Don't be Complacent: Global Liquidity Waning

By: Henry To | Fri, May 20, 2005
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Dear Subscribers and Readers,

Please participate in our latest poll! The question this week is: Do you believe that global economy growth is slowing down? Please vote and also share your thoughts.

I hope our subscribers are enjoying the current uptrend in equity prices. As of Wednesday evening, the Dow Jones Industrial Average blew through resistance at 10,400 (which also represented the 50-day and the 200-day moving averages, ditto the Philadelphia Bank Index (which closed at 100.13), and the Retail Holders (RTH) - despite the relative underperformance of the biggest retailer of all - Wal-Mart. Since our buy message on May 4th (and our buy commentary on May 5th), the brand name/large cap stocks (KO, SBUX, MRK, HDI, YHOO, EBAY, and INTC) that we recommended as a group (with the exception of MRK) have done very well. For what it's worth, I still like Big Pharma here, as evident by my "buy recommendation" (along with a buy recommendation from the Bank Credit Analyst) of MRK this morning at $32.85.

Given that the major indices have been up three days in a row, it is very normal to see somewhat of a consolidation phase over the next few trading days (and possibly extending into late next week). Over the short-term, the market is overbought, but over the intermediate term (two to three months), the market is still nowhere near overbought. Investors who are already long the major brand name/large cap growth stocks should sit tight and be patient.

All this being said, we shouldn't be complacent here. If one is currently investing based solely on what the NYSE Specialist Short Ratio is saying (see last weekend's commentary), then one should now be fully-invested - and just sit and wait for a potential 30% to 50% return in the major stock market indices. But one thing is bothering me (as my long-time readers should know, something always bothers me about the market).

What is it, Henry? What is bothering you? Well, maybe two things, actually. Firstly, the market never got that oversold per most of of my technical indicators during all the corrections in 2004 and early 2005. Virtually all my technical indicators got very oversold at some point in time during the last 12 to 15 months, but not all at once. Moreover, in terms price movements in the Dow Industrials and the S&P 500, we have never gotten a correction of 10% or more (although we did come close a couple of weeks ago when the Dow Industrials briefly touched 10,000). In recent months, indicators like the NYSE ARMS Index and the NYSE McClellan Summation Index did not really get to the oversold status that I wanted. Secondly, nothing is ever this easy when it comes to making money in the stock market. For example, let's just say that the market did reach a fully oversold condition two weeks ago. What now? Well, over the last four to six weeks, I have been literally pounding the table arguing my case for a global economic slowdown beginning between now and within the next few months. Recent events (such as curbs on Chinese imports, the decline leading global economic indicators and the rise in bond spreads, the Federal Reserve raising rates, and so forth) have only reaffirmed my beliefs for the likelihood of such a scenario occurring.

Remember what I wrote over the last two weeks about foreign reserves held in the custody of the U.S. Federal Reserve Banks? The acceleration in foreign reserves have been declining ominously, suggesting that world trade is slowing down after accelerating at a very brisk pace since the beginning of 2003. In nearly all cases, this has resulted in a rise in the U.S. Dollar Index. Throughout my commentaries and in my posts on our discussion forum, I have mentioned an ultimate target of 90 to 95 for the U.S. Dollar Index. It is also interesting to note that whenever the U.S. Dollar Index has gone up or whenever foreign reserves growth has declined over the last 20 years, some kind of economic crisis has nearly always followed. The most notable of them were the 1997 Asian Crisis and the 1998 Russian, Brazilian, and LTCM crises. The continuing rise of the U.S. Dollar Index has also been supported by a recent commentary from the Bank Credit Analyst, but if you're still not convinced, following is a monthly chart which I just constructed showing the level of the U.S. Fed Funds rate (set forward 20 months) versus the level of the U.S. Dollar Index:

Monthly Effective Fed Funds Rate (Set Forward 20 Months) vs. the U.S. Dollar Index (January 1982 to Present) - Notice the correlation between the Fed Funds Rate and the U.S. Dollar Index.  The Fed Funds Rate has historically led the U.S. Dollar Index by 18 to 20 months.  Whenever the Fed has raised rates, the U.S. Dollar has nearly always followed through on the upside as well.

Again, please note that the level of the Fed Funds Rate has been set forward 20 months - suggesting that the Fed Funds Rate has historically had a lead time of about 20 months. Since January 1982, the correlation between the level of the Fed Funds Rate and the U.S. Dollar Index has been approximately 64%. If we are to follow historical precedent, then the U.S. Dollar Index should continue to have an upward bias over the next 12 months - which would have bearish implications for global economic growth. As a result, I believe there is a good chance that the Fed may stop tightening as soon as this summer is over (with the Fed Funds rate ultimately peaking at 3.25% to 3.75% for now.

So dear readers, what will it be this time, given that the global credit scenario had been so lax since the beginning of 2003? Like I have mentioned many times before, China has a huge overcapacity problem in terms of manufacturing and in other things like steel production. Perhaps it is in domestic (U.S.) real estate? As much as the U.S. bears would like, I am not going for the latter scenario just yet - mainly because I think the long bond can still continue to hold its own here. I believe the overcapacity in China is a much bigger problem and the tightening of liquidity growth (the monetary base in Japan only increased 1.2%, 2.0%, and 3.0% in February, March, and April, year-over-year, respectively, while Europe has had good liquidity growth, but most of it went towards the maintenance of a welfare state) around the world will have a large impact on China than the United States. As I have mentioned before, when it comes to a marginal user of credit, China is one of the best candidates out there.

Another good candidate is perhaps a heavily-leveraged emerging market economy that depends significantly on the export of commodities (such as oil) to sustain its current GDP. I have also said before the oil has topped out here, and yesterday, the market reinforced my opinion when oil finally declined below its 200-day moving average. Now, here is an interesting chart of the Commodity Research Bureau (CRB) Index I want to show to my readers, courtesy of

The Commodidollar Index approached the upper-end of its nearly 20-year range just a couple of months ago!

The chart on the highest panel is a weekly chart showing the Commodidollar - i.e. the level of the CRB Index times the level of the U.S. Dollar Index. In other words, the weekly Commodidollar is showing us what the "world price" of the CRB Index is at any given time. Is this important? You bet it is. The Commodidollar Index is not just showing us how high commodities are on a US$ basis (that is done by the absolute of the CRB Index), but it is showing us how high world demand has been for commodities. It is particularly interesting to note that the level of the "Commodidollar" will increase whether commodity prices or the U.S. Dollar increases. As you know, I am now calling for a continuation of the recent rise in the U.S. Dollar Index. Under this scenario, commodity prices don't necessarily need to decline, but since the "Commodidollar" is still trading near the high of its 20-year range, I believe there is a good chance commodity prices will continue to decline for the rest of 2005.

Conclusion: In a world economic slowdown scenario, U.S. equities have historically outperformed. We will continue to overweight U.S. equities - specifically, the major brand names/large cap growth stocks. We will continue to avoid commodities, financials, and to a lesser extent, homebuilding stocks. In fact, commodities may represent a good shorting opportunity once the current rally has settled down somewhat. Ditto for companies that specialize in outsourcing such as IBM, INFY, and ACN. However, in a globalized world such as ours, I am getting increasingly worried about a possible "domino effect" not unlike that of the 1997 Asian Crisis which subsequently indirectly caused the 1998 Russian, Brazilian, and then the LTCM crisis. While this current rally should still have sometime to go, I am also not getting complacent (yes, we do try to always look ahead) mainly because we did not get a "fully oversold" situation back in late April/early May. What is a "fully oversold" situation, you may ask? Well, I want to see the 10-day MA of the NYSE ARMS Index hit a high of 1.5, and the corresponding 21-day MA hit a high of 1.3. I also want to see a much lower NYSE McClellan Summation Index (comparable to the May 2004 readings), along with a Nasdaq high-low differential ratio of under negative 10%. In terms of prices on the major indices, I want to see them break the early August 2004 lows (for the Dow Industrials, its late October lows). That may or may not be caused by a major economic crisis somewhere in the world, but until that happens, I don't believe we can get the "blow off" rally that I have been looking for to end this cyclical bull market nor even a decent quality rally of any kind going forward.

Best of luck to our subscribers in the coming week! Don't forget to participate in our new poll!

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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