Rising Rates Now a Given

By: Henry To | Wed, Mar 15, 2006
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Dear Subscribers,

We switched from a 25% short position to a neutral 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. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,021.59), this position is 151.59 points in the red - but again, given that the market is now showing signs of a classic "blow off" top, this author is betting that this position will ultimately work out.

We then added a further 25% short position on Monday afternoon (February 27th) at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. However, I have warned our readers that we were looking to exit this 25% short position as soon as we could - in order to control for risk/volatility. We subsequently decided to exit this last 25% short position last Friday morning at a DJIA print of 11,035 - giving us a gain of 89 points. This latest signal was sent to all our subscribers on a real-time basis. True, the market did not get severely oversold on the way down. Breadth has also been getting progressively worse, but the refusal of the Dow Industrials to fall further given the negative sentiment (as exemplified by the latest readings in the AAII and Investors Intelligence Surveys) had this author worried. The least we could have done (even though we still maintain our longer-term bearish views) was to pare down our 75% short position in our DJIA Timing System to a more manageable 50% short position, and this is what we chose to do. In retrospect, this was a good move, since the Dow Industrials rallied further to close at 11,076.34. For now, we will remain 50% short at least until the next Fed meeting on March 28th.

Again, please note that I will be taking the next weekend off since I will be in Connecticut for an actuarial seminar. Thanks for your patience - but whatever happens, you will definitely find a short "ad hoc" commentary from me. Taking some time off will also give me some down time to reflect on the big picture of both the stock market and the world's financial markets.

Over the last four weeks, virtually all of the stock markets in the Middle East suffered serious corrections. Finally, the Kuwaiti government could stand no more - as it pledged US$700 million at the end of last week to support the Kuwaiti stock market. Folks in Kuwait are now scrambling to find "the reasons" being the recent fall. But after a 600% rally since 2002, and given that global leverage is high and global liquidity is declining, what more can you expect? Not only is this a sign of desperation, but readers should know that such intervention/manipulation in the free market has never worked in the long-run. Thomas Lamont and Richard Whitney could not stop the crash during 1929. The London Gold Pool had to abandon its price-capping scheme of gold at US$35 an ounce in 1968. Neither could the Hong Kong government achieve success during the emerging market panic of 1998. The current situation is especially relevant given that the selling in both the Middle Eastern markets and emerging markets in general is nowhere close to exhaustion. In fact, this author would argue that we are still in the topping out process in emerging markets in general. Going forward in 2006, Middle Eastern investors and emerging market investors in general should brace for more losses.

In previous commentaries, I have argued that the world's stock and bond markets are now dangerously overbought and overleveraged - all in the midst of a tightening global liquidity situation. That is why I think emerging market investors should brace for more losses up ahead, as well as commodity investors and any other investors who choose to "invest" in cyclical or speculative issues.

Readers must be getting tired of all our discussions on bullish sentiment (as indicated by record low emerging market spreads and record low implied volatility levels), high degree of global leverage, and tightening global liquidity. So this week I will take a different route - and discuss something that probably has a more immediate impact on your investments (in particular, your bond investments as well as other investments that are interest rate sensitive) than anything else. Readers may recall that we first discussed long-term interest rates in our March 27, 2005 commentary ("Rising Rates not a Given"). At that time, many Wall Street analysts were calling for a resumption of a rise in long-term rates in light of a declining dollar and a rising CPI. I argued at the time that "rising rates were not a given," and that in fact, yields should start to decline for the foreseeable future - citing, among other things, the extreme bearish sentiment in bond timing newsletters, relatively low assets in the Rydex Government Bond fund, and the fact that both the Chinese and the Japanese had no intention of paring down their U.S. Treasury holdings.

When our March 27, 2005 commentary was published, the yield on the 30-year Treasury bond was 4.84%. Over the next two to three months, the yield of the 30-year Treasury bond fell over 60 basis points and did not hit bottom until it retreated to a yield of approximately 4.2%. Since that bottom in June to July of last year, the 30-year bond yield has risen over 50 basis points and is now sitting at 4.74%. Given that the 30-year yield is now sitting near the top of its 18-month trading range (see the following chart courtesy of Decisionpoint.com), one would think that buying bonds here would be a no-brainer. This author would argue otherwise.

30-Year T-Bond Yield - 1) Publication of our March 27, 2005 commentary: The yield on the 30-year bond would ultimately fall by over 60 basis points over the next two to three months... 2) The 30-year Treasury yield is now trading near the top of its 18-month trading range. Is buying bonds a no-brainer here? This author would argue otherwise.

First of all, it is important to mention here that investors are now getting more sophisticated and that financial transactions are now getting more complex by the day. Because of this, dear readers, we will always strive to evolve and try to stay ahead of the curve (see lesson three in our commentary "On Jesse Livermore And His Legacy"). It is not sufficient to be more sophisticated if you are still one step behind the crowd. For example, in the most recent article on the Middle East, BusinessWeek states that the Middle Eastern countries are now much better positioned than they were in the last boom/bust cycle from 1973 to 1985 - and therefore there is a much lesser chance of a bust this time around. They cite familiar reasons such as more private sector participation, more sophisticated acquisitions in Europe, Asia, and Turkey, as well as more sophisticated investments in asset classes such as real estate and private equity funds (as opposed to parking those petro-dollars in bank accounts). What they ignore, however, is that the business cycle has not gone away - and that folks who are generally financially less sophisticated than their U.S. and Western Europe counterparts will always, by definition, be contrarian indicators and bear the majority of the pain in a typical boom/bust cycle. Today, this author would argue that real estate in many parts of the world are overvalued, and that private equity is in a huge (and soon-to-burst) bubble. Ironically, parking their petro-dollars in cash this time around may not be such a bad idea, after all. Not to mention that the Middle Eastern countries are still very much dependent on oil - and that their private sectors are grossly inefficient compared to the United States. Going forward, the biggest concern of countries such as Saudi Arabia is demographics. Unless oil stays at $60 a barrel and rise to $100 a barrel by the end of the decade, the welfare state in many of these countries will be close to collapsing.

Another example of the need to evolve: This is the same old saw, but I would argue that the concept of globalization is as important as ever. At $35 to $40 a barrel, everyone thought that crude oil was overpriced in early 2004 (for an example of this, read Chapter 3 of Barton Biggs' "Hedge Hogging"). All their models based on historical data and events confirmed this. Barton Biggs had a model telling him "fair value" was approximately $32.50, while the rest of Wall Street had a model claiming fair value was somewhere in the upper $20s. All the OECD leading indicators confirmed this as well. The majority of these folks could not be more wrong, however, as they all failed to anticipate the increase in Chinese demand (whether it is real or ultimately artificial) and most importantly, the lack of spare production capacity and its psychological effect on crude oil traders. The price of oil proceeded to steadily rise, topping $70 a barrel by the time Hurricanes Katrina and Rita made landfall on the Gulf Coast.

Oil - Light Crude - Continuous Contract - Decisionpoint's Price Momentum Oscillator embarked on a steady decline since the top in late August 2005. With the price of oil now right at support at the 50 DMA, and given continuing global liquidity tightening, my guess is that oil will convincingly break below $60 a barrel in due time.

But just as everyone and his neighbor (and his neighbor's dog) is now looking for crude oil to break $80 a barrel or even $100 a barrel, this author would now argue otherwise. Note that the price of crude oil has been steadily losing momentum since the ultimate top in late August 2005. Moreover, many of the oil majors have boosted their capital spending by 25% to 35% over the next few years. Inventory levels all across the world are now near or at all-time highs. To illustrate briefly, following is the latest U.S. crude oil inventory chart courtesy of the Energy Information Administration:

Latest U.S. crude oil inventory chart

U.S. crude oil stocks for the week ending March 3, 2005 topped 335.1 million barrels - approximately 25 million barrels above the high-end of its five-year average range and 32.5 million barrels above last year's levels. Sure, inventory levels didn't matter on the way up - but it will matter on the way down. More importantly, spare capacity is projected to rise by 500,000 barrels a day this year - which should go a long way toward alleviating the fears of a worldwide shortage in oil in 2006. It is also interesting to note that despite the cumulative "destruction" of 135 million barrels of oil supply since the end of August 2005, inventory levels are still 25 million barrels above its five-year high. Should the 2006 hurricane season pass through without any major disruptions to oil supply in the Gulf of Mexico, there is a very good chance that oil prices will collapse back to $50 a barrel or even below. Once oil prices start to decline, the downtrend will be further exacerbated by E&P producers who have failed to so far hedge their forward production (thinking that oil prices will continue to remain high).

The fact that oil prices should ultimately experience a significant correction is also being confirmed by the action in our MarketThoughts Global Diffusion Index (MGDI). For newer readers, I will begin with a direct quote from our May 30th commentary outlining how we constructed this index and how useful this has been as a leading indicator. Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages." Since the middle of 2004, the action of the MGDI and the CRB Energy Index has experienced a significant divergence - most probably due to unanticipated demand in China and the lack of global spare producing capacity. Given that oil demand from China is showing little signs of a significant jump this year, and given that spare production capacity is set to increase 500,000 barrels a day this year, both the action in our MGDI and the CRB energy index should continue to converge going forward. Following is the monthly chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Energy Index from March 1990 to January 2006. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to March 10th (the February OECD leading indicators won't be released until early in April). In addition, all four of these indicators have been smoothed using their three-month moving averages:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the Dow Industrials & the CRB Energy Index (March 1990 to January 2006) - 1) Historically, the rate of change in the MGDI has also led or tracked the YoY% change in the CRB Energy Index very closely. The divergence continues, despite the 2nd derivative of the MGDI going into positive territory for the second consecutive month since November 2004. 2) Unless there is a military conflict in Iran, energy prices still have further room to fall.

Historically, the MGDI has done a very good job of leading or tracking the CRB Index and energy prices. In short, the latest reading of the MGDI (even though the second derivative is now in positive territory) still suggests that both the CRB Index and energy prices will continue to correct going forward. Moreover, the leading indicator of the OECD leading indicators - the world's major commodity currencies such as the Australian dollar, the New Zealand Dollar, and the South African Rand have been significantly weakening in the last few months. The last holdout is the Canadian dollar, but after making a new 14-year high the week before last, the Canadian dollar has declined in earnest - even in light of the latest 25 basis point hike by the Canadian central bank. This author expects the Canadian dollar to continue to weaken going into 2006 - and thus for the MGDI to weaken again going forward as well.

But anyway, I digress. Let's now go back and talk about the long bond. While the long bond (both the 10-year and 30-year U.S. Treasuries) is definitely quite oversold right now (after the yield of the 30-years rose 25 basis points in as little as two weeks) - and thus may rally at any given moment - there is a good chance that the long bond will continue to decline going forward (and thus for yields to rise). In previous paragraphs, I discussed the need to continue to evolve when it comes to the financial markets (this concept should be applied to life in general as well, as many of our readers should know!). Folks who continue to model or predict the long bond based on domestic indicators only is definitely not seeing the whole picture. Alan Greenspan and Ben Bernanke had previously mentioned the "global savings glut." Some folks have argued a combination of things, such as the large-scale purchases of Treasuries by the Japanese and Chinese governments as well as defined benefits pension funds' inclination to better "match their liabilities" by buying long-term government bonds. These factors are perfectly logical and may well all be true, but this author would also argue that the Bank of Japan's policy of "quantitative easing" which began in March 2001 (and which officially ended last week) also played a large role in compressing yields all around the world.

So what do you mean, Henry? How did the Bank of Japan policy of "quantitative easing" compress yields all around the world, especially yields here in the United States?

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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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