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The BRIC's Monetary Policies

(May 1, 2011)

Dear Subscribers and Readers,

Let us now begin our commentary with a review of our 13 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;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

The S&P 500 futures are up over 10 points as the White House announces that Osama Bin Laden has been killed by US Special Forces.  Details are still sketchy.  While the practical on-the-ground implications may be small, the geopolitical and the psychological implications would be huge.  Strains in the US-Pakistani relationship have recently been a low point, and the fact that Bin Laden's compound was well within Pakistani territory will lead many to question whether US aid to Pakistan is worthwhile, especially in light of ongoing corruption charges and the inadequacies of Pakistan's civilian bureaucracy.  On a side note, the successful penetration of Bin Laden's network and his assassination will boost civilian confidence in US intelligence and counter-terrorism efforts.

Let's now get to the gist of our commentary.  It is no secret that most EM countries, including South Korea, are dealing with inflationary pressures as their respective central banks have been “behind the curve” in tightening rates (the Federal Reserve's QE2 policy hasn't helped, but the Fed should be more concerned with domestic inflation and jobs—not those overseas).  Specifically, as shown in the following chart (courtesy of Goldman Sachs), the inflationary pressures in the BRIC (Brazil, Russia, India, and China) are broad-based:

For all the talk about rising food and energy prices in China, it is interesting to see that Chinese inflation (at 5.4% in March) is actually the lowest among the BRIC countries.  Moving on, there is no doubt that the central banks of the BRIC countries will continue to hike their policy rates.  However, unlike most developed countries, the BRIC (and other EM) countries typically used other policy tools at their disposal, such as raising reserve requirements, allowing for more currency appreciation, etc.  To understand the actions of each central bank, we must understand the “nuts and bolts” of BRICs' monetary policy, as summarized in the following table (courtesy of Goldman Sachs):


Goldman Sachs expects Brazil, India, and Russia to hike their policy rates by a further 125 basis points, and China by 25 basis points by the end of this year (please see following chart, again, courtesy of Goldman Sachs):

Starting with Brazil, we know that Brazilian policymakers have been very hesitant to raise rates as they believed this would attract too much capital flows.  Instead, they have tightened policy through other means, such as gradual currency appreciation, as well as measures that slow credit creation, such as a tax on foreign fixed income inflows.  Meanwhile, China has relied mostly on a hike in the required reserves ratio, although this has not had much effect as it has been offset by increased foreign exchange inflows.  Similarly, interest rate hikes have been too small to have any practical effects.  As for India, the Reserve Bank of India has mostly targeted on the amount of system liquidity—causing significant fluctuations in overnight borrowing rates.  At this time, the Reserve Bank of India is still reviewing its monetary policy, and has proposed shifting to a single policy rate target.  Finally, Russia is shifting towards more of an inflation-targeting regime.  Previously, Russia was more interventionist in the FOREX markets in order to target inflation—however, it is now moving towards using interest rates instead.  As a result, Russia will allow the Ruble to have more flexibility than it previously had.

As mentioned—given the psychological implications surrounding the death of Osama Bin Laden, and the market's positive momentum, the line of least resistance is still to the upside.  While our technical indicators have improved slightly, both our liquidity and valuation indicators have continued to deteriorate.  We know that the Fed's QE2 policy will expire at the end of June, and there is no evidence suggesting the Fed will ease any further.  Furthermore, it remains to be seen whether Japan will flood its banking/financial system with more liquidity over the summer as it seeks to rebuild.  If the Dow Industrials and the S&P 500 make new highs in the face of deteriorating technicals, we will look for a higher-than-expected correction this summer.  Again, should the Dow Industrials and S&P 500 continue to rally (preferably to over 13,250) on dismal upside breadth and/or volume, we will go 50% short in our DJIA Timing System.

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 in the following chart from January 2008 to the present:

For the week ending April 29, 2011, the Dow Industrials rose 304.55 points, while the Dow Transports rose a whopping 224.15 points.  Note that both Dow indices are now close or have made fresh three-year highs.  The momentum behind this rally—as well as the psychological implications surrounding the death of Osama Bin Laden—should propel the market further.  However, given the weakness in our technical and global liquidity indicators, we still expect the market to experience a correction soon.  We remain neutral in our DJIA Timing System, and may shift to a 50% short position should the Dow Industrials rally further on weak upside breadth/volume.

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 four-week moving average of these sentiment indicators increased from a reading of 21.4% to 22.5% for the week ending April 29, 2011.  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 1998 to the present:

After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA has declined to 22.5% last week.  Although there is likely more upside for this sentiment indicator and for the market over the short-run, the lack of a correction over the last few months suggest that the market is highly vulnerable to a deeper-than-expected correction.  We will retain our neutral position in our DJIA Timing System, and will likely shift to a 50% short position if the Dow Industrials rally to over 13,250.

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.  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 slightly from 117.8 to 117.7 last week, and has stabilized and is now back at neutral levels.  Similarly, the 50 DMA is also at neutral levels.  There may be more upside in both sentiment and the market in the foreseeable future, especially since valuation levels remain decent.  However, should the market rally further, we will likely go 50% short in our DJIA Timing System.

Conclusion: While the broader geopolitical and economic implications of Osama Bin Laden's death are uncertain, there is no doubt that the short-term psychological implication is positive—suggesting more upside for the stock market.  As for the BRIC countries, inflation remains a concern.  However, the central banks of these respective countries (now) recognize the importance of tightening sooner rather than later—and are utilizing other “alternative” policy tools, in addition to the policy rates.  Despite high inflationary pressures in the BRIC countries, we still believe their respective central banks will eventually have things under control.  We remain neutral in our DJIA Timing System and will likely go 50% short if the market rally further on weak upside breadth/volume.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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