The U.S. Dollar is Going Up

By: Henry To | Tue, May 3, 2005
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Dear Subscribers and Readers,

Please continue to vote in our latest reader survey! I know it is always difficult to start paying for something that has always been free - but my partner, Rex, and I personally feel that this is the most sustainable model that we can have for our newsletter going forward. Even if you don't intend to subscribe, please just take a little of time to vote just so we can get as much feedback as we can. Moreover, I want to thank you to all of you who have taken the time out to vote or to send me emails making suggestions for the website. I know everyone who is interested in the markets is always busy and so I greatly appreciate your time!

Now, let's discuss the stock market and the controversial topic of the U.S. dollar and how it may affect the markets and the world economy in the coming months. In summary: I do not like what I see, and it now looks like the herd is wrong, wrong, and wrong once again. The upshot to all this is: It really will not take much of an effort for investors to make money in the markets during the next 12 to 24 months. I will elaborate later in this commentary.

Let's first discuss a different but rather interesting and relevant topic. If you happened to not agree with my U.S. Dollar and market analysis, I hope you'd at least learn something new from the discussion of this topic! Anyway, let's move on.

Over the weekend, I picked up the latest print issue of the "Scientific American Mind." There is an immensely interesting article (the cover story) in the publication which I would like to point out - entitled "How Brilliance Arises Creativity in Every One of Us." Since the beginning of World War II, there have been significant progress made in studying the human brain and how it works, but we are still learning something new (and unexpected) about the human brain everyday. The first article discusses how researchers have been making significant progress in "uncovering the secrets" to creative thinking in human beings, giving us some examples along the way. It starts off with a discussion of a former high school art teacher who started having great difficulties in performing her job when she turned 43, and eventually had to quit because she could no longer even remember the names of her students at age 52.

The neurologist diagnosed her with "frontotemporal dementia" - a dementia that selectively damages the temporal and frontal lobes of the brain - primarily in the brain's left hemisphere. Quote: "These regions control speech and social behavior and are intimately involved in memory. Patients often become introverted, exhibit compulsive behaviors and lose inhibitions that would otherwise prevent them from acting inappropriately toward others in social settings." You could say that the teacher essentially became partially brain-damaged, but the result? Her creative powers multiplied tremendously. The realism in her art-training (she has been involved in painting since she was very young) over the years was essentially repressed, and her paintings and art became much more emotionally charged. The fascinating thing was that this wasn't an isolated case. One more quote:

Miller [the neurologist] later identified other men and women whose latent creativity burst forth as frontotemporal dementia set in - even in patients who had little prior interest in artistic pursuits. One man, a stockbroker who had never before been touched by the muse, traded his conservative suits for the most radical styles he could find. He developed a passion for painting and went on to win several art prizes. Another person began to compose music even though he had no musical training. A third invented a sophisticated chemical detector at a stage when he could recall only one in 15 words on a memory test.

You may ask: Why is this relevant to us, Henry? Well, I have emphasized this in our commentaries in the past. Being successful in the 21st century workforce (more so in the United States, in particular) would not only require the essential language and mathematical skills, but it will require great creativity skills as well. This has always been the case, but the importance of creativity has been further magnified by the advent of automation and by the huge increase in the availability of human capital from the integration of the Chinese and the Indian workforce in the global economy during the last 10 to 20 years. Fortunately, creativity is not only restricted to people with frontotemporal dementia. In fact, studies have shown that originality and creativity is not innate; that is, every one of us has the ability to create and innovate - if we only know how to harness it.

Moreover, it is not intellect that counts. In fact, our modern educational system has done a very effective job in suppressing our creativity at an early age. A final quote: "Research suggests that we start our young lives as creativity engines but that our talent is gradually repressed. Schools place overwhelming emphasis on teaching children to solve problems correctly, not creatively. This skewed system dominates our first 20 years of life: tests, grades, college admission, degrees and job placements demand and reward targeted logical thinking, factual competence, and language and math skills - all purviews of the left brain."

The article recommends several exercises that the reader can do in "exercising" the right side of his or her brain, such as:

This very idea of how creativity is born, while not surprising, is very important. Like I said before, the ability to innovate or create is a trait that will be further and further emphasized in the 21st century workforce. You may not make a single cent in the stock market (hopefully, this is not the case since I believe we will be able to help our readers to successfully navigate the markets in the coming years), but at least you will succeed greatly in your personal career. Our newsletter is as much about investing in the other aspects of your lives as investing successfully in the stock market - other aspects that will also benefit or enrich your lives (perhaps even more so than being able to invest successfully in the stock market) going forward.

But wait, creativity is also an essential trait to have when it comes to being able to successfully invest in the stock market. Remember what we discussed in our Jesse Livermore article a few weeks ago? In that article, I continually emphasized that the main reason for the sustained success of Jesse Livermore was because of his ability to evolve and to continuously improve himself and his methods. The failure of him doing so (after the Crash of 1929) was the ultimate event that made him bankrupt for the final time (which he never recovered from).

In my many analyses of the stock market, I always continue to look for new indicators. I also go back very often to make sure that my current indicators are still working and to continually find ways to interpret them in different (but logical) ways. But then, you may ask: Why do we still try to incorporate the Dow Theory in our analyses - a theory that first emerged more than a hundred years ago? To which I answer: But this is the true essence of the Dow Theory - while the underlying philosophy of the Dow Theory has not changed (such as valuations and the concept of a primary trend), various commentators and stock market analysts have built upon the theory. Since the Dow Theory is but a series of basic tenets and observations, the great Dow Theorists such as Hamilton, Rhea, Schaefer, and Russell were able to continue to evolve the Dow Theory to suit their own analytical and investment styles. This author will continue to use the Dow Theory in subsequent newsletters but will also continue to evolve the Dow Theory as I see fit. Interestingly, a number of writers have written against the Dow Theory over the last one hundred years, and to this day, not a single one of those authors' arguments have held water. The latest being this:

Let's now get onto the main gist of our commentary. A couple of subscribers have mentioned to me that some of the newsletters out there may be entertaining and interesting to read, but all they are interested in is to make money (or to not lose money) in the stock market. What I have just discussed will help you in both your investing and your career going forward, but then, you can get this information from somewhere else anyway, right? Before I go on, let me say this: Part of my job is to "filter out" most of the advice out there and to present the most useful advice that I think my readers can get. You can say that our website acts as part-aggregator and part-advisor/filter when it comes to financial or investment matters. But if all you're looking for is specific investment advice, then you have come to the right place as well.

Let there be no mistake: The consensus (not just in the U.S. but around the world) currently out there is that the U.S. Dollar is flat-out sick and that over the long-run, it will continue to sink. Chinese peasants are swapping in their U.S. dollar bills for Chinese Renminbi - waiting for the inevitable rise when the Chinese revalues their currency, or so they think. Various Chinese miners who have gotten wealthy by supplying coal and other energy sources to the various industrial and power companies in the country are now using that money to speculate in real estate, and the ones that want to borrow more money to do so usually do their borrowing in Hong Kong - in U.S. dollars so that when the Chinese revalue the Renminbi, they will get a double windfall, or so they expect. The Taiwanese people are also getting into the act, en masse. And here the typical contrarian should ask: Is it really that easy?

Well, folks, just like in late 1999 when everyone were buying stocks thinking it is an easy game - the answer is a resounding "no." The FOMC meets again this Tuesday, and they are expected to raise the Fed Funds rate to 3% - which is slightly below the inflation rate. The next one after this meeting will be on June 29/30, when the Fed Funds rate is expected to rise to 3.25% - a rate that is slightly higher than the inflation rate and the dividend yield of the Dow Utilities. At that point, holding investments in cash starts to become attractive.

Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value. Following is a chart of the annual return of the U.S. Dollar Index vs. the growth in the amount of foreign assets held in the custody of the Federal Reserve from January 1981 to February 2005:

Annual Change in U.S. Dollar Index vs. Annual Rate of Growth in Foreign Reserves

Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that the recent change in the growth of foreign reserves have been immensely negative - suggesting that the line of least resistance for the U.S. Dollar is now up - made all the more authoritative given that the U.S. Dollar was near a 10-year low just three months ago, and given that the U.S. Dollar is now very undervalued relative to the Euro on a purchasing power parity basis.

The following chart showing the level of foreign reserves vs. the annual change in foreign reserves (again from January 1981 to February 2005) may be even more interesting to some of our readers:

Foreign Reserves Held at the U.S. Federal Reserve vs. Annual Percentage Change in Reserves (%)

Ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard as opposed to the Gold Standard that has been in place since the end of World War I. Therefore, as world trade expanded, the demand for dollar has continued to increase - and with it, the continuing increase of foreign dollar reserves held at the Federal Reserve Banks. It is interesting to note that various financial crises or economic recessions (see above chart) have usually occurred when the annual change of dollar reserves is slowing down or experiencing negative growth. This growth rate has been as high as 36% as recently as August of last year but it is now obviously slowing down. In a world awash of liquidity for the last few years, it is unavoidable that there will be a misallocation of capital somewhere in the world. In fact, one can argue that there has been a gross misallocation of capital in the real estate asset class in various parts of the United States. Now, please keep in mind that the U.S. has the most efficient and transparent markets in the world. If certain U.S. asset classes experience a misallocation of capital, what can one say about the real estate market or the steel-making capacity in China, for example? Liquidity will hide this misallocation as long as liquidity is increasing, but once this game of "musical chairs" stops (which I think is already happening), then - look out below.

(Note that this fits perfectly with my six to nine-month forecast of a "flight to quality" scenario that I have been discussing for the last couple of months.)

This recent trend of declining foreign dollar reserves held at the Federal Reserve Banks is also reaffirming my view that the growth in world trade is now slowing down - thanks to the recent renewed backlash against Chinese imports and outsourcing/offshoring. In the short-term, the outsourcing and offshoring trend has probably been overdone, but in the long-run, I remain bullish on both outsourcing and offshoring. I have not shown this here but when world trade slows, commodity prices as measured by the CRB Index usually goes down - including oil prices. For readers who have always wanted a direct view from us on the markets - well, our message for this week is: Buy the U.S. dollar and sell all commodities and commodity stocks, including oil stocks. I believe they have now topped out in the intermediate term (for the next couple of years).

We will keep track of this event (similar to a slow motion ship wreck) for our readers as it continues to unfold. As a result of the upcoming world economic slowdown, I believe U.S. equities will continue to underperform (in the absolute sense) in the intermediate term. I do not expect a huge unwinding of U.S. equities, however. Like I said before, most of the misallocation of capital is actually occurring in other countries - especially in "credit and energy-marginal" countries such as China and India - where the markets are still not transparent enough. Moreover, because of our recent offshoring of manufacturing and now research (traditionally very cyclical industries) into the shores of China and India and other countries, we have now exported a part of our "cyclicality" to these countries - making our domestic economy more stable and less subjected to the business cycle. If there is a crash somewhere in the world, it will happen in either China or India (whether one is talking about the local real estate or stock markets).

Let's now take a look at the recent action of the stock market via our daily chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to April 29, 2005) - 1) Both the Dow Industrials and the Dow Transports violated their secondary lows over two weeks ago (after a hugely speculative phase in the Dow Transports which makes it the more authoritative) - suggesting that the cyclical bull market is now in danger. 2) Both the Dow Industrials and the Dow Transports AGAIN exhibited weak action last week (action which was even weaker than the week before), with the former rising 34 points (compared to 70 points the week before) and the latter actually declining 13 points (compared to a an increase of 57 points the week before) for the week.  Nearly all the upside came last Friday.  Same message from last week: The trend of both indices remain down until we indicate otherwise.  The levels to watch are 10,071.25 on the Dow Industrials (recent low of Dow Industrials made on April 18th) and 3,382.89 on the Dow Transports (recent low of Dow Transports made on April 15th).

While Friday's bounce was impressive from several analysts' points of views, the overall weekly action was actually pretty weak - as the Dow Industrials only rose 34 points while the Dow Transports actually declined 13 points for the week. Like I said before, I still do not believe we have reached a sustainable bottom yet as far as the major indices are concerned. If one looks at the various individual stocks (please check out our brand-name watching commentary from last week) then one can see that the average stock on the NYSE or the NASDAQ has definitely broken down. The levels to watch on the Dow Industrials and the Dow Transports is the 10,071.25 closing low made on April 18th for the former and the 3,382.89 closing low made on April 15th for the former. If both the Dow Industrials and the Dow Transports close below those levels anytime during this week, then I believe we will embark on a more significant decline.

Let's now take a look at our popular sentiment indicators. The markets are still very oversold per these indicators, but again, this has been the theme for the last four to five weeks already. Let's first take a look at the bulls-bears% differential in the AAII survey:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey decreased from 4% to negative 5% this week - moving us into oversold but dangerous territory once again.  Again, readers please keep in mind that the most serious declines have occurred while the AAII bulls-bears% differential is in negative territory.  Readers please stay tuned.

After getting into positive territory slightly less than two weeks ago, the AAII Bulls-Bears% Differential is now again in negative territory - declining from a positive reading of 4% last week to negative 5% this week. Yes, this indicator is oversold (once again), but please keep in mind that the most serious stock market declines has occurred during the time this indicator is in negative territory.

The bulls-bears% differential in the Investors Intelligence Survey is now finally reaching deeply oversold territory:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey further decreased from 21.5% to 14.3% in the latest week - the lowest reading since the 9.4% reading in late August 2004.  This reading is finally confirming the oversold readings in the AAII survey, although this author would still want to see a sub-10% in this survey reading before I would be comfortable in going long here.

Please note that at 14.3%, the Bulls-Bears% Differential in the Investors Intelligence Survey hasn't been this oversold since late August of last year. It now increasingly looks like that a short-term bottom is quickly approaching (in terms of time frame but perhaps not in the number of points in the major indices). I will let me readers know if I think we see a short-term bottom anytime soon, but longer-term wise, is it a good enough bottom to warrant a buy-and-hold strategy? Probably not.

Now, the Market Vane's Bullish Consensus vs. the Dow Industrials:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading has been at the 59% level for the last two weeks - a level not seen since late August of last year  and 2% lower than the 61% reading in late January.  However, I still do not believe that the 59% reading is overly low.  For comparison purposes, this reading got to as low as 56% in mid August of last year but I am still looking for a reading closer to 50% before I am willing to consider to go long in our DJIA Timing System here.

While the readings of the last two weeks (both at 59%) were at levels not seen since late August of last year, this reading is actually still quite overbought from a historical point of view. Like I have mentioned in my previous commentaries, I want to see this reading get closer to 50% (or 56% - which was the 2004 low - as I mentioned last week) before I would be willing to consider going long n our DJIA Timing System. For now, we wait.

Quote from last week: "My guess is that the bounce in both the Investors Intelligence and the AAII is merely a bounce - and does not indicate a convincing reversal in the percentage of bulls and in the stock market. Moreover, this author would still like to see at least a sub-56% reading in the Market Vane's Bullish Consensus survey before we would consider going long in our DJIA Timing System."

After experiencing a jump (with the bulls-bears% differential in the AAII survey moving into positive territory) last week, the bulls-bears% differential in both the Investors Intelligence and the AAII surveys again experienced a significant decline this week, suggesting that last week's "reversal" was merely just a bounce. Again, any potential reversal here is not going to convince me unless we once again get deeply oversold readings in both of these sentiment indicators - along with at least a sub-56% reading in the Market Vane's Bullish Consensus Survey.

Conclusion: Readers who have followed and read our commentaries for the last four to six weeks should be clear on where we are now heading. The world economy is now slowing down and any misallocation of capital should be obvious to everyone in the coming months as the amount of world liquidity experiences a deceleration of growth going forward. I expect the domestic equity markets to underperform in an absolute sense and I expect emerging markets and commodities to significantly underperform going forward. I apologize to everyone who has opened a foreign currency bank account but the U.S. dollar is going up in the coming months. The best way for investors to make money here is to get into cash and into a short-term domestic CD or a money market account.

Finally, the market has been oversold for weeks but the bounces have so far still been dismal. Let's see what the market can do in the coming weeks but I think the best scenario we can look for here is a rally to work off its current oversold conditions before it goes down again.

Signing off,


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. 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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