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September 26, 2007

Putting Things Into Proper Perspective
by Henry To

Important note: Many of the following charts were created using the Reuters Ecowin service - a service that I am currently trialing. However, as I have mentioned before, this data is not cheap - and there is a good chance I won't end up subscribing to the services UNLESS I get many more subscribers over the next few weeks. For those who have wanted to subscribe to our newsletter, now is the time to do so! For existing subscribers, please pass this message on to your friends or family who may be interested in our services.

Dear Subscribers,

Let us begin our commentary by first providing an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on September 23rd, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). Given the relatively weak rally (both in breadth and in volume) we have witnessed since the mid August lows, there is a good chance we could see a retest in the major indices before we see a sustainable bottom in the U.S. stock market. For those who prefer to stay long, our favorite stock selections are still those within the large cap (preferably mega cap) growth areas, as well as Asia ex. Japan and China. Also, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last five weeks, there is a good chance that the Dow Industrials could to another all-time high over the next couple of weeks. Should this occur, however, chances are that many other major market indices will not confirm this all-time high, such as the Dow Transports, the Dow Utilities, the S&P 400, the Russell 2000, the American Exchange Broker/Dealer, the Value Line Geometric, and the Philadelphia Semiconductor Indices. Should the Dow Industrials make another all-time high - preferably in the 14,200 to 14,500 area, and should this be accompanied by weak breadth and divergences among many market indices, then there is a chance that we will establish an initial 50% short position in our DJIA Timing System. As always, whenever we change signals in our DJIA Timing System, we will email all our subscribers on a real-time basis informing of the change.

Let us now get into the subject of our commentary. Thanks to the modern age of instantaneous communications, video feeds over the internet, and the explosion of the blogosphere over the last few years - not only is news transmitted as rapidly as ever, but every piece of news is now also rapidly analyzed, interpreted, and communicated by professional investors, economists, and bloggers alike. Getting a true edge no longer means having access to a Bloomberg terminal and a direct line to the NYSE. For individual investors, trying to get a true edge in this day and age will require patience and focusing on the long-run, as opposed to short-term trading or trading based on emotions. No doubt this is a difficult endeavor for both professionals and amateurs alike, as squeezing out our emotions - especially in a volatile market environment - is contrary to human nature. This purpose of this weekend's commentary is to do just that - especially given the incredible events that had witnessed just last week, such as the 50 basis point cut in the Fed Funds rate, the Bank of England's bailout of Northern Rock (and implicitly the entire UK financial system by guaranteeing all deposits at Northern Rock), the Canadian dollar reaching parity with the U.S. Dollar, the ongoing contract talks between the UAW and GM, and the intense media focus on former Fed Chairman Alan Greenspan, whose biography "The Age of Turbulence" was released last Monday, and is now officially the number one best-selling book on both Amazon.com and Barnes & Noble.

As the title of our commentary suggests, the purpose of this commentary is to "put things into perspective." For starters, let us discuss the recent action of the Canadian Dollar. As many folks should know by now, the Canadian Dollar officially reached parity wit the U.S. Dollar last Thursday - a level that has not been achieved since November 1976. However, for folks who think that the Canadian dollar will go straight up from here and want to go long, I urge you to reconsider. For one, the Canadian dollar is now highly overbought - it traded at US$0.95 as recently as early September and only US$0.93 in mid August. The rapid appreciation in the Canadian Dollar has not only made the currency highly overbought on a short-term basis, but over a longer-term basis as well - as per the following chart showing the percentage deviation of the Canadian-U.S. Dollar exchange rate from its 200-day simple moving average from January 1978 to the present:

As discussed on the above chart, the percentage deviation of the Canadian Dollar from its 200 DMA is now nearly 11%, making it the third most overbought level since January 1978, or just 2% below its record high deviation of nearly 13% in June 2003. Even if one believes the Canadian Dollar will rise still further, it is now time for a breather.

Furthermore, from a contrarian standpoint, it is important to note that the Commercials are now holding a record short position on the Canadian dollar futures contract (courtesy of the Commitment of Traders report and http://www.softwarenorth.net) - a short position that has not been this big since late July (after that record high short position in July, the Canadian dollar would go on to correct more than 2% over the next five weeks):

From a trade standpoint - while the Canadian trade balance still remains decidedly positive - it is important to note that during July of this year (August data hasn't been released yet), the total value of all crude oil and natural gas exports from the Canada to the US actually declined US$74 million on a year-over-year basis, despite the fact that the US dollar had continued to decline over the prior 12 months. The following monthly chart (courtesy of Reuters EcoWin) shows the year-over-year change (in US$ terms) of Canadian crude oil and natural gas to the US from January 1996 to July 2007:

Finally, from a political standpoint, there are now loud political voices asking for the Bank of Canada to slash overnight rates by 50 basis points from the current rate of 4.50% to 4.00%. Given the recent rapid rise of the Canadian Dollar over the US Dollar, chances are that the Bank of Canada will at least stand pat at its next meeting on October 16th.

Why we are thinking of going short in our DJIA Timing System

Now that we have (hopefully) put the recent rise in the Canadian Dollar in perspective, this author is also hoping to put the latest rally in the stock market in perspective as well. From a technical standpoint, the latest rally from the market's mid-August lows had been less than spectacular from both a breadth and volume standpoint (this is also true from a Dow Theory standpoint, but we will get to that later in this commentary). Some of the best work that attempts to measure the true buying power and selling pressure of the U.S. stock market has been done by Lowry's - but for those that do not subscribe to Lowry's - one can also easily see this in the relative weakness of many major indices, such as the Dow Transports, the Dow Utilities, the S&P 400, the Russell 2000, the American Exchange Broker/Dealer, the Value Line Geometric, and the Philadelphia Semiconductor Indices. From a visual standpoint, the relative weakness in stock market breadth can be seen in the very weak A/D line of the Wilshire 5000 ever since its mid-August lows, as well as during last week when the Fed slashed the both the discount and the Fed Funds rate by 50 basis points (following chart is courtesy of Decisionpoint.com):

Moreover, given the huge decrease in short interest over the last two months, it is not inconceivable to conclude that a significant part of the latest rally from the mid August lows was driven by short-covering. The following monthly chart showing outstanding NYSE short interest vs. the Dow Industrials from November 15, 2000 to September 14, 20007 illustrates this perfectly:

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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