Soros on Soros,” the interviewer asked George Soros to clarify on his investing philosophy – specifically on his technique of “setting himself outside the process.”  The interviewer then asks: “What do you mean exactly?  How do you get outside?”  To which Soros replied: “I am outside.  I am a thinking participant and thinking means putting yourself outside the subject you think about.  Perhaps it comes easier to me than to many others because I have a very abstract mind and I actually enjoy looking at things, including myself, from the outside.”

Soros then emphasizes that “detachment” is the key.  This author cannot agree more, as my best investments, ideas, and trading have occurred when I view the current action or current events in the financial markets as part of a historical process or in the context of a much bigger picture.  Getting “detached” means seeing the big picture but also evaluating the situation from an objective standpoint.  When evaluating one's actions or investments, it is imperative that you view yourself or your own actions from the standpoint of a third party.  This applies to virtually everything in life but is all the more important when it comes to evaluating the financial markets.  If I had not been successful at it, I would not have gotten out of my technology stocks in late January 2000; nor would I have gotten into the gold and silver miners in late 2000.  Having this “trait” is also forcing me now to remain idle out of the stock markets – at least until we experience a more oversold situation.

I know, this is easier said than done – especially if one already “has a stake” in the stock market (whether it is through your IRA account, 401(k), etc.), but I believe the investor who can do this over the long-run can make a decent sized “fortune” in the stock market – at least a stake that one can retire on.  Speaking of the “big picture” and being objective, let's now take a look at our first chart of the night – that of the Russian stock market:

Russian Trading System (RTS) Index ($RTSI) - The Russian stock market has appreciated more than 20% since the end of 2005, and more approximately 130% since a year ago!

What's wrong with the above picture?  I know – I am out of it, and I should “get with the program” or get left behind by this “new era” in Russian equities.  Don't I know that oil and natural gas supply will “peak” in the next few years?  Don't I know that “things are different this time?”

Before we discuss this any further, it should be kept in mind that this author was one of the few that was calling for $80 crude oil in our August 29, 2004 commentary (when oil was trading at a “mere” $42 a barrel).  When I initially wrote that commentary, I anticipated that crude oil will gradually rise to that level by the end of this decade.  A mere 12 months after I wrote that commentary, the spot price of crude oil had already hit $70 a barrel, with natural gas topping out at nearly $15/MMBtu at about the same time (with another brief spike to that level in mid December 2005).

The “upshot” of this huge rise in such a quick timeframe is the demand destruction that came with this spike – and a subsequent “rush” to boost capital spending by many E&P companies.  Today, both domestic inventory levels of crude oil and natural gas are at ample levels.  World spare capacity of crude oil is expected to rise 500,000 barrels per day in 2006, and excluding the shut-down caused by Hurricanes Katrina and Rita, the growth of domestic natural gas production last year was the highest since 1994.  If no shut-down had occurred, natural gas inventory levels would be a further 600 Bcf above where we are now.

But let's give the benefit of the doubt to the Russian equity bulls and assume that the “peak oil” argument has come credibility in the foreseeable future (this author is still long-time bullish on crude oil prices, but I also feel that the current uptrend is definitely much overdone).  Is the Russian stock market a place to invest in for the long-run?  After all, this is a country that so famously defaulted on their sovereign obligations a mere seven years ago.  Many energy companies have also been recently nationalized.  The Russian economy can also be liken to the “Wild West” – where folks focus much more on short-term gains than long-term returns (and they think that Wall Street was short-term focused!).  Capital flight continues to be a huge risk.  On top of all this, the demographics of Russia is one of the worst-looking in recent history – its population is projected to witness a decline not seen since the days of the Stalin purges.  Young talent continues to leave the country – with many older folks staying behind – thus putting a greater burden on its welfare system.  Following is an annual chart showing the historical (and projected future) population of Russia, courtesy of the folks at GaveKal:

Russia, Total midyear population - Dramatic decline in population

Let me ask this question again: Is Russia a country that one wants to invest “in the long-run?”  Moreover, is Russia a country that one wants to buy after a 130% gain over the last 12 months – especially given that oil is now trading down from $70 to $58 a barrel?  Such a game can only occur in the face of extreme complacency and a lack of respect for risk – and right now, we are in such an era.

Speaking of energy prices (the same view would apply to base metals prices as well), let's now take a look at our MarketThoughts Global Diffusion Index (MGDI) and what it is currently telling us.  For those who do not recall, the MGDI has historically done a very good job of leading or tracking the CRB Index and energy prices.  In short, the latest reading of the MGDI (even though the second derivative is now in positive territory) still suggests that both the CRB Index and energy prices will continue to correct going forward.  For newer readers, I will begin with a direct quote from our May 30th commentary outlining how we constructed this index and how useful this has been as a leading indicator.  Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages."

Following is the monthly chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Energy Index from March 1990 to December 2005. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to February 15th (the January OECD leading indicators won't be released until early in March). In addition, all four of these indicators have been smoothed using their three-month moving averages:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the Dow Industrials & the CRB Energy Index (March 1990 to December 2005) - Historically, the rate of change in the MGDI has also led or tracked the YoY% change in the CRB Energy Index very closely. The divergence continues, despite the 2nd derivative of the MGDI going into positive territory for the first time since November 2004.

As I mentioned in many of our commentaries since May 30, 2005 and on the above chart, the rate of change (second derivative) in the MGDI has historically led or tracked the YoY% change in the CRB Index very closely.  While the rate of change in the MGDI has ticked up significantly in recent months (suggesting that the decline in the annual growth of the MGDI has slowed down), it should be noted here that the divergence between the rate of change in the MGDI and the year-over-year change in the CRB Index continues – even though are they in the midst of converging.  In our December 11, 2005 commentary, I stated: “Because of this unusually long period of divergence [between the second derivative of the MGDI and the Y-o-Y change in the CRB Index], this author fully expects the commodities that have been driving the rise in the CRB Index (energies and metals) to be significantly lower in price come 2006 (most recently in September, export volumes of commodities from Australia have declined on a year-over-year basis all across the board after three quarters of average growth).”  Since our December 11th commentary, the price of natural gas has more than halved, while the price of crude oil ticked down slightly from $60 a barrel to $58 a barrel.  If the action of the CRB Energy Index is to “catch up” with the action in the MGDI, this author would not be surprised to see crude oil touch the $45 level – especially as both the Federal Reserve and the European Central Bank are not done with their rate hikes just yet.

In the more immediate term, this author can claim with confidence that a significant portion recent speculative activity in the commodity markets and in the emerging markets have been funded by borrowing in Yen.  There is no definite data on this, but this is what the author is hearing – and this also makes intuitive sense and is further confirmed by the recent plunge in both energy and metals prices while the Yen has gone up.  Moreover, given that the Japanese domestic market (and the economy) is performing better-than-expected, and given that the end of the fiscal year is quickly approaching in Japan, it is no surprise that the Japanese is already repatriating capital back home.  This repatriation should accelerate going into March 31st – and coupled with the fact that the Fed is scheduled to hike the Fed Funds rate yet again on March 28th (with the ECB hiking on March 2nd), hedge funds that have borrowed in Yen to buy commodities or emerging market assets are definitely going to be in trouble.  And this in the midst of continued inventory building, huge bullish sentiment (the Market Vane's Bullish Consensus for copper hit 95% a couple of weeks ago, and 93% for sugar #11 at the same time), a parabolic move into early February, and a 31% decrease in the Chinese importation of copper in January, etc. This is going to be one interesting quarter for commodities and emerging market assets!

In the meantime, complacency and the “search for yield” still rules in many markets out there – and also in the domestic stock market as well.  However, there continues to be many divergences in the domestic stock market, such as the primary non-confirmation of the Dow Transports by the Dow Industrials, the declining number of new highs vs. new lows (on both the NYSE and the NASDAQ), as well as the following chart showing the percentage of NYSE stocks above their 200-day exponential moving averages vs. the NYSE Composite:

Percentage of NYSE stocks above their 200-day exponential moving averages vs. the NYSE Composite - Huge divergences in breadth and the price performance of the NYSE Composite!

Readers please note that huge divergence that is currently in play as shown in the above chart.  Could breadth continue to get worse while the price performance of the NYSE Composite (and the major market indices) continue its three-year uptrend?  Can the Dow Jones Industrial Average rocket to the 11,400 to 11,500 level before correcting?  Sure, it could – but readers should note that a continuance of the current uptrend in the face of deteriorating breadth usually means that when the correction finally does come, it is going to correct the market in a big way – definitely bigger than what we have seen since the beginning of the cyclical bull market in October 2002.

Finally, the following weekly chart (with data updated to February 15, 2006) showing the relative strength of the Philadelphia Bank Index vs. the S&P 500 is still giving us a dire warning: That the global liquidity situation continues to deteriorate and that it is probably not a safe time to invest in risky assets (including domestic small caps and mid caps) at this point:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1) The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards. 2) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 3) Relative strength of the Bank Index finally broke through support convincingly approximately nearly a year ago and and has stayed down since - with the exception of a back-kiss off the same line in April 2005 and early November 2005. After trying to push through resistance in November 2005, the Bank Index started struggling again relative to the S&P 500 since late December - signaling a new downward trend in relative strength. Bottom line: Global liquidity continues to deteroriate. 

Signing off,

Henry K. To, CFA

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