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Why the Yen Could Rise Further

(September 5, 2010)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 12 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145; giving us a gain of 302.93 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

We asserted in last weekend's commentary that the Bank of Japan's decision to expand its bank-loan program by 10 trillion Yen (US$116 billion) to 30 trillion Yen was a disappointment to FOREX traders, as it is merely a “drop in the bucket” given the vast size of the FOREX market.  The Yen initially declined last Monday but quickly rebounded.  Again, we doubt Japanese policy makers are bold enough to do anything that would have a significant impact on global liquidity levels, despite ongoing political pressure on the Bank of Japan to be more aggressive.

According to the Bank Credit Analyst, the Bank of Japan would need to expand its bank-loan program or purchase assets totaling 33 trillion Yen (US$389 billion) in order to match a US$1 trillion asset purchase by the Federal Reserve, relative to the size of its economy.  I highly doubt Japanese policy makers are bold enough to implement such a program.  However, this is probably the minimum amount needed in order for the Bank of Japan to have a chance at lowering the value of the Yen—not to mention a chance of having an impact on global liquidity levels!  The Bank Credit Analyst claims that the market expects the Fed to purchase an additional US$1 trillion of assets over time.  I agree, but I also expect that the Fed would start “small” by announcing a package in the $250 billion to $500 billion range at its next meeting on September 21st.  Nonetheless, there is nothing the Bank of Japan can do to stem the rise of the Yen at this point, given the sheer size of the Fed's easing policy, the lack of coordination among the world's central banks (at least in terms of the Yen intervention issue), and the lack of global political support for a lower Yen.

Interestingly – despite the Bank of Japan's new easing policies – primary liquidity in Japan remains challenged, as exemplified by the following chart showing the year-over-year growth in the Japanese monetary base (along with the year-over-year change in the growth rate, or the 2nd derivative), versus the year-over-year change in the Nikkei Index:

The year-over-year growth in the Japanese monetary base hit a short-term peak at 6.1% at the end of July 2010 (its highest level since August 2009), but declined to just 5.4% at the end of last month.  More importantly, the absolute level of the Japanese monetary base actually declined in August—suggesting that the Bank of Japan remains timid (at least to the end August).  Obviously, this is old news, but until we see a much more positive move in the Japanese monetary base, we would not be too bearish on the US$/Yen.

Moreover, the Yen isn't really that overbought against the USD.  While Friday's close of 118.64 (i.e. one Yen = US$0.011864) is high by historical standards (surpassing its November 2009 highs and close to its April 1995 record highs), the Yen is only 6.59% above its 200-day moving average, as shown in the following chart:

Note that at its November 2009 highs, the Yen traded as high as 9.36% above its 200-day moving average.  More glaringly, the Yen traded as high as 20% above its 200-day moving average at its April 1995 record highs!  The question is: How many hedge funds are short the Yen, and how many of them are still hoping for the Yen “carry trade” (not versus the USD, but against other higher yielding currencies) to bail them out by the end of the calendar year?  As the year draws to a close, I expect hedge funds to take a hard look at their Yen short positions—thus potentially setting up a Yen “blow off top” scenario.  Again, I would not be surprised if the Yen makes an all-time high against the U.S. Dollar sometime in the next several months.  At the very least, I expect the Yen to become much more overbought until it reverses against the U.S. Dollar.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2007 to the present:

For the week ending September 3, 2010, the Dow Industrials rose 297.28 points, while the Dow Transports rose 202.50 points.  After holding at 10,000 last week, the Dow Industrials managed to rally back to its 200 DMA, while the Dow Transports rose decisively above its 200 DMA.  While the technical condition has drastically improved, subscribers should remain concerned about “whipsaw risk,” as the market has been really volatile and “indecisive” over the last several weeks.  Combined with the  lack of bullish signals from our global liquidity indicators and the lingering default risks for Greek sovereign debt, probability suggests that the market action will remain tough for the rest of the summer, if not into October.  Of course, the latter will depend on the results of the next FOMC meeting on September 21st.  For now, we will remain 50% long in our DJIA Timing System, and should eventually shift to a 100% long position depending on the market action and fundamentals in the coming weeks.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators decreased from a reading of -3.3% to -5.6% for the week ending September 3, 2010.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

The four-week MA has now declined two weeks in a row, while the 10-week MA at -6.1% (not shown) is now at its most oversold level since May 2009.  However, while this sentiment indicator has gotten more bearish, it is still not that oversold compared to the readings of mid to late July.  We will thus wait for a more oversold reading before shifting to a 100% long position in our DJIA Timing System, and would do so only once our liquidity indicators improve.  In the meantime, the action of the U.S. stock market will likely remain tough into October.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

The 20 DMA decreased from 107.0 to 101.3 last week, while the 50 DMA also reversed—declining from 104.9 to 103.9.  We would not read too much into this reversal as both the 20 DMA and 50 DMA are very oversold.  However, since our liquidity indicators are not supportive of the bullish case, chances are that the market will be mired in a consolidation period into October.  We will thus only shift to a 100% long position once liquidity conditions improve or if the stock market becomes more oversold.

Conclusion: Similar to last week's conclusion, the global liquidity situation remains precarious despite the latest easing by the Bank of Japan.  More importantly (at least for those looking for a decline in the Yen), the Bank of Japan's 10 trillion Yen expansion of its bank-loan program would need to be at least 3.3 times as much in order to have any significant impact on the US$/Yen relationship, given that the market is expecting the Fed to eventually purchase an additional US$1 trillion of assets.  Again, we expect the Fed to announce a resumption of its quantitative easing policy on September 21st—starting with a $250 billion to $500 billion commitment to purchase more U.S. Treasuries.  The biggest “bang for the buck” would be for the Fed to purchase private sector assets, such as AAA-rated asset-backed securities (which would allow the “shadow banking system” to supply more credit to the economy) or even AAA-rated corporate bonds (although we don't expect the Fed to exercise this option).  Finally, given the challenging liquidity conditions, we remain on a wait-and-see approach in terms of our DJIA Timing System.  Until our global liquidity indicators improve or until the U.S. stock market becomes more oversold, we will stay with our 50% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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