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June 06, 2006

Will We Ever See a World Awash With Oil Again?
by Henry To

Dear Subscribers,

First things first, dear readers. We have been debating this for weeks but things are just now being finalized. I will be moving to Los Angeles sometime in mid to late July - along with my fiancé who is going to get her PhD (in biochemistry) at UCLA. As many of you may know, I am an actuary/pension consultant by day, and market strategist/analyst by night. Well, that will be no more. I will still be staying with my current company with my move to Los Angeles, but will be working for the Investment Consulting group instead. Among my many new-found responsibilities will be to help develop investment policy, set asset allocation, and select money managers for pension funds, foundations, and endowments. Subscribers who are in the West Coast should feel free to drop me a line should you wish to. Things have been great for me in Houston but it is now time to move on.

By the way, does anyone have any experience in shipping an aquatic pet over long distances? We have a six-inch red-eared slider that we need to ship - and apparently, we are not allowed to carry them onto any of the domestic airplanes. Thank you in advance!

In last weekend's commentary, I discussed the oversold conditions of the U.S. "mega-caps" - paying special attention to mega-caps in the retail sector, such as WMT and HD. I essentially played "Devil's advocate" and asked the question: "Given the stock market is the ultimate leading indicator, could many of the large-cap retail shares have already bottomed (such as WMT at $42.50 and HD at $35), even as the U.S. economy slows down later this year due to the bursting of the housing bubble?" There are many other supporting factors to this argument, such as the hugely oversold condition of these stocks, their relative undervaluations (such as relative to themselves historically as well as relative to the S&P 500), as well as the fact that the consumer credit growth has been growing at a rate below nominal GDP for the last three years. The latter is especially important, as this means that consumers are not totally tapped out and still has a source of credit to tap once their housing ATM is shut down later this year. Finally, investing guru Bill Miller of Legg Mason has over 30% of his assets in the consumer discretionary group in both his Opportunity and Value Trust funds. As a semi-aside, the undervaluation of the U.S. mega-caps can also be witnessed in the following "market valuation graph" showing Morningstar's valuation of the companies with "below average" business risk (usually, the bigger the company is, the less the accompanying business risk). Note that Morningstar's valuation of these stocks is now near levels which we have not seen since early 2003. The following chart is, of course, courtesy of Morningstar.com:

Ultimately, whether one wants to buy the consumer discretionary stocks will come down to this: Do you think that the current stock prices of retailers have already discounted the upcoming consumer slowdown due to a housing slowdown? Do you believe this housing slowdown will merely cause a slow down in the growth of consumer spending or do you believe it will cause a consumer-driven recession - a consumer-driven recession which we haven't experienced since 1990 to 1991? This author will admit something: I don't know, and neither does anyone else including Ben Bernanke or Goldman Sachs. That is why the Federal Reserve is always assessing and re-assessing - and that is why the Fed has remarked that any further rate hikes going forward will be dependent on upcoming data.

However, this author has always been willing to add his own thoughts, and this time will be no different. In our many commentaries over the last 12 months, I have constantly said that the Fed was not done yet - even in the midst of the destruction wrecked by Hurricanes Katrina and Rita. Earlier this year, I continued to harp on this theme, saying that the Fed will not stop until the commodity markets have taken a pause or if the stock market suffers a correction or if the current account deficit righted itself. Over the last few weeks, however, it has become clear that many of the general commodity indices and emerging markets have now popped - and combined with the ongoing housing slowdown, the Fed has most probably nearly finished its job. This has also been the message coming from Ben Bernanke - when he stated that both the CPI-U and the PCE deflator inherently overstate consumer inflation (I know many of our subscribers will take issue with this comment, but please do keep in mind that sometimes, perception is more important than reality). Moreover, the ECRI Future Inflation Gauge has been giving us benign readings for the last three consecutive months - and I have no doubt that the Fed is also watching this indicator as well. Again, the important theme for our readers is this: It does not really matter whether we have inflation or not, but whether the Fed thinks so going forward, and what they intend to do with regards to monetary policy. For now, it looks like that the June 29th rate hike will be the final rate hike for this cycle - with the next one most probably a rate cut instead.

The only remaining question for this author is whether the last rate hike will be a 25 basis or a 50 basis point hike. With the exception of the 1997 cycle, the Greenspan Fed has always ended his series of rate hikes with either a 50 basis or a 75 basis point hike. Given Bernanke is supposed to be more hawkish than the Greenspan Fed, and given that he needs to establish a reputation for being a strictly "inflation-targeting" Fed Chairman, there is a real chance he will hike by 50 basis points in the June 29th meeting but signal to the markets that the Fed is done. This will also send a message to the commodity markets that the Fed is serious about clamping on speculation in the metals and in gold - but at the same time, give the speculators "a chance" to "correct their ways" on their own (since they will be pausing). Finally, what the Fed doesn't finish in the commodity markets will be finished by the ECB and the Bank of Japan. The U.S. economy will most likely have a slowdown, but it doesn't make sense for us to go any further risk a recession just because both the ECB and the Bank of Japan have been too loose with their policies.

So Henry, what are you saying? What you just said opposes the views of the many commentators who have been complaining of an out-of-control Fed printing money left and right.

Yes, what I just said with regards to the Fed is at odds with many commentators out there, especially the doom-and-gloomers who have been predicting the imminent collapse of the U.S. economy for the last five years. To illustrate my views, let me give you an update on what our MarketThoughts "Excess M" (MEM) indicator is saying. Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale for using this is two-fold:

1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.

2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has just stopped publishing M-3 statistics, this author has now revised our MEM indicator accordingly. Instead of using M-3, we are now choosing to use a monetary indicator that most closely resembles the usefulness of M-3 - that is, a measurement which tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy. We went back and found one measurement which is very close - that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 which the Fed is still publishing on a weekly basis). That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator. Following is a new weekly chart showing our new MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

As can be seen in the above chart, our MEM indicator is still significantly in negative territory - meaning that the Fed has continued to more or less tighten (lack of growth in the St. Louis adjusted monetary base) even as speculators and investors alike continue to take on risks (increasing pseudo M-3). That is, the Fed has not been loose at all. Most of the recent monetary growth has come from commercial banks and the private financial sector, but even the monetary growth coming out of those sectors is low relative to what is occurring in the Euro Zone. Following is a monthly chart showing the year-over-year growth in M-3 for the 12 countries in the Euro Zone from January 1980 to April 2006:

As evident on the above chart, the Europeans have been even more "loose" with their monetary policies than Americans, as the most recent year-over-year growth of M-3 in the Euro Zone hit a high of 8.9% - a high not seen since early 1990 when East Germany were being integrated with the democratic world. For comparison purposes, the most recent year-over-year growth of M2 less M1 plus institutional money funds is approximately 6.5% - a number which is actually lower than nominal GDP growth. As for Japan, readers should go back to our April 30, 2006 commentary ("Divergences and the Dash to Trash") for an idea on how much liquidity the Bank of Japan has created in recent years - starting with its zero interest rate policy and then moving to its "quantitative easing" policy starting in March 2001. Most recently, however, Japan has ended its quantitative easing policy, and the Japanese monetary base has plunged in response. Following is the year-over-year growth in the Japanese monetary base vs. the Nikkei from January 1991 to May 2006:

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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