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Making Sense of all the Confusion

(November 1, 2007)

Dear Subscribers and Readers,

With oil prices rising to nearly $100 a barrel, gold at near record highs (for all intent and purpose, gold are at record highs, save for two days in January 1980), 3Q GDP growth at 3.9%, the S&P 500 near record highs, the US Dollar Index at new multi-year lows, the Fed chose again to cut both the discount rate and the Fed Funds rate by 25 basis points, bringing them to 5.0% and 4.5%, respectively.  Moreover, even the “traditional” leading indicator of the Fed's monetary policy – US manufacturing utilization levels – was still indicating “no Fed cut,” as manufacturing utilization levels were still near multi-year highs, courtesy of the following chart from Reuters EcoWin:

Monthly Capacity Manufacturing Utilization vs. Average Fed Funds Rate

As can be seen on the above chart, the Fed has usually cut only when capacity utilization is on the decline.  The current mantra from the bears is, not surprisingly, the “death of the US consumer,” but given the extremely weak U.S. Dollar (especially relative to the Indian Rupee, the Korean Won, and other currencies which don't show up on the U.S. Dollar Index), and given that global economic growth still remain decent (although as indicated by the OECD leading indicators, global economic growth is slowing down), it thus comes as no surprise that manufacturing capacity utilization is still holding up.

A better illustration of just how world economic growth is currently doing would be the readings on our global overbought/oversold model as of as of the close at October 31, 2007, a model that we first discussed in our August 2nd commentary.  As we mentioned in that commentary, the inner workings of this global overbought/oversold “model” are rather simplistic.  For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages.  Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998.  This way, we are comparing apples to apples and can control for country or region-specific volatility.  Following is our Global Overbought/Oversold Model as of the end of October 2007 (note that we have also added the CRB Total Return Index in this model since our August 2nd commentary):

Global Overbought/Oversold Model as of the October 31, 2007

As can been seen on the above table, there is currently no stock market in the world today that is oversold.  By “oversold,” I mean any percentile ranking on any timeframe which is below the 15th percentile (i.e. a current % deviation that is more oversold than 85% of its readings going back to December 1998), or approximately one standard deviation.  At the end of September, there were three countries that fit that criteria: 1) Jordan (oversold on a two and three-year basis), 2) Ireland (oversold on a 6-month basis), and 3) Austria (also oversold on a 6-month basis).  Since the end of September, these three countries have rallied 15.36% (this is not a typo), 2.22%, and 7.37%, respectively.

There is no doubt, however, that many global central bankers are still worried by the current credit crunch in the mortgage and asset-backed markets that were initially triggered by the peak in the subprime market.  For example, the Federal Home Loan Banks System has been acting as a lender of last resort for many banks (including Countrywide Financial and Washington Mutual) that have been shut off from the commercial paper market – borrowing a record $163 billion from this government-sponsored “Depression relic” during August and September.  Quoting the Bloomberg article:

The home loan banks ``were the only game in town for a lot of borrowers,'' said Jim Vogel, head of agency debt research at FTN Financial a securities firm in Memphis, Tennessee. They are ``like an old watch your grandfather left you years ago, and you pull it out of the drawer and find it's the only timepiece you have.''

“You don't want to use the phrase `going out of business' in the press, but they would be in a much, much worse liquidity position if they didn't have the Federal Home Loan Bank system sitting out there,'' said Paul Miller, an analyst at Friedman Billings Ramsey Group Inc., a securities firm in Arlington, Virginia.

As discussed by GaveKal earlier this week, many global central bankers have also expressed both dismay and disbelief on why the world's stock markets continue to rally, given the underlying credit crunch that is still in place.  What they had not discounted, however, is the fact that while speculators and lenders are now staying away from the US and European real estate markets, many of them are still willing to snap up emerging market equities, emerging market real estate, or to lend money to these speculators at current prices and interest rates.  In other words, the liquidity is not flowing to where they should, but in those asset classes that are still rising, such as emerging market equities, gold, crude oil, and emerging market real estate.

In light of these events, it comes as no surprise that the Fed has indicated it will stay neutral for the foreseeable future, pending more data from the financial markets.  At this point, it is still too early to glean the “strike price” of the “Bernanke Put,” assuming that they are more reluctant to further cut rates going forward.  Looking at their most recent record going back to mid August, the “strike price” is probably in the range of an S&P 500 level of 1,400 to 1,475, but as I mentioned before, the Fed is probably willing to give the market more “leeway” as long as GDP growth (or GDP growth estimates) don't go below the zero line, in light of everything that has happened since ((a housing market that is still in trouble, made worse by record oil prices, multi-year low USD, etc.).  Moreover, much of the rest of the world is still in a tightening mode (the European Central Bank would have raised rates already if the Euro wasn't already at such a high level, given its higher-than-expected inflation reading yesterday), given that consumer price inflation is still rising in much of the world today.

In light of a Fed that is more reluctant to lower rates going forward, it again makes more sense to focus on the stock markets instead.  As I mentioned in our weekend commentary, liquidity within the U.S. corporate bond and U.S. stock markets are still relatively tight, given both rising yield spreads and given the relatively weak breadth in the U.S. stock market.  The latter can be witnessed in the most recent lower highs in the advance/decline line of the S&P 500, as illustrated by the below chart, courtesy of

SPX A-D Lines 1998-Present - Lower highs in the S&P 500 A/D line, despite the fact that index has been one of the strongest market index over the last six months...

Signing off,

Henry To, CFA

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