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Where is Global Inflation Heading

(July 10, 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.

China has been in the news quite a bit recently.  Aside from the indebtedness of its local government and the internationalization of the RMB, one ongoing theme throughout this year has been the upside “surprise” in Chinese inflation.  For the month of June, the Chinese CPI rose to 6.4%, surpassing consensus of 6.2%, on rising food prices and housing prices.  Many economists believe this will taper off, as food price inflation is projected to decrease in the second half of the year.  Meanwhile, U.S. inflationary pressures have continued to abate, as evident by the ECRI Future Inflation Gauge reading falling for three straight months.  The expiration of the Fed's QE2 policy will no doubt put a lid on U.S. inflationary pressures over the next six months.  Finally—with the Bank of Japan cutting back its liquidity creation (as mentioned in our mid-week commentary) and with the latest plans by the EU to “ask” Greek sovereign debt holders for “voluntary haircuts”—my sense is yes, global inflationary pressures will continue to abate over the second half of this year.

One wildcard is the resilience of crude oil prices.  As I am penning this commentary, however, August 2011 WTI crude oil is trading at $94.975 a barrel, down $1.225 a barrel from last Friday.  Meanwhile, base metal prices have also declined significantly over the last three months, as shown in the following chart:

Note that nickel prices topped out in summer 2007, lead in Fall 2007, and aluminum in summer 2008.  In fact, none of these three metals is currently anywhere close to their all-time highs—and all have declined over the last three to six months.  While copper and tin prices have made new highs in 2011, they have also declined significantly since those all-time highs.  The weakness in metal prices, combined with a Chinese slowdown and general declining global liquidity, suggests that global inflationary pressures will be tamer in the second half of this year.

Finally, despite what many pundits are saying about copper “supply issues,” the official LME warehouse stocks is still high relative to the levels over the last five years.  In fact, copper inventories have been rising since the end of last year.  In addition, there exist other inventories not accounted for in the official LME stocks, such as various Chinese inventories and any physical stocks being accumulated (if any) by upcoming copper ETFs.  This suggests that copper (and other base metals) prices will likely continue its decline, further easing global inflationary pressures over the second half of the year:

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 July 8, 2011, the Dow Industrials rose 74.43 points, while the Dow Transports rose 0.24 point, after rising by a whopping 289.33 points (or 5.5%) the week before.  While the Dow Transports made an all-time high, this was not confirmed by the Dow Industrials.  Moreover, the market is highly overbought in light of the recent rally—thus, I urge subscribers to remain cautious.  Given our weak liquidity indicators and the lack of an oversold condition in the recent correction, the market action should remain tough this summer. We remain neutral in our DJIA Timing System as we take a wait-and-see approach.

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 3.5% to 8.7% for the week ending July 8, 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 2000 to the present:

After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA declined to 3.5% the week before last—near its most oversold level since mid-September last year. Despite this oversold condition, and especially in light of last week's bounce, this indicator still isn't as oversold as it was during last summer's correction.  We will retain our neutral position in our DJIA Timing System, as we believe the market should remain tough this summer.

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 101.8 to 101.2 last week—remaining close to its most oversold level since late July 2010.  Meanwhile, the 50 DMA declined to a new low, and is now at its most oversold level since early August 2010.  While this indicator's oversold conditions suggest the market could rally further, the fact that our other sentiment indicators is not as oversold is troubling—and suggests caution is warranted when purchasing stocks, especially given the weak liquidity conditions.  We will remain neutral in our DJIA Timing System and will take a wait-and-see approach.

Conclusion: As global liquidity conditions remain tight in the second half of the year, other factors are conspiring to ease the global inflationary pressures, such as a Chinese slowdown, the weakness in base metal prices and the inevitable haircut taken by Greek sovereign debt holders.  In the meantime, I believe the U.S. stock market remains in a consolidation period this summer.  I also believe that both the Euro and the Yen are unattractive relative to the U.S. Dollar.  We remain neutral in our DJIA Timing System, for now.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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