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Still a Believer in the Dollar Rally Scenario

(November 23, 2006)

Dear Subscribers and Readers,

As subscribers may know, the U.S. dollar index took a beating yesterday, declining approximately 0.7% overall – and declining 1.0% against the Yen and 0.8% against the Euro on a pickup in jobless applications and a lower-than-expected reading in the University of Michigan Consumer Sentiment Index.  However, it is interesting to note that even before these two reports were released early yesterday morning, traders had already discounted a 50 basis point ease in the Fed Funds rate by Fall 2007, along with a corresponding 50 basis point rate hike in both the Euro Zone and Japan by the same time next year.  The reports released yesterday morning did nothing to change that view – and given that these reports are not relatively indicative of future economic growth (or holiday sales in the case of the U of Michigan Consumer Sentiment Index) anyway, my guess is that the fall of the U.S. Dollar Index was more of a panic selling on relatively light pre-holiday trading more than anything else.

I continue to believe that economic growth in the Euro Zone will be lower-than-expected in 2007, given the additional 3% increase in the German VAT and the increase in Italian income taxes starting January 1, 2007.  Moreover, the recent weakness (quarter-over-quarter growth of 0% in GDP and lower-than-expected consumer spending in October reported yesterday) in the French economy is particularly notable – given that 1) Together with Germany and Italy, France makes up the “Big Three” out of all the countries in the Euro Zone, and 2) Unlike both Germany and Italy, France has been experiencing higher-than-average growth in both private consumption and disposable income since 1999 – the year when monetary union in the Euro Zone occurred and when the Euro was adopted as its single currency.  Following are two graphs comparing cumulative growth in the countries of the Euro Zone before and after the monetary union on January 1, 1999 – courtesy of the European Commission:

Cumulative growth in the countries of the Euro Zone before and after the monetary union on January 1, 1999 - courtesy of the European Commission

Aside from the recent lower-than-expected consumer spending, there is also something else of concern: housing prices in France.  Quoting the Bloomberg article: “After rising more than 10 percent a year since 1999 and more than 15 percent in the past two years, French house prices are likely to flatten out by the end of next year, he said. The strength of the market has helped push spending on home- equipment goods, which last month surged 19 percent from a year earlier.

In other words, the surge in French housing prices have actually been higher than the rise in median housing prices here in the United States.  While this “housing bubble” in France does not have to top out at current levels, it is difficult to see French housing prices continuing its astronomical rise over the last few years, given that the European Central Bank has indicated it will continue to hike interest rates.  Moreover, as can be seen from the following chart, the French housing market has been the second-best performing market since 1992 – right behind Spain.  Following are two charts showing the rise in housing prices in the Euro Zone countries from 1992 to 2005 (with the 2000 housing prices = 100):

The rise in housing prices in the Euro Zone countries from 1992 to 2005 (with the 2000 housing prices = 100)

Sharp-eyed readers should notice that German housing prices have actually been trailing many Euro Zone countries over the last ten years.  The inevitable question now is this: Sure, the increase in the German VAT from 16% to 19% will impose an additional burden to German consumers, but what about a potential German housing boom?  Given that German housing prices have been trailing virtually all of Europe for the last ten years, surely the German housing market should now become attractive – especially relative to the Spanish and French housing markets.

That is definitely a good question – but this author sees two initial flaws with this conjecture.  Firstly, the European Central Bank is in the midst of hiking rates, not easing them.  And make no mistake: The ECB is – at this point – targeting European housing prices, since there is little to no inflation showing up in the consumer price indices.  And given that the European Central Bank effectively makes policy for the entire Euro Zone, it is difficult to see the German housing market taking off while the ECB is busily hiking rates and targeting the housing market.  Secondly, there has been little to no economic reforms in Germany over the last 12 months, despite the rhetoric that has been coming out right before the Presidential election earlier last year.  For example, foreign ownership of German residential real estate continues to be severely restricted – and German REITS have specifically been prevented from acquiring residential properties for investment purposes.  In other words, the German residential real estate market (if you can really call it a “market”) remains as unattractive as ever, and thus any “housing boom” that emerges out of the German real estate market will most probably not be significant enough to have a positive impact on consumer spending going forward.

Finally, here is something that not many economists have mentioned before: It is important to note that in terms of manufacturing activity and manufacturing exports, the countries in the Euro Zone collectively represent the highest cost producer in the world today.  This is a direct result of both the high Euro (relative to the U.S. Dollar, the Yen, and to virtually all Asian countries including the Renminbi and the South Korean Won) and the relatively high wages and low productivity.  In other words, the countries in the Euro Zone is the marginal producer – not unlike oil sands companies in terms of oil production, U.S. steel companies or the position of the “12th man” on a basketball team when all of the starters and even the “6th man” and the “7th man” has been injured and cannot play.  In a world that has been experiencing an inflationary boom with capacity constraints (similar to the experience we have had from early 2003 to May 2006), the marginal producer always experiences substantial economic growth, given that – just like the 12th man on a basketball team with seven injured players – it has just gone from being a producer that have never produced in the recent past to a producer that is suddenly competitive on a global scale (because of high prices resulting from capacity constraints).  However, given that much of the world is expected to be mired in an economic slowdown in 2007, and given the fact that China, Japan, and Vietnam have been spending immense amounts of sums on capital spending, there is a good chance that much of these capacity constraints will simply go away next year.  If that is the case, then not only will European economic growth decline substantially, but also the trade balance for the entire region will be hard hit as well.  In such a scenario, the European Central Bank will have no choice but to ease – to both jump start domestic spending and investments and to make its exports more competitive relative to other manufacturing countries.

I will now end this commentary with a quick discussion on the NYSE short interest – which was just released at the close on Monday.  Following is the monthly chart showing the NYSE short interest vs. the Dow Industrials from November 15, 2000 to November 15, 2006:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to November 15, 2006) - For the month ending November 15, 2006, total short interest on the NYSE decreased approximately 96 million shares to 9.65 billion shares - the first monthly decrease in short interest since February 2006. Despite this, however, the short interest on the NYSE continues to remain high. In fact, the latest short interest reading still represents the third highest on record. Chances are that more shorts will need to cover their positions before we will see a significant top in the stock market.

As mentioned on the above chart, total short interest on the NYSE declined 96 million shares to 9.65 billion shares in the latest month.  Nothing substantial has changed however (even though this is the first decline in NYSE short interest in nine months), as the current short interest on the NYSE is still the third highest on record.  In terms of sentiment, valuation, breadth, and momentum, we are still not close to even an intermediate term top in the stock market just yet.

Have a great Thanksgiving, everyone!

Signing off,

Henry To, CFA

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