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Risks Still to the Downside

(August 9, 2007)

Dear Subscribers and Readers,

It is good to be “back” and to be again writing a “full-blown” mid-week commentary for every one of you.  I again apologize for not being able to publish a full-blown commentary last weekend, as my partner/webmaster, Rex, was traveling the entire weekend.  However, in our “ad hoc” commentary that I sent on Sunday evening, I believe it captured most of what I had wanted to say at the time – the gist being that even though the markets were getting very oversold at the time, the best thing to do would still to be patient and wait a few more weeks before getting back into the long side, especially if one is buying individual stocks.  There were two major reasons for this: 1) We have finally – after nearly five years of easy liquidity and high monetary velocity (that is, the increasing propensity of investment bankers and investors to take more risks) – witnessed a “sea change” in liquidity and psychology, and that this thus deserves a “re-rating” of both asset prices and implied volatility in the financial markets going forward, 2) Even should the major indices bottom out soon, there would still be many stocks making new lows over the next few weeks, and thus there would still be ample opportunities to go long during that time.

I want to start this commentary by asking our subscribers to read John Mauldin's latest weekly commentary – more specifically, his first few paragraphs regarding the probability/possibility of higher headline inflation numbers during the latter parts of this year.  Quoting Garry Shilling's comments from John's article: "If you look carefully at the CPI figures (and tinker with the monthly numbers), you'll also discover that even if the figures average a 2% annual rate in the months ahead, the year-over-year headline CPI inflation rate will be pushing 4% by November. This is already 'baked in the cake.' Since Bernanke is clearly concerned with the inflation expectations of the public, as well as the Fed's credibility, that headline CPI figure may create some complications for cutting rates in the months ahead, unless resource utilization falls out of bed."

Note that this “inflation problem” is more of a function of what transpired in the latter half of last year, as opposed to what economists believe are going to happen in the last four months of this year.  That is, even should inflation remain benign (i.e. at about 2% or so) for the rest of this year, higher headline inflation numbers going forward are now a guarantee.  This higher inflation view during the 2nd half is also being confirmed by the latest CPI projections from Morgan Stanley, as shown in the following chart:

Note that higher headline inflation is not only going to be a US phenomenon in the latter parts of this year, but a Euro Zone phenomenon as well.  Combined with rising labor costs in both Asia and the Middle East, raw material costs in construction, food costs in China (and now starting to be passed on to other goods and services), and all-time highs in the Baltic Dry Freight rates, it is almost a given that world monetary policy would going to remain tight in the latter parts of this year, unless 1) the global equity markets break through last Friday's lows in a substantial way, or 2) we witness mass write-downs in the financial sector, due to a combination of hedge fund losses, significantly lower buyout/investment banking fees, and so forth – which not coincidentally, should also be accompanied by a substantial decline in the stock market.

Following is a chart showing the Baltic Exchange Dry Index vs. the CRB Index – both of which are near all-time highs:

While the stock market rallied as a response to the relatively hawkish Fed statement on Tuesday afternoon, this author believes that it was mostly a response to the short-term oversold conditions of the stock market.  Given Tuesday's late afternoon rally, and given Wednesday's 153.56-point rise in the Dow Industrials, the market – in the short-run – is not in oversold territory anymore.  Moreover, as I am typing this, the Eurodollar market is still factoring in a 75% chance of a 25 basis point ease in the Fed Funds rate by the December meeting, and a 100% probability of an ease in January 2008.  Assuming that headline inflation will spike higher later this year, it will be politically difficult to start easing by January, unless we witness some kind of dislocation in the financial markets, or unless commodity prices start plunging.  At this point, I believe our Fed Chairman is still more concerned about building his long-term effectiveness and reputation as an inflation-fighting Fed Chairman more than any short-term concerns – and so I would not be surprised if he continues to stand pat on the Fed Funds rate for longer than what most economists or investors are expecting.

As for the latest action in the stock market, the quality of the latest rally has been mediocre at best.  For example, a Lowry's intermediate sell signal was triggered on July 26, 2007 and shows no signs of reversing.  Moreover, Lowry's proprietary index of selling pressure has only gone down one single point over the last three days, even as the Dow Industrials rose over 475 points, showing that investors still have a high desire to dump their stocks into any significant rally.  For comparison purposes, Lowry's Selling Pressure Index rose a whooping 20 points last Friday alone.

Moreover, the mediocre breadth in the most recent three-day bounce can also be witnessed in the anemic rise in the NYSE common stock only A/D line (the following chart is courtesy of

Moreover, while the number of NYSE new lows that we are seeing is definitely something to write home about, this author personally does not believe it is an indicator of a severe longer-term oversold condition (although it would definitely qualify as a short-term oversold condition).  As a matter of fact, the multi-year high in the number of new lows in recent days is not that surprising, given the wide and impressive breadth that we have witnessed in this cyclical bull market since the October 2002 lows.  The following long-term chart (again, courtesy of showing NYSE New Highs vs. New Lows from 1968 to the present illustrates this perfectly:

Again, given the number of record new highs on the NYSE in recent years, it is reasonable to expect record new lows in any subsequent corrections.  As opposed to a longer-term oversold condition, the recent number of record new lows – to this author – is more of an indicator of two things: 1) Increasing divergences among different sectors and industries within the US stock market, and 2) Change of leadership within the stock market, from more speculative to less speculative, blue-chip type of stocks.  More importantly, this signals the fact that the stock market environment that many investors have become so familiar with over the last few years is shifting, as opposed to being a signal to establish long-term long positions.  Subscribers please take heed.

Signing off,

Henry To, CFA

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