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A Review of the Stock Market

(April 19, 2007)

Dear Subscribers and Readers,

As I am finishing up this commentary, the June S&P 500 futures contract is down nearly 10 points, and many Asian markets are having their worst down day since the middle of March.  At the same time, I am also told that net hedge fund exposure to equities rose to 59.2% from 56.5% last week.  Interestingly, the last time hedge fund exposure to the stock market was this high was immediately prior to the late February/early March sell-off in equities, when net hedge fund exposure touched a high of just slightly over 60%.  At the bottom of the last sell-off, net hedge fund exposure dropped to as low as 48%, but it has since bounced back as hedge funds rushed back into the global equities.  Could they be disappointed, once again?

Indeed, if one chronicles the amount of net hedge fund exposure to equities since mid 2002, one would find that net hedge fund exposure has never gotten higher than 62% (it hit this level in early December 2004).  To the extent that hedge funds are now driving the direction of the global equity markets, this suggests that the short-term potential upside of the stock market is rather limited.  For folks who haven't been keeping track of any other stock markets besides the domestic market, following are some weekly charts of the more popular global market indices.  Indeed, the overbought condition of the world's stock markets becomes quite evident after one has taken a good look at the following charts (courtesy of

Australia ASX All Ords Composite ($AORD)

As of April 18, 2007, the Australian All-Ordinaries Index is up more than 25% from its mid 2006 lows.  Since the end of the bear market in late 2002 and early 2003, the Australian stock market has more than taken advantage of the latest commodity boom – more than doubling in four years.  For foreign investors (especially the Japanese and Americans), this has been a doubly good ride, as the Australian dollar also rose approximately 50% against the US$, bring total gains of more than 200% from the lows of late 2002 to early 2003.

German DAX Composite ($DAX)

The biggest market in the Euro Zone hasn't been weak either, as the German DAX Composite actually closed approximately 4% higher than the late February highs as of April 18, 2007.  Moreover, it is up more than 30% since the mid 2006 lows, and has more than tripled since the early 2003 lows.  Combined with a 30% appreciation in the Euro since early 2003, U.S. investors could have reaped a greater than 300% total return in German equities if they had invested in the early 2003 lows.

London Financial Times Index ($FTSE)

Of course, the UK market has not been weak either, although it is “only” up about 17% or so since the mid 2006 lows.  However, the FTSE has more than doubled since the early 2003 lows.  Taking into account currency gains, of 25% or so, this would have resulted in a gain of 150% or so for U.S. investors if they invested in the FTSE in early 2003.

Hong Kong Hang Seng ($HSI)

One of the major stock markets in Asia, the Hong Kong market (as represented by the Hang Seng Index) has also performed strongly – rising over a third since the mid 2006 lows and up nearly 200% since the early 2003 lows.

Tokyo Nikkei Average ($NIKK)

Even Japan – one of the worst-performing economics over the last 15 years – has seen a dramatic performance in its stock market (as measured by the Nikkei) since early 2003, more than doubling from a level just slightly under 8,000.  Since the mid-2006 lows, the Nikkei has also managed to rally more than 25%.

Shanghai Stock Exchange Composite Index ($SSEC)

Of course, we can't discuss the world's stock markets without at least devoting some space to the Chinese stock market.  Even since the bear market (which began in 1994) ended in mid 2005, the Shanghai Composite Index has appreciated more than 250%.  As of the beginning of this year, the Shanghai Composite has rallied over 30% alone, and has nearly risen 150% since the mid 2006 lows.

For investors who have been watching the development of the Yen carry trade, there is now no denying the fact that the Yen has again become very oversold – similar to levels we witnessed immediately prior to the late February/early March correction.  Moreover, the fact that not many folks are now talking about this oversold condition (especially against the Euro and the Pound) suggests that we need to be more careful than ever.  Following is a chart illustrating this oversold condition – a daily chart showing the Euro-Yen cross rate vs. its percentage deviation from its 50-day moving average from February 1999 to the present:

Euro-Yen Cross Rate vs. Percentage Deviation from its 50 DMA (February 1999 to Present) - The percentage deviation of the Euro Yen cross rate from its 50-day moving average hit a level of 3.10% at the close on Monday - continuing its recovery from the decline during late February and early March. At the most recent bottom on March 5, the percentage deviation from its 50 DMA declined to negative 3.59%, the most oversold level since June 7, 2005.  For now, one cannot conclude that the carry trade is over yet - although on both a technical and purchasing power parity basis, the Yen is now very oversold relative to the Euro. Both carry traders and stock market bulls should now be very careful.

As mentioned on the above chart, the percentage deviation of the Euro-Yen cross rate from its 50-day moving average hit a level of 3.10% at the close on Monday – representing the most overbought (of the Euro vs. the Yen) level since August 8, 2005 (when it hit a level of 3.16%).  Given that so much of the world's liquidity is now dependent on the “funding” from Japanese institutional and retail investors – not to mention hedge funds and private equity funds borrowing in Yen (as well as Korean homeowners who take out mortgages denominated in Yen) – there is no question that the world's stock markets are now very vulnerable to a correction going forward, especially since we're now passing from a seasonally strong period (and month) into the weaker six months of the year.

For now, however, we remain 100% long in our DJIA Timing System, as we believe that the market's intermediate term trend remains up – given decent valuations (we probably won't significantly trim down our position until or unless the Barnes Index hits a level closer to 70 – it is currently at 57.60), decent breadth and volume, and relatively bearish to neutral sentiment.  The stock market also remains well supported by private equity buyouts and insider buying.  Stay tuned for further updates.

Signing off,

Henry To, CFA

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