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The Battle between the Bulls and the Bears

(July 10, 2009)

Dear Subscribers and Readers,

First of all, we would like to thank our subscribers for being patient with us on the one-day delay of our mid-week commentary.  We figured it was important to update you with the latest liquidity information from the world's central banks and not wait until the weekend.  As it were, we were not disappointed.  Let us now dive right in and discuss the most important indicators we are currently tracking.

After running an extremely loose policy for the last eight months, China's Ministry of Finance finally started selling its one-year central bank notes (CBNs) again yesterday.  In order to mop up excess liquidity, the Ministry of Finance implemented a plan to issue 35 billion yuan of three-month and one-year CBNs.  This follows the tightening move made by the People's Bank of China last week through pushing up money market rates and draining cash from the country's banks.  The shift by the Chinese government from an extremely loose to a slightly or semi-loose policy will definitely impact global liquidity growth at the margin and put a damper on both risk-taking and commodity prices.

The second (but just as important) item on our list was the surprise announcement by the Bank of England yesterday to effectively bring its quantitative easing policy to a close.  As covered in our last weekend commentary, the Bank of England has consistently purchased between 6 to 7 billion pounds in Gilts, commercial paper, and corporate bonds on a weekly basis – effectively monetizing these debts and creating money “out of thin air” in the process.  For the week ending July 2nd, the Bank of England purchased 6.5 billion pounds (US$10.6 billion) in debt. As of July 2nd, the Bank of England has purchased 105.6 billion pounds of debt, and was only 19.4 billion pounds away from its self-restricted limit of 125 billion pounds (with an option to raise the limit to 150 billion pounds).  Many analysts and traders were looking for the Bank of England to raise its limit from 125 billion to 150 billion pounds yesterday.  Without lifting the ceiling, the Bank of England would no longer be able to purchase any more assets in just a couple of weeks at its current pace (6 to 7 billion pounds weekly).

As soon as the Bank of England released their statement to effectively end their QE policy, the 10-year gilt sold off nearly 20 basis points while the FTSE 100 declined by nearly 20 points.  With both the European Central Bank and the Bank of Japan no longer flooding their markets with liquidity, the Bank of England and the Federal Reserve has been the only two major central banks willing to monetize their debts and “print money” to prop up global liquidity over the last two months.  With the Bank of England (and to a lesser extent, the People's Bank of China) now halting its QE policy, it is now solely up to the Federal Reserve “to pick up the slack.”

Unfortunately – as we covered in last weekend's commentary – while the Fed has signaled its commitment to its QE program, the pace of its asset purchases has slowed down over the last seven weeks.  For the week ending July 1st, the Fed's asset purchases amounted to only $9.3 billion (its lowest level in four weeks).  The Fed's purchases for the latest week (ending July 8th) were just as muted, clocking in at $12.4 billion, as shown in the following weekly chart:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - Even though the Fed purchased a significant amount of Treasuries and agency securities during the middle of June, the Fed's purchases have stalled over the last seven weeks compared to where they were in April. The Fed's purchases for the latest week were as muted - clocking in at just US$12.4 billion - only a slight improvement from the week prior! This suggests that the Federal Reserve is nowhere close to being as accommodative as it was during the early March to mid May period...

As we mentioned in last weekend's commentary, the “Bernanke Put” has disappeared, at least in the short-run.  We have no doubt it will come back if oil embarks on a sustainable decline below $60 a barrel or if the Dow Industrial Average declines below 8,000, but even then, any liquidity injection will take awhile to work through the global financial markets.  In addition, the technical condition of the US stock market still does not look good.  Specifically, investors' reaction to both Ruby Tuesday's and Alcoa's earnings reports (the two most significant earnings reports this week in our book) were extremely disappointing.  In both cases, both stocks did very well during after-hours trading and at the opening the next day – but both stocks ended up in negative territory by the end of the day as selling pressure overwhelmed buying power.  This is definitely bearish action.

The struggle between the bulls and the bears is also evident in the following chart showing the new common stock 52-week highs vs. new 52-week lows on the NYSE:

NYSE Common Stock Only New Highs and New Lows

As circled in the above chart, virtually all common stocks on the NYSE has not made new 52-week highs or new 52-week lows since late March.  This is one of the longest periods in memory – and suggests a lack of clear direction in the stock market (this scenario is also being played out on the NASDAQ Composite as well).  Given the lack of liquidity creation by the world's major central banks (with the Bank of England and the People's Bank of China now joining this club), bears have a good chance of winning this battle.  We continue to expect a stock market correction over the next two weeks as 2nd quarter earnings reports are released, but would view any major correction as a longer-run buying opportunity given the decent equity valuations and the amount of capital sitting on the sidelines assuming we hit 7,000 to 7,500 on the DJIA.

Signing off,

Henry To, CFA

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