Have Currency Investors Gone Loonie?

By: Henry To | Tue, Dec 20, 2005
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Below is an extract from a "subscriber's only" commentary originally posted at marketthoughts.com on 18th December 2005.

Dear Subscribers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. At this point, this author has no position in the stock market - although one strategy that he is seriously thinking of implementing is buying fundamentally strong stocks that may be subject to tax-loss selling in the next couple of weeks. Please keep in mind that the final day to do any tax-loss selling is December 28th, as stock trades take three business days to settle. A couple of stocks that I am currently looking at is SNDA and SAFM - but please note that my research on these two stocks is still very preliminary at this point. As always, this should not be construed as specific investment advice.

So is the recent price spike in natural gas due to manipulation of prices - as many lawmakers in the House have contended? Well, that depends on how one defines "manipulation." Make no mistake; the recent price spike in natural gas definitely does have some fundamental basis. While storage levels are still above its five-year average at this point, the bulls would argue that an extended cold spell would render storage levels below its five-year average, given that over 20% of Gulf Coast production (around 2 Bcf/day) is still shut in at this point. At the same time, the bears (like me) would argue that at current prices, many of the industrial demand have already been destroyed. Moreover, the cumulative production loss due to Hurricanes Katrina and Rita are now over 500 Bcf - suggesting that storage levels would be another 15% higher than the historical five-year average had there were no production loss. While prices in the short-term are notoriously volatile and unpredictable, the current natural gas price of the March 2006 contracts and beyond are - in the views of this author - definitely overvalued.

Of course, markets are inherently known for its volatility and irrationality. Throw in the fact that natural gas prices have historically been three times as volatile as crude oil prices and you have a real recipe for a price spike during a colder-than-expected winter. We had first discussed this possibility in our July 31, 2005 commentary. Going forward, however, this author sees significantly lower natural gas prices for 2006 and 2007 - assuming we don't experience a similar shut-in experience in energy production going forward. This is my fundamental view. Such a view is not fool-proof (is there anything such as fool-proof in life), however, since going forward in the next few years, the amount of money that will be invested in commodity funds are expected to at least double or even triple from current levels. In such a scenario, both oil and natural gas prices could continue to rise even if the market is well-supplied, given the inherent "inelasticity" of demand in energy commodities. All barring a U.S. or world recession, of course.

In our commentaries over the last few weeks, I have discussed that a significant top in the stock markets won't be complete "without the Dow Industrials overtaking the 11,000 level and luring many of the "sideline investors" back into the stock market - thus completing this last "blow off" phase of this cyclical bull market." I still subscribe to this view. Interestingly, the DJIA 11,000 level was the recent subject of Mark Hulbert's editorial on Marketwatch.com. Once this last "wall of worry" (the worry that the Dow Industrials is still not able to surpass the 11,000 level) has been removed, then all the bears and sideline investors would be sucked in - thus setting up for a significant top in the stock market.

Let's now get into the heart of this commentary. As many of subscribers know, the "Loonie" is the unofficial nickname of the Canadian Dollar. Given the rise in natural gas, oil, and gold prices over the last few years, investors should expect no less than a sharp rally from one of the world's premier "commodity currencies." The Canadian dollar has not disappointed, as it has been the best performing currency in the developed world over the last 12 months. That being said, let me pose this question to our subscribers: How hot is hot? That is, at what point do we conclude that prices are out-of-line with fundamentals, even though those fundamentals are justifying a high price in an underlying currency, commodity, or stock market index? Let's first take a look at the following long-term monthly chart of the Canadian dollar from 1977 to the present:

Is the Canadian dollar about to surpass a 14-year high?

As one can see from the above chart, the Canadian dollar (cash prices) is now on the verge of surpassing a 14-year high - to a level not seen since early 1978 - when OPEC threatened to take over the world and during the tail-end of the last secular bull market in commodities.

Again, the relatively high price of the Canadian dollar may or may not be fundamentally justified. As investors in the financial markets, what we should be asking is: How hot is hot? We also know that the uptrend in the Canadian dollar is now three years old - which indicates that least a "breather" is due even if the Canadian dollar is supposed to rocket higher in the longer-run. What we also know is that on a purchasing parity basis, the Canadian dollar is now significantly overvalued compared to the U.S. dollar. While this is not a great timing tool per se, it does indicate that the Canadian dollar rally is now getting overstretched on the upside. We are now near the point where the Canadian dollar has historically reversed back to the downside.

Okay Henry, all that is well and good - but when can we expect the trend to stall out or even reverse? In other words, being a good professor/economist is one thing, but how many of them have made money in the stock or financial markets? Can you give us more information timing-wise?

These are all good questions, and I do not expect anything less from our very own subscribers! As I have mentioned, the Loonie is one of the premier "commodity currencies" of the world - the other major two being the Australian dollar and the South African Rand. As many currency "investors" should know, however, both the Australian dollar and the South African Rand have already peaked during the late 2004/early 2005 period. That is, despite escalating gold, natural gas, and commodity prices in general, two of the three major commodity currencies have not confirmed on the upside by making a concurrent multi-year high against the U.S. dollar. Should investors in the Canadian dollar be worried about this? You bet they should.

The non-confirmation of both the Australian dollar and the South African Rand on the upside is one indication of how lop-sided the rally in the Canadian dollar has become. Another clear indicator (that is, one which does not involve any conjectures or guesses) is by looking at the Commitment of Traders report on the Canadian dollar futures contract being traded on the Chicago Mercantile Exchange. Following is a weekly chart courtesy of Software North LLC - showing the net short and long positions of large speculators (e.g. hedge funds), small speculators (e.g. retail investors), and commercials (entities that usually take the other side of the large and small speculators) throughout 2005:

Extremely short position being taken by the Commercials!

As can be seen from the above chart, the net long positions of large and small speculators are now at an unprecedented high - as exemplified by the extremely lopsided positions in the Canadian dollar futures contract. Five years ago, the large speculators could have been termed "sophisticated money." Today, with currency funds being started everyday and with so much money flowing into the commodity sector, that is no longer the case. That is, this author does not have a problem in viewing both the large and small speculators as contrarian indicators in this case.

More follows for subscribers...


 

Henry To

Author: Henry To

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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