Divergences and the Dash to Trash

By: Henry To | Thu, May 4, 2006
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Dear Subscribers,

Again, I would like to continue to get feedback and suggestions from our subscribers - especially thoughts on individual stocks and industries. Readers can either send us a short "commentary" on their pick or pan complete with a "big picture" analysis of why a particular stock or industry is a good (or bad) pick. Please also disclose any positions that you may have in the stock or industry. Again, detailed financial analysis is not required but I would definitely like to see some demonstrated knowledge that you have at least read the latest 10-K and the 10-Q. Picks can be based on valuation (and the belief that the firm's profits can be sustained going forward) or growth - but please, no momentum plays or penny/bulletin board stocks. Going forward, I will attempt to publish a subscriber's pick (or pan) at least once a month - complete with my own analysis and feedback This way, we can learn more from each other - which is essential since we have many readers working across many industries (and countries). As they say, "no one has a complete monopoly" on knowledge - and ultimately, forcing yourself to put down your thoughts in writing is the best way to learn. Please also feel free to continue to post your thoughts on the market or individual stocks on our MarketThoughts Discussion Forum!

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 (11,367.14), this position is 497.14 points in the red. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 - giving us a gain of 89 points. We subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. We had been trying to get rid of this latest 25% short position over the last three weeks. We had opted to wait for a more oversold condition before covering it - but it was not to be, as the Dow Industrials rallied a whopping 194.99 points the Tuesday before last (partly because of the March 28th Fed minutes released in the early afternoon). Again, we are now 75% short in our DJIA Timing System.

As of this point, we still do not anticipate changing our positions in our DJIA Timing System anytime soon. However, this author believes that a potential trigger point will be the May 10th Fed meeting. Should the market continue to rally or hold on to its current gains going into the Fed meeting, there is a strong likelihood that the market will sell off right after the Fed meeting - contrary to what many analysts and retail investors are currently expecting. In that case, there is a good chance that we will go 100% short in our DJIA Timing System. Again, we will let our readers know on a real-time basis once we have decided to make changes to our positions in our DJIA Timing System. We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: "A Change in our DJIA Timing System").

Going forward, we would (and we hope our subscribers would) like to focus more on specific stocks and industries (since that is where the "big money" is made) - although we would definitely continue our macro economic and stock market analysis at least once a week. Again, any suggestions or thoughts are always welcome.

Since our mid-week commentary on Dell, I have received some good feedback - both on our discussion forum and through email. Please continue to send in your thoughts and analysis. Interestingly, the current thoughts of our subscribers on Dell are generally more negative than the mainstream. Among the chief concerns were:

Like I mentioned in our mid-week commentary, the price of action of DELL and HPQ have been trending in opposite directions since July 2005. While the new CEO of HPQ (Mark Hurd) is still trying to fix HPQ's problems, it is noteworthy to mention that Dell has benefited significantly from Carly Florina's missteps while she was CEO of HP. Is HPQ going to continue to take hits from Dell? Not if they could help it. Please note that HPQ remains one of the greatest American companies in this author's books - as it has continued to build shareholder value and reinvent itself through thick and thin since 1939. That being said, Dell remains heavily oversold - and should definitely be on the watch list for those who would like to purchase Dell at a discount to where it has been trading at over the last eight to nine years.

Latest Poll: Please participate in our latest poll on the prospects of Dell. Do you think that Dell is a buy, a hold, or a sell?

I would like to start this commentary on a different note to what we discussed last week (those topics being rising inflation as exemplified by a spike in the Cleveland Fed Median CPI and the so-far lack of a significant slowdown in the housing sector). This week, I would like to again discuss liquidity, divergences, and the "dash to trash" phenomenon that we are currently witnessing in the stock market.

On Liquidity

This author has to admit - global liquidity (and what is relevant to the U.S. stock market) is getting more difficult to track by the month, as both China and India becomes global players in the world financial markets. Make no mistake, however: global liquidity continues to decline, as the European Central Bank is now signaling a further 100 basis point increase by the end of this year and as the Bank of Japan phases out its "quantitative easing" policy. In retrospect, however, there is little doubt that this author had underestimated the rise in Japanese liquidity over the last few years - and the effect this had on asset classes around the world, such as commodities, sovereign bonds, and to a lesser extent, domestic and international equities. The following chart from John Mauldin's latest commentary (and originally produced by GaveKal in Hong Kong) shows this plainly - as the Japanese monetary base immediately took off once the BoJ started its QE policy and actually surpassed the U.S. monetary base by the end of 2002. Quoting GaveKal: "One of the trademarks of perma-bears is to blame all the world's ills on an hyper-active Fed whose policy shifts endanger the state of our economies and the value of financial assets. But is this a fair indictment? Judging Fed policy by the growth rate of the US monetary base (see chart next page), we find that the US monetary base has been growing fairly steadily and in line with US GDP growth. In fact, if one wants to blame a central bank for volatility in global monetary aggregates, one should instead turn to Japan. "The chart below shows the US monetary base, the Japanese monetary base - in dollars - and the sum of the two (also in dollars) ... What emerges from this graph is very simple: all the volatility in the US + Japanese base aggregate has come from the Japanese part of the component. The volatility in global M has in the past thirty years come from Japan."

US & Japanese Monetary Bases in Dollars

Not only did this aid Japan's economic recovery, this ample liquidity also began to spill over to the global markets beginning in 2005 (when the Yen embarked on a multi-month decline) and basically muted the tightening effects of the U.S. Federal Reserve since June 2004.

Now that the Bank of Japan is phasing out its QE policy, this ample liquidity will began to disappear from the world's markets. We're starting to see the first effects of it now - as the Yen started its bounce from its low of 0.8250 in December to its current level of 0.8850. This decline in global/Yen liquidity has also been eating at the edges of the Yen carry trade, as both the currencies of Iceland and the New Zealand took a huge hit in the last few months.

In the meantime, the speculators are continuing to "fight the Fed" - as our MarketThoughts Excess M indicator continues to turn down from negative 2.47% to negative 2.55% in the latest week (please see our April 9, 2006 commentary for an in-depth discussion of how our MEM indicator is constructed). Following is a weekly chart showing our MEM indicator, the 52-week change in the St. Louis Adjusted Monetary Base, and M-2 outside of M-1 plus institutional money funds:

Make no mistake: There is still some "liquidity spillover" from the Bank of Japan but the world's three major Central Banks have and continue to "mop up" excess global liquidity. Initial signs include the collapse of the Icelandic Krona, the New Zealand dollar, the rising Yen, as well as the collapse of the Middle Eastern equity markets over the last nine months. At the same time, both the hedge funds and retail investors are "investing" whatever they have left in commodities, emerging market securities (including Russian equities and Iraqi bonds), and U.S. small and mid caps. Historically, whenever Main Street hits Wall Street and fights the Federal Reserve, it has ALWAYS ended in tears. This time will be no different.

Speaking of commodities and emerging market equities, Bill Miller of Legg Mason (who has the enviable record of beating the S&P 500 for 14 consecutive years - not an easy feat for a mutual fund manager) had this to say about these "asset classes" in his first quarter commentary last week. I will quote:

A big difference between today and the commodity bull markets of the 1970's is that then the US Fed monetized the rise in prices leading to persistent inflation. Today central banks are withdrawing liquidity, not adding it. So far there has been no impact on commodities, and except for a few scattered areas of the world, most assets and markets are continuing to rise. I think that will get more difficult to sustain, especially if liquidity becomes scarcer. The first to feel the pain could be where the gains have been the greatest, which would be emerging markets and commodities.....

The excitement and enthusiasm surrounding commodities, and the belief that they will continue to rise, is not surprising. People want to buy today what they should have bought 5 or 6 years ago; call it the 5 year psychological cycle. Today people want commodities, emerging market, non US assets, and small and madcap stocks. Those were all cheap 5 years ago and had you bought them then you would be sitting on enormous gains. But 5 or 6 years ago, everyone wanted tech and internet and telecom stocks, and venture capital and US mega caps. The time to buy them was in 1994 or 1995, when they were cheap. But in 1994 or 1995, people wanted banks and small and mid caps, which should have been bought in 1990, and well, you get the picture.

Many subscribers have contended that this secular bull market in commodities will last 10 to 15 years. I concur with this, since there has been an extreme underinvestment in many of the sectors that are involved in producing commodities from the early 1980s - such as oil & gas drilling, refining, gold, silver, copper, iron ore, uranium mining operations, and so forth. At the same time, we are seeing unprecedented surge in demand from the emerging markets, especially China and India. However, readers should keep in mind that the uptrends in many commodities over the last three years or so have been extreme in their own right - especially in commodities such as copper, natural gas, and zinc. Moreover, just like the various sectors in the stock market, every commodity is different. That is, not all commodities are going to top out at the same time. For example, during the 1970s bull market in commodities, cotton prices effectively topped out in September 1973 - a full six years and four months before the final top in gold and silver prices. Sure, cotton made a somewhat higher high in October 1980, but anyone who held on after the September 1973 top was effectively wiped out - as shown by the following chart showing the daily cash price of cotton (cents per pound) from June 1969 to December 1980:

Daily Cash Price of Cotton (Cents Per Pound) (June 1969 to December 1980) - Despite the secular bull market in commodities in the 1970s, cotton prices pretty much topped out in September 1973 - making a lower high in July 1976 and never made an all-time high again until October 1980. As of Friday at the close, cash cotton closed at a price of 47.5 cents a share - half the price of the September 1973 top.

As of last Friday at the close, the cash cotton price closed at 47.5 cents per pound - half the price of the peak in prices during September 1973. More recently, the rise in natural gas prices that we experienced last year has also been corrected in a big way - with the current spot price below $7.00/MMbtu and with the January 2007 contract closing at $11.36/MMBtu last Friday. This is a far cry from the $15.50 gas price that we experienced right before Christmas of last year. Should our natural gas infrastructure remain intact during the hurricane season this year, then natural gas (deliverable during the winter) could effectively retest the $10 level - even should we experience colder-than-normal weather during the upcoming winter.

More follows for subscribers...



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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