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Inflation Still a Factor

(March 19, 2006)

Dear Subscribers and Readers,

It is my fourth day here in Hartford, Connecticut and it is freezing – at least to this native Houstonian anyway! Four days ago, I was enjoying 75-degree weather. Today, the temperatures here are about 40 degrees – and it feels like 30 degrees with the wind chill, etc. I hope many of you are enjoying much warmer weather than me!

It appears to me that my thoughts regarding “short-term positive correlation” in the stock market in last Thursday's commentary may have been a little bit misunderstood. In that commentary, I stated:

Since September 2001, the 250-day moving average of two-day trends have been consistently below 125 – suggesting that an up day is now most likely followed by a down day as opposed to vice-versa.  Translation: Not only is the market no longer displaying trending behavior that was very prevalent during the 1960s and early 1970s, it is actually displaying an anti-trend behavior (most probably due to the increasing popularity of trend-following systems in the last 30 years).  As a matter of fact, we are now at a point where the S&P 500 is displaying the strongest “anti-trending” behavior.  This is one more reason why this author does not like to cover on breakouts or sell-short on breakdowns.  Usually, these are followed by short-term reversal patterns – even if one is “in harmony” with the more intermediate trend.”

In other words, should the author determine that he is wrong in maintaining the 50% short position in our DJIA Timing System, I will cover our short position – but not until we get a neutral or oversold reading in the stock market.

Note my last sentence in the third paragraph: “Usually, these [breakouts, etc.] are followed by short-term reversal patterns – even if one is “in harmony” with the more intermediate trend.” In illustrating the work done by, I made my case on why I do not like to generally cover short positions or enter into long positions in major market indices on “breakouts” since in the very short-term, breakouts of indices have tended to be followed by significant reversals. One can verify this by back-testing some kind of trading system that short sells the market on breakdowns during the great 2000 to 2002 bear market on the Dow Industrials or the S&P 500 – and subsequently covering on breakouts. Even in the midst of a huge bear market, one would have most likely lost money following such a “breakout” system.

Again, let me reiterate what I said last Thursday morning: As a rule, this author does not like buying on breakouts and selling on breakdowns – not because this author is stubborn but mainly because such a system would have produced a lot of losses over the last few years.  Let me reiterate what I have mentioned before: Buying on breakouts (in general) only makes sense in a rip-roaring bull market AND ONLY when not many folks are doing the same thing.  Today – with the proliferation of momentum trading systems and momentum publications like Investors Business Daily – and given that we are no longer in a secular bull market – it can be argued that neither of these conditions hold.  Sure, one of these days we will get the lone exception.  But please keep in mind that being able to navigate the markets successfully involves knowing the probabilities and be disciplined enough so as not to fade them. While breakouts (especially in individual stocks) are still very powerful signals as to how strong a stock is, being successful in trading today generally means waiting for the same stock to be oversold again – which will require a lot of patience and timing skills. As for the Dow Jones Industrial Average over the last two years, it has generally not been profitable by buying on breakouts or selling on breakdowns.

As I stated in our commentaries over the last few weeks, the internal breadth of the stock market is continuing to deteriorate – even as the NYSE A/D line moved to an all-time last week (please note that it took the NYSE A/D line over seven months to make another high). The NASDAQ may already have made a top on January 11th when it closed at a high of 2,331.36. In fact, more often that not in the last two years, the stock market has subsequently suffered a significant correction very soon after the NYSE A/D line made an all-time high. More importantly, the cyclical bull market that began in October 2002 has been mostly led by small and mid cap stocks. In general, the smaller the company, the better it has performed over the last three-and-a-half years. Because of this huge small and mid cap performance, there is a good chance that the NYSE A/D line may top out at the same time as the Dow Industrials or the S&P 500 – not unsimilar to the topping out patterns of the cyclical bull markets in 1946 and 1966.

If you read nothing else this week, please read the latest Investors Insight by John Mauldin, the latest weekly commentary from the Hussman Funds, and Bill Gross' (of PIMCO) latest monthly commentary. While this author may not agree with everything they say, it is always important to listen to their ideas (and hopefully, mine as well) and make up your own minds. What I like about their commentaries is that they have always brought a very insightful historical perspective on the markets – a perspective that is required in order to keep your feet planted firmly on the ground and to not to go out there and do anything crazy.

JP Morgan stated more than a hundred years ago that “the market will fluctuate.” While cycle work theory does not have a place in the Dow Theory, Charles Dow – the founder of the Wall Street Journal and the Dow Theory stated more than a hundred years ago that the market has tended to move in cycles – from undervaluation to overvaluation and back to undervaluation again. In other words, the markets do fluctuate – and it seems that right now, many investors out there are now pricing in “Pollyanna scenarios” for their favorite companies – despite ample signs of tightening global liquidity (as indicated by both rising short-term and long-term interest rates), the inability of both the German and French economies to reform, the overcapacity in China's steel, construction, and auto industries, and early but sufficient signs of a significant housing/homebuilding slowdown in the United States.

While betting on a 5% Fed Funds rate by May 10th may now seem to be a safe bet, it is still not obvious to this author that we are out of the woods yet. First of all, there is now evidence that labor is finally getting the upper-hand, as exemplified by decreasing non-farm productivity and rising unit labor costs during 2005. Following is a chart I previously showed in our September 11, 2005 commentary – when I stated that the Fed will definitely continue to raise rates even though as many “experts” at the time were questioning such a move in the wake of Hurricanes Katrina and Rita:

Y-O-Y Change in Output Per Hour (Productivity) vs. Y-O-Y Change in Unit Labor Costs (1982 to 4Q 2005*) - 1) Quarterly productivity and unit labor costs statistics for 2005 began the year with a bang (when labor costs rose above productivity for the first time since 2000) but have been generally muted since the third quarter. That being said, we are definitely not out of the woods yet - given unemployment below 5%, rising labor costs in both China and India, and so forth. 2) * Note: The 1Q to 4Q 2005 percentages are obtained from comparing the productivity and unit labor costs to the 1Q to 4Q productivity and unit labor costs in 2004.

For the first time since 2000, the increase in unit labor costs rose above those of productivity increases during the early parts of 2005. While these numbers have “moved in the right direction” in the final two quarters of 2005, we are still definitely not out of the woods yet. The question is: Will labor costs stay muted and will productivity continue to increase?

I would now argue that inflation is anything but subdued – given a headline unemployment rate of less than 5%, rising labor costs in both China and India (U.S. Steel has just commented that China's steel exports are no longer competitive with their prices given high iron ore prices and increasing labor costs in China), and a continuing rise in commodity prices straight into the stratosphere. I apologize for being so repetitive – but the key is and has been China for the last decade. Not because of the fact that China is consuming oil or copper at a tremendous pace, but because of the fact that China has been exporting huge deflationary forces to the developed world (in consumer and intermediate goods via its extraordinary low cost labor force). For the first time in a long time, however, labor costs may no longer give China the upper hand, as exemplified by U.S. Steel's most recent comment that Chinese steel producers are no longer a threat to U.S. steel producers. The is further reinforced by the most recent meddling/intervention by the Chinese government in iron ore pricing negotiations with suppliers after iron ore prices rose 71% over the past year.

In India , the costs of offshoring IT operations have increased 12 to 15% over the last year. While the labor costs differential between the India and the U.S. is still as much as five-hold, that gap is rapidly closing, and is projected to shrink to only two or three fold within the next four to five years. Moreover, (anecdotally, as there has been no scientific study done on this) the quality of offshoring services from India in the last couple of years has deteriorated dramatically.

Sure, companies can always relocate their manufacturing or IT operations to Vietnam or Africa , but readers should not forget that collectively, China and India contains the largest, most-educated labor force in the world today. The diminishing competitiveness of their labor forces (in terms of costs) and the continued rise of commodity prices are finally allowing U.S. companies (and more importantly, U.S. labor) to regain their pricing power. Bottom line: The deflationary forces being exported from both China and India are no longer as strong and are getting weaker by the day. The productivity and salary “squeezes” that the airlines and auto parts manufacturers have gotten from their union employees are also at an end – short of a GM bankruptcy in the next few months. Moreover, the February ECRI Inflation Gauge is still signaling higher-than-expected inflation up ahead. And the GaveKal CPI Diffusion Index (a proprietary inflationary indicator that is essentially an advance/decline line of CPI components) is still in a continuing uptrend. Combined with a still-rising commodity market, it is thus not obvious to this author that the Fed will stop at a Fed Funds rate of 5% - unless one of three things occur from now to May 10th :

  1. The stock market declines by 10%

  2. Gold, oil, and copper prices decline to below $500 an ounce, $50 a barrel, and $2.00 a pound, respectively

  3. The U.S. current account deficit shrinks dramatically in the next two months – which is not likely to happen

Historically, the Fed has not stopped its hiking campaign unless some kind of financial accident has already occurred – such in the wake of the 1987 crash, the 1994 bond debacle, and of course, the bursting of the technology bubble in spring of 2000. In order to contain inflationary forces, the Fed cannot allow speculation to get more rampant – and in doing so, the Fed will curb speculation all across the board – including the stock market, commodity markets, and real estate. In order words, the Fed will not be convinced unless some sort of “accident” has occurred in the financial markets.

In last weekend's commentary (“ Rising Rates Now a Given”), I also stated that the official end (and gradual phasing out) of Japan 's “quantitative easing” policy will have a profound and a most significant impact on the world's bond markets. Under “quantitative easing,” the Bank of Japan did what the Federal Reserve would have done should Greenspan have failed to pull us out of the 2001 recession and what Bernanke has recently proposed – they manipulated Japan's yield curve on the long-end by buying up Japanese government bonds all across the yield curve, including Japanese 10-year government bonds. Since this policy is now coming to an end, I argued that the yield of the Japanese 10-year government bond would now rise. From the end of June 2005 to the date of our last weekend's commentary, the yield of the 10-year JGB rose from 1.17% to 1.66%. As of last Friday, the yield of the 10-year JGB rose further to close at 1.72%. Since March 2001 (when the “quantitative easing” policy first began), Japanese private investors have struggled to look for yields by buying sovereign bonds in both the United States and in Europe . Given that Japanese private investors are the world's largest creditors as a group, this had the effect of pushing down yields all across the globe (as I have shown, the monthly yields of the 10-year JGBs and the 10-year U.S. Treasuries have had a 70% correlation from March 2001 to March 2006). This policy is gradually being phased out – and rates should now rise all across the board and across the globe.

Given higher rates on both the short-end and the long-end of the yield curve, there is now an even better chance that the market is in the midst of topping out. For now, we will remain 50% short in our DJIA Timing System, but don't be surprised if we move to 75% short again in the days ahead – even before the March 28th Fed meeting. We will let you know more about our plans as soon as both NYSE short interest and margin debt data are released in the next few days.

Take care everyone – and stay warm. I will see you again this Thursday morning.

Best regards,

Henry K. To, CFA

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