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A Year-End Surprise in the Dollar?

(November 12, 2006)

Dear Subscribers and Readers,

As of Sunday afternoon on November 12th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that “the death of the U.S. consumer” has been way overblown.  We are also very bullish on good-quality, growth stocks.  We are no longer as bullish as Sysco, given its recent run-up since early August and given the inevitable rise in its food costs on the back of the current strength in the agricultural commodities. 

The strong recovery of the major indices from the correction during the week prior to last suggests that the market is technically strong, even though it is still short-term overbought.  Probability suggests that the market should still be in a corrective phase over the next couple of weeks – but any correction that develops from current levels should be relatively shallow to trade around.  Moreover, even should breadth top out here, the major market indices typically should still have four to six months to run being forming a significant top (based on action in a typical bull market).  And finally, many of the major hedge funds out there are underinvested and underexposed to U.S. equities in general (not to mention that a favorite trade of many “quant” hedge funds since 2000 have been short the VIX and U.S. stocks – a trade which started to unravel for the first time in July of this year) and as the end of 2006 approaches, many of these hedge funds will be in an unenviable position of trying to beat the S&P 500 – by either buying “high beta” stocks (such as growth stocks) or by leveraging up on S&P 500 futures.  So again, while it may be tempting to take quick short-term profits here, I urge our readers not to get “cute” and to try to time this market on a short-term basis.  For a good reason why, please refer to the conversation between “Old Partridge” and Elmer Harwood in the book “Reminiscences of a Stock Operator,” the “fictional biography of Jesse Livermore by Edwin Lefevre. 

As an extension to our commentary on the South Korean economy in our mid-week commentary, folks who complain about the “toughness” of the relatively new U.S. bankruptcy laws must be glad that they don't live in South Korea, as South Koreans are almost “criminalized” should they ever file for personal bankruptcy.  In some cases, for example, folks who declare bankruptcy are stripped of their professional licenses, are unable to ever open a bank account, and sometimes would have to quit their job if they work for a public financial institution.  While I am definitely bullish on South Korea going forward, this tough bankruptcy law definitely makes it difficult for entrepreneurs to start their own businesses or to take a risk and embark for the career or job that they have always loved.  While South Koreans are as intelligent and resourceful as Americans are, this can act as a debilitating force in the development of new technologies and in commercializing those technologies.  Moreover, the venture capital industry is backed by only a small base of institutional investors – as can be gleaned from the following chart:

Limited Partners of VC Funds by Type

As can be seen from the above chart (courtesy of the most recent IMF paper on South Korea), a significant portion of VC funding in South Korea comes straight from the government, and since the VC budget is reviewed on an annual basis, consistent individual VC funding from the government could only be viewed as uncertain at best.  Moreover, the average lifespan of VC funds in South Korea is only five years, vs. ten years in the United States.  Given the tough bankruptcy laws and given the lack of an institutional and sophisticated venture capital industry, it is definitely difficult to envision any “ground-breaking” or “paradigm-shifting” technologies or companies emerging out of South Korea anytime soon (despite the population's strong academic achievements and very high overall R&D spending relative to the rest of the developed world).

Let us now discuss the subject of this weekend's commentary – the U.S. dollar.  I first wrote about the U.S. dollar in our May 1, 2005 commentary.  For readers who have not been with us for that long, that was the first commentary in which I started discussing the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index.  In that commentary, I stated:

Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve.  By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005!  That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied.  This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.

Since our May 1, 2005 commentary, this inverse relationship has more or less still hold true, as evident by the following monthly chart showing the annual change in the U.S. Dollar Index. vs. the annual change in the rate of growth (second derivative) in foreign reserves:

Annual Change in U.S. Dollar Index vs. Annual Change in Rate of Growth in Foreign Reserves (Monthly Chart) - Should be converging! The surprise for the rest of this year may be a rising dollar - as the market starts to discount lower economic growth in the Euro zone and the major commodity economies.

Please note that the second y-axis has been inverted.  This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks.  Please note that while the recent change in the growth of foreign reserves have been increasing and is now hugging the zero line (implying that the dollar should remain at the same level as it did this time last year), the U.S. dollar index has been even weaker, as the annual return is now less than negative 7% (the value of the U.S. Dollar Index at the close last Friday divided by the November 2006 monthly close).  Historically, the action in the U.S. Dollar Index and our foreign reserves indicator does not diverge for long – suggesting that the U.S. dollar should now start to rise – all things being equal.

As our subscribers should know, however, not all things are equal.  As a matter of fact, there could be thousands of variables impacting the value of the U.S. dollar against the Euro, Pound, Yen, Canadian Dollar, Australian Dollar, Swiss Franc, etc., at any given time.  One of those variables is sentiment, and while there isn't a consistently reliable sentiment indicator on the direction of the U.S. Dollar (with the exception of the Newsweek cover at the end of 2004 and possibly the Commitment of Traders data), it is probably worthwhile to mention that the Rydex family of funds has recently created a “Rydex Dynamic Weakening Dollar” fund – which is essentially a mutual fund that attempts to mimic the returns of a portfolio that is 200% short the U.S. Dollar Index.  Unlike the COT report, such a chart showing the amount of assets (either on an absolute or a cumulative flow basis) is very representative of what the typical retail investor is thinking (as institutional investors would just go short the U.S. dollar with the futures contract) with regards to the future direction of the U.S. Dollar.  Following is a daily chart courtesy of showing the action of the Rydex Dynamic Weakening Dollar Fund, but more importantly, the level of assets and the cumulative flows into the fund over the last 17 months:

Rydex Dynamic Weakening Dollar (RYWBX)

As can be seen from the above chart, the level of bearish dollar assets remains high by historical standards (although I will admit, it is a short history).  Moreover, the comparable amount of assets in the Rydex Strong Dollar fund (not shown) is a paltry $20 million.  Given this and the U.S. dollar bearish chatter I have been witnessing on my discussion boards, there is a good chance that the U.S. dollar would rise from current levels.

Another variable which is important to the future direction of the U.S. Dollar is the performance of the economy, i.e. the performance of the U.S. economy relative to Europe, Japan, Great Britain, Australia, etc. going forward.  The most recent third quarter weakness in France notwithstanding (the French 3Q GDP growth number came in at precisely 0% as opposed to an estimate of 0.5%), leading indicators in the Euro Zone in general have been consistently getting weaker relative to leading economic indicators for the U.S. economy.  Quoting from the November 10, 2006 press release of the OECD Composite Leading Indicators publication:

The latest composite leading indicators (CLIs) suggest that slow economic expansion lies ahead in the OECD area. September 2006 data show improved performance in the CLI's six month rate of change in the United States and Japan, but weakening performance in the Euro area. The latest data for major OECD non-member economies point to a weakening outlook for Russia and India, moderating growth in China and steady expansion in Brazil. [emphasis mine]

Following is the relevant chart showing the performance of the OECD Composite Leading Indicators for the Euro Zone, the major five economies in Asia (Japan, China, India, Indonesia, and South Korea), and the U.S.:

OECD Composite Leading Indicators

As shown on the above chart, the most recent readings of the U.S. leading economic indicators have been trending up and are about to surpass the readings coming out of the Euro Zone.  Moreover – given that Germany is scheduled to increase its value-added tax (VAT) from 16% to 19% starting on January 1, 2007, and given that Italy has already raised income taxes in their 2007 budget, there is no question in my mind that economic growth in Europe will be less than that of the American economy in 2007 – thus preventing further rate hikes by the European Central Bank.  All these factors should be bullish for the U.S. Dollar.

Let us now shift back to the stock market and 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 October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to November 10, 2006) - 1) After over six years, the Dow Industrials has finally surpassed its all-time high (on October 3, 2006) of 11,722.98 made on January 14, 2000, while the Dow Transports surpassed its all-time high of 3,783.50 (made on May 12, 1999) way back in December 2004. 2) For the week ending November 10, 2006, the Dow Industrials rose 122.39 points while the Dow Transports rose 65.51 points. While the Dow Industrials has already completely reversed the loss of the week before last, the Dow Transports has only managed to recover 50% of that loss. Going forward, the Dow Transports is definitely the index to watch - although the continuing weakness in oil prices should definitely help. While the two popular indices are still somewhat overbought, readers who are long should continue to hold on for now - and not try to be *cute* in timing any subsequent corrections - as I believe that both of these indices will be at higher levels where they are now by the end of this year.

For the week ending November 10 , 2006, the Dow Industrials rose 122 points while the Dow Transports rose 66 points.  As mentioned on the above chart, the Dow Industrials managed to reverse entirely the loss from the week before last – but meanwhile, the Dow Transports continues to lag (recovering only 50% of that loss).  While the noticeable underperformance of the Dow Transports is definitely a red flag (especially in the absence of rising crude oil prices), it is still not much of a worry at this point.  However, this weakness in the Dow Transports (along with the general weakness of the Dow Transports since early July) should continue to be monitored.  For now, this merely looks like a corrective phase in both the Dow Industrials and the Dow Transports.  We continue to remain 100% long in our DJIA Timing System, given that the intermediate trend remains up and given that we expect the Dow Industrials to reach a higher level by the end of this year than the level it closed at last Friday.  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 28.0% for the week ending November 3, 2006.  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:

With the exception of the week ending September 29, 2006, the four-week MA of this indicator has been rising relentlessly since early August – and has again risen in the latest week despite it already being in overbought territory the week before.  Readers who have been looking to initiate new long positions in the stock market should continue to wait until after this indicator has experienced more of a correction in the upcoming weeks.

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending November 10, 2006, the four-week MA of the combined Bulls-Bears% Differentials rose from 28.0% to 29.6%. Given that the stock market may still be in a corrective phase and given that this indicator is still overbought, readers may want to wait for better prices before initiating new positions here. The intermediate-term trend, however, remains up.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  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) - The 20 DMA hit its lowest reading since late October 2002 on September 15 and has since reversed and has even risen above the 50 DMA - suggesting that the market has bottomed and that the trend continues to be up. That being said, the ISEE Sentiment is rising back up very quickly - and thus bulls should not be *buying the dips* here until we some pullback at least in the 20 DMA.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment reversed back to the upside five weeks ago (from 101.5 to 108.2) and has risen further to 144.4 in the latest week (up from 138.1 the week before).  Meanwhile the 50-day moving average also reversed on the upside from an extremely oversold level of 109.1 five weeks ago to the current reading of 122.9.  The fact that the shorter-term moving average has reversed back to the upside and has now crossed above the 50-day MA suggests that the market has already bottomed and that the intermediate uptrend remains intact.  However, given the recent relentless rise in the ISEE sentiment (the 20 DMA is now way above the 50 DMA) and given the latest correction in the stock market, bullish readers should definitely be concerned about initiating long positions here.  Anyone that wants to initiate long positions in the stock market should wait until we see some kind of dip in ISEE sentiment – at least in the 20-day MA.

Conclusion: Despite all the recent jitters surrounding the potential diversification of the reserves of the People's Bank of China into Euros or Yen, probability suggests that the U.S. dollar should rise over the next two to three months, and a good case could be made for holding the U.S. dollar no matter whether one looks at the amount of foreign assets held in the custody of the Federal Reserve, the current bearish sentiment among retail investors (which should act as a good contrarian indicator), or U.S. economic growth vs. European and Japanese economic growth going forward in 2007.  Moreover – given that the Democrats have now assumed control of both the House and the Senate, and given that Senator Kent Conrad of North Dakota should head the Budget Committee going forward (he is very much a budget hawk and has made balancing the U.S. budget as a very important goal), there is a good chance that the budget deficit should decrease in 2007 – which should also be bullish for the U.S. dollar.

As for the stock market, it is still currently short-term overbought and is looking like it is still in a corrective phase – a phase which began slightly over two weeks ago.  However, even though both the market and sentiment is still too overly bullish on a short-term basis, the intermediate term trend remains up – as we are nowhere close to any kind of exhaustion yet.  Moreover, the relative valuation of the stock market – compared to bonds, and even real estate and commodities – is still low on a historical basis.  From this standpoint, we are definitely nowhere close to a top (although the readings in the Barnes Index can just spike higher if the bond market just collapses from here).  As I have mentioned many times before in both our commentaries and in our discussion forum, predicting a top is definitely the most difficult practice in the field of the investing. It is not a science, but an art. It simply cannot be done on a consistent basis. As I have said over the last few months, investors should now overweight U.S. domestic large caps and growth stocks – as opposed to cyclical stocks and anything that has to do with commodities.  Again, we remain 100% long in our DJIA Timing System and do not intend to shift to a less bullish stance for now.

Signing off,

Henry To, CFA

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