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Canadian Dollar Now the Lone Holdout

(September 17, 2006)

Dear Subscribers and Readers,

Let us now take care of some “laundry work.”  Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 – giving us a gain of 290 points.  In retrospect, this call was definitely wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification).  As of the afternoon on Thursday, September 7th, this author entered a 50% long position in our DJIA Timing System at a print of 11,385 – which is now at 175.77 points in the black.  A real-time “special alert” email was sent to our subscribers informing them of this change.  As of Sunday afternoon on September 17th, this author is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco (“Sysco – A Beneficiary of Lower Inflation”), etc.  I am also getting very bullish on good-quality, growth stocks – as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general).  The market action in large caps, retail, and technology have all been very favorable so far – and I expect it to remain favorable at least for the rest of this year.

In our August 20, 2006 commentary (“The Evolution of the Markets”), I had asked our subscribers to keep track of three indicators in order to get a sense of whether the rally was sustainable.  They were (in order of importance): the Nasdaq Daily High-Low Differential Ratio, the Dow Jones Utility Average, and the U.S. Homebuilders ETF.  Since that commentary, all three indicators have performed well – with the homebuilders finally breaking above its 50-day moving average and its early August highs early last week, as shown by the following daily chart of the XHB (the S&P Homebuilders ETF) courtesy of

XHB (ST SPDR Homebuilders ETF) AMEX

Not only was this breakout confirmed by the immense trading volume last week, it was also confirmed by the extremely bearish sentiment on the homebuilders among retail investors.  Such extreme bearish sentiment could be witnessed in many informal surveys (one of which I illustrated last week), the talk of a “housing bubble crash” among many economists (such as during a gathering of the NABE last week – not to mention Nouriel Roubini's discussion on, and even extreme bearish sentiment among homebuilding executives.  Apart from a few of these individuals among the three groups, most of these folks can be regarded as contrarian indicators.  As an aside, I do not remember seeing any of these individuals calling for a top in homebuilders early this year, as this author had done in his April 13th commentary.  Quoting our April 13th commentary, when the XHB was trading at nearly $44 a share: “It is said that the best investments are investments which will make you money when you are right but which won't lose money if you're wrong.  In the current scenario, the shorting the homebuilders may actually fit this bill – as investors are still discounting rosy conditions even in the midst of a slowdown in the residential market – all within a backdrop of rising rates, rising material prices, rising labor prices, and the rising costs of acquiring new plots of land.  Even if the secular bull market in housing is still well and alive … probability still suggests at least a “mid-cycle slowdown” scenario…”  To those who did not short homebuilders earlier this year, you have now lost your chance – and there is no way I would now touch homebuilders with “a ten-foot pole” on the short side.

The same could also be said for commodities – which include crude oil, gold, silver, copper, steel, etc.  These include both the commodities themselves and the miners as well as the manufacturers of steel products and refiners of gasoline.  The significant top in commodities is something I have been discussing over the last few months, and so far, both the downtrend (technicals) and the fundamentals remain intact for a declining commodity market.  Readers who want a refresh of the long list of reasons could check out our past commentaries including our June 11, 2006, August 17, 2006, and September 7, 2006 commentaries.

That being said, many of the popular commodities have declined to rather oversold levels lately, including the commodities that I mentioned in the previous paragraph.  Moreover, while two of the three major commodity currencies have decisively rolled over (those being the Australian and the New Zealand Dollar), it is interesting to see that the third and probably the world's major commodity currency – the Canadian Dollar – is still holding its own.  Until the Canadian dollar starts to roll over, this author is not willing to call the end cyclical bull market of commodities just yet (although we are definitely getting close).  Following is a monthly chart showing the year-over-year changes in the Canadian Dollar vs. the CRB index and the CRB Energy Index from March 1990 to September 2006.  Please note that these indicators have all been smoothed on a three-month rolling basis and that we used September 15, 2006 data as the September month-end data:

Year-over-Year Change in the CRB Index and the CRB Energy Index vs. the Year-over-Year Change in the Canadian Dollar (March 1990 to September 2006*) - Note that the Canadian Dollar has historically had a significant positive correlation to both the CRB Index (54%) and the CRB Energy Index (61%). At this point, the commodity boom won't be offically over until the Canadian Dollar starts to roll over in a big way.

As one can see on the above chart, the historical correlation between the Canadian dollar and the CRB and the CRB Energy Index has been quite significant (correlation of over 50%) over the last 16 years or so.  Consequently, any breakdown of the major commodity indices without the confirmation of the Canadian dollar on the downside should be viewed as suspicious.  At the very least, a non-confirmation on the part of the Canadian dollar should at least lead to some kind of bounce in commodities in general.  Are we about to see such a bounce – given that the Canadian dollar is still holding on?  Particularly in gold or crude oil?  This author would not be surprised if either gold or crude oil bounce over the next week or so – but any buying in either gold or silver should be short-term only in nature and should only be bought if sentiment and technical indicators confirm, such as extreme bearish sentiment in the Hulbert Gold Newsletter Sentiment Index (HGNSI), declining assets in the Rydex Precious Metals fund, etc.  As of Sunday evening, I still do not see any reason to buy crude oil or gold for even a short-term trade, although that may change should the prices or either crude oil or gold continue to plunge in the coming days (and which is unconfirmed by a declining Canadian dollar).  Readers please stay tuned.

Long-term subscribers should know that there has been one popular commodity that we have “neglected” to discuss over the last 12 months or so.  While “yours truly” did buy some silver coins back in 2001 when silver was trading at $5 an ounce, I had always been reluctant to discuss silver – given the opaqueness of the silver market – with one side shouting that the world is about to run out of silver and the other side stating that there is still plenty of silver, not just on the ground, but in inventories as well.  Moreover, unlike crude oil, the industrial demand of silver has been declining significantly in recent years (the headline number for industrial demand did increase 0.7%, but that includes demand from electroplated jewelry), given the substitution of digital cameras for film cameras (silver demand from photography declined 14.2% last year to 208.2 million ounces, according to the CPM Group).  In other words, unlike demand for crude oil, the demand for silver does not have to skyrocket even as the Chinese and Indian economies continue to industrialize and modernize in the next five to ten years.  As a matter of fact, the demand for silver in the photographic industry can conceivably take another 100 million ounce hit in the next few years (which is significant given that total silver demand is projected to be 765.7 million ounces this year).  Sure, silver can be treated as a currency in extreme circumstances, but it continues to remain a distant second to gold when it comes to being a substitute for the major trading currencies of the world (those being the dollar, the Euro, the Yen, and the Sterling).

So Henry, what is your reason for buying silver in 2001?

Aside from the fact that silver was trading at one of its lowest levels since recorded history (in real terms), one of the major reasons as to why this author bought silver in 2001 was the fact that silver had been in a deficit situation since 1990.  Moreover, it is interesting to note that digital cameras had still not caught on in 2001 – not to mention that this author did not see the “digital camera trend” coming at that point.  Whatever the total world inventory situation was, I figured it was a no-lose situation, given the fact that silver was so oversold on a multi-decade basis.  In the worst-case scenario, I could always use the Silver Eagles I purchased as a trading currency (its face value was one dollar per coin).

However, it seems like mining technology has definitely caught up to the silver hoarders, as many silver miners have continued to increase their supply of silver at minimal costs over the last few years.  Combined with a silver price of above $10 an ounce, and one has the incentive to continue to explore and mine.  All this – coupled with decreasing demand from the photographic sector, is projected to result in a supply surplus of silver for the first time since 1989, as shown by the following chart courtesy of the CPM Group:

Silver Market Supply/Demand Balance

Following is essentially the same information but presented in a different way, again, courtesy of the CPM Group.  The $64 billion question now is: Can the price of silver continue to outperform given the following supply/demand situation?  Again, note that the newly-created investment demand from the Silver ETF cuts both ways, as investors who had previously bought the Silver ETF now has a much easier way to dump his or her silver back on the market – not to mention the fact that the existence of the Silver ETF also makes it easier for folks who want to short silver without doing it via futures:

Silver Market Surplus/Deficit

My guess is that silver will continue to underperform going forward and will have a hard time breaking above $15 an ounce until we see a deficit situation once again.  Let us now discuss the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to September 15, 2006) - For the week ending September 15th, the Dow Industrials rose 169 points while the Dow Transports rose 209 points - resulting in the most powerful up move since the bounce off the mid August bottom. More importantly, the Dow Transports managed to close above its August 16th high of 4,421.05 this Wednesday - when it closed at 4,451.45 - suggesting that this rally has just gotten much more sustainable. Readers please stay tuned, but my guess is that the Dow Industrials will most probably close above its all-time high at some point in the next few weeks.

For the week ending September 15, 2006, the Dow Industrials and the Dow Transports both enjoyed the most meaningful rally since mid August – the former rising by 169 points while the latter rising by 209 points.  More importantly, the Dow Transports managed to close above its August 16th high of 4,421.05 last Wednesday.  As I mentioned in last weekend's commentary, this is an important development, as I stated then: “In order for the stock market to embark on a sustainable rally going forward, it is imperative to see the Dow Transports to continue to close above its August 11th low.  And in order for a healthier rally going forward, it is imperative for the Dow Transports to close above its August 16th closing high of 4,421.05.”  The fact that the Dow Transports managed to close above its August 16th high so quickly implies further strength in both the Dow Industrials and the Dow Transports going forward.  The question now is: When will we shift to either a 75% or 100% long in our DJIA Timing System (from the current 50% long position)?  According to the Stock Trader's Almanac, the week after expiration during September has been a down week for 12 of the last 15 years.  Given that the major market indices are now short-term overbought, there is a strong likelihood that this week will be a down week.  Should the Dow Industrials experience some kind of consolidation phase on relatively low volume or okay breadth, then this author would not hesitate going 75% or 100% long (implying an additional 25% or 50% long position) in our DJIA Timing System.  Readers please stay tuned.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% in late June to 17.6% in the latest week.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - As I have mentioned before, our most popular sentiment indicators have been and are definitely oversold - with the four-week MA of the combined Bulls-Bears% Differentials bottoming at 1.7% in late June (now at 17.6%). Given that the four-week MA has since reversed, readers may now want to look for higher prices here - and the market most probably won't endure a significant correction until this indicator gets overbought again.

There is no doubt that the four-week moving average of our popular sentiment indicators have reversed to the upside – suggesting a continuing trend of higher prices at least until this indicator gets overbought.  Again, should the market correct in the upcoming week on weak volume or okay breadth, then don't be surprised if this author shifts to a 75% or 100% long position in our DJIA Timing System.

A couple of weeks ago, I had introduced a new sentiment indicator that has worked well in the past and which I believe will continue to perform relatively well at least for the foreseeable future.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISEE Sentiment vs. S&P 500 (October 28, 2002 to Present) - Lowest reading since late October 2002 - suggesting that the market has bottomed or in the process of bottoming...

As one can see from the above chart, the 20-day moving average of the ISE Sentiment is now at a level not seen since late October 2002, and has in fact continue to decline further from last week's levels (from 108.7 to 105.8).  Meanwhile, the 50-day moving average is now at a level not seen since the recording of this indicator (declining also from 116.0 to 113.7).  This suggests that the market has already bottomed or is in the processing of bottoming out (most likely the former) – and is preparing itself for a powerful up move at some point in the next few months.

Conclusion: As I mentioned last week, while folks all around us are predicting a further stock market correction over the next couple of months, it is important to remember the one big difference between this past hiking cycle and virtually all the cycles prior to the 1994 to 1995 hiking cycle.  The big difference is: Similar to the 1994 to 1995 rate hike cycle, this current cycle had been preemptive in nature – in that the Federal Reserve had attempted to “take away the punchbowl” as early as it can (in fact, as early as June 2004), while many of the past hiking cycles didn't actually start until inflation really got out of hand (e.g. the 1970s).  In those previous cycles, the Fed ultimately had to raise the Fed Funds rate to 8% to 15% - thus not only crushing inflation but the rest of the economy and stock prices as well.  The fact that his one has also been preemptive is evident by the popping of the housing bubble and the peaking of both gold and crude oil prices with the Fed Funds rate only at 5.25% (for comparison purposes, the Fed Funds rate peaked at 6% on February 1, 1995) – suggesting that the Fed does not have to raise any further – which should be a boon for both the stock market and the economy going forward.

As for the one big difference between the current hiking cycle and the 1994 to 1995 hiking cycle, it is this: While both had been preemptive in nature, the current hiking cycle had also been well-communicated in advance and did not involve any big increases (as opposed to a huge 75 basis point hike on November 15, 1994).  This has the additional effect of significantly decreasing volatility in the financial markets – as evident by the lack of high-profile hedge fund blowups and stock market volatility over the last two years compared to the 1994 to early 1995 period (when many hedge funds were forced to close).  In other words, there probably does not have to be a 10% correction in the S&P 500 before we see a sustainable rally going forward.

As for commodities such as crude oil or precious metals such as gold, I am now cautiously bearish (even though I believe that they have made significant tops), given that commodities are now very oversold on a short-term basis and given that non-confirmation (so far) by the Canadian dollar on the downside (again, note that both the Australian and the New Zealand dollar have confirmed by rolling over).  However, any position on the long side should be strictly short-term in nature – but for now – I do not even see any short-term trade materializing on the long side just yet.

Signing off,

Henry To, CFA

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