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Not Too Hot and Not Too Cold?

(October 26, 2006)

Dear Subscribers and Readers,

As virtually every one and his neighbors should know, the FOMC meeting concluded at 2:15pm ET yesterday afternoon.  The Fed decided to stay pat with a targeted Fed Funds Rate of 5.25% (no surprise here) – and the FOMC statement was not a surprise either.  On the conclusion of the Fed meeting, the chances of a 25 basis point rate hike in January as implied by the Fed Funds futures declined from 16% to 10%, and folks are now betting that the Fed will cut rates sometime by the second quarter of 2007.

In other words, the Fed is now on the record stating that the U.S. economy is in a state of being “not too hot and not too cold,” although both myself and the other Fed governors are watching for signs of persistent and entrenched inflationary pressures. However, while this author is definitely supportive of an ease sooner rather than later – it is definitely of note that crude oil prices continued its ascent (eventually rising over $2 a barrel) after the conclusion of the Fed meeting.  Natural gas prices also rose nearly 10%.  Moreover, the base metals such as nickel, tin, zinc, and aluminum have also been enjoying healthy rallies – with the prices of the majority of these metals now at or close to all-time highs.  Following are daily charts of the spot prices for these four base metals from January 2002 to the present.  Let us first start with zinc – the element mostly common the manufacture of steel and in the production of batteries:

Daily Cash Prices of Zinc at the LME (US$ Per Ton) (January 2002 to Present) - The spot price of zinc is now either forming a double top or making an all-time high. Is this going to cause the Fed to hike going forward?

Of course – to say that the Fed will hike going forward because of continuing strength in zinc prices is definitely a stretch.  Most likely, the strength of zinc is attributed to the continuing strength of the Chinese steel and construction industries – leaving both zinc supply and inventories at a critically low level.  Most likely, the strength of zinc is a signal to the Chinese government and the Bank of China that they are failing in their efforts to curb rampant credit/construction/speculation growth in the country.

Tin – a base metal that is used in coating lead or zinc or steel to prevent corrosion has also been hitting all-time highs:

Daily Cash Prices of Tin at the LME (US$ Per Ton) (January 2002 to Present) - The spot price of tin actually making all-time highs as we speak. Is this now getting too hot for the Fed's comfort? Or will other central banks (such as the ECB) take up the task?

Nickel – a metal primarily used in the production of stainless steel, magnets, and coinage – has been “enjoying” a even more of a thrilling ride, as exemplified by the below chart:

Daily Cash Prices of Nickel at the LME (US$ Per Ton) (January 2002 to Present) - An unprecedented spike in the spot price of nickel - running up a further 49% after early May - the point at which all other metal prices made significant peaks. Again, is this a signal that the central banks of the world will continue to get tighter going forward?

Again, the question here is: Will this induce the Fed to hike going forward?  Probably not – but given that the above three metals are steel-related one way or another, the latest rally in these metals is certainly telling us that the Chinese government is not making much of an effort (surprise, surprise) to curb credit, economic, or speculation growth.

As far as what metals we should be watching for signs of inflation or higher-than-expected economic growth in the U.S., I would suggest looking at gold, silver, copper, and aluminum prices.  Gold, especially, has been acting very weak over the last few weeks – but should it take out the $600 level on the upside, then a Fed rate hike sometime down the road will again be on the table.  Meanwhile, both silver and copper are off their May highs but are still trading at respectable levels.  They should continued to be watched going forward.

As for aluminum, it has certainly been the least documented metal (out of gold, silver, copper, and aluminum) in both our commentaries and in our discussion forum.  So without further ado, let us take a look at the following daily chart of aluminum spot prices from January 2002 to the present:

Daily Cash Prices of Aluminum at the LME (US$ Per Ton) (January 2002 to Present) - The spot price of aluminum is nowhere close to its peak in May - but nonetheless, it has staged an impressive rally since mid-September. Stay tuned...

While the latest rally in aluminum prices is certainly not indicative of a resurgence of inflationary pressures, readers should definitely note that the spot price of aluminum is now at its highest level since May 31st.  Just like the action in gold, silver, and copper, this should also be something to watch out for going forward.

To me, the interesting thing about yesterday's Fed meeting is that most of the language in the FOMC statement was probably drafted before yesterday's rise in crude oil and natural gas prices.  Moreover, should the latest rally in the base metals continue, and should gold, silver, copper, and aluminum prices (not to mention corn) continue their rallies over the next week or so (the $600 level on gold and the $3.60/pound level on copper are the crucial levels to watch) then there is a good chance that the Fed will again be considering rate hikes again (even though the St. Louis Adjusted Monetary Base has been growing at its slowest pace in five years).

In light of this possible uncertainty, I would like to ask our subscribers to be careful in initiating long positions over the next few weeks, given that the market is: 1) Discounting a “not too hot and not too cold” scenario, or in other words, a “Goldilocks” scenario, and 2) Very overbought on both a short-term and intermediate term basis and is in need of some kind of correction.  It is no coincidence that we are now again hearing James Glassman calling for “Dow 36,000” and that both newsletter sentiment and our popular sentiment indicators have been ticking up over the last few weeks. 

That being said, the latest short interest on the NASDAQ has just been released – and interestingly, the latest short interest statistics show that the bears continue to be stubborn – not just on the NASDAQ but on the NYSE as well (which showed in last weekend's commentary).  Given that the NASDAQ is still in a bull market, the huge amount of short interest on the NASDAQ will provide a “cushion” for the stock market going forward.  Following is a monthly chart showing the amount of shares shorted on the NASDAQ vs. the value of the NASDAQ Composite from September 15, 1999 to October 13, 2006:

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to October 13, 2006) - Short interest on the NASDAQ rose 60.9 million shares in the latest month and is now at another record high of 7.41 billion shares. Short interest on the NASDAQ has now made all-time highs during seven of the last eight months. The 12-month increase in short interest is still at a high of 24.74% - marginally lower than last month's reading of 26.53% and the 34.27% reading in September 2001. Unless we are going to have another tech bust (which is not likely), then there is a good chance the NASDAQ Composite will continue its rally in the coming months.

As mentioned on the above chart, short interest on the NASDAQ rose another 60.9 million shares in the latest month - rising to a record high of 7.41 billion shares – the seventh record high for the seventh time out of the last eight months.  More importantly, the 12-month increase in the NASDAQ short interest is still at a very high level of 24.74% - marginally lower than last month's 26.53% reading and the 34.27% reading in September 2001.  Again, unless the bears are right and informed – meaning that unless we experience another technology bust – such as high short interest on the NASDAQ Composite should provide the “fuel” necessary to maintain the current rally in the coming months.

Despite this possibly uncertainty, and despite the overbought condition in the stock market, we continue to remain 100% long in our DJIA Timing System, since this author believes that – even though a correction is inevitable in the next few weeks – the stock market's trend remains up and thus both the Dow Industrials and the S&P 500 should be higher by the end of this year compared to yesterday's close.  This is also consistent with the recent action in the Dow Utilities (historically a leading indicator of most of the post World War II bull markets in the U.S.), as it closed at another all-time high yesterday.  Readers please stay tuned.

Signing off,

Henry To, CFA

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