Our Position on the U.S. Dollar and an Update on Energy Prices

By: Henry To | Tue, Aug 16, 2005
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Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of Friday at the close, the Dow Industrials stood at 10,600.31 - giving us a slight gain of approximately 15 points. No potential new signals this week - while the number of offerings should be muted this week, the combination of ever-rising energy prices and the poor performance of the large caps and brand name stocks should continue to put pressure on the major indices in the next week or so. The coast should be clearer as we head towards the end of this month and towards early September. For now, we will advice our readers to tread carefully as this market is still pretty overbought (although you won't see it judging by the Rydex Cash Flow Ratio).

I encourage our readers to keep track of the demographics situation and its potential impacts on savings and the financial markets going forward. The behavior of the aging population in the developed world and in China is going to have profound changes in the years ahead - and most strategists and governments have not fully prepared for this. For example, most market strategists have continued to forecast typical bull market performance for the stock market during the next five to ten years, despite the following:

  1. As the baby boomers begin to retire throughout the developed world, the savings of the general population will not be sufficient to support current market valuations as the former begin to liquidate a substantial part of their equity holdings to finance their retirement and to reduce their risks.

  2. The savings and potential savings of China, India, and Eastern Europe will also not be sufficient to support this "shortfall" in savings - even if these three countries/regions continue to grow at their current rates in the next five to ten years. The position of Dr. Jeremy Siegel that these countries will finance this shortfall in savings and in the current account deficits of the developed world (Japan is forecast to shift to a deficit situation by the end of this decade) just does not hold too much water - even if the Chinese, Indians, and Eastern Europeans whole-heartedly want to.

Combined with our lack of energy policy and lack of fiscal discipline and it is not difficult to envision a scenario where the secular bear market reasserts itself within the next few years - unless Western Europe and Japan implement major economic and structural reforms - which may still take a few years to play out even if they do happen. While I am definitely not predicting the end of this current cyclical bull market as of yet, we are definitely nearer to the end than the beginning.

Okay, I apologize for being so pessimistic - especially on a Sunday evening - I sincerely hope that I am wrong on this, but if we are to continue on our current paths, then it is very difficult to envision a more optimistic scenario ahead for the financial markets. For those who are prepared, however, this will be a great time to pick up undervalued assets, as well as being able to enjoy the immense productivity and technological gains that globalization will have wrought. Despite our current lack of fiscal discipline and domestic savings, I still believe the United States will be the best-prepared when it comes to the developed world - as Americans have historically been very self-reliant and responsive to change (think the relative lack of a welfare state and the economic dominance of very young companies such as Yahoo!, eBay, and Google) - traits which will be very important as we move forward in the 21st century.

All this - quite appropriately - serves as a basis for our discussion of the U.S. Dollar. Whether the Federal Reserve intended to or not, the latest series of rate hikes should serve to increase the savings rate (it is now essentially zero) and to partially restore the integrity of the U.S. Dollar. Make no mistake - as pointed out in our Thursday commentary, there will be a scramble and significant competition for savings among the developed countries within the next two decades. Hiking the Fed Fund rate now will help the U.S. accomplish these two purposes - at the very least, it is a good start. Moreover, the U.S. Dollar is not totally out of the woods yet, and so raising ST rates here will continue to make sense, if one's objective is to restore the integrity of the dollar. Historically, the direction of the Fed Funds rate has led the performance of the U.S. Dollar Index by 18 to 20 months, as shown by the following chart:

Monthly Effective Fed Funds Rate (Set Forward 20 Months) vs. the U.S. Dollar Index (January 1986 to August 2005 (Projected)) - 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.

Please note that the latest "end-of-month August" data is actually dated as of August 12, 2005. The latest correction in the U.S. Dollar Index from the 90 to the 87 level is merely a correction, in my opinion. Ever since we communicated our bullish position in the U.S. Dollar in our May 1st commentary (when the U.S. Dollar Index was at the 84.44 level), we have experienced significant ups and downs - and the latest correction from the 90 level is no different. Going forward, there will continue to be many consolidations, but if current consensus in the level of the Fed Fund rate play out (i.e. a Fed Funds rate of 4.00% or 4.25%) by the end of this year, then there is no question in my mind that the U.S. Dollar Index would be back at 90 or above again.

On a related note, GaveKal has done a lot of work on evaluating the amount of Central Bank Reserves and the U.S. current account deficit, and their conclusion is this: The amount of U.S. Dollar Reserves held in Central Banks around the world far outpace the combined their current account surpluses with the United States - suggesting that a significant amount of dollar reserves are actually borrowed reserves! It looks like the U.S. Dollar carry-trade is still alive and well - but at some point this will end as the costs of borrowing U.S. Dollars increase (and as the growth of Chinese real estate prices pauses). Anecdotally, this author is still getting a lot of ads in any given days telling me to open a forex account where I can make a fortune by leveraging up and buying one million Euros with only $US20,000 in equity, etc.

Now, a quick update on crude oil and natural gas prices. Ever since our bullish commentary on natural gas a couple of weeks ago, the commodity (looking at the spot price) has jumped nearly $1.50/MMBtu - which is energy-equivalent to a rise of $7.50 per barrel in crude oil prices (i.e. this is not something to sneeze at). Judging from the following chart showing the natural gas vs. the crude oil spot price, however, it looks like that natural gas prices (despite the recent upside spike) are still lagging crude oil prices:

Month-End Henry Hub Natural Gas vs. WTI Crude Oil Spot Prices(November 1993 to August 2005*) - 1) Historically, natural gas prices have pretty much tracked crude oil prices here in the United States.  More importantly, the historical volatility in natural gas prices is far greater than that of crude oil (as noted by the wider movements in natural gas prices and by the two upside spikes at the end of December 2000 and February 2003).  Given the wide variations in weather patterns in recent years and give the tight supply situation, I think we are overdue for another such spike. 2) Natural gas prices spiked along with oil in the last two weeks but still lagging?

Please note that the August "end-of-month" prices are actually as of August 12, 2005. This suggests a potential of a further rise in natural gas prices - especially if the United States experiences warmer-than-expected weather in the next few weeks. Going forward, however, the commodity is very vulnerable to a significant correction, given its overbought condition and given the continuing worldwide economic slowdown as indicated in our MarketThoughts Global Diffusion Index (MGDI).

Nowhere have we been more wrong in our analysis than our "prediction" of lower oil prices just up ahead for the last few months now. That being said, a more recent dichotomy with regards to crude oil has emerged, as indicated by the following chart showing the relative performance of the Dow Transports vs. the Oil Service HOLDRS (OIH), and vs. the price of crude oil since October 1, 2002 (with base = 100):

Relative Performance of the Dow Transports vs. Oil Service HOLDRS vs. Crude Oil (October 1, 2002 to August 12, 2005) - 1) The Dow Transports are not confirming the recent higher highs in both the OIH and in WTI Crude oil... 2) Ever since the cyclical bear market bottomed in October 2002, the DJTA, the OIH, and crude oil have all moved in sync with one another - until now...

Readers please note the positive correlation between the Dow Transports, the OIH, and the price of crude oil since the end of the cyclical bear market in October 2002. Since that fateful bottom, the prices of these three indices/commodity have been moving in sync - that is, on the upside - with the exception of the last five months. On March 4, 2005, the Dow Transports made a new all-time high. Since then, however, both the OIH and the price of crude oil have gone on to make significantly higher highs, but yet the Dow Transports has failed to confirm. Is the recent weakness of the Dow Transports signaling weaker crude oil prices or a weaker economy just up ahead? My guess is a little bit of both, but in the meantime, crude oil prices can rise another $5 to $10 a barrel before topping out. That is, I would not touch crude oil right now. One has to wonder if a hedge fund or if a supplier of fuel (such as what happened to China Aviation Oil late last year) has been caught on the wrong side of the trade?

In the short-run, the bears in crude oil will still have to give the benefit of the doubt to the oil bulls, as the current bullish sentiment in crude oil is still nowhere as high as bullish sentiment in prior peaks in oil prices during 2004:

WTI Crude Oil Spot Prices vs. Bullish Sentiment(January 2003 to Present) - 1) The three most recent spikes of oil prices in 2004 were accompanied by bullish sentiment that were even more bullish than the current sentiment - despite current oil prices in the 60s. 2) Interestingly, the current rally in oil prices (at over $65 a barrel), is still not accompanied by a higher high in bullish sentiment - suggesting that there is still upside potential for oil prices...

At some point, crude oil would be a short - but not before we see another spike in bullish sentiment or the announcement of the collapse of a hedge fund/an industrial company who was caught on the short side of crude oil (I don't believe the collapse of Delta will qualify here as a bankruptcy restructuring would further cut costs while negligibly reducing capacity in the airline industry). Given the non-confirmation of the Dow Transports of both the OIH and the price of crude oil on the upside, however, this author does not believe the current rally in oil prices can last much longer - but bears please be careful as I wouldn't be surprised if crude oil prices "blow off" another $5 or $10 a barrel before collapsing. Times are going to get interesting just up ahead, and I promise our readers that we will keep track of this situation on a near-daily basis.

The resiliency of the financial markets around the world continue to amaze - given the restrictive monetary policies here in the United States, in Japan, and in China, as well as record high energy prices (which acts as a huge tax for both corporations and consumers as the majority of world oil revenues flow to sovereign governments). In a post on our discussion forum last Friday, I stated (with regards to the usefulness of monetary policies in a deflationary economy):

"In a deflationary economy, consumers can defer their purchases of goods (computers, DVD players, plasma TVs, cars, etc.) and fully expect the corresponding prices to be lower three to six months from now. The rapid advances in technology is further accelerating this trend - along with the advent of the internet where price discounts can be and are rapidly communicated.

"That is, in a deflationary economy, the velocity of money tends to go down and stay down over time. What are the implications? It is this: Monetary easing by the Fed is now much more muted as a "jump start" tool for the economy than it was back in the 1945 to 1990 period. In an inflationary economy, one does not need much inducing to start purchasing goods. This is different in a deflationary economy. The monetary base can go up ten times and the consumer may still not take the bait.

"Conversely, if the Fed wants to put the brakes on the economy, it can be very simply done. Just put your foot on the monetary brakes and consumption will slow down dramatically. That is, in deflationary economy, consumers are very sensitive to monetary tightening but not sensitive at all to monetary easing. Combined with high energy prices and aging demographics, and one can argue for a significant slowdown in the economy during the next few years - perhaps even a full-blown recession. I think it is just a matter of time before the stock market responds to this worldwide monetary tightening."

The combination of a restrictive monetary policy (and the expectations that the Fed Funds rate will continue to be more restrictive going forward) and high energy prices should be producing strong headwinds for the market - but yet the market refuses to budge. The main reason has been the huge activity in cash acquisitions, stock buybacks, and the lack of offerings so far this year compared to last year. Indeed - as TrimTabs as outlined before - the market should be much higher (around 30% as measured by the S&P 500) if retail investors had also bought the same amount of equities they have been purchasing on a historical bull market basis. As we move towards the latter part of this decade, the aging of the population around the developed world will cause many more headwinds for the equity markets.

Looking at the Dow Industrials vs. the Dow Transports, one is currently still seeing a indecisive market - with both the Dow Industrials and the Dow Transports actually rising for the week despite ever-increasing oil prices:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports(July 1, 2003 to August 12, 2005) - 1) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials! 2) For the week, the Dow Industrials and the Dow Transports rose 42, and 16 points, respectively.  For now, the question of whether these two indices are weakening or just consolidating has not been answered.  On the one hand, the Dow Transports holding so well in the face of skyrocketing oil prices is very impressive, but on the other hand, the Dow Industrials has been very weak for the last 18 months - and at its highest point on March 4th, was still 800 points away from its all-time high set in January 2000.  At this point, I am still relatively comfortable with our 25% short position in our DJIA Timing System - especially in light of ever-rising oil prices and the breakdown of high-profile brand names such as Cisco (Wed) and Dell (Friday).

One notable development from last week, however: The collapse of the brand name stocks continues - with both Cisco and Dell releasing disappointing earnings reports during the week. I will provide an update of the brand name stocks that I am currently watching on Thursday morning. For now, the market is still running on emotions, but I believe it is just a matter of time before investors pay attention to the restrictive monetary policies, high energy prices, and the continuing disappointments from the brand name companies. For now, we will continue to remain 25% short in our DJIA Timing System - given the continued underperformance of the large caps and specifically, for the Dow Industrials.

As for our sentiment indicators, it is interesting to see both the Investors Intelligence Survey and the Market Vane's Bullish Consensus in overbought territories - but with the readings of the AAII survey in an oversold condition. Since the Market Vane's Bullish Consensus has been "more correct" over the last two years, however, we should most probably defer to the readings of this survey. More importantly, it is interesting to note that the most dramatic of declines have almost always occurred while the AAII survey is in an oversold condition. Readers should tread carefully here:

DJIA vs. Bulls-Bears% Differential in the AAII Survey(January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey again spiked lower from 22% to 11% in the latest week.  While this survey is now definitely oversold and 'should' signal further gains in the stock market ahead, readers should keep in mind that the most dramatic declines in the stock market have occured in the face of an oversold reading in the AAII survey.  For now, however, we will stay 25% short in our DJIA Timing System.

The AAII survey by itself is signaling further gains in the stock market ahead, but taken together with both the Investors Intelligence Survey and the Market Vane's Bullish Consensus, it may actually be giving us a warning signal. Alas, no one said that this would be easy.

Like I mentioned above, the sentiment readings coming out of the Investors Intelligence Survey is now in overbought territory - with the latest reading rising from 34.8% to 39.8%:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey(January 2003 to Present) -  Meanwhile, the Bulls-Bears% Differential in the Investors Intelligence Survey got dramatically more overbought last week - rising from a reading of 34.8% to 39.8% - a reading not seen since the first week of January 2005.  Combined with the 'reassurance' of further hikes in the Fed Funds rate and given ever-rising oil prices, I would say that we are pretty comfortable with our 25% short position in the DJIA Timing System.

It is interesting to note, however, that the AAII survey was in comparably overbought territory a couple of weeks ago. Given this occurrence a couple of weeks ago and given the current readings in the Investors Intelligence Survey in the Market Vane's Bullish Consensus, is it reasonable to assume that the sentiment indicators are already signaling a ST top in the stock market? We will find out more as this week progresses.

Our sentiment discussion concludes with the Market Vane's Bullish Consensus. Following is the latest weekly chart showing 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 declines from 69% to 65% in the latest week - finally breaking the streak of 11 consecutive weeks of over 65% readings.  The ten-week moving average of this reading declined slightly from 68.3% to 68.1% - suggesting that bullish sentiment may have turned?  If so, then this would be a red flag for the bulls, given that the Market Vane's Bullish Consensus is reversing from such an overbought level as well.

With regards to the above survey - last week, I stated: "Based on purely the above chart, the market is a "screaming sell" - as the ten-week moving average of the Market Vane's Bullish Consensus is now at an eight-year high (up from a seven-year high as of last week) at 68.3% - the most overbought ten-week reading since August 1997. However - like I have said many times before - tops are inherently difficult to call, and this author will definitely wait for an overbought confirmation from both the AAII survey and the Investors Intelligence Survey before switching to a more bearish position."

The question to ask now is: Have we just received confirmation from the AAII Survey and the Investors Intelligence Survey? There is a good chance we have - and the extremely bullish sentiment Market Vane's Bullish Consensus is definitely something to be reckoned with - especially in light of continuing monetary tightening, high energy prices and a continuing breakdown in the major brand name stocks. Since the Dow Industrials has definitely been one of the weakest market indices, we feel pretty comfortable with staying in a 25% short position here.

Conclusion: The uptrend of the U.S. Dollar Index is still intact - and the recent correction of the U.S. Dollar Index is merely a correction - not the beginning of a new downtrend. The continuing hike in the Fed Funds rate will mean the end of the U.S. Dollar carry trade in due time - and should give a good boost to the savings rate at least temporarily. As for crude oil prices, there are now more signs of a impending correction in the crude oil price - given the non-confirmation of the Dow Transports of both the OIH and the price of crude oil on the upside (despite them having moved in tandem on the upside ever since the cyclical bear market bottomed in October 2002).

As for the equity markets, I am getting very wary on the bull trend that began in April 15th - especially in light of continuing monetary tightening, ever-rising energy prices and a further breakdown in brand name stocks such as Cisco and Dell. We will remain 25% short in our DJIA Timing System for the rest of this week and will reevaluate next weekend.

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. 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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